No Diet for Bold Men

September 2008 Salvatore Ruscitti & Dr. Hans Black

During this past Labor Day weekend, Japanese Prime Minister Yasuo Fukuda suddenly tendered his resignation after only a brief eleven months in office. Prime Minister Fukuda has long been suffering from diminishing public support and general political gridlock in the Japanese legislature. Fukuda’s resignation comes less than one year after his predecessor, Shinzo Abe, also quit, citing virtually the same reasons for his departure. In recent years, Japanese politics has been marred by a revolving door at the prime ministerial level. The country has had no less than five prime ministers in the past ten years, owing to an increasingly paralyzed legislature. The revolving door of political leaders may be marking the end of the near half-century grip on power by the ruling Liberal Democratic Party (L.D.P.).

In order to better comprehend Japanese politics, one must first understand the structure of the country’s rule-making body. The Japanese Diet or legislature is comprised of two parliamentary chambers, an upper and a lower house. Since it was formed in 1955, the L.D.P. has held the balance of power in Japan. However, in July 2007, the L.D.P. lost control of the upper house to the ascendant Democratic Party of Japan (D.P.J.), the official opposition. The loss of the its five-decade majority in the upper house came after it was discovered that the government misplaced more than 50 million pension records. Since then, both Abe and Fukuda have been frustrated by a resulting hung Diet. The political gridlock recently forced the lower house to use its two-thirds majority to override upper house vetoes on a range of government legislation. The move sharply eroded Fukuda’s approval rating and resulted in the D.P.J. blocking the Prime Minister’s first two choices for candidates to lead the country’s central bank. It took three-weeks to resolve the impasse, but not before the temporary vacancy at the top of the Bank of Japan caused a measure of international embarrassment.

In addition to the stalemated Diet, Fukuda was also facing growing opposition from within his own coalition. Junior coalition partner, the New Komeito Party has been pushing for a general election through an early dissolution of the Diet. Lobbying efforts from Komeito recently forced Fukuda to include a tax cut for low-income earners as part of the government’s spending measures to boost the economy.

Fukuda will remain Prime Minister until parliament approves a successor. The L.D.P. is likely to hold a leadership vote within weeks to elect a new president. Taro Aso, the L.D.P.’s secretary-general, is seen as the leading candidate to replace Fukuda. Aso is popular within the L.D.P. and was installed in his post in a bit of political maneuvering last month after Fukuda reshuffled his Cabinet. However, new leadership at the L.D.P. is unlikely to "un-hang" the Diet. The problem with Japanese politics stems from the lack of a stable majority government. This problem will not be resolved until a general election realigns the political landscape in a manner that paves the way for the implementation of a strong legislative agenda. The L.D.P. is required to hold lower house elections before September 2009. Until then, Japanese politics will likely stay mired in political gridlock.

Before Abe and Fukuda’s brief stints as national leaders, Japan enjoyed some political stability under Junichiro Koizumi, who served the third longest tenure as Japan’s prime minister since World War II. While Koizumi’s reputation as a reformer may have been somewhat overstated by his popularity with the public, he did manage to curtail government spending and force Japanese banks to rid themselves of bad loans. However, he too faced stiff opposition for some of his measures, and from within his own party. In 2005, Koizumi was forced to call snap elections over opposition to his plan to privatize Japan’s postal savings service. He won a large majority and eventually passed the postal privatization bill, but the episode underscored the difficulty in implementing novel reforms in Japan. Japan’s unease with change is especially vexing for an economy confronting the challenges of an ageing population and a large public deficit.

The resignation of Fukuda comes at a particularly inopportune time for Japan. The country’s economy has deteriorated significantly since the beginning of the year, and similar to most other regions in the world has brought Japan to the brink of recession. Exports, the main engine of economic growth, have fallen for the first time in three years due to the global slowdown. Meanwhile, rising prices for fuel and food have undercut domestic spending. The combination of falling exports and rising costs are eroding corporate profits, thus forcing businesses to cut back production, investment, and hiring. Last month, the Cabinet Office reported that Japan’s economy contracted at an annualized pace of 2.4% in the second quarter. With household sentiment at an all-time low, the outlook for the economy continues to look dire and, increasingly, observers feel that we are revisiting the very difficult days of 2002-2003.

Given the current economic backdrop, the risk is that the next prime minister will increase government spending to shore up the economy and his popularity ahead of likely elections next year. Such measures will endanger the government’s goal of balancing the budget by 2011. Tax revenue already came in below plan for the fiscal year ended March 31. The tax revenue shortfall is likely to expand further this fiscal year. Ultimately, the Japanese government will have to issue more debt. For a country with a public debt which is running at 182 percent of G.D.P., the bond market’s realization of such an outcome may introduce further challenges to an economy dependent on low borrowing costs. At the moment, we see no reason to change our outlook for a further weakening in the economy as well as a further weakening for the Japanese yen. As we have stated before, much will depend on the health and the ability of consumers in other G7 nations to continue buying. We continue to have our doubts that this will occur

Busy Summertime

September 2008 Dr. Hans Black

Beyond all the remarkable headlines that we have seen in recent weeks concerning the slowing of the world’s economy and, of course, the dramatic Olympic games, the events in the South Caucuses have also been very important and have generated considerable comment. Following the attempts by the Government of Georgia to try to regain control of two breakaway regions – South Ossetia and Abkhazia – the Russian army’s well calculated and thoroughly rehearsed entry into Georgia has been the geopolitical news story of the year. In a period of two weeks the Russians have successfully woken up anyone who might have been asleep recently, or perhaps since the end of the Cold War, that they are in fact back. Secondly, the actions in the South Caucuses, irrespective of what else you may think, will have a long lasting effect of recalibrating downwards investors’ appetite for risk in certain developing countries. Beyond the obvious casualties of the economy of Georgia, investors in the Ukraine and other former Soviet Union countries must surely be having second thoughts. Indeed, we estimate that these dramatic events will cause many to think twice before embarking in ventures into new emerging countries.

While it has almost been axiomatic to expect better performance in developing markets in recent years, we suspect that the recent bouts of under performance will continue to linger. China which has now dropped over 55% year to date is a good example of how markets can reverse. Suddenly problems in the South Caucuses, political turmoil in Bangkok, as well as new difficulties in Korea, all point to the sudden reversal of fortune that can occur in immature and often times ill-liquid markets. While many are quick to dismiss the problems in Georgia as regional, we are not so sure, as we believe that greater difficulties in the global economy usually breed less tolerance in regional political disputes, which may have been dormant for years.

The under performance which we expect in most, if not all, developing markets will prove to be just another aspect of a generalized under performing global economy and mixed with vastly more difficult credit conditions. The particular problems in the South Caucuses will also have the effect of making investments in some eastern European countries undergo a vastly more rigorous review. Lest we forget that Russian gas pipelines, the so called umbilical cord of Europe, are a reality which has to be reckoned with and undoubtedly these events have also contributed to the recent weakness of the euro.

The summer months have been anything but quiet. The early weeks of July provided us with almost crash like conditions in global bank shares. This has been followed by a tremendous reversal downwards for the price of petroleum, as well as other commodities, while the dollar has been soaring. Finally, the political turmoil in the former Soviet Union region of Georgia has also added to the excitement. As a follow-up to the tumultuous summer of 2007, when many of the CDO problems (collateralized debt obligations) were first discovered, one has to wonder whether we will ever again return to a reasonably quiet summertime.