By River Akira Davis

TOKYO —The steady course of the Japanese economy and business environment that has helped attract a torrent of investment in the past two years could be undercut by the political turmoil resulting from the country’s parliamentary elections on Sunday (27).

Japan’s economy, though not growing by leaps and bounds, has inched back from the disruptions of the COVID-19 pandemic. The emergence of long-sought inflation has given the Bank of Japan room to raise interest rates for the first time in nearly two decades.

Following moves by Warren Buffett last year to increase his holdings in some of Japan’s biggest trading firms, investors have shifted their money to Japan from China, which has economic and geopolitical risks. Corporate earnings in Japan have remained solid and government-led changes, such as guidelines recommending takeover offers be given serious consideration, have prompted companies to take steps to enhance their appeal to investors.

Stocks in Japan have experienced one of their strongest rallies in decades. The benchmark Nikkei 225 index is up nearly 50% since the beginning of 2023.

Now, the Liberal Democrats — the political party that has governed Japan for all but four years since 1955 — has lost its majority in the powerful lower chamber of parliament, leaving the future structure of the government and direction of its economic policies uncertain.

“The reasons that Warren Buffett and others got excited about Japan are not lost, but you need the background that is a stable macro environment,” said Jesper Koll, a director at Monex Group, a financial services firm. “For now, the bastion of stability element that has made Japan attractive is not going to be working.”

Many political analysts expect the Liberal Democrats to stay in power. But the party faces the immediate challenge of securing opposition party allies and the majority of votes in the lower house necessary to form a government.

The opposition parties in this month’s campaign did little to draw out robust debates about the economy, instead focusing primarily on punishing the Liberal Democrats for a long-simmering political finance scandal.

On Monday (28), the Nikkei 225 and Topix indexes rose 1% to 2%, likely reflecting expectations that political turmoil would cause the Bank of Japan to delay raising interest rates again. The yen weakened slightly against the dollar.

A weakened yen may provide a temporary boost, but “political instability will be a concern for financial markets and further out may contribute to falling stock prices,” said Takahide Kiuchi, executive economist at Nomura Research Institute and a former policy board member at Japan’s central bank.

In recent years, Japan’s rock-bottom interest rates have driven investors to seek higher returns abroad, weakening the yen. This, in turn, lifted the share prices of major Japanese companies that benefited from increased profits overseas. But following a surge in inflation, the central bank raised interest rates twice this year and indicated plans to continue doing so.

For now, weakened politicians in the Liberal Democrats and emboldened opposition parties are expected to push for policies — such as grants, subsidies and tax cuts — intended to appeal to voters, many of whom are on pensions and weary from rising inflation.

Shigeru Ishiba, whose tenure as prime minister is in question following his party’s losses, had said before the election that the government would create a supplementary budget bigger than last year’s $85 billion spending plan. But to entice the support of opposition parties, the Liberal Democrats may be forced to increase that budget further.

“As the country looks for a way forward, there will be some uncertainty,” said Stefan Angrick, a senior economist at Moody’s Analytics in Tokyo. But “a measure of stability will remain,” he added because even the leadership of Japan’s main opposition party embodies much of the traditional Liberal Democrat policies.

Still, amid the near-term political squabbling, some growth-oriented changes sought by investors may be put on the back burner, Koll said. These include legal reforms that would promote consolidation in Japan’s fragmented industries, which had made some progress before the election.

Koll and other economists suggest that the Bank of Japan could actually serve as a stabilizing force.

Before the election, most major banks and research firms anticipated the next interest rate increase would come late this year or early next.  The Japanese Central Bank is set to release its next monetary policy statement on Thursday (31)

Although political pressures on the Bank of Japan may intensify in the coming months, the bank’s governor, Kazuo Ueda, has made it clear that as long as the economy remains on track, the bank will raise rates at its own pace, Koll said.

“In that way, the BOJ may actually be that bastion of stability,” he added.

-New York Times