Will Europe be hit by the Japanese syndrome?

Analysis - 09/11/2017

Almost 30 years after the biggest property bubble in a developed country, Japan looks like a text-book case of chronic economic crisis. But recent economic data appear to contradict this view. Is Japan about to emerge from a long period of stagnation and deflation or is the country doomed to suffer more of the same?

It is a question which does not only concern Japan. During the eurozone crisis, Japan and its “lost decade” led observers to establish a number of parallels with Europe. Latent deflation, economic stagnation or soft growth, ageing populations, high debt levels and chronically low interest rates all suggested Europe was due to suffer Japan’s fate, a striking contrast with the US recovery and China’s economic achievements.

As Europe and Japan share some things in common, Europeans are entitled to ask -five years after the eurozone crisis peaked- if they might follow in Japan’s steps.

The Japanese crisis

Japan was an example to follow for some time but in 1989 the country started to run into major financial and economic problems. After 4 years of accommodating monetary policy designed to halt the Yen’s rise – it had doubled against the US dollar between 1985 and 1988, the Bank of Japan (BoJ) raised its discount rate from 2.5% in April 1989 to 6.5% by August 1990 in an attempt to stifle alarming property market speculation. The bubble had risen to unprecedented levels fuelled by corporate and individual excesses. Hence the seriousness of the crisis and the resulting losses suffered by banks. This brutal correction aggravated a situation where growth was already running out of steam amid the negative effects from the yen’s appreciation.

It was only when a major banking crisis started to loom that the government started to act



The property market correction served as wake-up call and increased Japan’s difficulties. Previously, debt-financed prosperity had papered over the cracks. The reality check was made even more painful by the government’s inability to react appropriately. True, the BoJ’s benchmark rates turned lower from 1991 and continued to fall even after 1994 when G7 countries were doing the opposite, but Japan’s financial system was too  fragile to benefit from cheaper rates.

The government only started to react vigorously when the first firms went bankrupt. In 1998, or 10 years after the bubble popped, they nationalised two specialist lenders, LTCB and NCB. And it was only in 2003 with a major banking crisis looming that the government decided on a legally robust solution. That meant nationalising Resona a large bank. This marked the beginning of the bank clean-up, a process which relied on NPL defeasance structures.

And inevitably, the delay in cleaning up only increased the costs. At the height of the crisis, it was estimated that NPLs represented 15% of GDP, tantamount to the technical bankruptcy of the banking system.

Th background to Japan's deflation

Japan’s vulnerable banking system simply reflected an excessively indebted private sector. This was the main cause of property price deflation, a situation which lasted much longer than the banking crisis itself.

Along with the banking crisis, Japan had to deal with a lasting and profound adjustment to its cost structure. The surge in the Yen between 1985 and 1989 was not the only factor. Despite its public image, the country’s domestic organisation was archaic and highly rigid. Costs in distribution and services in general had long been preserved by numerous agreements between companies but they were forced to gradually come into line with practices seen in other countries. The problem was that the compression of prices in the services sector, the deflationary impact of the higher yen and competition from abroad all weighed on the economy just as land and property prices were falling.

Cost adjustment was spearheaded by a new generation of companies including Fast Retailing and Uniqlo which boosted profits by attacking anomalies and entrenched privileges. This new source of competition added to the downward pressure on prices from imports from China and other emerging countries.

The areas which really illustrated Japan’s deep deflation were land and property prices between 1991 and most of the 2000-10 period (note though that this came after prices more than doubled in 1987-1991). Retail price index falls were more moderate, apart from the 2000-2004 period which saw some significant declines. In other words, Japan was hit before other countries -but for its own specific reasons-by a period of very soft inflation rather than lengthy deflation in the prices of goods and services.

The structural aspects of the Japanese crisis

The traditional keiretsu company model, an industrial group with a bank at the centre, has been called into question. And the limits of Japan’s governance model have been demonstrated on numerous occasions. Moreover, as in other developed countries, automation and computerisation have weighed on wages. Japanese companies have been moving towards international standards but still have room for progress. In far too many cases, they have been too slow to make adjustments to an economic model that has proved inappropriate or simply out of date.

To make matters worse, Japan’s demographics are adding to the cost from the financial crisis and the subsequent impact on growth and price trends. The falling birth rate has not only hit the working population but has, in recent years, affected the entire population. This in turn has hit growth as well as corporate and government finances.

Changing prospects?

The Japanese model still has some advantages. Many companies have proved dynamic in adapting to different conditions and the emergence of new players and new markets. Their industrial strengths are still intact, innovation is strong and companies have gained by going international and seeking to diverse geographically by making acquisitions abroad. They have, in the main, recovered some financial solidity and profitability. Natural disasters like Kobe (1995) and Fukushima (2011) were severe shocks to the system but they also encouraged companies to reinvent themselves. The interruption of nuclear electricity production at Fukushima led to a surge in natural gas imports and threw the trade balance out of kilter. It has, however, now recovered and there was a surplus in June 2017. Japan was hit by the slowdown in emerging countries but is now gaining as their economies recover.

One of the most encouraging aspects is the recovery in corporate investment



Economic data in recent quarters have shed new light on Japan. For the first time in 20 years, Japan has notched up six quarters of growth in a row. One of the most encouraging aspects is the recovery in corporate investment. Japanese companies had continued to expand abroad, especially in emerging countries, but domestic investment had stalled. But it has recently picked up pace, a positive factor for growth but also a sign that confidence is returning after a long period of defensive behaviour and withdrawal.

Abenomics

Can we conclude that Shinzo Abe’s policies have been successful? He has been prime minister for 5 years and on October 22 won his third election. In fact, his reform programme has been rather timid and its trajectory uncertain. And the 2014 rise in VAT was incoherent. Shinzo Abe has been a shrewd operator but shifts in Japan actually owe more to companies than government initiatives to promote structural changes. The government’s main contribution has been to stimulate the economy by spending.

Monetary policy has proved the most decisive aspect of Abenomics’ three main pillars. From 1999, the BoJ singlemindedly conducted unorthodox monetary policy which was also designed to prevent the yen appreciating. The bank stepped up its efforts from 2015 and bought assets worth the equivalent of $700bn a year. Its actions may have been somewhat erratic but they have played a decisive role in recent quarters. It now holds 44% of Japan’s government debt.

The official end to deflation

Year-on-year CPI has been positive since the autumn of 2013, apart from a brief episode in the second and third quarters of 2016. Declaring the official end of deflation will require no repetition of such negative quarters. In 2006, the government set up four indicators: as well as the CPI and the GDP deflator over a year, they included the annual change in unit labour costs and the output gap. Between 1995 and the summer of 2017 there had not been one quarter where all three YoY indicators and the output gap were positive!

The CPI (YoY) has been positive since the fourth quarter of 2016. Actual growth rates have once again been higher than potential growth for three quarters and the BoJ says the output gap is therefore in positive territory. According to the OECD, unit labour costs have been growing each year since 2015 (with the exception of the first quarter of 2017).

Only the GDP deflator remained negative in the second quarter of 2017. This was due to steep rises in import prices which only had a very limited impact on the CPI. But the deflator could very well turn higher over a year when the next report is released and it will almost certainly do so before the end of  2018 due to base effects.

This means the Abe administration will be able to proclaim the official end to deflation in a matter of months, if not weeks. Even so, the BoJ still has its work cut out with inflation which is still largely below the official 2% target. For proponents of the Philips curve (the historical inverse relationship between rates of unemployment and corresponding wage inflation), Japan is still partly an enigma. After all, the job offer/job seeker ratio has hit 1.49, its highest level in 43 years. The unemployment rate fell to 2.8% in July. But the difficulty companies experience when hiring has not yet fed through to overall wage inflation. The persistently high percentage of employees staying in the same company for their entire career has put on lid on wage rises as long as inflation remains tame and the traditionally low participation rate for older people and women has more or less helped fill job offers.

Will Europe go through a Japanese phase?

The European crisis has played out very differently from Japan. Inherent weaknesses from a single currency zone have added to each country’s specific difficulties in dealing with property market corrections, low productivity and overstretched government finances. Bank fragility is the one thing they have in common. This stems from the rise in non-performing loans during the 2007-8 financial crisis which the eurozone’s sovereign crisis only made worse.

A Japanese-style crisis was avoided thanks to the ECB’s unorthodox monetary policy



Like Japan, Europe’s banks and regulators went through a period of hesitation but eurozone governments and EU institutions were much quicker to react, albeit in ways that sometimes looked like improvising. A Japanese-style crisis was avoided thanks to the ECB’s unorthodox bond buying and a series of rate cuts as well as the introduction of bank liquidity measures at the end of 2012. Despite highly complex collective management, Europe managed to introduce new arrangements like the (as yet unfinished) banking union and the resolution mechanism. It also set up a European regulator in the form of the Single Supervisory Mechanism (SSM). Of course, the EU’s very moderate retail price inflation is worrying but the threat of genuine deflation has now been ruled out. Some European countries have seen a drop in property prices but with no mediumterm decline in prices for goods and services. In September, the eurozone’s retail price index was up 1.5% over 12 months (+1.1% ex food and energy).

And the recovery in EU corporate and consumer confidence is reflected in the synthetic economic confidence indicator which has now hit a 10-year high. European budgetary policy was restrictive for a long time and thus very different from Japan’s focus on economic stimulus. But Europe has now turned less orthodox, a move that is reinforcing the potential for growth. Countries like France and Italy, which were the slowest to recover, have been making up the lost ground.

Japan's lonely road

Japan’s population is ageing faster than anywhere else in the world and its demographic decline is now a fact. The population is shrinking by more than 200,000 a year and the UN expects it to have contracted by 15% by 2050. Japan has always refused to resort to immigration whereas Europe has often been reluctant but generally more open. This is largely a cultural issue and the current Japanese government looks unlikely to change that.

Japan’s population is ageing faster than anywhere else in the world and its demographic decline is now a fact



Japan’s debt has stabilised at more than 230% of gross GDP but it is still an open question. Analysts have frequently warned of imminent crises but falling nominal rates and central bank and bank asset purchases have prevented these happening. But with the government deficit at 4.2% in 2017, can Japan afford to see it rise further? Ironically, any BoJ success in raising inflation would create problems for the government debt. The bank has so far opted to keep 10-year interest rates at zero. If the Fed and ECB managed to normalise their monetary policies, the yen could very well be the adjustment variable in an increasingly untenable situation.


Japan-Europe: the parallel is more apparent than real

Europe’s economic situation generally looks better than Japan’s. Both zones have things in common but there are profound differences. Both have ageing populations but Europe is declining at a slower pace. Germany is expected to see its population fall by 3% by 2050 whereas France’s is seen increasing by 9%. Labour market rigidity is also higher in Japan where “flexicurity” reforms have not yet been introduced.

Europe’s companies have generally moved faster than Japan’s. Restructuring has been faster and strategic rethink deeper. As a result, GDP per hour worked is $45 in Japan or much lower than the $60-70 seen in France, Germany and the US.

Persistent worries over government debt are another thing in common. in the eurozone, debt represented 89.2% of aggregate GDP (83.5% for the EU) but with very different figures for Germany (68%) and Portugal (125%). Europe’s governments have abandoned austerity in the last two years but with the average eurozone deficit running at 1.5% in 2016, they are clearly still committed to some form of budgetary discipline. Fortunately, the task will be made easier with tax revenues from the ongoing recovery.

Japan is the world’s third largest economy and its biggest creditor. It has frequently proved its ability to rebound. As for Europe, it would be rash to be over optimistic about its problems but the coming months could see a number of deep-seated initiatives. This will first mean long and difficult talks but Europe’s economic, structural and institutional aspects now offer strong potential for a recovery, future development and openness that are a long way from Japan’s unique situation.

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