Prime Minister Shigeru Ishiba hoped to strengthen his legitimacy as head of government through a popular referendum by calling early elections. But the opposite happened, with his party's historic rout and the loss of an absolute majority.
For want of an alternative, Ishiba remained Prime Minister. But he now heads a minority government, liable at any time to be toppled by a motion of censure. As a result, the Japanese Prime Minister is severely weakened and has to enlist the support of minor parties at every turn to secure approval for his policies. This situation could be more conducive to pursuing the reforms that have begun in recent years. On the contrary, Japanese policymakers have resorted to the old recipes of the past to support the country's economic activity.
The Prime Minister has announced a massive debt-financed economic stimulus plan. He plans to increase public spending by 21900 billion yen (€136 billion). Japan will use the money to pay a one-off allowance of 30,000 yen (€186) to every low-income household, with a bonus of 20,000 yen per child. To contain inflation, currently at 2.3%, subsidies to reduce the price of gas and electricity will resume for a few months. The stimulus package will also boost reconstruction aid for the region hit by the terrible earthquake of January 1, which claimed over 200 lives and was ravaged by torrential rains in September.
A constrained monetary policy
To support the stimulus package proposed by the Prime Minister, the smaller parties called for further costly measures. In particular, a tax reform that would raise the ceiling on tax-exempt income is on the table. In its current form, it would reduce state and local government revenues by up to 8,000 billion yen (€50 billion) a year. The Japanese government is preparing an indigestible cocktail for public finances. Lower taxes and higher public spending will further swell public debt, already at over 250% of GDP.
In recent years, the Bank of Japan has ensured painless financing of this debt by buying up government bonds on a massive scale and keeping 10-year interest rates at around 0%. But this extraordinary policy has pushed the yen to an all-time low on the foreign exchange market, a level that has more disadvantages than advantages.
In particular, the extreme weakness of the Japanese currency has pushed up the price of imports, leading to a price slide that has hit Japanese households hard, as wages have failed to keep pace with rising inflation. This is why the Bank of Japan has begun normalising its monetary policy. It raised its key rate twice, from -0.10% to +0.25%, and allowed long-term interest rates to rise to over 1%.
This is a positive development for the Japanese economy, where free money did not encourage companies to prioritise the most profitable investments and kept zombie companies with little innovation alive. Monetary normalisation was also expected to cause the yen to appreciate more in line with its actual value.
However, with the return of old-fashioned budgetary recipes that constantly inflate public debt, the monetary authorities will have to curb their desire for monetary normalisation or risk creating financial turbulence. This could potentially delay the much-needed revival of the Japanese economy, a prospect that should be a cause for concern.
Is economic renewal in jeopardy?
According to the latest activity surveys, the Japanese economy is at a standstill despite recording weak growth of 0.2% in Q3. This is partly due to weak household consumption, whose purchasing power is eroded by inflation. However, Japan's major companies have increased salaries by 5.1% this year, the highest increase in 30 years, and the minimum wage has been raised by 5%.
But this is not enough to offset soaring inflation in essential products such as rice, which has jumped 59% in a year. With the government's fiscal stimulus plan, Japan's domestic demand and economic activity should pick up in the coming quarters. However, this short-term upturn will come at the expense of reforms and long-term GDP growth, which will remain weak at less than 1%.
We can also expect greater financial volatility with political uncertainty and the return of the old fiscal recipes. This is already the case for the yen, which has halted its appreciation since the announcement of early elections. If monetary normalisation is put on hold, the Japanese currency could again plunge to historic lows. This prospect does not bode well for Japanese debt, which offers low interest rates but previously offered the prospect of significant currency gains. Don't buy yen-denominated bonds.
The Tokyo Stock Exchange has also lost some of its appeal due to the latest political developments. It remains interesting only as a small long-term diversification. Buy 5% Japanese equities.