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China's "difficult, wrenching change" and Japan's post-election letdown

·Editor in Chief

Japan's stock market slumped 1.6% overnight Monday despite a rousing victory by Japanese Prime Minister Shinzo Abe's party in parliamentary elections. A reaction to Friday's rout in U.S. market was cited as the catalyst for the decline but the question begs: What would have happened if Abe's party had lost?

Japan's Nikkei 225 has risen nearly 75% since Abe gained power in December 2012 (vs. a roughly 40% gain for the S&P 500) as he successfully pressured Japan's central bank to launch a series of aggressive policy actions, which have boosted asset prices and weakened the yen. Monday's election was widely viewed a referendum on Abe's economic policies and his party's victory means Abe doesn't have to stand for election again until 2018, which presumably means a continuation of so-called Abenomics.

"For those who want the Japanese economy to reflate I think this is fundamentally good news," Cardiff Garcia of FT's Alphaville says of the election results. "There was really lower voter turnout...[but] at least it reinforces expectations of what [Abe's] going to do next year: Skip the next tax hike and really continue to put pressure on the central bank not to ease up" on its quantitative easing program.

As to the market's reaction, "I stopped trying to make sense of the Japanese stock market a long time ago," Garcia quips, before considering the serious challenge Abe continues to face in reforming Japan's economy. "The 'third arrow' of Abenomics, structural reform, hasn't proceeded as quickly as the other two," he notes. "The Japanese can keep pushing on fiscal and monetary policy to generate demand and that's a good idea... but in the absence of structural reforms you're not going to get the long-term breakout growth that is Abe hoping for."

In other news from major Asian economies, China's central bank is now forecasting the economy will grow 7.1% in 2015 vs. an expected 7.4% in 2014 and the official target of 7.5%.

An economic slowdown is the "new normal" for China, according to Communist Party officials and judging by the market's fairly muted reaction to the news. The Shanghai Composite rose 0.5% Monday after dropping as much as 1.6% intraday.

"The Chinese government has been telegraphing for a while this is going to be a difficult, wrenching change as they move away from an investment-led, export-driven model to one based more on consumption," Garcia notes. "They're trying to communicate that the average Chinese citizen is going to benefit from this."

Chinese policymakers are trying to manage the socioeconomic fallout from this shift as much as the financial market reaction, Cardiff explains, pointing to the following commentary from GlobalSource Partners on this "rebalancing" theme:

  • While policymakers almost certainly understand that the interest rate cuts announced by the PBoC two weeks ago will slow the pace of rebalancing, the asymmetry of the change in rates was designed to minimize the adverse impact on rebalancing, and indicate just how complex China’s adjustment is likely to be.

  • Next year will be a very important year for China because possible strains in the banking system and the intensity with which the reformers present their case will give us a better sense both of how much debt capacity the country retains and of how well positioned Xi Jinping and his allies are to implement the needed reforms.

  • In order to understand the economic and political challenges Beijing’s leaders face, it is important to place China’s rebalancing in the appropriate context. In the 1980s China’s leaders under Deng Xiaoping were able to liberalize the economy and dramatically change the institutional structure of power in spite of elite opposition. The completion of the reforms left China ready for an investment-driven growth model that delivered astonishing increases in wealth.

  • It also delivered unprecedented imbalances. China’s leaders under Xi Jinping will once again have to liberalize the economy and dramatically change the institutional structure of power in spite, once again, of elite opposition.

Aaron Task is Editor-in-Chief of Yahoo Finance. You can follow him on Twitter at @aarontask or email him at altask@yahoo.com.