This week, Japan will hold its 48th general election of the House of Representatives on Sunday, October 22nd. Affected by corruption scandals, the supporting rate for the incumbent Prime Minister Shinzo Abe slipped to 35% in July, lowest level since he took office. However, benefited from the recent positive economic development, as well as Abe’s nationalism against the increased tension with North Korea, the support for Abe’s Cabinet rebounded in recent months. To take the advantage of such momentum, Abe announced the snap election one year ahead of the original schedule. In our view, due to the weak and fragmented opposition parties, the ruling Liberal Democratic Party (LDP) is expected to attract the most votes, however, whether the LDP could obtain the absolute majority in the lower house is the key to watch; and a significant loss in seats could weaken Abe’s power of policy making, or even his chance of re-election.    Despite the recent unsatisfactory moods towards Abe’s government, Japan’s opposition parties are also in disarray, with deep fragmentations. The internal divergence has split the biggest opposition party, the Democratic Party (DP), into two: the conservative part merged into the newly established Party of Hope (Hope); and the liberal part launched a new party, the Constitutional Democratic Party. Competition among such a fragmented opposition means that the anti-LDP vote could be split; and with no clarity on their own policies, the odds for the oppositions to win are slim.    In this week’s election, at stake are 465 seats in the lower house, and the LDP currently holds a large majority on its own (288 out of 475 seats), with the ruling bloc (LDP and Komeito) wielding a 2/3 majority (323 out of 475). We define three scenarios for the outcome, based on seats obtained: 1) business as usual: the LDP maintains its majority and the ruling bloc obtains 2/3 majority (at least 310 seats); 2) weakened power: the LDP maintains its majority but suffers a significant loss in seats, that the ruling bloc fails to obtain the 2/3 majority; and 3) the worst case: the LDP loses its majority and can only hang on with support of Komeito; and Abe could be forced to resign.    Our baseline case is the “business as usual” scenario,as the recent positive economic momentum supported the effectiveness of Abenomics, and provided the biggest tailwind for the LDP. However, on policy side, we do not expect major policy changes under all three scenarios. Given the still nascent economic recovery and core CPI inflation still around 0%, any aggressive fiscal consolidation or monetary tightening will put the growth and inflation development at risk. On the other hand, the government’s high budget deficit and high debt level, as well as the big chunk of BoJ’s holdings in the government bond market and ETF market (as a result of massive asset purchases under QQE) also rule out any large-scale fiscal or monetary stimulus in the foreseeable future.    But under the worst case, Abe’s possible resignation could increase uncertainties on monetary policy. As the terms of Governor Kuroda will expire in April 2018, and the QQE has received heavy criticism, the new cabinet could appoint someone with very different views on monetary policy. But, as we have stated, the BoJ has already implicitly reduced bond purchases, and the economic condition still cannot afford aggressive monetary tightening. Thus, even uncertainties will increase under the worst case, we still do not expect to see dramatic changes regarding monetary policy.    Finally, for market reactions, we expect to see limited moves under the “business as usual” scenario, but could see some short-term impacts with increased volatilities under the “power weakened” scenario. Under the worst case of LDP losing majority, which could possibly lead to Abe’s resignation and the end of Kuroda’s term, we expect to see negative market reactions for a relatively longer time, with steep appreciation of the yen and drop in Japan’s equity market. However, we expect such negative impacts to gradually fade out when the market realizes that there is actually not much room in the policy space for making changes and that Abenomics could still go on even without Abe.

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