Japan: General Election & Fiscal Policy - Reform Inevitable
morganstanley.com
Takehiro Sato (Tokyo)
Spending cutbacks unavoidable no matter who forms the next administration
The month of August typically features ministry preparations, including floating various new ideas, for budget requests submitted at end-August as the foundation for the following fiscal year’s initial budget. Recent political upheaval such as Diet dissolution and the resulting general election, however, have cast a shadow over this schedule. Yet the new administration still has to prepare the F2006 budget at some point. Media reports indicate that the MoF will maintain the August deadline for budget requests and move ahead with budget planning. This has not been confirmed.
The fiscal policy outlook is unclear given the possibility of a new administration taking office. However, we expect the F2006 budget to strongly incorporate fiscal structure reforms, regardless of whether reformers seeking a small government or conservatives interested in a larger government form the new administration, since debt servicing costs and social guarantee outlays are quasi-fixed items and Japan’s fiscal policy already has fairly limited flexibility. Social guarantee costs are largely decided without major reforms.
We have prepared an outline of the F2006 budget and the JGB issuance plan using some rough assumptions. Our conclusion is that spending cutbacks are unavoidable no matter who forms the next administration.
Debt servicing costs at nearly ¥20 trillion of the projected ¥82.5 trillion F2006 budget
We conservatively estimate that the government will collect ¥46.0 trillion in tax revenue, up ¥2.0 trillion from the F2005 initial budget, assuming higher tax revenues in F2006 and upside from eliminating special income tax cut incentives. We project ¥3.8 trillion in non-tax revenue, on par with F2005.
Let’s turn next to spending. We forecast ¥19.5 trillion in debt servicing costs (¥10 trillion in fixed-rate redemption and ¥9.5 trillion in interest payments), remaining at more than 40% of tax revenue. We expect a ¥0.6 trillion Y to Y decline in regional tax grants to ¥15.5 trillion due to fiscal cutbacks by local governments, although the outlook for reforms in tax distribution between national and local governments promoted by the Koizumi administration is unclear at this point. As for the general spending, however, the Koizumi Cabinet has just set a ceiling for F2006 general budget requests on August 11, in which it will be only a ¥0.2 trillion rise to ¥47.5 trillion, even reflecting natural growth in social guarantee costs with the aging society.
These values limit total spending to ¥82.5 trillion, a ¥0.3 trillion increase from F2005 and suggest that the government will need to issue ¥32.7 trillion in new fiscal resource bonds (-¥1.7 trillion YoY). This might be favorable for the bond market if new fiscal resources bonds appear likely to be mostly unchanged or even somewhat lower. The main challenge, however, is a steady rise in JGB redemption value as an aftermath of fiscal stimulus measures implemented a decade ago in supplementary budgets.
Longstanding issue: Sustainability of government debt
There is constant uncertainty about whether the market can smoothly absorb the additional issuance value with the economy close to overcoming the recent mini adjustment phase and bank lending nearly bottomed out. Healthy current account surpluses and debt repayment to rectify corporate balance sheets have funded Japan’s fiscal deficit during asset deflation. Looking ahead, the current account surplus is unlikely to disappear considering steady expansion of the income account surplus. But corporate balance sheet corrections will not last indefinitely. In fact, flow of funds data for Jan-Mar indicate a slight rise in fund-raising by the private, non-financial sector in F2004 for the first time in eight years since 1996. It might seem unusual for companies to expand fund-raising when they have abundant surplus liquidity at hand. We think it could suggest that balance sheet cutbacks are finally ending after companies eliminated financial leverage under pressure from asset deflation. In other words, companies might be shifting to forward-looking strategies that target higher capital efficiency by increasing financial leverage, rather than simply utilizing surplus liquidity to buy back and retire their own shares or increase shareholders’ compensation. While this shift is a sign of the economy moving in the right direction, it also affects the domestic savings-investment balance and could raise some concerns about the sustainability of government debt.
BoJ support as a last resort
Government choices are limited to fiscal austerity or increased public purchases with JGB issuance and market absorption values heading for record highs in F2006. The former will depend on the economic policies of the new government formed after the general election scheduled for September 11. We previously explained that government options are highly restricted due to the natural upward trend in debt servicing costs. Policy flexibility is minimal even if anti-reformists interested in a larger government gain control. We would not expect delays of more than 1-2 years in the full elimination of special income tax reduction incentives (expected in F2006) and a consumption tax hike (F2008).
The latter choice is taboo, but could enable the government to postpone concerns about near-term market conditions. A recent example is the additional round of refinancing for the BoJ refinancing portion approved in the F2005 budget preparation process. The government and BoJ agreed to a renewal of TBs, which were issued in F2004 to replace long-term JGBs held by the Bank reaching maturity, in F2005. This strategy reduced market absorption for F2005 by nearly ¥10 trillion from the initial forecast. A similar move in F2006 could also trim ¥10 trillion from market absorption and alleviate market conditions concerns. The Bank has not commented on whether it will continue such support from F2006.
The above-mentioned approach clearly raises issues and might violate Article 5 of the Fiscal Law, which prevents fiscal deficit financing by the central bank. However, opinions are split on whether this means that the Bank is enslaved to the government’s debt management policy. The total value of TBs owned by the BoJ does not change even if it reduces refinancing to TBs. This happens because Bank refusal to accept TB refinancing forces the MoF to issue TBs in the market to cover the shortfall, and the Bank ultimately has to purchase the TBs in buying operations to counter capital shortages in the short-term money market. The only difference is whether the BoJ purchases TBs directly from the MoF or from the market. In either case, government efforts to avoid increasing issuance of medium- and long-term JGBs are inflating TB holdings at the BoJ. This process circumvents the BoJ’s banknote rule on medium/long-term JGB holdings (a rule to limit the medium- and long-term JGB holding within the amount of bank notes in circulation) since the duration of TBs held by the Bank is effectively being lengthened.
Reforms inevitable
The BoJ’s increased involvement in the debt management policy was initially an emergency measure addressing the 2008 crisis. However, the redemption peak in F2008 is simply the first peak and BoJ holdings of short-term JGBs will continue piling up unless the central government delivers a surplus in the primary balance. The government could become addicted to the solution described above. Also, we anticipate greater instability in Japan’s policy management if the general election on September 11 produces a minority government. All bills will have trouble passing given the current power balance in the Upper House, requiring a coalition for each individual bill. Renewed concerns about a debt crisis might emerge in the market, and the bond market will send warning signals to the central government against resorting to deficit financing.
Yet we think the clear threat of such conditions should force the next government, regardless of its make-up, to pay close attention to fiscal discipline.
In conclusion, we do not anticipate a major policy shift from the current government’s reform emphasis. A non-reformist administration, meanwhile, would have difficulty in surviving due to market pressure. I personally therefore have a favorable view of the latest political upheaval as a constructive step toward a regrouping of Japan’s political world. I also expect a constructive reaction from asset markets. |
