Markets Await German Elections, Japan Data

The global capital markets will focus next week on regional elections in Germany and a key economic report in Japan.

Germany holds three state elections, two on Sept. 5 and one on Sept. 12, and the polls warn that the ruling Social Democrats are in for a drubbing. Japan releases second-quarter GDP on Thursday, and most observers suspect the economy stagnated or contracted slightly after eye-popping first-quarter annualized growth of 8.1%.

State Elections in Germany

The German elections are important, even though the market impact is likely to be minimal. Since Oskar Lafontaine resigned as finance minister back in the spring, the Social Democrat-led government has become somewhat more friendly toward business and has stepped up tax-reform and pension-reform efforts. However, the rank and file appears not to have made the same transition.

Unlike in the U.S. and the U.K., where control of the center-left party (the Democratic and Labor parties, respectively) was captured by the moderate wing, the German SPD did not undergo such a transformation. Gerhard Schroeder, the Chancellor, was a moderate face on a left-of-center party, led by Lafontaine. Incessant bickering within the SPD and with the junior coalition partner, the Greens, and confusing policy signals have caused popular support for the government to wane in recent months.

The government's position in parliament is precarious and will be even weaker following the upcoming state elections. In the Bundestag, the lower chamber, the government enjoys a 21-seat majority. However, 34 Social Democrat deputies have indicated they do not support the government's budget proposal for next year, which includes 30 billion marks ($16.3 billion) in spending cuts. In the upper chamber, the Bundesrat, where the states are represented, the SPD's hold is even more tenuous. Its members hold only 33 seats in the 69-seat chamber and not all of them support the government's budget.

Of the three state elections, two (Bradenburg and Thuringia) are in former East Germany. Over the past year or so, it appears the convergence between the west and east has slowed and some macroeconomic variables suggest divergence.

This, as well as the increasing reluctance of the west to subsidize the east, is likely to cause a political backlash against the government. The state government in Bradenberg is led by the SPD, while in Thuringia, a coalition of the Christian Democratic Union governs. The polls warn that in the East, center-right and right-wing parities are likely to benefit from the protest vote.

The election in Saarland could be even more dramatic, as it was Lafontaine's base. The current premier, Reinhard Klimmt, has been critical of the Schroeder government and refuses to support his deficit-reduction plan.

The impact on German assets and the euro should be marginal, but as the largest economy in the euro zone, policy paralysis (if that is the result) or a dilution of fiscal reform efforts would not be a constructive development.

And in Japan, Meanwhile

Japan reports GDP for the April-June period. No one really expects the pace of first-quarter growth to be sustained. News that the economy stagnated or contracted will lend credence to claims by Japanese officials that the economy is too fragile to tolerate an appreciation of the yen. The combination of the strengthening of the yen and the backing up of Japanese interest rates is tantamount to some degree of tightening of monetary policy.

A consensus appears to have been formed for another supplemental budget to provide stimulus for the economy. Most hints from officials are in the 5 trillion to 10 trillion yen ($45.4 billion to $90.8 billion) range. A surprisingly weak report, though, could see the size increase toward the 15 trillion-yen level that some officials have suggested.

The weaker the economy and the larger the supplemental budget, the more likely the U.S. Treasury will intervene jointly in the foreign exchange market.

Most observers are still caught up in the idea that foreign buying of Japanese equities is fueling the yen's advance. While it is true that foreigners are buying Japanese stocks, the picture of portfolio flows is more complicated. The most recent Ministry of Finance data that tracks flows on a settlement basis show that foreigners bought almost 1.7 trillion yen worth of Japanese stocks in the April-June period. However, during that same period, foreigners sold a whopping 4.9 trillion yen of Japanese fixed-income instruments.

More sophisticated observers note that currency risk is more likely to be hedged on fixed-income investments than on equity investments. This suggests that a portfolio shift from Japanese bonds to stocks may indeed involve greater demand for yen. However, given the large discrepancy of nearly 3-to-1 between bond sales and equity purchases, it is difficult to make the case that foreign portfolio flows were a driving force propelling the yen higher in the April-June period.

Comparable data for a more recent period is not yet available, but there is little reason to think that the basic trend has radically changed. Instead, the most compelling, although not totally satisfying, explanation of yen strength has to do with what Japanese investors are doing more than what foreign investors are doing.

Specifically, between January 1998 and June 1999, Japanese investors bought 9.3 trillion yen of European bonds and 1.9 trillion yen of U.S. bonds. For a number of reasons, some of which relate to regulatory changes and increased pressures to mark to market, Japanese financial institutions have been engaged in a large-scale currency hedging operation.