Abe-nomics, Tokyo’s winning the right to stage the 2020 Olympics, modest improvements in the economy and a consumption tax increase intended to signal resolve in dealing with it high government debt levels have given Japan new hope. The Prime Minister has stated that ‘Japan is back!’ But the reality is somewhat different.
Activity is easily mistaken for achievement. The frantic activity of the Japanese government has prompted optimism, notably amongst foreign observers, that Japan can achieve a reversal of its economic drift.
Under second time Prime Minister Shinzo Abe, Japan has initiated an ambitious ‘three arrows’ economic recovery plan, christened ‘Abe-nomics‘.
The first arrow is a Yen 10.3 trillion (US$100 billion) fiscal stimulus program increasing public spending. The second arrow is a further easing of monetary policy to increase demand, investment and inflation to 2%.
The third arrow is structural reforms to increase incomes and improve Japan’s industrial competitiveness and productivity. Japan’s total factor productivity in the manufacturing, non-manufacturing and agricultural sectors is the same as in 1991.
The program is designed to increase growth, income, spending and inflation as well as reducing the value of the Yen to increase Japan’s exports. The hope is that it creates a self-sustaining virtuous cycle of rising prices, rising wages and increasing economic activity.
The policies have all been tried before, with limited success.
The government’s spending program follows 15 stimulus packages between 1990 and 2008. Based on previous experience, it may provide a short-lived boost to economic activity but will not create a sustainable recovery in demand.
Investment will be mainly in non-tradable, non-competitive sectors like public infrastructure and construction, frequently adding to over-capacity and earning poor returns. The OECD recently identified the inefficient and ultimately wasted investment that characterised previous packages.
In celebrating Tokyo’s successful 2020 Olympics bid, Mr. Abe cited the event as ‘a trigger for sweeping away 15 years of deflation and economic decline‘. But the 2020 Olympics, unlike its predecessor, will have limited impact, highlighting Japan’s problems.
Unlike 1964, the economy is much bigger and requirements for infrastructure lower. The new expressways and the Shinkansen ‘bullet train’, launched for the earlier event, will be absent.
Investment for the 2020 event will be modest, with plans only for a new stadium replacing the original 1964 structure. Events are to be staged in compact setting, using primarily existing venues and facilities.
Total Olympics related investment will be much less than the 3.6% of GDP in 1962. The forecast economic impact of the 2020 event is expected to be less than 1% of GDP.
Japan has maintained a zero interest rate policy (ZIRP) for over 15 years and implemented several rounds of QE. The new plan will assist the Japanese government to finance its spending. It may also help devalue the Yen and boost asset prices.
But given that short term rates were near zero and 10 year rates around 0.50% before the announcement of the plan, the effect of monetary initiatives on real economic activity are likely to be less significant
Structural reform requires deregulation of inefficient sectors of economy, opening them up to domestic and foreign competition. Reform is needed of taxation, trade policy, labour markets, environmental laws, energy policy, healthcare, services as well as population and immigration.
Many ‘reforms’ are vague statements of objectives. Many of the ideas are old. Many policies have been tried before unsuccessfully. The required changes are also politically and culturally difficult.
Reform of agriculture would require reducing large or eliminating agricultural subsidies tariffs as well as anti-import restrictions on rice and dairy products. It would require changes in land laws that limit the size of farm plots. But attempts at serious reform put the government in conflict with its own supporters and financiers such as the farm lobby.
Initially, the Japanese stock market responded positively, rising around 70% since late 2012, with foreign buying a significant factor. The Yen fell against the US dollar from around Yen 80 to Yen 100, a decline of around 25%. JGB interest rates fell initially anticipating BoJ buying.
But in May 2013, Japanese financial market began experiencing increased volatility. The stock market fell sharply by over 20%, with daily price moves of 3-7% being experienced. JGB interest rates increased sharply, rising from around 0.50% to 0.90%. The Yen also reversed its fall. Financial market volatility was sharply higher.
The reversals reflect closer scrutiny of the program’s inherent contradictions.
Historically, a 10% fall in the US dollar/ Yen exchanges rate generally results in an increase in GDP growth of around 0.3%. But changes in the structure of Japan’s economy mean that a lower currency may not have the same effect on exports and growth today.
The global economic environment is weak with Japan’s major trading partners such as the US and Europe trapped in an environment of low or no growth.
In response to the stronger Yen and cost pressures since the mid-1980s, Japanese manufacturers have relocated production overseas, reducing the benefits of a lower exchange rate.
Japan’s export industries have declined over the last 20 years. In 1992 Japan exported about 67% of the total exports from major Asian mainland exporters from China, Korea, Thailand, Malaysia, Singapore, Indonesia, India, Philippines and Taiwan.
In 2003 Japanese exports were just over the 30% of major Asian mainland exports. By 2012, Japan’s exports were about 15% the size of these Asian mainland exporters.
Many Japanese exporters based in Japan are financially weak. Japanese firms no longer have a significant technological advantage over competitors, primarily from South Korea, Taiwan or China.
Devaluation of the Yen also pushes up the cost of imports. Since March 2011, Japan’s trade balance has been negative reversing decades of surpluses. This reflects the shift of production overseas by Japanese companies. But the most significant factor is the Fukushima nuclear disaster which led to the shutdown of Japan’s nuclear power plants. This has increased import of fuel, oil and liquefied natural gas.
Increasing inflation to the targeted 2% level is designed to break the hold of disinflation or deflation on the economy. It is seen as essential to strong nominal growth, increased consumption and ultimately reducing debt.
Unfortunately, the simple adoption of a target does not guarantee rising prices. Before the recent initiatives, inflation, including energy but excluding cost of fresh food, fell 0.5% per annum in the year to March 2013, the highest rate of deflation in two years.
There are limited signs of higher prices in the wider economy, at least as yet. The new initiatives may also create the wrong kind of inflation.
Japan needs demand driven inflation, reflecting the effect of increasing wages, higher consumption and increased purchasing power. Lack of income increases, low economic growth and also an aging population means a structural lack of demand. This is exacerbated by over-supply and excess capacity in many industries.
The regulatory environment and benign shareholders prevent industrial consolidation. Low interest rates encourage banks to maintain loans to zombie companies, which can cover the interest cost but have no viable business, preventing rationalisation of capacity. A stagnant market and over supply means permanent pressure on companies to maintain market share and minimal price increases.
Current policies are more likely to create cost push inflation. Devaluation of the Yen has increased the cost of imported goods, such as imported energy costs, which have driven an 11% increase in the cost of electricity.
Higher costs may, in fact, reduce consumption unless incomes rise commensurately. But wages reached their lowest level since 1992 in January 2013, albeit before the current initiatives.
Higher incomes would also increase Japan’s cost structure. In combination with higher energy and other imported input costs, it would reduce not improve Japan’s international competitiveness without significant labour market reforms.
Stagnant incomes are not offset by the wealth effect of higher stock prices. The bulk of Japanese savings are held as low-yielding bank deposits. Over 80% of Japanese households have never invested in any security. 88% have never invested in a mutual fund.
Shares represent around 7% of Japanese household financial assets, compared to around 25% in the US. Rising stock prices affect a very small portion of the population, boosting consumption of luxury items rather than driving broad based increases in consumption.
The conventional analysis that the current initiatives will increase consumption may prove incorrect. Rising costs may reduce purchasing power, unless matched by rising wages and real incomes. This would reduce spending and confidence, reducing the effectiveness of Abe-nomics.
The chances of Prime Minister Abe’s program succeeding are limited. The failure of charismatic and popular Prime Minister Koizumi’s ambitious policies in the early 2000s evidence the difficulty of implementing even modest reform in Japan.
Bloomberg columnist William Pesek summed up the increasing doubt: ‘This faith that Japan is just one huge spending package away from bliss is becoming more detrimental with each passing year and credit downgrade. Abe-nomics really is more religion than reality.‘
Debt and Demographics
Abe-nomics’ ultimate problem is that does not address Japan’s two problem ‘Ds’ – debt and demography.
Japan is one of the most heavily indebted developed countries. Its total debt to GDP is over 500%, compared to the US’s 370%. Japanese gross sovereign debt is around 240% of GDP, while its net debt is around 135%, substantially higher than most developed countries.
The government borrows to finance over 50% of its spending. Prime Minister Abe’s program is likely to lead to further deterioration in public finances.
To stabilise debt levels, Japan would need to move to a structural surplus (budget deficit before interest payments on government debt) of 3-4%, compared to a current deficit of around 8%. Given the lack of growth and deteriorating demographic profile, the required tax increases or spending cuts may not be feasible.
In October 2013, Mr. Abe announced the implementation of an increase in the consumption tax from 5% to 8%, initiated by the previous government. A further rise to 10% is planned in 2015 but is contingent on economic conditions.
Even this modest rise was resisted by Mr. Abe’s own party and advisors. The rise is well short of the 20% rate of consumption tax needed to stabilise public finances, as calculated by economic modellers.
The government has sought to allay concerns on the effects of the tax increase by new public works spending, cash grants and other stimulus measures totalling Yen 5 trillion (US$ 50 billion), absorbing around 60-70% of the revenue generated.
The stimulus, which is additional to the earlier large spending package, is inconsistent with the increase in consumption tax, which was designed to bolster Japan’s ‘credibility’ in financial markets as to its efforts to bring its debt under control.
The government argues that the revenues from the higher tax are permanent whereas the increased spending is temporary. But the government is also looking at corporate tax cuts, which would reduce the long-term revenue impact.
The effect on overall government finances and debt levels depends ultimately on its impact on economic activity. When Japan last increased tax rates in 1997, it triggered a recession.
Although some factors (the Asian crisis, weaknesses in the Japanese banking system and simultaneous reductions in government spending) are not relevant, the effect on the Japanese economy remains uncertain. Given recent improvements have been driven by higher consumer spending, the effects of higher consumption taxes on this trend will be closely watched.
A falling saving rate driven by an aging population and stagnant incomes will increasingly make it more difficult for the government to finance spending domestically, at least at current low rates.
Forecast current account deficits will complicate the government’s financing task. Japan’s large merchandise trade surplus has shrunk and will remain under pressure reflecting weak export demand and high imported energy costs.
Japan may also face increasing stress on its government finances from higher rates. Increased borrowing costs may be driven by several factors.
If Japan has to resort to financing from foreign investors rather than domestic Japanese investors, then its interest rates may increase, perhaps significantly. If current policy initiatives result in inflation reaching its 2% target level, then interest rates on JGBs will need to rise. If Japan’s risk profile continues to deteriorate, then investors may require more compensation to purchase JGBs.
Higher interest rates will increase the stress on government finances. Despite low interest rates, approximately 25% of tax revenue is used to service outstanding government debt, compared to 6% in the US. At higher rates, Japan’s interest payments will be an unsustainable proportion of tax receipts.
Higher JGB rates will also trigger problems for Japanese banks, pension funds and insurance companies. For example, JGBs total around 24% of all bank assets, which is expected to rise to 30% by 2017.
According to the Bank for International Settlements, the JGB holdings of Japan’s banks equate to 900% of their Tier 1 capital, compared with about 25% for UK banks’ exposure to gilts and 100% for US banks’ exposure to US Treasuries. Higher rates increase the risk of a Japanese banking crisis.
An aging population, a shrinking workforce and an increasing dependency ratio of the number of aged supported by a reduced number of workers are integral to Japan’s problems.
Current initiatives will have limited impact on low fertility rates, immigration levels or increase labour force participation rates. Prime Minister Abe’s programs may exacerbate economic risks without addressing the demographic problems.
The policy deficiencies point to several discontinuities.
Like other developed countries, Japan’s deep-seated fundamental problems are within its real economy. It needs to deal with it debt levels, demographics problems as well as declining competitiveness and the industrial leadership that underpinned its recovery from The Second World War.
These structural problems cannot be dealt with by adjustments in fiscal and monetary policy, despite attempts by governments and central bankers to convince audiences to the contrary.
Japan’s Kamikaze Economics
Until 2013 and Abe-nomics, years of disappointing economic data and moribund policy meant that it was fashionable to dismiss Japan. But it remains the world’s third largest economy after the US and China.
Japan is also financially significant. Its large foreign asset holdings, totalling around US$4 trillion, make it the world’s biggest net international creditor. The BoJ is the largest investor in US Treasury bonds, with holdings of around US$1 trillion. Japanese banks, insurers and corporations wield significant influence in financial markets.
Abe-nomics has implications outside Japan. A Japanese recovery would assist the global economy recovery and generating demand for imports to Japan. Japan would also continue to be a source of capital to the rest of the world.
Failure would be equally significant. If economic growth does not pick up then a combination of budget and trade deficits that require financing would affect the global economy. Japan’s overall current account may move into deficit as soon as 2015.
Japan would gradually run down its overseas investments, selling foreign assets and repatriating the capital. The selling pressure would affect prices and rates for a wide range of assets, transmitting financial market volatility.
At the same time, the BoJ’s aggressive monetary policy and devaluation of the Yen may lead to large outflows of private capital from Japan. Seeking yield and preservation of purchasing power, Japanese investors may move money into foreign markets, with destabilising side effects.
In the 1990s, aggressive easing by the BoJ in the aftermath of the end of Japan’s bubble economy led to a large and rapid outflow of capital, fuelling rapid increase in debt levels especially in Asia, which was one of the factors underlying the Asian monetary crisis of 1997-1998. There is now a heightened risk of a repeat of that episode.
The devaluation of the Yen, against other Asian currencies such as the Chinese Renminbi and South Korean Won, increases Japanese export competitiveness at the expense of competitors. It forces affected nations to become ‘shock absorbers’ to Japan’s attempted revitalisation, through reduced exports and lower growth.
But this risks retaliation from affected nations. Facing a reduction in competitiveness, China, South Korean and Taiwan, may intervene in foreign exchange markets to reduce the appreciation of their currencies. Trade restrictions may be introduced to reduce Japanese exports.
In seeking to offset the effect of aggressive Japanese monetary policy, affected countries may be forced to reduce rates, risking over expanding credit supply and increasing the risk of subsequent debt crises.
But ultimately, Japan’s significance lies in the fact that it is a laboratory for the global economic and financial crisis. Japan’s predicament has marked similarities as well as some differences with that in many developed countries. In both its policy successes and failures it may provide a useful guide to the fate of other troubled economies and policy prescriptions.
Prime Minister Shinzo Abe’s program is also evocative of a different episode of Japanese history – theKamikaze or ‘Divine Wind’. By the end of The Second World War, Japan had suffered several crucial military reversals, lost the air war due to losses of aircraft and flight crew and its declining economy made it increasingly unable to support the war effort.
Desperate, Japan used kamikaze attacks against allied shipping where pilots literally crashed their planes into the target. 4,000 kamikaze pilots died. But the poor success rate (only a small number of attacks hit their target) was not able to change the course of the war.
The attacks were based on tradition and culture, embodied in the Samurai and Bushido code of conduct, where death is preferable to the shame of defeat. The current policy initiatives have a desperate kamikaze element. Like the war efforts, it is unlikely to succeed in changing Japan’s economic trajectory.
for Markets and Money
© 2013 Satyajit Das
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money
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