Looming election may be nail in coffin for Japan's fiscal reform

By Leika Kihara and Tetsushi Kajimoto TOKYO (Reuters) - Even as a new party under a populist female leader scrambles the outlook for Japan's general election next month, one thing is clear: the winner will loosen a grip on the government's runaway debt as lawmakers forego higher taxes or boost spending. Prime Minister Shinzo Abe wants to use the revenue from a planned sales-tax hike not to pay down debt but to spend more on education and other popular programmers. Tokyo Governor Yuriko Koike, whose "Party of Hope" is challenging Abe's ruling coalition by effectively absorbing Japan's largest opposition party, wants to put off the tax hike altogether. "Japan has yet to emerge from deflation as consumption, which makes up a large portion of the economy, remains weak," she told a briefing on Thursday, criticizing Abe for doing little to prop up household income. The debate is shifting to how much more to spend and in what areas, rather than on what is acceptable within the limits set by Japan's public debt, which at well over twice the size of its economy is the biggest among industrialized nations. "Regardless of who wins, there will be increased spending because that's how you win votes," said Koichi Haji, chief economist at NLI Research Institute. "Very few lawmakers call for fiscal reform," Haji added. "That may be fine now, but there's no telling when loss of market trust in Japan's finances could trigger a spike in bond yields." Japan's ballooning public debt has not bothered the bond market much so far, as investors trust the country can repay public debt with its huge current account surplus and abundant domestic savings. But the long-term risk is that snowballing social security spending for a fast-ageing population will strain government finances, making it more vulnerable to a sudden spike in borrowing costs that would hurt the economy. Japanese government bond (JGB) prices tumbled on Thursday, with the benchmark futures posting their biggest fall in three months, as investors braced for bigger spending. WHITHER THE THREE ARROWS? Abe came into office in 2012 vowing to eradicate two decades of economic stagnation with "Abenomics" -- his three policy arrows of fiscal spending, monetary stimulus and structural reforms. While the fiscal and monetary support reflated the economy, critics say Abe has made little progress on structural reforms. In announcing a snap election for Oct. 22, Abe said he will proceed with the sales tax hike in 2019 but divert more proceeds to education and child care, and less on debt payment. He acknowledged it was now "impossible" to fulfill his promise to balance the budget -- excluding debt service and new bond sales -- by March 2021 as planned. Finance Minister Taro Aso said Japan will delay the timing for meeting the target by several years, with a new deadline to be set by the middle of next year. "What's worrying is that the delay (in achieving the fiscal target) would make it impossible for the government to put the brakes on spiraling fiscal spending," said Hideo Kumano, chief economist at Dai-ichi Life Research Institute. "The government may resort to bigger fiscal stimulus if a pull-back in demand after the 2020 Tokyo Olympic Games pushes the economy into a downturn." Finance ministry officials charged with drafting the state budget are relieved Abe will proceed with the tax hike, but stress the need to set a new deadline to keep spending in check. "It's a good thing that the premier has stuck with a primary balance goal, even with a delay," a senior ministry official said. "Japan's fiscal discipline will remain intact as long as we set a new timeframe." FISCAL DISCIPLINE Koike's new party, on the other hand, calls for freezing the sales tax hike, makes no mention of balancing the budget and proposes boosting "wise spending" - without giving details. "An opposition win would mean even bigger spending and a collapse of Japan's fiscal discipline," said a ruling party lawmaker close to Abe. Critics say the Bank of Japan's ultra-easy policy is partly to blame for a lack of discipline in Japan's fiscal spending. Politicians so far are paying no price for being lax about spending because the BOJ pins the 10-year bond yield at zero, essentially letting the government borrow for free. BOJ Governor Haruhiko Kuroda says his bank isn't printing money to bankroll public debt. But some policymakers worry that the central bank could be forced to maintain its ultra-easy policy for longer than it wants, for fear that slowing its bond buying could trigger a spike in bond yields and push up government borrowing costs. "Once the economy slumps, there will be demands for more fiscal spending. Lawmakers may pressure the BOJ to keep its monetary spigot open," said a former BOJ executive who retains close contact with incumbent policymakers. Rating agency S&P says Abe's decision to ditch the fiscal target timeframe won't affect Japan's sovereign debt ratings. But Kim Eng Tan, senior director of sovereign ratings at S&P in Singapore, warns against complacency. "I have no real concern right now about delaying the primary budget target," he said. "However, it does prolong the period in which finances are at risk to a sudden increase in interest rates." (Additional reporting by Stanley White and Kaori Kaneko; Editing by Bill Tarrant)