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Japanese Economy Update

The Difficult Homework Due After the Election

  Senior Research Fellow


Immediate Politics

The ordinary session of the Diet has closed as scheduled, and the attention of the politicians and the media is shifting from economic policies to the upper house election due on July 21st. It is certainly an important political event because of the opportunity it provides in aligning the parties that controls the two houses of the Diet. The so called “twisted” situation has been the major obstacle for advancing any policy agenda by the government.

Even acknowledging the importance of the election, however, we should be aware that the economic agenda would not stand still, and certainly would not disappear. There is a number of difficult homework that has to be submitted after the election. The first one that the government is going to face, and probably the most difficult one to deal with, is the designing of the fiscal consolidation program.

Guidelines for Requests for FY2014 Budget

According to the usual procedure for this time of the year, what awaits the government after the election is the initiation of the formulation process of the FY2014 budget. To begin with, the Council for Economic and Fiscal Policy (CEFP) will start their discussion on the principles which the FY2014 budget would have to satisfy. It will form the basis for the Finance Ministry’s guidelines for submissions of budget requests by ministries due by the end of August.

This year’s process it is not going to be a business-as–usual kind. The FY 2014 budget would have to be consistent with the long-term fiscal consolidation program which is yet to be formulated. The government needs to make a concrete plan for “halving the primary deficit by FY2015, and achieving primary surplus by FY2020” as stated in the “Basic Polices for Economic and Fiscal Management and Reform” authorized by the Cabinet in June 14.

In advance of the full plan, the government is expected to announce the “Medium-Term Fiscal Strategy for FY2014 ~ FY 2016” and publish the revised version of the “Economic and Fiscal Projections for Medium to Long-Term Analysis”, the last of which was published in August 2012 and which provided projections up to FY2023.

The main challenges the government faces in the discussions on fiscal consolidation are as follows:

Finalizing Consumption Tax Rate-Hike

First, the consumption tax rate-hike, the single important commitment in terms of concrete measures for fiscal consolidation, needs to be finalized as quickly as possible. So far, it is expected to be finalized in September. However, the tax-rate hike needs to be finalized by the time “Medium-Term Fiscal Strategy” and “Economic and Fiscal Projections” are announced if they are to be credible. Also, surge in demand in anticipation of the tax-rate-hike is expected to take place well before September (it is the time-limit for the application for old rate for construction and other contracts whose implementation extends into the period after April 2014). Furthermore, one of the most important sources of information, the GDP figure for the April-June quarter of 2013, will be announced in August 12th, albeit in a preliminary status. It may be revised in September, but it still provides an important data for assessing the economic situation. Taking theses into consideration, there is a case for bringing forward the date of the finalization of the consumption tax rate-hike.

Meeting the First Target for Fiscal Consolidation

Second, even if the consumption tax rate-hike is finalized, there is still a need to announce additional plans in the Medium-Term Fiscal Strategy in order to achieve the first target of the fiscal consolidation; namely the halving of the primary deficit by FY2015. When the last “Economic and Fiscal Projections” was published in August 2012, it showed that the halving of the primary deficit by FY2015 was achievable (deficit of 2.6-3.2 percent of GDP in FY2015 against the target of 3.2 percent). However, the primary deficit for FY2013 at that time was 5.2 percent of GDP whereas the most recent estimate for FY2013 has worsened to 6.9 percent even excluding the special expenditures for reconstruction of the Tohoku area. The concrete measures to fill the additional gap (1.7 percent points according to the estimate mentioned above) need to be clarified.

Meeting the Second Target for Fiscal Consolidation

Third, the specifics for realizing the second target for fiscal consolidation, namely the achievement of primary surplus by FY2020, have to be made clear as soon as possible. This would also be the required response to the statement in the 2013 Lough Erne G8 Summit Communique stating the need by Japan “to address the challenges of defining a credible medium-term fiscal plan.” There are some important inputs on the way, such as the final report by the National Commission on Social Security Reform which is due by August 21st. However, reflecting the difficulty of reaching consensus on both the expenditure and the revenue side measures, even the procedure for incorporating the inputs and drafting the plan is not yet set out. The discussion needs to be hastened and show achievements in order to maintain credibility and secure the stability of the market.

Before the Risk Premium Starts to Rise

In the recent months, there have been arguments that long-term interest rates should stay low in order to prevent them from harming the economy. It is hard to prevent them from rising especially if the current QQE by BOJ succeeds in raising the expected growth rate and inflation rate. However, not all upward movements are tolerable, especially when they come as a result of a rise in sovereign risk premium.

Japan’s long-term interest rate has remained low in spite of the already high and even growing public debt (“the dog hasn’t barked” according to the IMF). The main reason behind the “puzzle” is considered to be in the current account surplus and the domestic holdings of government bonds. If that is so, we should be aware of the fact that, because of the aging of the population and the Great East-Japan Earthquake, current account is expected to turn deficit in the medium-term. If that actually happens the situation would rapidly change with foreign investors becoming increasingly influential.

However, that is not when the long-term interest rate may start rising. The reshuffling of portfolios of the domestic investors, especially those of the financial institutions, would take place much earlier, in anticipation of such changes. Therefore, long-term interest rate may start to rise well before the turning of the current account to deficit.

From fiscal-consolidation’s point of view, the problem is not that there is not much time left for us. Rather, the problem is that we don’t really know how much time is actually left.