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Market turbulence poses first serious test for Abenomics

Japan's Prime Minister Shinzo Abe delivers a speech at a dinner during the 19th International Conference on "The Future of Asia" in Tokyo Ma
Japan's Prime Minister Shinzo Abe delivers a speech at a dinner during the 19th International Conference on "The Future of Asia" in Tokyo Ma

By William Mallard

TOKYO (Reuters) - This week's turbulence in Tokyo markets exposes a key risk of Prime Minister Shinzo Abe's all-in strategy to revive Japan's economy - if investor confidence falters, the government and the Bank of Japan may be left with few options to turn the tide.

On Friday, the Nikkei share average <.N225> had another tumultuous session, traversing a 7.1 percent range between positive and negative territory before ending up 0.9 percent.

The violent moves kept investors on edge after a 7.3-percent slide on Thursday, the sharpest drop for the Japanese stock market since the 2011 earthquake and tsunami.

At the same time, the 10-year-bond yield, a key interest rate linked to home mortgages and business loans, has almost tripled from the 0.315 percent record low it plumbed in early April just after the central bank announced its plans for a massive increase in asset purchases.

The wild market gyrations represent the first serious test for Abe, who has become a popular figure at home and on Wall Street for pro-growth policies featuring massive monetary easing, a big burst of government spending and a promised "growth strategy" centered on deregulation and trade liberalization.

Another issue is the danger of the debilitating side-effects on asset markets stemming from the eventual roll-back of the U.S. Federal Reserve's massive stimulus - external risks that Tokyo could do little to overcome.

In fact, Thursday's Nikkei rout was triggered by weak factory activity data in China, Japan's second-biggest export market, and on concerns sparked by Fed chief Ben Bernanke's suggestion that its bond-buying could be tapered this year.

Most analysts and many overseas investors seemed ready to write off the Nikkei's tumble as an inevitable wave of profit-taking.

The average has only slipped back to its levels as of early May and remains up nearly 70 percent since mid-November when it became clear Abe was likely to be become premier and implement his reflationary policies.

"It's just a speed bump, in my view," said New York-based fund manager Audrey Kaplan at the $656 million Federated InterContinental Fund who has increased the Japan weighting in her fund to 20 percent from 15 percent at end-March.

"The economic conditions in Japan are substantially better than they were a few months ago. That will support the market."

But one challenge for Abe and his hand-picked BOJ chief, Haruhiko Kuroda, is that the positive wave of investor and consumer sentiment has run far ahead of sustainable gains in the world's third-largest economy in key measures such as income or corporate spending, analysts say.

'THE MARKET EFFECT'

Consumption has picked up and exports have stabilized on Abenomics, especially the unprecedented easing by the BOJ, which has vowed to end 15 years of entrenched deflation and tepid growth by doubling the supply of money to generate 2 percent inflation over the coming two years.

Supporters of Abenomics say it's the best chance Japan has of escaping the liquidity trap as changing perceptions will create a virtuous circle of consumption, bigger company profits, investment and higher wages that ultimately revitalizes growth.

In his first response to the market turbulence, Kuroda, largely unruffled, told a seminar that bond market stability "is extremely desirable."

The BOJ chief also struck an optimistic stance on the bank's policies.

"What's most important is that the effect (of our monetary easing) creates a positive cycle of production, income and expenditure in the economy, leading to a gradual rise in prices. That's our hope and something that's achievable. We're in the process of this taking shape," Kuroda said.

The yen is down more than 20 percent against the dollar and interest rates have remained relatively low, cheering investors and Japanese exporters.

Japan's seven automakers, one of the main beneficiaries of the weaker yen, have outlined plans to increase capital spending by almost 15 percent this financial year on a global basis but those plans will take time to play out.

In the meantime, keeping consumer, corporate and investor confidence is crucial.

"Japan's economy is turning up because confidence is improving and households are spending even though their incomes aren't rising," said Koji Haji, chief economist at NLI Research Institute. "It's the market effect."

Abe's cabinet members lined up after Thursday's market plunge to say they would press on with existing policies.

"The government is steadily making progress with steps to revive Japan's economy," Economics Minister Akira Amari said on Friday. "I don't see any problems there."

THIRD ARROW

It's not clear what the government or BOJ could do if the markets decisively turn on Abe.

He cannot easily ramp up government spending or postpone a planned sales-tax hike without endangering confidence that Japan has a plan to rein in its huge debt pile, which at well over double annual economic output is the biggest in the developed world.

A Japanese government advisory panel is set to warn in the coming days that there is "no guarantee" that domestic investors will keep financing the debt, raising the prospect of a damaging spike in bond yields, according to a draft report.

That raises the stakes for Abe's "third arrow", growth strategies expected to be announced in June and to include tax changes to encourage corporate investment, steps to encourage more women in the workforce and liberalization of the power and healthcare sectors.

Indeed, analysts say a durable revival in the economy will depend to a large extent on Abe's third arrow, a thorny challenge that has fazed many of the prime minister's predecessors.

"The important thing now given the high level of market expectations for Abenomics is how quickly the growth strategies that we will get in June can catch up," said Mitsubishi UFJ Morgan Stanley fixed income strategist Naomi Muguruma.

"These steps won't have an immediate effect so it will be important for the government to keep policy steps coming in rapid succession that secure market confidence."

Kuroda's BOJ also faces a challenge in keeping long-term interest rates in check.

"He will have to do something," said Joseph Capurso, a strategist at Commonwealth Bank of Australia in Sydney. "Like what? Buy more JGBs and buy enough to convince the market yields can come down."

The 10-year bond yield briefly rose on Thursday morning to 1.0 percent - a level flagged by many analysts as a worry line for the BOJ as it could begin to push up mortgage and other borrowing costs and threaten a nascent recovery.

NLI's Haji said the BOJ could be forced to change the way it buys bonds.

It could augment the auctions it runs now with financial institutions with a new procedure to buy bonds directly from the market, he said. Such a step could allow the central bank to respond more quickly and in a targeted way along the curve.

"That may be one of the very few means left for the BOJ to stabilize markets," Haji said. "The only reason it's not doing this is because it would be tantamount to debt monetization. But it is already essentially bankrolling debt, so what's the difference?"

(Additional reporting by Leika Kihara, Hiroyasu Hoshi, Hitoshi Ishida, Sophie Knight, Lisa Twaronite, Yuko Yoshikawa; Editing by Kevin Krolicki and Shri Navaratnam)

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