Japanese Politics Making Bond Investors Nervous

Includes: EWJ, FXY
by: Darrel Whitten

Japanese voters appear ready to roll the dice again on who will run their country in the July 2010 Upper House (House of Councillors) elections, where half of the seats in this chamber (a total of 242) will be up for re-election.

The Democratic Party of Japan (DPJ) along with other coalition partners currently has 122 seats plus 7 seats held by the Social Democratic Party (SDP), which gives them a majority just under 53% at present. Close co-ordination with the Social Democrats was credited with helping the DPJ and Mr Hatoyama win a landslide victory in lower-house elections last year. Serious differences of opinion however emerged after months of disordered waffling regarding the Futenma US marine base, and the Hatoyama Administration’s apparent caving into US demands to keep the base where it is on the southern island of Okinawa. As a result, the SDP has parted ways with the DPJ and will not be part of the coalition this election.

The latest voter poll taken by the Nikkei economic journal and TV Tokyo shows a dramatic decline in the support level of the Hatoyama Cabinet, from 75% last September to 22%. Further, support for the DPJ has plunged from 59% after last year’s elections to 25%. However, support for the opposition Liberal Democratic Party (LDP) remains even lower, at 23%.

In other words, Japanese voters are particularly unimpressed with both major political parties, meaning neither may gain/keep enough votes in the upcoming elections to gain/maintain a majority n the Upper House, meaning the most likely result is yet more reshuffling to reform a coalition government that could be even more ineffective than the current Hatoyama Administration.

If the DPJ loses a large number of seats, as appears increasingly likely, the DPJ could well lose its majority in the Upper House (House of Councillors), which would represent a massive “trading places” with the LDP. Prior to the LDP’s big loss in the lower house elections last August, the DPJ, with its majority in the Upper House, was inhibiting passage of LDP-sponsored bills and generally slowing down the legislative process, which significantly delayed the timely passage of a much-needed supplementary budget, for example.

Stumbling Toward a Fiscal Crisis

The current administration was expected to map out two long-term plans in June to reign in the alarming increase in Japan’s government debt, which in gross terms is now at some 200% of GDP. One of the plans ostensibly is a medium-term fiscal plan that will include binding caps on spending for the state budget over the next three years. The second is believed to be a set of longer-term targets for Japan’s finances that would ostensibly include a timetable for bringing the Japanese government’s primary balance into surplus and reducing the large public debt-to-GDP ratio.

The Cabinet Office estimated this fiscal year's primary balance would be JPY33.5 trillion ($371 billion). Fiscal hawks like Finance Minister Naoto Kan and National Strategy Minister Yoshito Sengoku want the party to commit to a sales tax hike after the general election. But the party's kuromaku (kingpin), Ichiro Ozawa is very reluctant to bring the issue of a sales tax hike to the fore because he knows better than anyone else it will cost the party votes.

Unless the DPJ can cut back on spending, the Ministry of Finance (MOF) forecasts new debt issuance could exceed JPY51 trillion yen ($551 billion) in the next fiscal year ending in March 2012. That would approach the hefty JPY53 trillion yen in debt issued in the year to March. Finance minister Kan wants to cap new debt issuance at the same level as the JPY44.3 trillion yen earmarked for the current fiscal year, but this could prove to be a tall order, given the strong opposition on both sides of the aisle against spending cuts.

What bond markets of course most care about is whether these fiscal targets, if they are indeed forthcoming, look feasible or not, as past (LDP) governments have failed to achieve their fiscal goals.

Another survey by BizReach Inc. indicates Japanese bankers and executives may vote for neither major party and instead throw their support behind former Financial Services Minister Yoshimi Watanabe’s Minnano-To (Everyone’s Party). Everyone’s Party is among a growing number of splinter parties formed from the disintegration of the LDP has lost control of Japanese politics after virtually 50+ years in power.

Brokers like HSBC Securities Japan still insist Japan can avert a surge in bond yields for the foreseeable future even as concerns grow over the record JPY883 trillion (USD9.8 trillion) of public debt, and believes there is little room for JGB yields to rise after the summer.

But this view, more prevalent within that without Japan, hasn’t deterred foreign economists and the media (such as the Economist) from repeating over and over the same basic scenario, i.e., that the accumulation of public debt in Japan is simply unsustainable. Some foreign investors are already positioning themselves for a financial “meltdown” in Japan as; a) As Japan’s people age and burn up their savings, they will have less and less money to invest in JGBs. The IMF calculations show that gross debt may exceed gross household assets by 2015. b) Japan cannot count on foreign demand being strong enough to support export-led demand, while the lack of growth in the domestic economy means tax generation is insufficient for Japan to grow its way out of the debt. One sign is that borrowing for the FY2010 budget will exceed tax revenues for the first time.

Fixing Japan’s serious structural problems will require bold political initiatives, but that is unfortunately exactly what the Japanese public and investors will not get this election. Japanese voters (and investors) have seen regime change, and are anything but impressed. Japan’s old guard (the “haves” and the political interests that work to protect this) pines for the status quo, but does not realize how inherently unstable the status quo is.

Disclosure: No positions