Golfing With Abe Was Easy; Now Comes The Hard Part

One day after the infamous handshake...

... and following some leisurely entertainment on Saturday morning in Palm Beach...

... the fun is now over.

... and as the Nikkei writes, "now that Japanese Prime Minister Shinzo Abe and U.S. President Donald Trump have made it through their first summit without clashing on trade or currency issues, the focus shifts toward a new framework for economic dialogue that the two leaders agreed to establish."

It is here that things are about to get a whole lot more difficult. The reason is that the two sides greatly differ on how to forge a free trade agreement and on whether the value of the yen may or may not be being manipulated. These matters make up only the beginning of a list of contentious issues.

Some key highlights of what is set to be a very sensitive relationship.

On Friday in Washington, Abe reiterated - on three occasions, including at a breakfast meeting at the U.S. Chamber of Commerce - that many Japanese companies are operating production facilities across the U.S. and are thus bringing jobs to the country. Abe seemed to be trying to school Trump, who seems to be still haunted by the 1980s trade friction between the two countries, on how much production Japan has shifted to the U.S., in an preemptive attempt to appease the US president, as explained last week.

Meanwhile, VP Mike Pence, who will lead the new economic dialogue with Taro Aso, Japan's deputy prime minister and finance minister, has a strong connection with Toyota Motor and other Japanese companies. He supported the Trans-Pacific Partnership, a multilateral trade agreement that Trump quashed in his first days in office. "As a negotiation partner, we have no doubts about him," a Japanese Foreign Ministry official said of Pence. A Japanese official in charge of international trade policy said Japan made certain progress at the summit by establishing a platform that is shielded from direct attacks from Trump.

Still, Japan is in no mood to step into the ring if the Trump administration calls for talks on a free trade agreement between the two countries. It fears the U.S. would try to pry open Japan's agriculture market, a tender spot for Japan.

Even if Japan agrees to free trade talks, it would be difficult for Japan to concede more to the U.S. than it did in the TPP negotiations, due to strong opposition from its farmers. On the other hand, the U.S. would likely make tough demands regarding automobiles.

Starting free trade talks with the U.S. is a big risk, one that could foster anti-U.S. sentiment among Japanese. Japan wants to avoid risking its access to the U.S. market and instead plans to focus on cooperating with the U.S. to improve American trade relations with China - a clever strategy designed to divert Trump's attacks away from Japan and toward the hypothetical enemy.

At the post-summit joint press conference, Abe said, "Foreign exchange issues will be discussed between the treasury secretary and the foreign minister."

But Trump quickly hit back. "As far as the currency devaluations," he said, "I've been complaining about that for a long time. And I believe that we will all eventually -- and probably very much sooner than a lot of people understand or think -- we will be all at a level playing field because that's the only way it's fair."

Japan has not directly intervened in the currency market to devalue the yen for five years, despite indirect intervention via monetizing hundreds of billions of JGBs every year. At last check, the BOJ owned over just 40% of all outstanding Japanese bonds. That said, last April, when the yen was strengthening, Aso said the ministry would take necessary measures if needed. With Japan's auto exports to the U.S. now on the rise, a weakening yen is prone to tempt Trump to criticize.

It is quite possible that the economic dialogue may exacerbate the exchange rate friction. The dialogue will cover both fiscal and monetary issues. Just as the strategic dialogue between the U.S. and China includes the heads of both countries' central banks, the Bank of Japan will be part of the macroeconomic talks. But some in the financial markets worry that having the BOJ involved in the process will limit its options; Trump has criticized the central bank's ultra-loose monetary policy, although when it comes to central bank manipulation, few can have as big an impact as what the Fed has done in the past few years.

At the press conference, Abe stressed that Japan and the U.S. can look to shared interests, like infrastructure. "The latest maglev train will carry you from here in Washington to New York, where Trump Tower stands, in just an hour," he said.

In the economic dialogue, the two countries will not only discuss macroeconomic and trade issues but also seek to cooperate in infrastructure, energy, cybersecurity and space development. Building high-speed railway networks and power stations in the U.S. would create jobs and lead to increased orders at Japanese companies. Working together on cybersecurity and space development could also present opportunities for the two governments to build trust.

But many development projects today are mere plans or proposals. Should bids ever go out on, say, a high-speed train between Washington and New York, the bidding would likely be hypercompetitive.

For now there is just more uncertainty to add - this time on the foreign policy side - to what Stan Fischer explained earlier in the day is already an excess of domestic policy uncertainty. Don't expect that to change any time soon.