Japan reported a robust 4.1 per cent annualised growth rate for the first quarter of this year and 3.8 per cent in the second quarter (according to the revised estimates released today). Prices are beginning to rise, injecting confidence back into real estate markets, although the stock market has now dipped from a five-year high amid worries about whether ‘Abenomics’ will go far enough. While the stock market reverse is a worry in the short-term, Abe’s three-pronged economic policy strategy is a huge step in the right direction, though only if all three arrows can be brought to bear on the target at once.

As Naohiro Yashiro, a member of the Council on Economic and Fiscal Policy to the previous Abe administration, notes in one of our two leads this week, Abe’s landslide victory in Japan’s upper house election ‘provides one of the strongest political mandates a Japanese leader has received in recent times’.

But Abe’s solid victory does not necessarily help in the pursuit of market-based economic reform. From the beginning, the worry was always whether Abe could fire the third arrow.

‘The sad reality’, says Yashiro, ‘is that the more the Liberal Democratic Party (LDP) wins, the more representatives of various pressure groups occupy Diet seats and cry for the protection of vested interest groups. The major obstacles against Abe’s reform policies come not from opposition parties but the ancient LDP members within, whose main goal is to redistribute the fruits of economic growth to their favoured pressure groups. Such politics have contributed to long economic stagnation and, with it, declining tax revenues, resulting in Japan’s substantial fiscal debt (amounting to over 200 per cent of GDP)’.

Yashiro accepts that the best way forward on reform in Japan is to adopt a strategy, favoured by Abe, of establishing special strategic zones in Japan’s major cities to free up markets and promote international openness. These zones would be reminiscent of the special economic zones used so successfully to promote openness in reform of the Chinese economy. The Japanese version of the strategy, however, would seek ‘to surround the countryside with the metropolises’, as the beach-heads of openness and economic and social cosmopolitanism.

‘At the core of this strategy is the creation of special strategic zones in Tokyo and other major cities that can provide international business environments on par with London and New York. For example, regulations on floor-area ratios will be eased to allow for more high-rise residential buildings in these zones to stimulate housing investment without relying on public funds. They are expected to attract more foreign and Japanese business workers in the central metropolitan areas which remain under-utilised. Regulations will also be eased to make it easier to set up international schools and allow foreign doctors to practice, which are important amenities for attracting foreign firms and personnel to Japan. Also, there will be relief from Japan’s higher-by-international-standards corporate tax rates and inflexible labour market regulations in special strategic zones’.

As Yashiro admits, it may be better to deliver comprehensive national reform if that could be done around the political blockades. But getting a toehold in the cities, he thinks, is better than failing altogether.

In our other lead essay, Takatoshi Ito, formerly the deputy vice minister for international affairs in the Finance Ministry, has a different worry about Abe’s resolve on the third arrow. Having got a range of public expenditure measures under way, there is now a dangerous push-back on fiscal consolidation — or lifting the consumption tax rate from 5 to 8 per cent next year and then to 10 per cent the following year to address Japan’s long-term debt problem.

Ito argues that a big push for regulatory reform is needed now, and Abe should not be reopening the debate about going ahead with the consumption tax increase on the dubious grounds that an alternative formula might be easier for the economy to digest. This would waste crucial time and political capital. As Ito says, ‘[e]conomists, market participants, consumers and businesses are all waiting for an early end to the consumption tax debate and a swift release of Abe’s third arrow’.

Without the missing arrow the market will lose patience and the risks to Japanese recovery will rapidly escalate.

Peter Drysdale is Editor of the East Asia Forum.