Markets & Finance

Japan: Can Abe Maintain Fiscal Reform?


From Standard & Poor's RatingsDirect

Early signals following the Japanese Parliament's election of new Prime Minister Shinzo Abe raise questions about a possible slowdown in the pace of fiscal consolidation in Japan (S&P sovereign credit rating, AA-). While these are still early days for Prime Minister Abe, three issues are casting a shadow over the government's options in setting fiscal policy: upper house elections in 2007, the makeup of the cabinet, and Abe's own stance on growth policies.

The departure of former Prime Minister Junichiro Koizumi leaves the Liberal Democratic Party (LDP), the majority party in Japan's coalition government, without a strong reformer. While Koizumi's policies tended to get watered down due to a lack of attention to the outcomes, to some extent his government broke the status quo that had been prevalent in Japanese politics.

Prime Minister Abe's new government is likely to be restricted in its ability to implement unpopular policies by the approaching upper house elections, slated for July, 2007. Measures supporting fiscal consolidation, such as raising the consumption tax, are therefore unlikely to be a top priority in the run-up

ELECTION RISK. Under Japan's parliamentary system, half the seats in the upper house will be contested. This half of the house was elected in 2001 in the LDP's strongest showing since 1992. Unless the LDP can replicate that year's stellar performance, it will be difficult for the party to increase seats. A drastic cut to the party's parliamentary seats would undermine Abe's position, and in the worst case, he would have to relinquish his positions of Prime Minister and party leader.

With Abe just having announced his new cabinet, the balance of power in the government has yet to emerge. Traditionalists within the LDP have been appointed to some of the top economic and fiscal positions. New Finance Minister Koji Omi is expected to implement policies more aligned with traditional LDP tenets than drastic reforms; this may slow fiscal consolidation.

A key question for reform progress is whether the new minister for economic and fiscal policy, Hiroko Ota, can equal or surpass the performance of the former minister of internal affairs and communications, Heizo Takenaka, who was also plucked from academia.

REFORM FATIGUE. Abe himself might prefer growth policies over fiscal consolidation, judging by the slogan used in his campaign for the LDP leadership and to some extent by the portfolio titles of his new cabinet. While the two policies are not necessarily incompatible despite prevailing views, a "no growth, no fiscal consolidation" position may also serve to slow fiscal consolidation.

There are also members of the LDP calling for more populist policies on public expenditure, particularly spending in rural areas that are experiencing reform fatigue. The temptation to implement economic stimuli in the form of increased spending on public projects may be too strong for the new government to resist.

So far, there are no clear policy measures in place to maintain the pace of reduction in Japan's fiscal deficit in 2007. Koizumi's structural reform plan had called for continuous cuts to general government fiscal deficits, to achieve primary balance (the fiscal balance between revenue minus revenue from debt issues and government expenditure minus debt interest and principal), by the early 2010s. But this plan may be under threat.

END OF EXPANSION? Global economic factors, such as a potential slowing of U.S. growth or higher oil prices, may undermine Japan's currently favorable macroeconomic environment. And the long expansion phase that Japan has enjoyed, soon to be the longest in its post-war history, could be coming to an end.

To what extent the new government can stick to the principles of public sector reform will have a major bearing on the direction of the sovereign rating on Japan. Standard & Poor's Ratings Services' outlook on its rating on Japan is currently positive. The two biggest constraints on the rating are Japan's fiscal position, which though improving, remains weak, and its high outstanding debt.

Critical factors are therefore the pace of fiscal consolidation, the stability of the Japanese government bond market, and interest rates. At the same time, the new government must maintain a reasonable pace of macroeconomic growth to generate stable revenue.

PENSION PROBLEMS. Reducing the fiscal deficit of the government will not be easy, particularly as the government's contribution to the national pension system will be increased to one-half of total contributions in 2009 from the current one-third, as decided during pension fund reforms in 2000. The change is expected to require additional financial resources of ¥2.7 trillion (0.5% of gross domestic product) annually.

According to the government's own projections, ¥16.5 trillion in savings will be needed to achieve primary account balance in fiscal 2011, to be achieved through a combination of spending cuts and revenue increases. How the new government can meet this challenging target is one of the most important issues for the future direction of the sovereign rating on Japan.


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