Japan
Abe's First 100 Days - A Road Map (II)
Aug 09, 2006

Robert Alan Feldman (Tokyo)

This is the second in a two-part series about signposts to judge progress of reform if, as expected, Cabinet Secretary Shinzo Abe becomes prime minister. The observations here are based on Abe’s new book, “Toward a Beautiful Nation” (Utsukushii Kuni e). Part I discussed Abe’s economic policy, and Part II discusses his foreign policy.

What’s new: Cabinet Secretary Shinzo Abe’s new book, Utsukushii Kuni e (Toward a Beautiful Nation (TBN)), outlines what he will do if, as expected, he succeeds PM Koizumi.

My conclusion: Markets will be skeptical of Abe’s foreign policy.
The black-and-white view of Abe as ‘right wing’ is wrong, but proving this will take time and action. He will have to clarify his approach to the Yasukuni Shrine issue.

Implications: Investors should look for foreign policy action during Abe’s first 100 days. Likely foreign policy elements include: (a) State visits to India, China and the US, (b) Steps on North Korea, (c) Vigorous PR diplomacy, and (d) A Pan-Asia Democracies League

Summary and conclusions

Now that Cabinet Secretary Shinzo Abe is highly likely to be Japan’s next prime minister, investor attention is turning to the policies he will advance. The foreign policy debate is complex and nuanced. Abe is often portrayed by the media as ‘right wing’ in light of his stance on North Korea abductions and his family’s political history. In contrast, he portrays himself as a principles-based pragmatist, in the mold of Churchill or John F. Kennedy. Investors will come to a conclusion only after they see Abe in action. Hence, the part of the risk premium in financial asset prices due to diplomacy worries will likely persist until the content and efficacy of Abe’s approach are clear.

Abe’s foreign policy philosophy

Although not directly related to the economy or to financial markets, investors are showing a huge interest in Abe’s prospective foreign policy. There are two key questions. (a) What is Abe’s philosophy on international relations? (b) How does he apply this philosophy to the many issues that affect financial markets?

A reading of TBN suggests that Abe’s philosophy of foreign policy is based on a triangular relationship between three concepts: values, identity and reciprocity. Values are the concepts by which a society defines its goals as a community. The relationships among these values — and often the trade-offs among them — define the identity of a nation. Finally, once nations have values and identities, their ability to keep peace with each other depends on agreements with reciprocity — which must be based on their respective identities.

For example, Abe emphasizes a number of values that define Japan (as he sees it), including democracy, rule of law, freedom of speech, equality of opportunity, separation of church and state, reliance on a minimum national standard for the social safety net, etc. By implementing these values through enforcement of laws, Japan creates a national identity. For example, Japan is quite serious about enforcing low levels of street crime and high levels of environmental and food safety. Many foreign residents find these two characteristics quite attractive, and decide to remain in Japan in part because of them.

Defending the values and identity of the nation is a fundamental role of the state, according to Abe. He declares that the nation-state is essential because it protects individual rights, including the minimum levels of social security that form part of the Japanese identity. Thus, Abe concludes that “national security and social security — these are my themes as a politician” (p.41).

Of course, other nations may have other sets of values and other trade-offs among them. So long as the overlaps in values and identity are large, national security is relatively easy. Nations can develop common rules (such as treaties) to create reciprocity, such as treaties for dispute resolution over borders, sea rights and trade issues. The key method for dispute resolution among such countries is persuasion within these sets of rules.

However, when value systems are very different and overlaps low, areas for reciprocity are naturally narrower, and rules of reciprocity are harder to enforce. Where rules for reciprocity are few or unreliable, national security requires a different approach, based on both “dialogue and pressure”. (Abe uses the phrase in discussion relations with North Korea, see p. 59.) Abe notes the case of Commodore Perry, who created the US-Japan Treaty of Commerce and Amity in 1853-54 using both. Japan’s struggle to end these unequal treaties is another case in point. It took 40 years for Japan to amass and demonstrate the military power that convinced western counterparts that the unequal treaties should be scrapped.

Thus, Abe views diplomacy as an interaction of values, identity and reciprocity. He applies this framework both to Japan’s bilateral relations and global relations — with some startling results.

Specific foreign policy issues

Japan-US relations.  Abe’s approach to the US is both pragmatic and idealistic. The pragmatic part is military defense. Abe views the US-Japan relationship as the bedrock for Japan’s national security, for the simple reason that Japan needs a nuclear-armed protector. Japan itself has and will retain a policy of non-possession of nuclear weapons, despite potential nuclear threats. Therefore, Japan must have an ally with nuclear deterrent capability. Who is available? Low levels of trust between Japan and China and between Japan and Russia rule out both of those countries as nuclear protectors. The US is the only credible partner. Abe says, “When one considers nuclear deterrence and stability in the East Asian region, the US-Japan alliance is essential, and is the best choice in light of the US’s influence on international society, its economic power and its pre-eminent military power” (p. 129).

The idealistic part comes in Abe’s very next paragraph. He says that “We must also recognize the point that the US and Japan share basic values, such as freedom, democracy, human rights, rule of law, fair competition and market economics. These are the joint values of the liberal nations of the world” (p. 129). With this background, Abe then makes a major point on reciprocity.  Citing the US-Japan security treaty, he notes that “the youth of America are obligated to put their lives at risk in order to defend Japan” (p. 130). However, because Japan currently denies the obligation of collective defense, it cannot help the US if the latter were attacked, even with efforts to rescue US personnel from combat casualties taken when defending Japan.

Abe makes the point that such a relationship with the US is not only a violation of reciprocity, but it also denies Japan an equal voice in international affairs. The lack of reciprocity spurs Abe to criticize those who condemn Japan for being subservient to the US. If Japan is mostly take and little give, why should the US listen to Japan’s opinions?

Abe discusses Japan’s actions in Iraq in this context, no so much as an issue in US-Japan relations but as a contribution by Japan to an international society that shares common values. Even if circumstances prevent Japan from full reciprocity in its military alliance with the US, Japan should — according to Abe — at least be more active in addressing issues of common international interest. In this sense, an Abe administration can be expected to continue and intensify cooperation with the US, when defense of key values is at stake. If anything, the US-Japan relationship will become closer under Abe, rather than looser.

North Korea. North Korea is the most immediate threat to Japanese national security, and this threat is not receding. North Korea’s drug dealing, currency counterfeiting, illicit arms exports and unresolved abductions remain important issues. Most critical, however, is North Korea’s development of nuclear weapons and missiles. Since North Korea shares virtually none of the values that Abe sees as defining Japan, relations with North Korea are a test case for Abe’s approach of balancing dialogue and pressure.

So far, Abe’s approach has been successful, at least in lining up other regional powers to press North Korea to change policies. Indeed, as Cabinet Secretary, Abe was the architect of Japan’s strategy for reacting to the recent North Korean missile tests. He first secured a common position with the US, and then took the matter to the United Nations (UN) Security Council. When China and Russia resisted the call for a UN resolution condemning North Korea (they had proposed a non-binding chairman’s statement), Japan and the US insisted on a full resolution, which would have forced China (or Russia) to veto — and thus lose credibility. In the end, a resolution was adopted, with sufficiently tough language. Any future provocations by North Korea would trigger a tougher resolution, and bind China to actions (such as economic sanctions) that would enhance Japan’s security.

There were some weak spots in Japan’s strategy, however. The US position in the world is extremely complex, in view of negotiations on other issues such as Iran’s nuclear weapons, the Iraq war, the Israel/Lebanon situation, etc. Japan had to consider the policy trade-offs of its ally when creating the joint position on North Korea. Moreover, Japan is not a permanent member of the UN Security Council. Japan just happened to have a rotating membership spot when the North Korean missiles were launched. Had Japan not been on the Security Council at this time, it would have had to rely on the US to bring up the issue. (Japan pays about 20% of the UN budget; the US another 20%, China 2% and Russia 1%.)

Going forward, one can expect an Abe administration to push aggressively for Japan to have a permanent seat on the Security Council — or at least to propose a more aggressive plan for UN reform. Given Japan’s large contribution to the UN budget, a test of the Abe government will be how it uses this power of the purse to promote UN reform.

Japan-China relations. Of the many bilateral relationships in the region, the Japan-China relationship is the most crucial to investors. So far, economic relations between the two countries have not been seriously affected by political problems. However, investors are worried that damage may occur.

As with the US, Abe’s approach to China has components of both pragmatism and idealism. The pragmatic part deals with both economic and environmental issues. Abe views Japan’s relationship with China as symbiotic and inseparable. He sees common interests in the two countries in energy development, environmental protection and economic growth. Indeed, ensuring stable, sustainable economic development in China is crucial to Japan’s national interest, says Abe, since social unrest in China is a threat to Japan.

With all this common interest, why have political relations turned sour? Abe sees this souring as a result of the need for the Communist Party of China (CPC) to develop a new ideology to replace the discredited communism of the Mao era while still keeping itself in power. According to Abe, the CPC has substituted nationalism for communism, as its claim to legitimacy. The easiest way for the CPC to be nationalistic is to be anti-Japanese.

Despite Abe’s view that the CPC is cynically manipulating Chinese public opinion, his recommended combination of dialogue with and pressure on China is very different from what he proposes for North Korea. With China, Abe proposes multi-dimensional dialogue, starting with more frequent contact between top leaders in the two countries. In this context, he proposes that issues be handled quietly, so as to avoid bilateral issues becoming hostage to domestic politics.

At a broader level, Abe also supports a much more active exchange student program between the two countries. By inviting more Chinese students to Japan, Abe hopes to spread knowledge inside China of the Japanese as human beings, and thus undermine the anti-Japanese propaganda campaign of the Chinese government at the grass roots level. The pressure comes from positive support for key Chinese needs, such as Japanese support for environmental protection in China and providing Japanese energy-saving technology.

Abe appeals for a separation of economic and political issues with China (p. 152-3). This is tantamount to saying that the common values of free trade and economic development should be the main basis for Japan-China relations. Abe says that the two countries “should not allow political problems to spark economic problems, not use economics to achieve political goals. Both countries should prize economic benefits, and respect each other. If the two countries can share these principles, further worsening of relations can be stopped and deterred” (p.153).

While this approach to relations with China is constructive in terms of values and (positive) pressure, it remains unclear whether China will accept Abe’s appeal. Thus, now that Abe has put his cards on the table, investors should watch the reaction of Chinese leaders to see whether they a political deal can be done. If so, fine. If not, then the dialogue between the countries will have to intensify for things to turn in the right direction.

Japan-India relations. Abe singles India out for special treatment, and sees India as new partner in the world of Asian democratic diplomacy (p. 159). He recalls India’s respect for Japan as the first Asian nation to defeat a western power (in the Russo-Japanese War of 1904-05), and cites Indian opinion polls that consistently list Japan as a country with which Indians have the most affinity. Abe is somewhat apologetic that India’s affection for Japan has been unrequited, until recently. He said that he “would not be surprised if Japan-India relations in a decade’s time were more important than Japan-US or Japan-China ties.” (p. 159)

Abe presents no specific ideas on how to push Japan-India ties forward, but new ideas are likely to emerge early in a new Abe government. In light of India’s needs for huge investments in infrastructure, Japanese companies could be major beneficiaries. Investors may wish to keep an eye on ODA budget allocations.

The Yasukuni issue

The final key aspect of reading an Abe government will be his stance on the Yasukuni Shrine issue. Among the debates are (a) whether the issue is domestic or international, and (b) whether it should be decided on the basis of legal, moral, historical or religious standards. This is an extremely complex issue, and is far beyond the scope of this paper (or my expertise). My only purpose here is to outline how Abe approaches the issue and potential implications for financial markets.

TBN includes long sections on the Yasukuni issue, and approaches it from three viewpoints — legal, diplomatic and moral.

From the legal viewpoint, Abe sees no problem with prime ministerial visits to the shrine, for two reasons. First, the implications of international law and domestic law must be separated. Even those convicted under international law were rehabilitated into society after their sentences were completed — and one even became foreign minister, with no objections from foreign powers. Second, Japanese courts have ruled on the constitutionality of prime ministerial visits to the shrine and have found them constitutional, despite the constitutional separation of church and state, “so long as the visits are for the purpose of a tradition of society”.

By diplomatic standards, Abe sees no problem either. In terms of law, Abe points out that the China-Japan Peace Treaty of 1978 prohibits both countries from interfering in the domestic affairs of the other. Since commemorating war dead is an internal matter, China has no right to interfere, Abe believes. Moreover, precedent argues against recognizing Chinese claims, according to Abe. The Class A convictees were enshrined in 1978, and several prime ministers visited the shrine in subsequent years. However, China never objected until 1985. Finally, if China views the visits as a symbol of revived Japanese militarism, the evidence is negative; Japan has taken no military action against any country for 60 years, and has no long-range missile capability. Japan respects human rights and does not suppress individual freedoms (p. 67-68). In Abe’s view, a country with such a track record cannot be accused of reviving militarism.

On the moral question, Abe asserts that every country has the right to honor its war dead. He cites the tragic sacrifices of youth in the kamikaze brigades, and their selfless service to their country. It is this sense of sacrifice for the community that Abe sees as the basis for an effective foreign policy that defends modern Japanese society from potential threats. On the question of whether the cause for which they died was dishonorable, Abe cites an American historian discussing the graves of Confederate soldiers in Arlington National Cemetery. Their sacrifice is honored at Arlington, even if the cause for which they fought (slavery) was unjust. No one objects to the US president visiting Arlington, despite the presence of the Confederate soldiers.

Since TBN was published, three new facts have come to light. First, new historical documents have been released showing that the Showa Emperor viewed the enshrinement of the Class A war convictees negatively. Implicitly — but not explicitly — this explains why he stopped visiting the shrine thereafter. Second, the press reported that Abe actually did visit the shrine in early April this year, quietly and without fanfare, but signed the guestbook with his official title of Cabinet Secretary. (Abe refuses in public to confirm or deny the visit.) Third, the South Korean government has injected a new ‘Asian values’ aspect to the debate. Responding to the report of Abe’s visit, the South Korean government said that Asian values discourage actions that the neighbors find distasteful.

So what happens next? Will Abe take the Showa Emperor’s refusal to visit as a reason to change his own view? Will Abe’s own visit in April constrain him to continue visiting, in order to prove his consistency? Will Abe accept the Korean version of ‘Asian values’?

At this point, no one knows the answers to these questions, but no resolution is likely soon. Indeed, Abe has as much as 18 months to make a decision. The typical commitment by politicians is to visit during a calendar year. Since Abe’s last visit was in April 2006, he has until December 2007 to decide whether to visit again. A lot could happen in the meantime, and affect his decision one way or another. Investors are likely to have to live with this uncertainty for some time.

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Indonesia
Normalization of Interest Rates Underway
Aug 09, 2006

Deyi Tan (Singapore)

Bank Indonesia cuts policy rate by 50bp to 11.75%

The policy statement indicated that “this decision was adopted in light of the continued macroeconomic stability in Indonesia, reduced risks from external factors, findings from various surveys and the economic and monetary outlook”.  The central bank’s move is largely in line with the recent market expectations; however, it is higher than the hesitant reduction over the last three months.  The bond market had begun to price in the probability of a 50bp cut since the press statement by the Deputy Governor, Miranda S Goeltom, on July 27, which indicated that there is greater room for rate cuts in the coming months.

Three key macro trends supporting aggressive cut in rates

While there is no surprise in the moderating inflation trend, we believe that BI has probably accelerated the pace of rate cuts on account of the continued deceleration in growth trends and the relatively comfortable external environment supporting a stable exchange rate. There are three key macro trends at work:

(1) Moderation of inflation in line with expectations. We expect CPI inflation to head below 15% from August 2006 onwards, possibly to as low as 6-7% by the year-end.  The deceleration is likely to be supported by the base effects of higher oil prices from October onwards.  Obviously, the risk is that the oil price rises above US$85 and/or the rupiah depreciates sharply, bringing about a second round of inflationary pressure.  On balance, we believe that domestic inflationary pressure will start dissipating in the second half of the calendar year.

(2) Persistent weakness in domestic demand. Most of the cyclical growth indicators show that growth had continued to slow until recently.  Consumption indicators, such as car and two-wheeler sales, and consumption credit indicate continued deceleration through to June 2006.  Similarly, capex trends as reflected in the capital goods imports, commercial vehicle sales and cement sales also indicate no recovery so far.  Broader measures of growth such as electricity consumption and total bank credit also indicate a similar trend.  The only area that indicates a marginal improvement in growth trend is goods exports.

(3) Stable exchange rate and external environment. After witnessing volatility in the May, the IDR has been relatively stable over the past month or so.

This favourable trend has been supported by: (a) improving macro stability (the fiscal impact of oil is now positive unlike in 2005); (b) improved trend in capital inflows, particularly foreign portfolio inflows; and (c) the recent change in market expectations for US interest rates, as reflected in Fed futures, which are now pricing in a peak rate of 5.38% compared with 5.58% priced in at end-June.

Changing our rate outlook for end-2006

While we were expecting the normalization of interest rates, our forecasts were building in slower rate cuts in the near term and aggressive rate cuts in 2007.  However, with a more supportive external environment and persistent weakness in domestic demand, BI now appears to be opting for a faster rate cut in the near term.  We are therefore now expecting the policy rate to be at 10.5% by the year-end, compared with the 11.5% expected earlier.  However, we maintain our 2007 year-end estimate at 9.25%.

Maintaining growth recovery outlook for the second half

Although growth has remained subdued in the second quarter of 2006, we believe that lower interest rates will support a recovery in domestic demand — both consumption and fixed investments — in 2H06.  We therefore expect GDP growth to accelerate to 5.5% YoY in the second half compared with 4.7% estimated in the first half of the 2006.  Our growth forecast assumes no major support from the potential acceleration in structural reforms by the government, particularly on infrastructure investment.

Potential reversal in global risk appetite — a key risk factor

We believe that Indonesia is highly vulnerable to a potential reversal in global risk appetite trends.  Global risk appetite-dependent portfolio flows, including equity and short-term debt securities, are by a large margin the most positive component in the balance of payments (BOP) financial account.

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