Japan Relaunches Spending Review to Fund Pledges and Curb JGB Yields

What happened

The Japanese government has relaunched its spending review initiative, known as DOGE, seeking to identify resources to fund Prime Minister Sanae Takaichi's policy pledges. This new phase of the review will focus on 201 special-purpose government funds, estimated to hold around 7 trillion yen (approximately $44 billion) by the end of the next fiscal year. The goal is to redirect idle or underutilized money back to the national treasury and implement stricter controls on subsidy programs, with the help of outside experts and evidence-based policymaking.

The initiative comes at a time of growing concern over Japan's public finances, which has pushed 10-year Japanese government bond (JGB) yields to multi-decade highs. The first phase of the review, which examined about 120 tax breaks, resulted in only three abolition proposals, leading to disappointment. Takaichi has pledged to cap new debt issuance at around 40 trillion yen, despite budget requests for next year reaching a record 143 trillion yen.

Why it matters

The spending review is an attempt by the Japanese government to demonstrate fiscal responsibility and find funding sources for its policies, such as a consumption tax cut on food from April 2027, in addition to demands for defense and industrial policy spending. The success of this initiative is crucial for the government's fiscal credibility and to alleviate pressure on JGB yields, which have risen due to the perception of increased fiscal risk. Takaichi's ability to fulfill her promise to limit debt issuance is a key factor for bond investors.

Furthermore, the reallocation of resources from funds and subsidies to finance a consumption tax cut raises a debate about economic effectiveness. Some economists warn that this could divert resources from supply-side investments to demand stimulus, which might have less impact on growth and potentially more on inflation. The results of this review are expected to influence year-end tax reform talks and budget negotiations.

Market impact

• Interest rates and bonds: The expectation that the spending review could generate savings and limit new debt issuance tends to ease upward pressure on JGB yields, especially long-dated ones. If the results are concrete and credible, there could be a reduction in the fiscal risk premium, leading to a drop in yields. However, the lack of substantial results in the first round suggests that the market may remain skeptical until concrete numbers are seen.
• Dollar and FX: An easing of fiscal concerns and a potential stabilization or drop in JGB yields could offer modest support to the yen. The Japanese currency has been pressured by interest rate differentials and concerns about debt sustainability. An improvement in fiscal perception may reduce risk aversion towards the yen.
• Equities: The impact on Japanese equities (Nikkei) is mixed. On one hand, reduced fiscal risk and stabilized bond yields can be viewed positively. On the other hand, reallocating resources from productive investments to consumption could create uncertainty about long-term growth, which might be a negative factor for specific sectors or the overall market, depending on the magnitude and detail of the measures.
• Brazil: Indirectly, an environment of less fiscal uncertainty in Japan and a potential stabilization of the yen could contribute to a global scenario of increased risk appetite, which tends to be positive for emerging markets like Brazil. However, the direct impact is limited, with global macro conditions and major central bank monetary policy decisions being more relevant for Brazil.

What to watch

Investors should monitor the concrete results of the new phase of the spending review, especially the numbers that will emerge from year-end budget negotiations. The credibility of the proposed savings and the Takaichi government's ability to keep debt issuance near the promised 40 trillion yen limit will be crucial. Additionally, statements and actions by the Bank of Japan (BoJ) in response to JGB dynamics and inflation will also be important, as they may signal adjustments in monetary policy.

Scenarios

Base Case: The spending review generates some savings, but not enough to completely eliminate fiscal concerns. JGB yields stabilize but remain at elevated levels, and the yen receives limited support. The BoJ maintains a cautious stance, with no major monetary policy changes in the short term. Risk Scenario: The spending review fails to produce significant results, increasing pressure on public finances and further pushing JGB yields higher. This could force the BoJ to consider more drastic measures to control the yield curve, or lead to a sharper depreciation of the yen due to a loss of fiscal confidence.

Original source: ForexLive (InvestingLive). For information only, not investment advice.