Post‑Abe Japan: A Bumpy Road Ahead

Greater risk of long-term political instability may create volatility in financial markets.

In a surprise announcement on 28 August, Japan’s longest-serving prime minister, Shinzo Abe, said he intended to resign due to ill health. Market reaction was fairly muted because challenges of COVID-19 suggest Japan’s extraordinarily loose macroeconomic policies are unlikely to be altered in the near term. However, we caution that longer-term political challenges may create market volatility or underperformance of Japanese risk assets.

Abe’s stability and longevity

Abe has served as prime minister for almost eight years, a time of stability that ended a period of high turnover of the nation’s political leadership (with six prime ministers in six years, including Abe’s first term from 2006–2007).

In our view, four drivers of the political stability and longevity of Abe’s second term have implications for a post-Abe Japan.

  1. Owning the Bank of Japan (BOJ)’s balance sheet. A key tenet of Abe’s policy during the Liberal Democratic Party (LDP) presidential campaign in late 2012 was targeting a 2% annual inflation rate. Once he became prime minister, the government and the BOJ entered into a policy accord in which the BOJ promised to achieve his 2% inflation target. Abe appointed Haruhiko Kuroda – a former Ministry of Finance (MOF) official and critic of the BOJ’s failure to fulfill its price-stability mandate – as BOJ Governor. Under Kuroda’s leadership, the BOJ was swift to deliver extraordinarily easy monetary policies, including massive qualitative and quantitative easing (QQE), a negative interest rate policy, and yield-curve control.
  2. A pragmatic foreign policy. While he struggled somewhat to build a strong connection with U.S. President Barack Obama, Abe quickly built a cooperative relationship with President Donald Trump. Abe’s commitment to the U.S.-Japan alliance (which had weakened under previous Japanese leadership) helped to ease U.S. pressure on Japan’s foreign exchange and trade policies. The BOJ was able to depreciate the Japanese yen (JPY) to undervalued levels without too much push back from the U.S. In addition, Abe’s foreign policy was broadly pragmatic: His commitment to the U.S.-Japan alliance did not come at the expense of the country’s connection with China (unlike the experience of Prime Minister Junichiro Koizumi, whose five-year term ended in September 2006 and preceded Abe’s first term as prime minister, and who visited the controversial Yasukuni war shrine during his presidency). In fact, Japan’s relationship with China improved markedly during Abe’s tenure, such that President Xi Jinping was scheduled to make his first visit to Japan this year (although it was canceled due to COVID-19). Japan has been able to benefit broadly from global growth, in large part thanks to these balanced relationships with the U.S. and China. Coupled with this, the weak JPY has supported Japanese corporate profit growth and helped Abe earn trust from Japan, Inc1.
  3. A pragmatic domestic policy. Abe’s pragmatism extended to domestic policy. He managed to maneuver from right to left, from growth policies to distribution policies. To be frank, Abe delivered little of substance, but generous Japanese voters gave credit for his attempt, which helped to weaken opposition parties.
  4. Opening up the government’s wallet. Though fiscal doves criticized the Abe administration’s consumption tax hikes (in 2014 and 2019), the administration at least succeeded in reducing the MOF’s prioritization of fiscal austerity and in making its spending policies more flexible. It is debatable how economically productive Abe’s fiscal policy has really been, yet it is clear that more flexible fiscal policy has at least been as politically effective as helping to implement his pragmatic distribution policy.

Challenges lie ahead

Japan’s next prime minister will be hard-pressed to follow Abe’s recipe for political stability and longevity. Why? Simply, the tides are going out.

  1. Foreign and national security policies will be much more challenging. Not only does the U.S. election add uncertainty, but the recent escalation of U.S.-China tensions complicates Japan’s foreign strategy toward both countries.
  2. Weak JPY policy will be harder to pursue with challenges to economic recovery in the U.S. and elsewhere, as well as the convergence of central bank policies.

What will be Abe’s economic legacy? In our view, the next leader(s) in Japan will unfortunately have to deal with the consequences of the political stability and longevity that Abe enjoyed.

  1. Few necessary economic reforms have been made. To be blunt, the Abe administration failed to make the best use of its political capital to address the structural challenges of an aging population, nor did it deliver necessary reforms for sustained economic welfare. The government only kicked the can down the road on a politically controversial discussion of already unsustainable public pension and healthcare systems. Labor mobility remains extremely low in Japan due to an inflexible labor system and regulation. What’s more, COVID-19 has revealed Japan’s remarkably poor implementation of information technology and digital solutions, both in private and public sectors. Japan will likely struggle more than other countries in reallocating labor and capital to adapt to the post-COVID world.
  2. Fiscal policy will hit the wall. In the near term, the current economic policy of fiscal easing financed by the BOJ will likely remain the COVID-19 policy response, no matter who Abe’s successor is. In the longer run, however, we expect higher probabilities of both tails in fiscal policy in the years to come. Future political leaders may resort to more aggressive monetary-financed fiscal easing, which may prompt a loss of investor confidence in Japan’s public debt trajectory, or at least trigger downgrades of Japan’s sovereign debt ratings. In contrast, Japan may prematurely choose fiscally hawkish, or at least less dovish, leaders – a possibility that should not be ruled out given the general public’s concerns about the nation’s debt exceeding 250% of its GDP this year.
  3. The BOJ may shift a gear toward policy normalization. Again, no policy change should be expected in the near term, either on the fiscal or monetary front, given economic uncertainty caused by COVID-19. Once the pandemic ebbs, however, we may see a different response from the BOJ, particularly after Kuroda completes his current term in March 2023 (or if he exits earlier). As the BOJ has repeatedly pointed out, side effects of super low interest rates accumulate over time, potentially costing the economy: banks’ profit margins may be squeezed, weakening their financial intermediation, and returns on insurance and pensions may be lower, adversely affecting consumer sentiment.

Over the medium- to long-term horizon, we believe these challenges will lead to increased risk of political instability and policy uncertainties, which could create more volatility in financial markets and likely weigh on Japanese risk asset performance. Japanese bond markets could also see increased volatility. Yields may decline further in the case of fiscal tightening, although they may rise if any extreme form of debt monetization finally causes the loss of investor confidence or triggers sovereign downgrades or the normalization of BOJ policy.

1 Japan, Inc. describes Japan's conversion into a corporate capitalist culture from the 1970s and 1980s until the 1990s. This culture is also defined by a centralized economic system encouraged by the government and central bank.
The Author

Tomoya Masanao

Head of PIMCO Japan; Co-head, Asia-Pacific Portfolio Management

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