A Chill In The Air For Economic Reform

But Japan's recovery has enough momentum that deadlock won't derail it

Japanese Prime Minister Junichiro Koizumi's four-year drive to overhaul the world's second-largest economy appears to be over. By dissolving the Lower House of Parliament after losing a key vote on Aug. 8, Koizumi has set the stage for his final act as Premier. That's because even if his government survives a snap election next month, refuseniks in the ruling party are now in cahoots with opposition parties to block Koizumi's agenda. What's more, his term as party head is supposed to run out this time next year, making him a lame duck.

That doesn't mean the slow-burn recovery Koizumi helped engineer is also dead in the water. The Japanese economy has built up enough momentum that the political uncertainty -- and likely gridlock -- ahead can't bring it to a halt, say economists. Indeed, the International Monetary Fund raised its economic forecast the same day Koizumi called for elections. The IMF now says Japan's gross domestic product will grow 1.8% this year, a big upward revision from the 0.8% it predicted as recently as April. "Whether you have a policy vacuum or not, right now it doesn't matter as far as the economy is concerned," says Jesper Koll, chief Japan analyst at Merrill Lynch & Co. (MER ).

Yet the Upper House's rejection of Koizumi's plan to privatize the postal system -- the trigger for the political crisis -- will be no boon to longer-term economic growth. It signals that Koizumi and his reformist allies have gone as far as they can in their campaign to trim government outlays, privatize more functions, and retool Japan's inefficient social welfare system. "The pace of the next set of reforms -- whether it's legal, fiscal, or health-care reforms -- could taper off," says Takahide Kiuchi, senior economist at Nomura Securities (NMR ) in Tokyo.

The defeated privatization bill was a key test because Japan Post does much more than deliver the mail. It is also the world's largest bank, with $3 trillion in assets, and a major provider of life insurance. In those roles, it competes with private thrifts and insurers. Those trillions have provided financing for hundreds of dubious public-works projects. Koizumi wanted to hive off the bank and insurance operations to curb such borrowing. This was a threat to old-guard members of the ruling Liberal Democratic Party, who want to safeguard funding for pork barrel spending in their home districts. The LDP anti-reform camp is now siding with opposition parties in Parliament to thwart more privatization.


Despite the setback, Koizumi's legacy as a reformer is secure. Since becoming Japan's Prime Minister in April, 2001, he has pushed through important changes to strengthen the banking sector, streamline the bureaucracy, and deregulate the economy. Unemployment is at a seven-year low of 4.2%, corporate profits are at record highs, and deflation is fading away. Bad loans at Japanese banks are down 47% since Koizumi took office, to about $161 billion.

The problem is that without continued efforts to restructure the economy, Japan faces a series of challenges. Government debt, while stable, stands at a record 140% of GDP. Corporate and public pensions are grossly underfunded. And the nationalized medical system is on the verge of insolvency.

Solving those problems will take strong leadership, but that's precisely what Japan may be lacking after the upcoming Lower House elections on Sept. 11. The LDP could still retain control of the Lower House, especially if the party forges ties to smaller groups. But that won't help Koizumi get postal privatization through the Upper House, whose members aren't up for election until 2007. And the main opposition group, the Democratic Party of Japan, is itself split on many reform issues. "Gridlock will occur regardless of who wins any Lower House election," says Robert Feldman, chief economist at Morgan Stanley Japan Ltd. (MWD ) in Tokyo. All of which looks likely to put the reformist agenda on ice -- even if Koizumi hangs on to power.

By Ian Rowley and Kenji Hall, with Hiroko Tashiro, in Tokyo

    Before it's here, it's on the Bloomberg Terminal.