Japan's government backtracked on 220 billion yen ($2.3 billion) in welfare spending cuts on Tuesday in a bid to lure voters, but the move could send bond yields higher as markets fret over the government's fiscal discipline. The government effectively put fiscal reform on hold for a decade as it adopted a new long-term reform target to allow it to issue a record amount of bonds to combat recession.
The economic policy outline for 2009, which serves as the basis for compiling next fiscal year's budget, will likely add to unease at Japan's ability to manage its colossal public debt. Long-term yields have risen on fears that government spending to counter the worst slump since the Great Depression is overwhelming investors with new debt.
Doubts also abound as the government led by Prime Minister Taro Aso's Liberal Democratic Party could lose power after more than half a century of almost unbroken rule in elections that must be held by October, according to media polls. The economic policy outline points to a fatal flaw common to both the LDP and the main opposition Democratic Party of Japan, which has its best shot ever at taking control: Neither have a credible plan to lower Japan's debt burden and provide a high level of social services to a rapidly ageing population.
"Fiscal discipline is a common issue for Japan, the United States and Europe," said Yuuki Sakurai, chief executive and president of Fukoku Capital Management. "What worries the market is there will be competition between Aso and the DPJ to enlarge the budget to win the election and stay in power. There's a consensus that long-term Japanese bond yields will rise further."
Senior members of the LDP twice rejected draft versions of the 2009 economic outline, which is drawn up by the top advisory Council on Economic and Fiscal Policy, as they sought to delete a pledge to cut annual increases in welfare spending.
Giving up on that pledge and the old fiscal reform target marks a rollback of former Prime Minister Junichiro Koizumi's reform drive to limit spending and reduce the size of government. Japan now aims to stabilise its ratio of debt to gross domestic product by the mid-2010s and to lower it steadily by the beginning of the 2020s, according to the outline.
The government also plans to halve the ratio of the primary budget deficit to GDP in at least five years after the economy recovers. The primary budget deficit excludes debt issuance and servicing costs. "We have to allow for a natural increase in welfare spending," Finance Minister Kaoru Yosano told reporters after the Cabinet approved the outline.
"The message we've heard on social services is to stop making cuts that are impossible to make. Past government policy allows us some flexibility to respond as the situation changes." Yosano added that Aso ordered him to set a ceiling amount for next fiscal year's budget by next week.
The previous goal of a primary balance by 2011/12 has been pushed back 10 years as the government aims to sell a record 44 trillion yen of new debt in the fiscal year to next March to finance regular spending as well as stimulus packages. The increase in debt starts with an auction of two-year bonds on Thursday.
Yields on benchmark 10-year notes, which last stood at 1.405 percent, could rise to 1.8 percent by March, according to Sakurai. Tax revenue for the year ended in March was 5 percent below government estimates, and the government could issue even more bonds to make up for the shortfall, the Nikkei financial daily reported without citing any sources.
Japan's fiscal condition is the worst among major economies, and the government expects the ratio of its long-term debt to gross domestic product to hit 170 percent by the end of 2009/10. The country's primary budget deficit is expected to rise to 8.1 percent of GDP this fiscal year, up from 3.9 percent in 2008/09.
"What the LDP is doing is for the election, but they're not looking at the whole picture," said Nobuto Yamazaki, executive fund manager at DIAM Asset Management. "We're in fiscal trouble and this problem needs to be solved. Concerns about supply are hurting Japanese government bonds." Yields on 10-year JGBs may rise to 1.7 percent by March, Yamazaki added.
The government pledged to increase spending on programmes to support raising children, shifting workers to full-time from contract status, and improve health care with tax reform - code for a sales tax hike - in 2011. The Cabinet also reiterated its pledge to raise the ratio of contribution from state coffers to basic pensions to 50 percent after 2010, funnel laid-off workers into the caregiver industry and consider tax exemptions with one-time payouts for the poor.
Japan's economy has passed the worst of its deepest recession since World War Two as exports show tentative signs of a recovery following a collapse in global trade last year. Still, economists say salaries are likely to continue to fall and expect the jobless rate to rise, which will hurt not only domestic consumption but also government tax revenues. Legislators have already passed a record budget and the country's largest ever stimulus package, bringing total budget spending for the year to next March to a record 102 trillion yen.
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