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Economy

Abe's big gamble on growth

Who says Japan lacks risk-takers? By calling a snap election halfway through his term in office, Prime Minister Shinzo Abe is doubling down on Abenomics, his project to revive Japan's economy and global standing. Either he wins a fresh mandate and dominates the political landscape for years to come or he becomes a lame duck virtually overnight.  

     At the same time, Abe has postponed his second hike in Japan's sales tax, planned for next autumn. It was the first hike in the sales tax, implemented this April, that did so much to derail the economic recovery and pull down the prime minister's previously sky-high support ratings.

     Now Abe has effectively admitted that he got it wrong -- an almost unheard of phenomenon among senior Japanese politicians and bureaucrats -- and is rowing back to the clear pro-growth strategy that originally made Abenomics such an attractive proposition.

     The tactical boldness is breathtaking. While these moves were being planned, Abe was on one of his many overseas trips, occupied with the complex choreography of meeting Chinese President Xi Jinping, then a tripartite summit with U.S. President Barack Obama and Australian Prime Minister Tony Abbott. Investors had considered the tax hike a "done deal," because it was so clearly what the Ministry of Finance, the Keidanren business federation and other interested parties wanted. Likewise, nobody was expecting an election, least of all the opposition parties now struggling with the logistic preparations for a mid-December vote.

Driving seat

Surprise is a powerful weapon, as Bank of Japan Gov. Haruhiko Kuroda demonstrated a few weeks earlier when he shocked the markets with a second round of "QQE," or quantitative and qualitative easing, and sent the Nikkei Stock Average racing to seven-year highs. The Abe administration, which appeared to have lost momentum amid sliding support ratios and weak economic data, has suddenly recovered control of events. 

     The repercussions should be felt internationally too. By freezing the sales tax hike, Abe has rejected the fiscal austerity pressed on him by not only his own financial bureaucrats, but also international organizations such as the International Monetary Fund and Organization for Economic Cooperation and Development. If Japan's bond and equity markets crash, as the fiscal hawks have been long predicting, the dangers of aggressive reflation will be clear to all. On the other hand, if the markets are well behaved and the economy picks up steam next year, then pressure to copy Abenomics will likely mount in Europe and elsewhere.

     There are good reasons for supposing that the second scenario is much more likely. The Japanese economy is not that far from a strong, self-sustaining recovery, despite the dismal second-quarter gross domestic product growth numbers, which put the country into a technical recession. The key driver will be the corporate sector, which is awash with free cash flow.

     Having spent the last 18 years paying down debt, Japanese companies will have to find new ways to use the money. Real returns to investments in plant and equipment have never been higher, suggesting that a new capital spending cycle could kick off at any time. Thanks to the most competitive yen since the dawn of floating currencies in 1972, major companies should begin to favor domestic over foreign production.

Turning a corner

By mid-2015, wage growth should be picking up at the same time as headline inflation dips towards 1%. Unemployment is at a 17-year low and the potential supply of new entrants to the workforce -- mainly women on part-time terms -- is steadily diminishing. As the trauma of the first tax hike fades, consumption should get back on track. Meanwhile, the positive balance sheet effects of higher stock and, particularly, real estate prices will bolster the balance sheets of households, corporations and financial institutions.

     As for the financial markets, just as it's rarely a winning strategy to "fight the Fed" so investors should think twice about "battling the BOJ,"  which will be hoovering up nearly all the net supply of bonds until the 2% inflation target is reached and also purchasing more exchange-traded funds and other risk assets.

     Furthermore, there hasn't been a genuine sovereign debt crisis anywhere in the world since the global financial crisis of 2008. Greece, Portugal and the other troubled eurozone issuers are no longer sovereigns in monetary terms, but more like U.S. municipalities such as Detroit.

      The world seems to have forgotten that bonds are strong when economies are weak and vice versa. When the BOJ finally exits from QQE, bond prices will fall and yields will rise, but that will be a healthy development.  

     If all goes to plan, the ever-underestimated Abe could remain in office until 2018. That would make him the longest-serving Japanese prime minister for 40 years and the second longest-serving since the country adopted a parliamentary system in 1888. Still, in the words of former British Prime Minister Harold Wilson, a week is a long time in politics. The next three-and-a-half weeks may feel like an eternity not just to Team Abe but to investors in the Japanese financial markets too.

Peter Tasker is an analyst with Arcus Research in Tokyo.

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