Japan: The third arrow will be easier to let fly

Market analysis - 4/25/2016

Economic growth is too weak to support another hike in the consumption tax next year. Since Abenomics has failed to deliver the hoped-for results, the BoJ will have to take bolder action.

Japan's economy is on the verge a fourth recession in less than six years (see left-hand chart below). GDP growth was just 0.4% for all of 2015, billed as the year of the big bounce. To make matters worse, the latest quarterly Tankan, or economic survey, showed that the mood among top executives in the country's leading corporations was souring (see right-hand chart below).

On our estimates, the Japanese economy has a potential growth rate of about 0.7% a year. The main reason why the pace has slowed so much is that the population is shrinking, by about 0.2% a year. In comparison, the population is expanding 0.5% a year in the Zone Euro and 0.9% a year in the United States (see left-hand chart below). In these circumstances Japan's total output of goods and services can only grow if Japanese workers boost their low level of productivity (see right-hand chart below). Unfortunately that would require sweeping reforms, including moves to modernise the labour market that the Abe government does not seem inclined to implement.

We should remember that, for three years now, Prime Minister has been trying to shore up the supply side of the economy. The first two arrows of his grand programme, Abenomics, consisted in cutting corporate taxes and orchestrating a fall in the yen, in a bid to encourage companies to invest and raise workers' salaries. But firms have not used their profits for those purposes. This year again, the shunto (spring wage negotiations) will probably end in gridlock. Most companies have offered pay rises that are significantly lower than those granted in 2015, claiming that the outlook for inflation is not at all encouraging enough to justify larger wage increases.


Now it is the third arrow of Abenomics, structural reforms designed to boost households' net worth (see left-hand chart below), that is essential to stimulate domestic demand and make growth sustainable. Without such reforms the benefits provided by the first two arrows, an expansionary budget policy (see right-hand chart below) and an inflationary monetary policy, will soon wear off and Japan will be left wallowing in the same mire that has prevented it from making much headway for over two decades.


Capital investment and consumption are also struggling. Abe recently went on record as saying that the second two-point hike in the sales tax (to 10%) would proceed as planned in April 2017, unless there was a new financial crisis or major natural disaster. He did not say whether the earthquakes that rocked the main southern island of Kyushu, on 14 and 16 April, marked the kind of "major" catastrophe that could prompt the government to review its position. Based on our own analysis, we believe that the projected increase in the consumption tax is inconceivable a year from now as it would plunge Japan back into recession and deflation. In a bid to drive up the stockmarket, by shoring up investor confidence, Prime Minister Abe prodded the civil servants' pension fund (GPIF) to invest massively in Japanese and foreign equities. The fund has reportedly lost €48 billion (of the €1.05 trillion it manages) in one year. This news could prompt Japanese consumers to save more.

The recent earthquakes raise other questions. Besides worries of new disasters, they are stirring debate about nuclear energy and Japan's electrical power supply. Based on the advice of the Nuclear Regulation Authority the government has decided to continue operating the Sendai plant, whose two reactors are the only ones in Japan that are still functioning.


Overseas Japan's multinationals are being hurt by the economic slowdown in Brazil, China and other emerging countries, where they have invested massively in recent years. They are also suffering from the downturn in orders for Japanese products in the US, most notably mining equipment. In February Japanese exports fell for the fifth straight month, by 4%.


Given the economy's struggle to gather steam, the BoJ could be forced to lower its growth and inflation forecasts and, ultimately, relax its monetary policy further. For the record the BoJ already injects the yen equivalent of about $730 billion a year via its Qualitative & Quantitative Easing (QQE). This unconventional programme distorts the supply-demand balance in the forex market, putting structural downside pressure on the yen. Yet currency dealers have already priced this trend into the Japanese currency's exchange rate (see left-hand chart below). On 29 January the BoJ further decided to lower its deposit rate into negative territory. The bank's governor, Haruhiko Kuroda, said he was prepared to take additional easing measures to spur growth if inflation stayed too far below the BoJ's 2% target (see right-hand chart below). In the coming months the central bank could step up its asset purchases, buy riskier assets, nudge interest rates down further or, more likely in our view, intervene more in the forex market.

The BoJ will probably have no other choice but to do more if it wants to stabilise the yields on Japan's sovereign bonds. The country's crushing public debt is now equivalent to more than 240% of its GDP, a record in the developed world (see left-hand chart below). And it continues to swell by over 4% a year.

Japan's solvency is not an issue, since its government bonds are 92% owned by Japanese citizens (see right-hand chart below). But this comfortable situation is deteriorating as the average age of the population rises. The proportion of Japanese over 65 recently crossed the symbolic 25% threshold. Moreover, to maintain their standard of living, pensioners are dipping into their savings. These nest eggs have so far been made up precisely of sovereign bonds, via postal accounts. In the future, the treasury will have to turn to international investors to finance the public debt. Or, more likely, the BoJ will have to increase its bond purchases. If it does the yen will depreciate as a consequence… and the stockmarket will take off again


Read more:

¨Abenomics Are a Failure, Not a Model¨

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