Reform Proposals Still Leave A Lot To Be Desired

BMI View: A successful implementation of Prime Minister Shinzo Abe's economic reform agenda would provide a major boost to Japan's economy and fiscal situation, but the lack of details surrounding certain key policies is a concern. Meanwhile, we view such reforms as a necessary but not sufficient for avoiding a fiscal crisis, with spending cuts likely to be crucial in reining in the deficit.

Prime Minister Shinzo Abe has unveiled his latest initiatives as part of his 'third arrow' of economic reforms, including cutting the corporate income tax and reforming the giant Government Pension Investment Fund (GPIF) to make it more equity focussed. While we believe that these reforms will be necessary in allowing the Japanese economy to avoid a fiscal crisis as a result of its huge debt load, they may not be sufficient. Furthermore, Abe may struggle to garner the political support to push through some of the more controversial elements of his plan.

GPIF Reform Will Be No Free Lunch

No Fiscal Surpluses In Sight
Japan - Government Deficit, % Of GDP

BMI View: A successful implementation of Prime Minister Shinzo Abe's economic reform agenda would provide a major boost to Japan's economy and fiscal situation, but the lack of details surrounding certain key policies is a concern. Meanwhile, we view such reforms as a necessary but not sufficient for avoiding a fiscal crisis, with spending cuts likely to be crucial in reining in the deficit.

Prime Minister Shinzo Abe has unveiled his latest initiatives as part of his 'third arrow' of economic reforms, including cutting the corporate income tax and reforming the giant Government Pension Investment Fund (GPIF) to make it more equity focussed. While we believe that these reforms will be necessary in allowing the Japanese economy to avoid a fiscal crisis as a result of its huge debt load, they may not be sufficient. Furthermore, Abe may struggle to garner the political support to push through some of the more controversial elements of his plan.

GPIF Reform Will Be No Free Lunch

One of the most eagerly anticipated moves is the change in the mandate of GPIF, the world's largest pension fund with USD1.3trn in assets. At present, the fund invests over half of its assets in Japanese government bonds and it is widely hoped that a heavier focus on equities will increase returns and help improve the government's long-term fiscal position amid deteriorating demographic trends. While such a shift in portfolio allocation may increase returns, it will come with risks, as we do not believe that the Japanese stock market offers good value at current levels. Besides, it leaves open the question of what would happen to government bond yields once demand from GPIF declines. In our view, the Japanese government debt problems are far too deep-rooted for a simple increase in GPIF equity exposure to have any substantial benefit.

No Fiscal Surpluses In Sight
Japan - Government Deficit, % Of GDP

Corporate Tax Cut A Positive, But Will Need A Replacement

The announcement of a reduction in the corporate tax rate is a step in the right direction, in our view, which will encourage more investment as profit margins are boosted. The government will lower the rate from 35% beginning in fiscal year 2015/16 (April-March). While Abe did not indicate the extent of the first rate cut next year, it is likely that the rate will fall to 30% over the course of several years. Both the government's and the ruling Liberal Democratic Party's (LDP) tax panels recently agreed to the policy, and there are hopes that the rate will eventually be reduced as far as 25%, as had been suggested by the government tax panel.

Abe has agreed with the LDP's tax panel that the government should find stable future funding to cover the consequent fall in tax collections as result of the lower corporate tax rate. A broadening of the tax base by restructuring existing tax breaks is likely to be introduced. As only one third of Japanese corporate currently pay corporate tax, owing to previous losses, the government may adopt a recommendation by the LDP panel that corporate tax revenues could be made more stable in economic downturns.

As we recently argued ( see 'Weighing Up The Political Scenarios', April 4), Japan's tax revenues are very low as a share of GDP relative to their developed market peers. However, raising taxes amid a fragile economic recovery poses major risks. The government will need to strike a balance between increasing revenues and keeping tax policy supportive of growth. We believe that the mix of higher sales taxes and lower corporate taxes should provide much-needed support to Japan's national savings rate, and should provide indirect support to fiscal revenues.

Abe's proposals also include a review of Japan's system of agricultural co-operatives to improve efficiency in the agricultural sector. The LDP is seeking to increase corporate participation in agriculture to boost the competitiveness of the nation's farms as pressure to cut import tariffs increases. The government is considering allowing non-food companies to own almost 50% stakes in farming entities from the current 25%, according to the party's farm- reform committee, and is looking to streamline approvals of land sales by individuals to farming corporations. In addition, Abe's proposals seek to revamp the country's labour market to give companies more flexibility to negotiate working hours and pay directly with workers rather than following national guidelines. The rapid shift from deflation to inflation, combined with the declining working-age population, is putting pressure on businesses to revamp their labour policies, and a freeing up of hiring and firing regulations, as well as greater female labour force participation, is sorely needed.

Details Thin On The Ground

Despite Abe's positive reform agenda, details of the plans were thin on the ground, and the lack of action plans regarding the implementation of several goals is a cause for concern. It remains to be seen if some of the more politically sensitive reforms can be implemented, particularly in areas such as labour market and agricultural reform, where support from his LDP support base and coalition partner New Komeito may be lacking.

Reforms Necessary But Not Sufficient

We believe the successful implementation of these reforms will be essential if a fiscal crisis and/or huge inflation is to be avoided, as economic expansion, and thus tax revenues, need to rise in order to plug the budget deficit and to reduce the need for debt monetisation. What will also be needed, however, is lower government spending, which is something that Abe's reform plans tend to suggest are not high on the agenda. With the fiscal deficit unlikely to fall below 6% of GDP any time soon, public debt at around 250% of GDP, and government spending on a rising trend, a cut in spending will be essential in order for the economy to regain its footing in a sustainable manner.

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Related sectors of this article: Economy, Fiscal Policy
Geography: Japan
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