By Leika Kihara

(Reuters) – Japan’s Liberal Democratic Party ruling coalition may lose its majority in the upper house in an election on Sunday, increasing calls for the government to boost spending and cut tax.

LOOMING POLITICAL UNCERTAINTY

Recent media polls indicate that the LDP coalition could lose its majority, raising the risk of political instability as the country struggles to finalize a trade deal with the U.S., raising fears of increased debt. Japan’s debt burden stands at about 250% of GDP, the highest in the developed world.

Prime Minister Shigeru Ishiba, seen as a fiscal hawk, faces pressure for potential increased spending by parties to secure political support, leading to a rise in bond yields to multi-decade highs. Yields might increase further if the likelihood of significant spending or cuts to the sales tax rises.

WOULD JAPAN HAVE A NEW PRIME MINISTER?

If the election loss is minimal, Ishiba could remain in office and seek cooperation with opposition parties to pass legislation. However, a substantial defeat might prompt Ishiba to resign, leading to a leadership contest within the party to select a successor. There exists a slim chance a new premier could emerge from an opposition faction depending on the election outcome.

WOULD JAPAN SEE BIGGER SPENDING?

Regardless of the election result, Japan plans to increase spending, as Ishiba has committed to providing cash payouts to households to alleviate living costs. The estimated 3.5 trillion yen ($23.6 billion) for these payouts will be financed through tax revenues. However, spending may escalate if the LDP coalition endures a significant loss, as there will be heightened calls from both parties for more substantial measures to ease the burden of rising living costs.

Some analysts predict that Japan could compile an additional budget around autumn to accommodate spending of at least 10 trillion yen, likely necessitating further debt issuance.

HOW LIKELY IS A CUT TO JAPAN’S SALES TAX RATE?

Japan’s sales tax is currently set at 10%, with a reduced rate of 8% for food items. Ishiba has resisted demands to lower the sales tax, which funds social welfare for a rapidly aging population. An electoral defeat might compel Ishiba to reconsider a sales tax cut, potentially causing significant financial shortfalls for Japan.

Without the proceeds from debt issuance, sales tax is Japan’s primary revenue source. In fiscal 2025, it is expected to generate 25 trillion yen, accounting for 21.6% of the total budget. Analysts predict that halving the tax rate could result in a revenue loss exceeding 10 trillion yen. A sales tax cut would require legislative approval through parliament, meaning any change would not happen until at least April.

WHAT WOULD BE JAPAN’S WORST-CASE SCENARIO?

A worst-case scenario involves a downgrade of Japan’s sovereign debt rating, potentially triggering a mass sell-off of bonds, yen, and Japanese stocks, along with increased borrowing costs for Japanese banks in dollars. Moody’s Ratings indicated that increased pressure for tax cuts could negatively impact Japan’s rating, depending on the magnitude and duration of such cuts. Japan currently holds an A1 rating, the fifth-highest.

HOW WOULD THE ELECTION OUTCOME AFFECT BOJ POLICY?

The ruling coalition has signaled a gradual approach to interest rate hikes, a stance shared with the leading opposition party, the Constitutional Democratic Party of Japan. Should smaller opposition parties gain influence, it could pressure the Bank of Japan (BOJ) to proceed cautiously with rate increases. However, the long-term trajectory for rate hikes by the BOJ is unlikely to change unless Ishiba is succeeded by vocal advocates for more aggressive monetary easing, such as Sanae Takaichi, who narrowly lost to Ishiba in last year’s LDP leadership race.

($1 = 148.1800 yen)