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By Joseph Moss, International Banker
The landslide election win for incumbent Prime Minister Sanae Takaichi and her Liberal Democratic Party (LDP) on February 8 represented a hugely significant development for Japan. The victory saw the LDP secure 316 out of 465 seats in the lower house—the largest result for a single party in post-war Japanese history—granting Takaichi a two-thirds supermajority, while its coalition partner, the Japan Innovation Party (JIP, or Ishin), claimed an additional 36 seats to give the ruling coalition an unusually strong governing mandate. But with the war in the Persian Gulf gravely affecting Japan’s energy security and Takaichi strongly pushing for fiscal expansion, concerns about Japan’s economic health over the coming months are becoming increasingly well founded.
Dubbed “Sanaenomics”, the new Takaichi administration seeks to implement a pro-growth agenda, largely through significant public spending and investment in key strategic industries. Indeed, it is the pronounced fiscal expansion that has most clearly defined Takaichi’s economic stance since taking office last October as Japan’s 104th prime minister. Of the ¥21.3 trillion ($135.5 billion) economic-stimulus package (approximately 3.7 percent of gross domestic product [GDP]) that was approved in November, ¥17.7 trillion has been earmarked for direct spending.
Japan’s industrial sector is the main recipient of this spending boost, with artificial intelligence (AI), semiconductors, quantum technology and shipbuilding all beneficiaries as Tokyo seeks to unleash a massive wave of public investment. Companies are likely to be offered various incentives through these spending measures to facilitate that investment surge.
Government expenditure on defence is also expected to be significantly bolstered. The 2021-24 administration of Fumio Kishida pledged to boost spending in this area from around 1 percent of GDP to 2 percent, with overall figures rising from ¥5.2 trillion in fiscal year 2022 to ¥8.9 trillion by 2027. Now, Takaichi looks set to further bolster the defence budget, although exact figures have not yet been published.
“In January this year, the United States issued its own National Defense Strategy that urges allies to raise security-related spending to 5 percent of GDP and ‘core’ military spending to 3.5 percent of GDP,” the Carnegie Endowment for International Peace recently noted. “If, taking US expectations into account, Takaichi were to aim—ten years from now, in the FY2036 budget—for ‘core’ defence spending equal to 3.5 percent of GDP, then with Japan’s nominal GDP in 2025 at roughly ¥630 trillion, 3.5 percent would amount to about ¥22 trillion.”
What’s more, the new government is planning to introduce legislation this coming autumn to suspend the 8-percent consumption tax on food for two years to ease inflationary pressures on households and thus alleviate the soaring cost-of-living. The policy is estimated to cost around 0.7 percent of GDP per year, if approved.
This series of unambiguously expansionist fiscal measures has raised much concern in Japan, the world’s most indebted advanced economy, with public debt currently exceeding 235 percent of GDP. If fully implemented, Sanaenomics’ policies will substantially increase that burden, particularly if growth does not accelerate sufficiently to offset higher borrowing and/or reduced tax revenues.
“Japan’s fiscal stance could loosen further because the LDP’s supermajority will enable the new government to implement policies with few obstacles. In particular, the two-thirds majority will enable the LDP to override Upper House vetoes where its coalition is in the minority,” Fitch Ratings warned in a February 9 report. “Our fiscal deficit forecast widens from 1.4 percent of GDP in FY24 to 2.4 percent in FY25 (year ending March 2026) and rises towards 3.7 percent by FY27. A larger fiscal package would be the main channel for deficits to overshoot our forecasts.”
January saw clear signs of market panic in response to Takaichi’s ambitious fiscal agenda, as a selling frenzy of longer-dated government bonds spiked yields. The 30-year JGB (Japanese Government Bonds) Treasury yield, for instance, skyrocketed from around 3.48 percent on January 16 to an all-time high of almost 3.88 percent on January 20, while the 40-year surged by more than 25 basis points to reach a record above 4.21 percent. And with fiscal worries still far from over, the 10-year yield touched its highest level since 1998 on April 10, above 2.44 percent.
The interaction between fiscal policy and monetary policy will also be central to Japan’s economic prospects during the Takaichi era. While fiscal policy is expanding, the Bank of Japan (BoJ) is seeking to tighten monetary conditions, having raised rates on four separate occasions since March 2024 to leave its benchmark short-term rate at 0.75 percent—the highest level since September 1995. Indeed, a widening divergence between the government’s and central bank’s policies could add upward pressure on bond yields, further inflating the cost of Japan’s public debt, especially given that its average residual maturity is estimated at around nine years.
“In other words, approximately one-ninth of Japan’s debt matures each year and will have to be refunded at higher yields. For the fiscal year ending March 31, 2026, Japan’s Ministry of Finance estimates that ¥135.8 trillion of JGBs will need to be issued to finance maturing debt,” according to Erik Norland, managing director and chief economist of CME Group. “This amounts to 20.4 percent of GDP worth of debt—in a single year. For every 1 percent rise in the average interest rates, this automatically adds 0.2 percent of GDP to Japan’s cost of funding and budget deficit.”
The Takaichi administration’s pro-growth policies should temper Japan’s debt woes, which Fitch predicted would help contain any near-term deterioration in the country’s sovereign rating. “Japan’s fiscal position has improved materially in the past several years, with narrowing fiscal deficits and higher nominal GDP growth reducing government debt to a forecast of just under 200 percent of GDP in the current FY25 from 222 percent in FY20,” the credit-ratings agency added. “Without new major fiscal packages, we forecast general government debt to GDP to decline further to around 195 percent over the next five years, even accounting for higher post-election deficits. A sharper rise in yields or weaker nominal growth would erode that buffer, particularly if combined with more expansionary fiscal settings than we currently expect.”
Japan’s weak currency remains a distinct challenge, one which Takaichi will be keen to address. Given the significant gap between US and Japanese interest rates, however, this may prove difficult to resolve. This gap has been instrumental in prompting investors to engage in the “yen carry trade”, whereby they borrow in Japan at a low rate and invest in the United States to earn a much higher return.
While that gap has narrowed over the last year, as the BoJ has continued to raise interest rates and the Federal Reserve (the Fed) has eased its monetary policy, the yen nonetheless weakened to multi-year lows during the first quarter. As the Japan Times recently noted, a stable currency is key to a strong and stable economy. “Historically, Japan has welcomed a weaker yen since that made its exports more competitive,” an editorial by the paper stated. “As the country has moved more of its supply chains overseas, however, a weak yen has become a drag on growth since it raises the price of imports. This has squeezed households as well, as they have faced stagnant wages.”
The most concerning of those imports at present is energy, with Japan dependent on overseas sourcing for around 85 percent of its energy consumption. With the Middle East responsible for a staggering 94 percent of Japan’s crude-oil imports (including the United Arab Emirates [UAE] at 43 percent and Saudi Arabia at 39 percent)—and with the closure of the maritime Strait of Hormuz, which crucially moves the overwhelming bulk of energy out of the region and into Asia and Europe—the resulting price spikes in oil and gas will almost certainly push inflation higher, adding further upward pressure on bond yields.
Takaichi has already approved the release of 50 days’ worth of oil and recently confirmed an additional release next month. “To ensure the stable supply of crude oil, we will release, starting in early May, the equivalent of roughly 20 days’ worth from the national reserves,” she said on April 10.
While Japan’s inflation slowed in February to 1.3 percent from 1.5 percent in January, the country’s central bank warned that inflation will likely increase due to sharply rising crude-oil prices. “Government support was a key factor in February’s dip,” according to Stefan Angrick of Moody’s Analytics, who also cautioned that “the relief likely won’t last”.