December is always a busy month in Japan and this year is no exception. On 21 November Abe announced he was dissolving parliament and would postpone a second-stage sales tax increase planned for October 2015. The move followed weaker than expected Japanese gross domestic product (GDP) data for both the second and third quarters of 2014 and worsening economic conditions. The dissolution sets the stage for a snap election and will see lawmakers actively campaigning for the upcoming poll on December 14.
The 18 month postponement to the next hike in sales tax will delay its introduction to April 2017. Following the rise from 5% to 8% in April this year, the further increase will raise the rate to 10%.
The two-stage increase was expected to provide the Japanese government an additional 14 trillion yen (JPY) – equivalent to US$118bn – in annual revenue to pay for reforms to boost home-based care for the elderly, support working mothers, pension and health-care expenses.
Japan’s third quarter GDP data, initially released on 17 November and since revised upwards, confirmed that the country had slipped back into recession. It was -1.9% (annualised) compared to Q2 (when it plunged by -7.3%), far below the consensus of market forecasts and the second consecutive quarter of negative growth.
Since his re-election two years ago, Abe has vowed to banish deflation with his “three arrows” of monetary easing, fiscal spending and structural reforms to promote growth. Results to date have been mixed.
Dramatic monetary easing by the Bank of Japan (BOJ) has seen JPY fall to its lowest in five years. The yen broke through 120 per dollar on December 4 the first time since 2007 and a 28% loss since Abe took office in December 2012.
Market participants expect Japanese and US monetary policies to continue to veer in opposite directions with Japan set to continue easing while the US begins tightening. This further divergence in Japan and US monetary policies is expected drive the yen even lower.
An increase in fiscal spending, on the other hand has yielded moderate results. Japan’s real fiscal year growth in 2013 was 2.2%. 0.7% of which came from increases in public investment. Unemployment in Japan has fallen and remains below 4% with many sectors reporting a shortage of labour.
Pressure from Abe’s administration also saw many major firms increasing wages this year as part of Japan’s annual spring wage negotiations, or Shunto. The 2 % increase secured by unions was however, was not enough to offset a fall in real wages as a result the April sales tax increase and JPY depreciation.
Search for Stability
The third arrow of Abenomics was fired earlier this year and centred on structural reforms and deregulation. So far, discussions of cuts in the corporation tax (currently standing at around 35%) have stalled along with further reforms.
On October 31 the BOJ unexpectedly expanded monetary stimulus, pushing JPY to its weakest level in seven years versus the dollar. For the most part, the currency’s depreciation has been viewed as positive for the equity market. The Nikkei 225, Japan’s main stock index, rose to 18,030 on December 8, its highest level in five years. Recently however, there have been increasing discussions on the demerits of a weaker currency.
According to a recent public opinion poll, the majority of voters agreed with the sales tax freeze. However, many also said that they do not understand the rationale for dissolving parliament and feel that this election lacks a meaningful theme.
A potential rationale is establishing political stability. If the Liberal Democratic Party wins in the upcoming election, the tenure of house members will extend to December 2018 and Abe’s to September 2018, greatly increasing the possibility of a long term administration.
The announcement of the sales tax postponement has led to worries about the deterioration of Japan’s fiscal discipline. Although many cite the stability of Japan government bond yields to argue that this is not a problem, it should be borne in mind that this stability is mostly due to purchases by the BOJ. Japan’s sovereign debt risk – as expressed by credit default swaps (the cost to insure sovereign bonds against non-payment) – is increasing to the highest level of the recent one year.
Although we experienced much calmer markets toward the end of summer, volatility has since returned and is expected to continue or even increase in coming months. As such, we see an urgent need to explore more effective, timely foreign exchange (FX) hedging strategies.
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