Is Japan still the Empire of the Rising Sun?

Market analysis - 9/21/2016

The BoJ’s balance sheet rose from 30% to 80% of GDP in three years. Despite these efforts, inflation dropped back below zero at the end of 2015. The government is shifting towards Abenomics 2.0, which reworks the three arrows. Fiscal austerity has been set aside, and the consumption tax increase has been pushed off until October 2019. Japan will have to consider opening up to immigration in view of its ageing population.

After Japan’s economy peaked in 1990, it became mired in decades of deflation. Still today, the value of the Nikkei 225 is half what it was then, and land prices are at their lowest since 1980. This collapse was not a question of chance but the result of a series of disastrous decisions: interest rates were kept too high for a long time, and it took far too long to recapitalise the banking system, which had been destroyed when the bubble burst at the end of 1980s; fiscal policy was tightened just before the 1998 Asian crisis; and more recently, Japan was hit by the global recession in 2008 and the destruction of its nuclear plants during the 2011 tsunami owing to insufficient safety precautions. To top things off, the Japanese population is ageing at an alarming rate. This demographic trend slows productivity gains – the economy’s growth potential – and is a burden on the national budget.


Former Prime Minister Junichiro Koizumi was the first to put in place policy guidelines (Honebuto no hōshin) aimed at kicking off in-depth reforms. He went after commercial banks’ non-performing loans and tried to privatise the postal-savings system. Unfortunately, these efforts failed. It was not until December 2012 that a second knight in shining armour arrived on the scene, Prime Minister Shinzo Abe, who was close to Koizumi. He quickly came up with a new strategy, Abenomics, with three main components (or ‘arrows’): monetary easing, fiscal expansion and structural reform.

Japan’s central bank, the Bank of Japan (BoJ), launched its arrow first. In 2013, BoJ Governor Haruhiko Kuroda embarked on an aggressive government bond-purchasing programme worth $500 billion per year. This was raised to $800 billion in October 2014. The goal was to quickly reach an inflation rate of 2%. The yen then fell 20% against the dollar, raising hopes that deflation had been conquered. Consumer prices also climbed in 2014 at an annual rate of 3%. The good times did not last, however, and inflation dropped to zero at the end of 2015. Not losing hope, Mr Kuroda tried to surprise the market in January 2016 by lowering short-term rates to -0.1% (see charts below). Unfortunately, the yen gained strength and inflation
dropped back into negative territory. But the BoJ spared no effort: its balance sheet grew from around 30% of GDP in 2013 to nearly 80% in 2016. In the space of three years, Japan caught up with the USA and the UK.


Given these poor results, the way forward is unclear. Monetary measures continue to expand, yet the marginal return is diminishing. Creating excess liquidity also has a number of side effects. For one, it distorts the allocation of resources: negative interest rates penalise savings, which are used to finance productive investment; and banks, seeing their profits suffer, hesitate to expand lending volumes, especially to SMEs. The BoJ’s massive purchase of government bonds has also dried up this market, which limits its scope for future buybacks. The monetary authorities are now turning to corporate bonds and the stock market, which could inflate valuations. Some observers expect even more extreme measures, such as helicopter money. This refers to dropping banknotes from the sky, but in reality, the BoJ would subscribe bonds directly from the government and monetise public debt, which would be used to finance infrastructure spending. These could be perpetual zero-coupon bonds, meaning they would never be redeemed and would not add to the cost of debt service. Admittedly, the cost of debt service is not very high right now (0.4% of GDP, see table) because interest rates are low, but it could rise quickly if interest rates pick up. Yet Mr Kuroda does not seem particularly keen on this approach, fearing a speculative
bubble and citing legal constraints.

Now the government is shifting towards Abenomics 2.0, which reworks the three arrows. Fiscal austerity has been set aside, and the consumption tax increase, designed to reduce the huge budget deficit (-4.9% of GDP, see table) and stabilise the massive public debt (131.7% of GDP, see table and lefthand chart below), has been postponed again, from April 2017 to October 2019. At the same time, an additional stimulus package worth 5.6% of GDP has been approved, although this package is mainly a series of measures meant to boost the job market. The actual amount will be less than half of the amount announced. Closer links between monetary and fiscal policy as seen here are increasingly popular in western countries as well.


In any event, these fiscal and monetary policies definitely have a short-term effect on economic activity. Because they do not increase productivity, they do not improve the growth trend or push up wages over the long term (see right-hand chart above). Wages have been pulled downward by stagnating domestic demand, the retirement of relatively well-paid baby boomers and a shift in jobs from the secondary sector to the tertiary sector, which pays less. And it is impossible to create inflation expectations without increasing household income. What is needed is a structural reform programme, especially in the area of employment. Abenomics 2.0 seeks to increase the participation rate, particularly
among women. It also targets the high level of discrimination evident in part-time jobs by expanding social benefits and improving day care for children. A higher minimum wage is under consideration. The programme will address job-market flexibility and employee mobility. The agricultural sector is to be deregulated, and imports will be boosted (trade agreements under the Trans-Pacific Partnership). At this point, spending on food takes up too much of household budgets and cuts too much into their purchasing power. In addition, Japan will need to pry open its doors to greater immigration in order to offset the ageing population. In view of what is happening in Europe, this will not be easy. But if Japan wishes to regain its lost prosperity, it will have to buckle down and implement the necessary measures.

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