Japan: Post-G7 Policy - What comes next? – ING

James Smith, Economist at ING, suggests that with co-ordinated G7 action unlikely to be agreed this week, it looks increasingly likely that Japan will “go it alone” and pursue bold fiscal expansion.

Key Quotes

“No joint G7 action expected – PM Abe is likely to “go it alone”. The risks to Japanese growth remain elevated, not least from external factors, which PM Abe had hoped could be mitigated with co-ordinated G7 action. But the political climate in Europe (migrant crisis and UK referendum) and the US (in an election year) means that such a deal is unlikely (incidentally, Japanese officials have since acknowledged this). As such, it looks increasingly likely that Japan will “go it alone” and pursue bold fiscal expansion.

Stay or go – Decision on consumption tax hike expected soon. In the FY16 budget, the government announced that 80% of public infrastructure investment will be spent by September (≈¥9.6 trillion). Although this should inject some energy into near-term growth, the concern is that the subsequent drop in spending in 4Q16/1Q17 could be problematic, particularly in advance of the planned April 2017 sales tax hike. This may be partly resolved if the tax hike is postponed; although the official line is that this will still go ahead, a recent Nikkei report suggested that PM Abe is considering a U-turn. Although if the planned move from 8% to 10% will boost public revenue by around ¥4 trillion, it may tip the economy into recession. Whatever the decision, an announcement is likely to quickly follow the G7 meeting (Nikkei flagged the 1 June when the current Diet session ends).

An extra budget (designed to bridge the gap after September) is now very likely, irrespective of whether PM Abe’s final decision is to postpone the hike (which we think is more likely) – although this will undoubtedly influence the size of the final package.

A subtle “helicopter drop”? Unlike extra budgets in FY13 and 14, where spending was offset by tax windfalls, a budget in the order of 2% GDP would need to be debt financed. This could be easily absorbed by the BoJ’s current QQE programme, which currently purchases over double the government’s JGB issuance each year. Thus, although not a “helicopter drop” in the purest sense, it is the arguably the closest substitute, particularly if carried out repeatedly over a series of years. Of course, the main difference is that this would pose serious fiscal sustainability questions (with debt now around 250% of GDP).

Expect more from the Bank of Japan? If (and it is a fairly big if) the fiscal policy boost is seen as having a meaningful shift in Japan’s growth outlook, then it is possible that some fundamental JPY strength may emerge (especially at a time where major trading partners are contending with political headwinds).

Overall, we see potential for some further USD/JPY downside (mainly coming from the dollar side), with a small window in 3Q16 for the pair to drop as low as 95 as US Election risk-premium is priced in.”