The leadership of a nation bears in its hands the fortune of countless people as the guarantor of law and the advocator of wellbeing, each judgment weights on the livelihood of many and the prospect of the generations to come. For the past two years, Asian nations have experienced several leadership transitions characterised by evolving dominant political figures especially among the leading economies, like Xi Jinping in China, Shinzō Abe in Japan and Narendra Modi in India. A particular question that concerns the financial markets’ participants is how political transitions affect equity prices.
Graph I shows the fluctuations of the major stock index in China, Japan, India and South Korea (SSE Composite, Nikkei, SENSEX and KOSPI respectively) compared to the S&P 500 from December 2011 to December 2014, with each red point representing respective latest political transition. While all four experienced a political transition within the past two years, the performance of their respective equity market was sharply different.
South Korea’s KOSPI is relatively the worst performer to date among the four countries, neither did it outperform the S&P nor did the political transition to the newly elected president, Park Geun-hye, change the course of the index. In contrast, leadership changes in Japan and India seemed to have a significant and immediate effect on their respective market. Nikkei almost doubled its value and SENSEX index enjoyed a similar increase with the surge starting a year ahead of the transition. The case of China is the most peculiar, the official ascend of Xi Jinping did not seem to have any distinctive effect on the stock market, however, Chinese stock managed to beat the South Korean by the end of the period due to a surprise and rapid surge in value starting around early July 2014.
Therefore, a thesis that one can put forth to explain these discrepancies is the policy differential hypothesis, meaning if the new leadership’s economic polices are largely unchanged from the previous one then, ceteris paribus, the transition would not have a significant effect on the financial markets.
Japan experienced up to eight political transitions since 2001, Graph II represents each transition with a red point. Notably only two prime ministers in the timeframe, Koizumi from early 2001 and Abe’s second mandate from late 2012, remained in office for more than two years. While both Koizumi and Abe adapted Quantitative Easing (QE) and others revitalizing policies, the effects on the stock markets were considerably different. In Koizumi’s term, Nikkei’s growth path showed no significant difference compared to the S&P’s, tumbling after the bust of the Dot-com bubble and surging in the pre-2008 period. However, in the post-2008 period, while S&P gradually recovered, Nikkei remained depressed until Abe took office with his signature policies, the Abenomics.
Abenomics or the “Three Arrows” policy consists of three branches of policies with the first two acknowledged as Keynesian policies, a combination of aggressive monetary easing and fiscal stimulus, and with a third one residing in structural reforms to raise potential growth.
Abenomics could influence the equity markets through several channels. First, the very nature of the QE programme, buying bonds and Japanese ETFs with increasing monetary base, could inflate asset prices. Second, QE made the already low bond yield even lower, forcing investors into risker assets. Third, Japanese central bank signalling of using QE to devaluate the Yen made Japanese stocks cheaper for international investors and enhanced the competitiveness of export oriented firms, increasing their profits. Lastly, hopes for the desperately needed structural reforms to revitalise the Japanese economy also boosted asset prices.
To illustrate the influence of QE on the stock markets, Graph III shows the relationship between USD/JPY, as a proxy for Japanese QE’s effect, and Nikkei since Abe took office. The relationship is highly significant for the period, in other words, devaluation of Yen (increase in USD/JPY) led to an increase in Nikkei and vice versa.
QE in Abenomics differentiate itself from QE in Koizumi’s term not only in its magnitude but also in its psychological effects on the publics. Abe’s size of political win enhanced the psychological effect due to his promise to keep the stimuli as long as necessary and his political power to achieve the promised structural reforms. The real objective of QE is not to just devaluate the Yen, but rather to increase inflation, hoping it will also increase wages, in order to stimulate the economy. However, the reality is that there is another urge for inflation, hence QE, and is that Japanese public debt, independent of its nature, is too high to be sustainable in the long run. Governments often opted to serve the debt either with inflation or with taxes, and history has proven the former to be their preferred choice.
Structural reforms, in the contrary, are more politically difficult to implement due to the presence of many different interest groups. Stimulus is only meant to withhold time allowing reforms to fix problems such as rigid labour system, gender inequality, uncompetitive corporate laws, aging population and trade liberalization issues. However, these reforms are yet to be fulfilled, and expectation would, sooner or later, face the reality that might disappoint many if Mr. Abe decides to use his political power to pursue others than economic and social progresses.
In the South Korea case, economic policies under the new president, Park Geun-hye, were fundamentally unchanged. South Korea shares many similar challenges with Japan, but while the incumbent leadership recognises the need of a more efficient and equal growth engine, unlike in Japan, political willingness for immediate and deep structural reforms remains weak and new policies announcement seemed to be too timid and unpersuasive for the financial markets to react. Korea’s new leadership shares with the Japanese’s the same idleness in structural reforms, and in absence of Japanese style monetary and fiscal stimulus, equity markets in Korea remain unaffected by the political transition.
SSE Composite’s sudden increase in July 2014 casts an inquiry into why Chinese political transition took more than a year to affect the stock markets.
Graph IV shows the progress of the SSE Composite since Xi assumed office with red points representing major events. A closer examination of the period found that at beginning of Xi’s presidency, the new administration’s focus appeared to be not in the economic and development but in regional disputes and domestic corruption struggles. Xi emerged, to the rest of the world, as a more assertive and dominant leader than many of his predecessors. Geopolitical uncertainty and corruption battles overshadowed reform commitments. However, markets sentiment began to change arguably from the 10th of April 2014 onwards (highlighted part on Graph IV) with the announcement of Shanghai-Hong Kong Stock Connect scheme. Successively, China moderated its focus on territorial disputes and began to focus more on economy and reforms, urged by continue evidences of economic slowdown. Xi’s commitment, before and during the APEC submit in Beijing, to lead China towards a more cooperative and growth-focused path in addition to the surprising move by PBOC to cut interest rate intensified market speculation of further stimulus measurements and that China can soon undertake another set of major reforms.
India’s SENSEX became one of the best performers globally in 2014 due to a bull market starting a year ahead of the general election that gave Mr Modi’s party a landslide victory and granting him an historic opportunity to improve India. Hopes triggered a stock market surge long before the transition that changed the horizon of a country politically dominated by the Nehru-Gandhi family with an out-dated economic agenda. Markets’ reactions reflect not only Modi’s commitment to reform India and his record in Gujarat, but more importantly his ability, as one of the most powerful prime ministers in Indian history, to implement those promised reforms, and the latter is sharply different to those of the previous administration. Therefore, the reaction to India latest political transition resembles those of Japan, with a set of different economic policies and a new political landscape as a plausible explanation behind stock markets surge.
Investors, like the publics, are rational agents subject to psychological impact, and like many other human sentiments, they let the expectation to overpower the reality in the short run. As long as people are more often led by desire than reason, expectation will remain a key determinant of asset prices. How transitions affect the equity markets is beyond what this short essay can do justice to, but certainly, evidences point toward that political transition alone cannot alter the direction of the markets. The key determinant often resides on the policies changes that come along with a new leadership, especially those policies that have short-term stimulus effects or reforms that can alter a nation’s institutional framework in the long run.
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