Abe Reloaded: Now The Hard Work Begins

BMI View: Japanese Prime Minister Shinzo Abe's electoral victory is very positive for political stability, but Abe faces colossal challenges in making Japan's economic recovery sustainable. The key to this lies with structural reform and immigration , but there are significant obstacles to achieving this.

Japanese Prime Minister Shinzo Abe and his Liberal Democratic Party (LDP)-led coalition have won a majority in Japan's House of Councillors (Upper House), taking at least 76 of the 121 seats that were contested in the 242-member chamber ( see 'All In On Abenomics', July 22). Now that he has a majority in both houses of the Diet (parliament), Abe faces a dilemma over how hard to push for economic reform. For many years, he has favoured revising Japan's constitution to ease restrictions on the use of Japan's military, the Self-Defense Forces (SDF). He has also championed patriotic values. In short, he wants to make Japan a great power once again, especially with China on the rise.

However, Abe will also be aware that one of the reasons that his first stint as premier in 2006-2007 came to an abrupt end following the LDP's severe losses in the 2007 Upper House elections was that he focused too much on boosting national defence and patriotism at a time when voters were more concerned about 'bread and butter' issues. Although Japan's security situation has become more challenging since 2007, due to the re-emergence of the Senkaku/Diaoyu islands territorial dispute with China and North Korea's increasingly provocative behaviour, voters have tended to be more concerned about economic issues. Following the LDP's victory, Abe pledged to keep his focus on the economy.

BMI View: Japanese Prime Minister Shinzo Abe's electoral victory is very positive for political stability, but Abe faces colossal challenges in making Japan's economic recovery sustainable. The key to this lies with structural reform and immigration , but there are significant obstacles to achieving this.

Japanese Prime Minister Shinzo Abe and his Liberal Democratic Party (LDP)-led coalition have won a majority in Japan's House of Councillors (Upper House), taking at least 76 of the 121 seats that were contested in the 242-member chamber ( see 'All In On Abenomics', July 22). Now that he has a majority in both houses of the Diet (parliament), Abe faces a dilemma over how hard to push for economic reform. For many years, he has favoured revising Japan's constitution to ease restrictions on the use of Japan's military, the Self-Defense Forces (SDF). He has also championed patriotic values. In short, he wants to make Japan a great power once again, especially with China on the rise.

However, Abe will also be aware that one of the reasons that his first stint as premier in 2006-2007 came to an abrupt end following the LDP's severe losses in the 2007 Upper House elections was that he focused too much on boosting national defence and patriotism at a time when voters were more concerned about 'bread and butter' issues. Although Japan's security situation has become more challenging since 2007, due to the re-emergence of the Senkaku/Diaoyu islands territorial dispute with China and North Korea's increasingly provocative behaviour, voters have tended to be more concerned about economic issues. Following the LDP's victory, Abe pledged to keep his focus on the economy.

Abe's Commitment To Reforms To Be Tested

Nonetheless, with Abe having won a solid mandate (albeit on a low voter turnout), he may well conclude that he has a free hand to focus on constitutional reform. Abe might thus decide to back away from the so-called 'third arrow' of Abenomics, namely bold economic reforms to improve Japan's business environment and make the country more competitive. The first two 'arrows', extreme quantitative easing and fiscal stimulus, have provided a much needed boost to the economy, but these are short-term prescriptions. Virtually all observers recognise that the 'third arrow' holds the key to a sustained Japanese economic revival. But this is also the most difficult 'arrow' to fire, because it would involve challenging Japan's vested interest groups (some of whom characterise reforms as American-style free market 'fundamentalism' that is at odds with Japan's culture). For this reason, Abe's 'third arrow' proposals appeared to be somewhat vague, when he tentatively unveiled them in June, and he also indicated that he would not pursue these until the autumn.

From our point of view, it is still far from clear that Abe himself is committed to such reforms, and even if he is, it is unclear whether the public would support neoliberal reforms in practice, even if they support the notion of a new growth strategy in theory. Japan's last reformist prime minister, Junichiro Koizumi, swept to power on promises of reform and enjoyed an uncommonly long five and a half years in office (2001-2006), during which Japan emerged from its 'lost decade' and enjoyed fairly robust economic growth. However, this was at least in part because the global economy as a whole was booming, thereby lifting Japan with it. After Koizumi retired, there was a partial backlash against his reforms, which were blamed for worsening social inequalities.

A further dilemma that Japan faces is how many immigrants the country should take in. Japan has the lowest proportion of foreign nationals among G-7 states, at less than 2% of its population. As far back as mid-2008, a group of LDP legislators proposed taking in 10mn immigrants by 2050, by which time they would constitute 10% of Japan's population. However, fears over the cultural transformation of Japan through immigration continue to obstruct progress on this front. Nevertheless, we maintain that it will be difficult to revive Japan economically without more foreign-born workers ( see 'Immigration Key To Reviving Long-Term Growth', February 27).

Factors That Could Derail Abenomics

Apart from the risk that Abe himself could abandon the 'third arrow' in favour of defence issues, the following developments could derail Abenomics:

Abe fatigue: Japanese voters are notoriously fickle, and several previous prime ministers have enjoyed high approval ratings, only for these to decline sharply within a year of taking office. Japan's low-tolerance political culture usually compels the prime minister to resign, if their approval rating drops below around 25%. Given the magnitude of Japan's economic problems, most premiers' popularity ratings decline to that level within 12 months of coming to power.

Opposition from within the LDP or New Komeito: The LDP has traditionally been faction ridden, and internal opposition from within its ranks (or from its New Komeito coalition partner) could force Abe to backtrack from structural reforms. The LDP has been keen to project an image of unity ahead of the Upper House vote, but now the party is secure in both chambers of the legislature, internal dissent could become more visible.

Geopolitical crisis in North East Asia: Although near-term conflict risks in the East China Sea or the Korean Peninsula have diminished, both 'hotspots' merit close attention. A military skirmish with China over the Senkaku/Diaoyu Islands or a new conflagration in Korea could force a prioritisation of defence issues in the public's mind (or Abe's mind) at the expense of structural reforms.

New natural disaster: Japan is very prone to natural disasters, and a new mega-quake (especially in the Tokyo Bay Area) could prioritise rescue and reconstruction efforts over economic reform.

New economic crisis: Critics of Abenomics, including BMI, warn that the first two arrows of extreme quantitative easing and fiscal stimulus could accelerate the onset of a debt crisis. Abe also faces a dilemma over whether to proceed with current plans (inherited from the previous government) to raise the consumption tax from 5%, to 8% in April 2014 and to 10% a year thereafter. The increase is deemed necessary to ease Japan's fiscal burden, but critics fear that it could tip the economy back into recession. That is what happened in 1997, when it was raised from 3% to 5%. If Japan were to slide back into recession, or worse, experience a Greece-style financial crisis, then Abe could fall from power, and a national unity government would probably be required, whose priority would not necessarily be structural economic reform.

Overall, following the Upper House elections, Japan arguably has its strongest political leadership since 2006. If Abe squanders this political capital and the opportunity to reform Japan, then investors are likely to be far more skeptical about future 'reformist' leaders, in the event that Abe fails.

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Sector: Country Risk
Geography: Japan, Japan, Japan, Japan
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