“Abenomics” has been likened to the decision to attack Pearl Harbor, to throw a Hail Mary pass and to undertake a bold experiment. Its mix of monetary, fiscal and reform policies championed by Japanese Prime Minister Shinzo Abe, who took office in late December, has won praise from Japan’s major trading partners and the World Bank. But will it work?
As leader of the long-ruling Liberal Democratic Party (LDP), Abe wasted no time in implementing his platform of aggressive monetary easing and stimulus spending aimed at jolting Japan out of its two-decades-long economic slump. The weakened economy has been accompanied by crippling deflation that has discouraged consumption and investment and weighed down wages and growth. Abe needs fast results to ensure a strong showing in upper house parliamentary elections in July that would give the LDP the kind of electoral mandate it wants to push ahead with economic reforms as well as other priorities on its conservative agenda.
So far, the results are mixed, though it is still too early to predict the final outcome. Some of the most important monetary-loosening steps had to wait until April for final approval. But the currency has already weakened considerably since the announcement last fall of the new direction the government wants to take on the economy — down from about 77 yen to the U.S. dollar last October to nearly 100 more recently. That has helped to end a spell of “endaka” or “high yen” rates that further eroded the competitiveness of Japan’s export manufacturers. By April, share prices had surged to their highest level in nearly five years, with investors flooding into the market anticipating an economic turnaround and better performance by major exporters like Toyota and Sony.
The End of Recession?
Japan appears to have edged out of recession late last year and may have turned the corner toward recovery. Still, economists are divided over whether Abe’s effort to “reflate” the economy and stimulate stronger demand, which is intended to bring a virtuous cycle of consumer spending and increased business investment, will actually work. Some experts believe Japan will only achieve sustainable growth if it endures a deeper recession that might force it to make structural changes to deal with long-term issues such as its shrinking and aging population and fading industrial competitiveness. Others are cautiously optimistic about Abe’s initiatives.
The LDP, in past years faulted for building “bridges to nowhere,” has long relied on robust fiscal policy — stimulus spending to spur demand through public works construction. But if larding the economy with pork barrel spending alone was going to work, Japan’s economy would have bounced back long ago, some analysts note. Monetary easing has likewise failed in the past: Interest rates have remained near zero for years, but have not enticed the kind of investment boom needed to spur growth. Consequently, Abe pushed the Bank of Japan (BOJ), despite its ostensible autonomy, to commit to achieving a 2% inflation target within two years. Supporters of this approach further contend that former BOJ governor Masaaki Shirakawa, who stepped down in late March, had failed to ease monetary policy quickly or boldly enough to break out of deflation and that his predecessors withdrew easing efforts too soon — before the economy was sufficiently jump-started.
Finance Ministry veteran Haruhiko Kuroda, who replaced Shirakawa as central bank chief, surprised many in Japan and elsewhere by announcing plans in April to expand the BOJ’s asset purchases so as to double the monetary base — the amount of cash in circulation plus bank reserves — to hit that 2% target. Kuroda also declared that, instead of conducting market operations based on interest rate targets, the price or inflation target would determine BOJ policy. Kuroda has been a long-standing critic of what he believes were timid BOJ monetary policies, and while the general direction he wanted to take the BOJ was clear before he was appointed, observers were nevertheless a bit surprised by just how aggressive an easing stance he has promoted.
The central bank is now buying a wider variety of assets and increasing purchases of longer-term government bonds, with maturities of up to 40 years, to help ensure lower long-term interest rates and to achieve “price stability.” The BOJ is also planning to buy ETFs (exchange-traded funds, which track an index) and Japanese real estate investment funds (REITs). “This is an entirely new dimension of monetary easing, both in terms of quantity and quality,” Kuroda said in announcing the plan. The impact on financial markets was swift: The benchmark Nikkei 225 stock index finished the day up 2.2%, while the dollar gained 3 full yen in currency trading.
A Dramatic Departure
Julian Jessop, chief global economist at Capital Economics in London, likens the Abe-Kuroda shock strategy to a poker player who bets all his chips. “What they have done is basically played all their cards at once,” Jessop says. “There is a risk if broad money and credit aggregates do not pick up and inflation does not pick up. Then, the policy would begin to fail,” he says. But desperate times call for desperate measures, and Jessop says he is cautiously hopeful. “I think the plans they have announced are exactly what is required to get Japan out of deflation and keep the economy growing, even if the demographics turn much less favorable. On paper at least, the policies proposed are exactly the right ones.”
Both critics and supporters of Abenomics agree Japan needs more than just the fiscal and monetary policy changes announced so far to achieve long-term growth. “In the medium and longer term, structural reforms will be needed for Japan to have sustainable growth despite the fact that its working population is steadily getting smaller,” Jessop says.
Therein lies the predicament, according to Masamichi Adachi, senior economist of JP Morgan Securities Japan. “The root of the problem is that Japan has not been and is not able to adjust socially and economically to the shrinking and rapid aging of its population, and to the changing outside world environment, such as globalization,” he suggests. Instead of launching the monetary easing and boosting spending at a time when Japan’s public debt is nearing 250% of its GDP, Abe should have immediately embarked on structural reforms and deregulation — the kinds of tough changes needed to spur innovation and entrepreneurship, create new business opportunities and boost employment, says Adachi, who is also a former BOJ official. He thinks there may be yet more easing if the BOJ’s latest tactics fail to push prices higher within the coming half-year or so.
Masayuki Kichikawa, chief economist and managing director at Merrill Lynch Japan Securities, is more upbeat about the prospects for Abenomics-style progress. Now that Japan has put monetary easing ahead of financial consolidation — expanding liquidity and weakening the yen — there is a greater chance of success, he says. “Japan had more than 15 years of deflation. Even if Japan can achieve a 1% inflation target, that would be a great achievement. In the past 15 years, the central bank and government administrations failed to achieve that. I am confident that Japan will turn its deflation into inflation of 1%, though I am not sure Japan can achieve 2%.”
Risks and Downsides
Apart from the issue of whether Abe and succeeding administrations will actually summon the political wherewithal to push through difficult job market and regulatory reforms over the medium and long term, questions remain about whether the reflation strategy will actually work. “What they are doing is very risky, and it is difficult to make those changes (in Japan),” says Franklin Allen, a Wharton finance professor.
Others, such as Jessop, question whether the monetary moves will be sufficient. “The plan to double the monetary base is absolutely the right thing to do, but my concern is it may not be enough. Japan increased its monetary base by 50% during the earlier experiment of quantitative easing 10 years ago [2001 to 2007]. That had no effect on the broad money aggregate and no effect on inflation either,” he notes.
There are limits to the central bank’s ability to manage long-term interest rates through asset purchases, since ultimately the market is subject to other influences, too. While yields for Japanese government bonds (JGBs) are bound to decline as the price rises due to the surge in purchases by the BOJ, if the 2% inflation target is reached, the central bank has said it will adjust policy for the sake of price stability.
“The first question that comes to mind is, ‘What will happen to the yields of 10-year JGBs?’” asks Allen. “Presumably, they will go up to something like 3% to 4%. The first effect of that is banks are going to be in trouble because they hold a very large amount of government bonds.” As of March 2012, a year before Kuroda’s bombshell, Japanese banks would face a combined 8.3 trillion yen in losses if the benchmark interest rate were to rise by 1 percentage point, according to the BOJ.
Moreover, since Japan’s public debt is well over 200% of its GDP — the highest among OECD (The Organisation for Economic Co-operation and Development) nations — the costs for servicing the debt will skyrocket as interest rates rise. “If the interest rate goes from 50 basis points to 3% to 4%, that means they may have to come up with an additional 6% or 7% of GDP to pay debt forward,” Allen points out. “So that would create a significant fiscal problem. I do not think they (the BOJ and the Japanese government) have provided very good explanations for how they will deal with those problems.”
Costs of a Lower Yen
Meanwhile, the weakening yen is eroding returns on yen-denominated investments and is already leading many investors to seek higher returns by selling their holdings of JGBs. “Kuroda overdid the monetary easing on April 4, which has made many people worried about the future of Japanese government bonds,” says Seki Obata, a professor at Keio Business School and a former Finance Ministry official. Japanese life insurance companies that hold longer maturities of JGBs are worried about the future of JGBs because of recent wild fluctuations in prices. “If life insurance companies think that the yen will continue to weaken, they will start buying foreign bonds without hedging foreign exchange risks. This will cause capital flight from Japan. Now I feel there is a greater possibility for this scenario,” says Obata, author of a popular book titled, Reflation is Dangerous.
Though such trends are uncertain, their potential impact would be massive: While Japanese mega banks hold short-maturity two-year government bonds, the life insurance companies carry JGBs with average maturities of 11 years to 12 years. About 44% of the life insurers’ 332 trillion yen in total assets, or 146 trillion yen, are in JGBs.
So far, officials have explained the wild swings in the JGB market after the BOJ’s April 4 announcement as just temporary adjustments to the central bank’s new buying strategy. On April 5, the yield on the benchmark 10-year government bond fell to an all-time record low of 0.315%, then rocketed to 0.620% before settling at 0.460%. But the BOJ has adjusted its purchasing plans, increasing the number of times per month to eight from six to help smooth out volatility.
Since about 90% of JGBs are held by Japanese and all are yen denominated, the risks of major disruptions or a collapse are limited, says Kichikawa. However, while he supports Abe’s approach, he is among the many who emphasize the imperative to reduce the government’s debt load in the medium to long term. “You have to balance economic growth and restoring fiscal health,” Kichikawa notes.
Meanwhile, the weaker yen already is helping Japanese companies increase their price competitiveness, and it is boosting the value of corporate profits, notes Kichikawa. But those short-term consequences must be fortified with longer-term changes to sustain growth, Adachi and Obata contend. “What Japan needs to attain a higher, sustainable growth rate is for each Japanese to be more productive, more innovative and more competitive,” Adachi says.
Structural reforms, such as allowing greater job mobility, bringing in more migrant labor, encouraging more stable employment for women and fostering more entrepreneurship are the most urgent measures Abe needs to undertake, Adachi adds. “Structural reforms will take a long time but would create real changes in Japan and boost Japan’s longer-term economic growth potential. This is different from fiscal and monetary policy, which immediately helps the economy.” Details of Abe’s reform strategies are due to be announced in June. “That will be just a beginning,” says Adachi, who notes that Japan has made many attempts to deregulate and implement structural reforms before, but failed.
Management by Crisis
In the end, the only way for Japan to truly emerge from its two decades of stagnation is through a crisis — such as a deep recession or a bout of hyperinflation if the BOJ’s strategy gets out of hand, contends Allen. “In the medium term, Japan needs to raise interest rates to a more normal level. That will cause a big recession but is the best way out for Japan.” By a deep recession, Allen means a significant increase in unemployment and bankruptcies for the legions of “zombie” Japanese companies that should go bankrupt, but haven’t, due to subsidies and other forms of protectionism by a government wary of a possible domino effect and surging unemployment. “This would cause great pain for people. On the other hand, 20 years of no growth also caused a huge amount of pain,” Allen says. Among those suffering are the many younger workers employed on temporary contracts, with low wages, scant benefits and few career prospects — who now account for more than a third of Japan’s total labor force.
Perhaps most important of all is the tenuous link between growth and the inflation target. Abe and other LDP leaders argue that by fueling expectations of future higher prices, policymakers can change consumer sentiment, inducing people to make purchases now rather than deferring them — as they have been doing for years in the expectation of seeing lower prices in the future. The surge in stock prices likewise is adding to discretionary income, boosting purchases of luxury items at big department stores.
But critics of the Abenomics strategy question whether consumers, whose purchasing power and real wages also have been declining for more than two decades, are really willing or even able to change their behavior and begin spending more. Abe was grilled by the opposition Democratic Party of Japan’s (DPJ) Banri Kaieda in Parliament in mid-April on the link between inflation and the higher wages and hiring needed to ensure that the economy takes off. Abe merely pointed to the change in atmosphere in Japan since he took over from the DPJ’s Yoshihiko Noda as prime minister in December. Generally, LDP members sidestep such questions, though they say they will reconsider a planned increase in the sales tax if it appears likely that it would undo any progress toward recovery.
Wages, Investment Must Rise
Abenomics will work, but only if wages rise and if companies start investing more, says Kichikawa. “If Japanese companies don’t start investing more or doing more M&A [mergers and acquisitions], then the structural problems will prevail.”
Whether wages will rise will depend, in part, on how much greater demand companies will see as the economy recovers. A significant rise in demand may prompt companies to increase hiring and wages to attract or retain talent, some experts say. Skeptics note that in Japan, as in other industrial nations, labor’s share of national wealth has been steadily declining, and that corporations have usually chosen to use their excess cash assets to expand through overseas M&A.
On April 19, Abe outlined several initiatives for his reform program, including a request to industries to expand maternal leaves to three years to enable more women to return to work after having a child. At present, about 60% of new mothers stop working at least for a few years, and when they return, very few get jobs at their old level. More often only low-paying part-time work is available, such as cashiering at supermarkets. Abe also proposed trial employment programs, increasing the number of students who spend time abroad and taking other steps to make Japanese workers better able to function in a global economy.
If the LDP does as well as expected in the July election — the DPJ was so thoroughly discredited in the lower house election that it is no longer viewed as a viable rival — Abe will gain extra time to carry out his economic agenda, notes Adachi. “We hope that his government will purse a ‘regime change’ of reform, and that the reform agenda will get better focused and articulated than the current cloudy rhetoric of the growth strategy,” he wrote in a recent report.
Allen puts the likelihood of success for Abe’s program at about 30%. “There is a significant chance things will stay as they are now,” he says. However, doing nothing is not an acceptable alternative. Abenomics may be an experiment, but it is one supported by economic theory and by economic principle, says Jessop. “If you are designing the policy on paper, this is what you do. It is all sensible. It may not work, but these absolutely are the right things to try.”