Japan’s critical election

Discussion and Analysis by Charles Porter:

Parliament is dissolved and the date is set for Japan’s election later this month. A bold political move by incumbent Japanese Prime Minister, Shinzo Abe, now looks likely to achieve its ultimate purpose. The significance of Japan’s election to the Yen cannot be understated. The importance spills over not just from politics, but also geopolitics, economics and the political economic architecture of Japan.

The date is set for 22nd October for Japan’s election. As the election result has become more certain in the polls, the upside potential to the election has been priced out of the market, leaving only downside risk of a surprise Abe defeat. This effect is not uncommon as the market reaches a consensus that the base case scenario for the election is a win for Abe’s Liberal Democratic Party. Therefore, this result becomes almost entirely priced in, leaving only dwindling uncertainty as the upside potential upon the election result.

So, why is Abe’s win so likely?

It’s probably not down to political pragmatism and the assumption that only an incumbent with a guaranteed win would call a snap election. Theresa May’s conservative government proved that well. In free and fair elections, the election result can almost never be certain and the underlying tensions within an electorate can be spun into either a weaker coalition government or oust the incumbent entirely.

It is, however, still likely that Abe foresaw a convincing likelihood of consolidating his position within the parliament of Japan’s bicameral political economy. What has more concretely led to the base case of Abe’s success is the apparent disarray of an opposition.

There was already wise money on Abe calling a snap election, however, just not so soon. This is because of the apparent present incapacity of the opposition party, the Democratic Party, to provide a viable voting alternative. Perhaps this is why they grabbed headlines early on announcing that they will not field a candidate for the election.

Instead, the main opposition party has enforced and teamed up with the Kibō no Tō, the Party of Hope. This party is certainly non-trivial. However, the success and recent popularity of Abe, who has been governing Japan for 5 years now, ought to be sufficient to counteract any swings in public favour towards the Hope Party. The Hope Party is certainly credible and admirable, founded by Tokyo’s first female Governor Yuriko Koike. However, with the tension continuing to mount and spill over from the Korean Peninsula, the proven and moderately successful state-level leadership of Abe is likely to triumph.

So why does the election matter?

The governing Japanese party arguably has more power over the Japanese economy than many advanced Western economies constitutionally allow. The (central) Bank of Japan’s independence is highly new and has, arguably, seen a moderate retrenchment following Abe’s election to the premiership.

Previously subsumed within a state department, the Ministry of Finance, the macroeconomy could be steered from a politically exposed office. Given the salience of the economy to Japan following enduring stagnant inflation, and at times deflation, the politicisation of central banking was not such a bad thing. Many would argue that because responsible and medicinal central banking was a salient voting issue within the Japanese electorate it generated a democratic and binding mandate to pursue economic growth with a lubricating inflation level.

Abe’s commitment to monetary stimulus, even within the now more independent central bank makes his election pivotal for markets, and particularly those exposed to foreign exchange. The confidence effect of what has been labelled ‘Abenomics’, his tripartite stimulus and (mild) structural reform program, is critical for Yen strength. With an unproven record of monetary policy, a high salience issue, on the part of the Party of Hope, both the market’s desire and the Japanese public’s support is likely to be consolidated within an Abe win.

There is a final and pervasive reason why those exposed to foreign exchange risk, perhaps not even to the Yen, should care about the Japanese election. The Yen is regarded as a safehaven currency, meaning that as uncertainty and risk enter the world environment, the value of the currency paradoxically rises. In effect, the value of safehaven currencies, and thus the Yen, should inversely correlate with the value of other developed currencies and assets.

A threat to the political composition and political economic exposure of a safehaven asset, and particularly a currency, can undermine its status. Therefore, a core trading relationship within the Yen could be threatened by political instability and upset caused by a non-base case electoral performance.

In summary, the intrinsic link between politics and economic governance, the status of the Yen as a safehaven currency, in addition to the normal tumult caused by an election, all make the Japanese snap election all the more important. A non-Abe, non-Liberal Democratic, result could at this point upset markets meanwhile another term of government is the market base case.