Japan’s Economy Gets a Boost — But Has a Long Way to Go

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The economic revival strategy prescribed by Japanese Prime Minister Shinzo Abe, dubbed “Abenomics” soon after he took office in December 2012, appears to be nurturing a long-awaited recovery. Even skeptics admit that the combination of extremely loose monetary policy, stronger public spending and reforms meant to foster competitiveness — the so-called “three arrows” of Abe and his brain trust, –have raised hopes among many Japanese, pushing share prices higher. Economists say it is too early to conclude, however, that the economy is on the road to a long-term, sustainable recovery.

“The mood in Japan and in the financial markets is much brighter now than before. In the short-term, Abe is doing well. But I have not changed my opinion about the longer term view on Abenomics,” notes Masamichi Adachi, an economist at JP Morgan Japan Securities Co. Ltd. “It will be very difficult for him to put Japan on track to have annual nominal 3% growth in the next 10 years.”

So far, much of the rebound in growth and market sentiment has resulted from a weakening of the yen that Economy Minister Akira Amari insists is an inevitable side-effect of massive monetary easing by the Bank of Japan. As the BOJ has pumped 70 billion to 80 billion yen a month into purchases of Japanese government bonds and other assets, the currency has weakened. That makes Japan’s exports relatively cheaper in overseas markets, while also increasing the yen-denominated value of repatriated profits of Japanese corporations. The resulting rise in profitability, and anticipation of that windfall, has spurred a rally in share prices (up roughly 55% over the year), helping boost some spending on watches and other luxury products by wealthy Japanese.

Meanwhile, the injection of massive amounts of cash into the economy, coupled with higher costs for imports of food and energy, is helping push prices higher — finally bringing to an end the 15-year spell of deflation that has discouraged investment and hiring by Japanese corporations, allowing Abe to declare initial victory in “reflating” the economy. “Japan’s GDP growth is doing fine now, but much of that is due to the exchange rate,” says Wharton finance professor Franklin Allen. “I am more optimistic than I was before because growth is higher than expected, but there is still a long way to go.”

Mixed Signals

Recent economic indicators are mixed. In November, Japan announced that growth in its GDP declined to 1.1% in the third quarter from 3.8% in the second quarter. Private consumption continued to rise in the third quarter but slowed to 0.4% in the third quarter year-on-year from a revised 2.3% in the second quarter, while public investment growth was 28.7% in the third quarter, up from a revised 20.6% in the second quarter. Weaker private consumption and weaker net profits were the main reasons. “People feel that the economy is picking up and life is much better only because all the Japanese TV networks and newspapers are reporting that the Japanese economy is growing,” notes Seki Obata, a professor at Keio University’s Graduate School of Business Administration.

“I am more optimistic than I was before because growth is higher than expected, but there is still a long way to go.” –Franklin Allen

Obata, author of the book Reflation is Dangerous, suggests that Abenomics-style policies — like “Reaganomics” in the U.S. three decades ago — are based on “trickle down” effects of public spending and enrichment of the wealthy and will not bring long-term stable economic growth in Japan. “Abenomics depends on the growth of old, established major corporations, which are benefiting from the weaker yen and increased consumption by wealthy Japanese aged 60 and over,” Obata says.

So far, for average and younger Japanese, the Abe era has yet to yield widespread improvement in incomes or employment. Most Japanese “are not getting higher wages and are not increasing their consumption. Only the top 10% of wealthy Japanese have increased their spending,” Obata points out.

However much they may fear a loss of purchasing power due to the inflation Abe is so keen to restore, middle and working class Japanese, whose incomes have been declining since 1997, are unlikely to increase spending much without a rise in their base wages, experts say. Unlike their elders, who enjoyed a more affluent era, savings are a luxury for many Japanese families, a third of whom have no savings at all.

“It is too early to say that private consumption is growing, since only high net-worth or rich people are buying expensive luxury items,” notes a spokesman for Credit Saison Co. Ltd., one of Japan’s major credit card companies. “Ordinary consumers are not really spending money like the wealthier individuals in Japan, though overall consumer sentiment is improving.”

And although it was the prudent choice given Japan’s eroding fiscal health, Abe’s announcement on October 1 that his government will follow through on a commitment to raise the consumption tax to 8% in April next year from the current 5% is expected to cast an even darker pall over consumption. Abe, mindful of the toxic impact previous sales tax hikes have had on his predecessors and the economy, has said he will offset the blow with tax cuts, subsidies to low income households and other measures.

Masayuki Kichikawa, chief economist at Merrill Lynch Japan Securities Ltd. in Tokyo, says that Abe’s program is already helping to push incomes higher. Nominal wages increased only 0.5% in July-September from the same period a year earlier, after 1.1% growth in April-June, mainly due to higher bonuses and increased hiring of part-time workers. Base wages have continued to fall.

“Wages are increasing, though it is not stable growth yet,” Kichikawa notes. “It is true that the increase in private consumption has been led by older, wealthy Japanese but it is spreading among other groups. We need the next step of real wage increases in regular workers’ monthly salaries…. Japan will be out of deflation with that next step.”

The Miseries of Endaka

Escaping deflation is essential, but it is only a first step toward a sustained recovery, observers say. Along with extreme monetary easing and hefty government spending — facilitated by Tokyo’s commitment to host the 2020 Olympics — Abe has promised major reforms meant to remove bottlenecks to growth, nurture innovation and improve the nation’s financial health. “There has been a lot of talk about the growth strategy, but there is no action so far,” Allen notes.

Many in Japan are skeptical that Abe can prevail over the many vested interests that so far have fended off deregulation and other attempts to improve the country’s faltering competitiveness. “I doubt he will be able to implement structural changes and deregulation as his growth strategy,” says Adachi, a former BOJ official. “What he can achieve will be little better than keeping the status quo in Japan.”

“… We expect the recovery to start dissipating soon and the inflationary impact of the weaker yen to fade.” –Marcel Thieliant

Apart from those internal headwinds, Japan is vulnerable to any number of external risks, the most obvious the national debt crisis in the U.S. Apart from the unwelcome threat to the credit-worthiness of trillions of dollars in U.S. debt held by Japanese financial institutions, the orgy of ongoing political brinkmanship could one day cause a flight back into the yen as a safe haven, pushing the dollar’s value lower and thrusting Japan back into the miseries of endaka or the strong yen.

If the U.S. were to default on its debt, “that will have a big impact on Abenomics and the Japanese economy, and Japan will not be able to move out of deflation next year. The yen could move to 80 yen to the dollar again and Japan will have no economic growth,” notes Kichikawa. Among other things, Japan would have to postpone the plan to raise the consumption tax in April, he adds.

The consumption tax hike remains a bone of contention in Japan, with some economists, including the main architects of the Abenomics strategy, arguing that it would have been safer to either postpone it or amend it to allow for a more gradual increase. On top of the 3% increase next April 1, another 2% increase a year later will raise it to 10% in 2015. “We need to understand that my administration’s top priority of putting an end to 15 years of deflation is no easy task,” Abe said in announcing the 2014 increase. “Furthermore, it is important to strike a balance between economic recovery and fiscal soundness,” he added.

Abe has promised stimulus measures totaling around 5.5 trillion yen, including cash handouts to low income families and tax breaks totaling one trillion yen for companies, tied to wage hikes and capital investment. Although the decision to raise the tax was taken under the previous, Democratic Party of Japan-led government, the dismal track record for past sales tax hikes suggests Abe did not take the decision lightly.

Economists estimate that the 3% tax hike next April will shift seven trillion to eight trillion yen from consumers into national coffers, while the stimulus package will inject five trillion to six trillion yen back into the economy. Along with Abe’s extra stimulus, the BOJ also may implement additional easing in the first quarter of next year. “Looking ahead, we expect the recovery to start dissipating soon and the inflationary impact of the weaker yen to fade. More easing should therefore still be required in due course,” says Marcel Thieliant, a Japan economist based in Singapore for London-based Capital Economics Inc.

Repaying Debt

With the tax hike looming, economists and analysts expect slower economic growth in the fiscal year starting from April 2014. But most do not expect the hit to the economy to be as severe as in 1997, the last time the sales tax was raised and tipped the economy, already shaken by the Asian Financial Crisis, back into recession. “I think it is unlikely that the tax increase will have such a big impact on the Japanese economy that it will reverse the current trend,” Adachi notes.

Junko Nishioka, chief economist and head of Japan research at RBS Securities Japan Ltd., expects Japan to have only 0.5% full year GDP growth in the fiscal year ending March 31, 2015, down from a forecast of 2.8% in the current fiscal year. “There will be a short-term big shock and the April-June GDP will be minus 5% to 6%, with a recovery after that period,” she says. “In 1997, there was no stimulus package implemented when they raised the tax, while Abe is being pro-active in announcing the new stimulus package.”

“There will be a short-term big shock and the April-June GDP will be minus 5% to 6%, with a recovery after that period.” –Junko Nishioka

Some argue that such low-single digit increases will do little to redress Japan’s dire fiscal situation. “If Japan would like to repay the debt it has accumulated in the long term, [the consumption tax] has to go up to more like 25%. The problem is you need growth to finance it. Japan needs 3% economic growth for decades to repay the debt it has accumulated,” notes Martin Schulz, a senior economist at the Economic Research Center of Fujitsu Research Institute.

Abe had little choice about raising the consumption tax, given Japan’s surging costs for social welfare as its population ages, and its growing national debt, which at nearly 250% of GDP is the biggest among wealthy industrial nations. Financial markets were counting on Abe to deliver on promises for “fiscal consolidation.” A failure to push ahead with the tax hike could have severely shaken investor confidence.

Though Abe appears likely to avoid the fate of other Japanese leaders who have lost their jobs following tax hikes, how the consumption tax will affect his relatively high popularity ratings remains unclear. Apart from the imperative to fix national finances, Abe may be gambling that by biting the bullet on a tax hike now, he will be in a better position to extend his tenure — this is his second term after an abortive first time around in 2006-2007 — in the 2016 parliamentary elections, says Adachi.

A stronger electoral mandate in 2016, if the economy is back on track, would clear the way for Abe to pursue conservative items on his political agenda, such as revising the Japanese constitution to allow the country’s military to take on a higher profile.

Abe’s yet-to-be realized structural reforms and deregulation plans are intended to help spur innovation and entrepreneurship, create new business opportunities and boost employment. Ideally, promises to open markets wider to trade in goods and services under the U.S.-led Trans-Pacific Partnership would create new markets for Japanese farm products, while dismantling barriers that coddle inefficient sectors of the economy. “What they need to do to change Japan is the ‘TPP’ kind of thing and the ‘Third Arrow’ growth strategy. I do not think that much is happening,” Allen notes. Ultimately, he adds, Japan needs to foster growth without having to run long-term structural deficits. “What they need to have is growth without having to rely on government expenditure and stimulus.”

The Luxury of Time

Unlike Greece or Spain, Japan has the luxury of time for drafting and carrying out reforms, since most Japanese debt is held by domestic financial institutions, says Nishioka. “Japanese financial institutions are continuing to buy Japanese government bonds even if Japan’s debt against GDP is above 200%. So the default risk is very low for Japan,” she notes.

But there are limits. Japan’s government debt as a percent of GDP will balloon to 245.4% in 2013, according to Moody’s, quoting International Monetary Fund figures. “Without progress toward eliminating the government’s primary budget deficit, Japan risks reaching a tipping point at which the market will demand a risk premium on [Japanese government bonds], making deficit financing and debt refinance very costly,” according to a Moody’s report on Japan’s consumption tax increase.

That day will come, inevitably, if Japan fails to shift course. Reassured by their country’s 4% official unemployment rate — compared with 8% or more in most rich countries — most Japanese are so far relatively content, and lack a sense of crisis, says Adachi. “I do not think Japan will change unless it experiences a real, painful recession,” he adds.

The question is whether the powerful bureaucrats in Tokyo’s Kasumigaseki district, and the lawmakers who rely on them to draft policy and get things done, will have the foresight and fortitude to carry out reforms needed to adapt Japan’s economy to such 21st century realities as a globalized, converging world and an aging and shrinking workforce.

So far, most officials seem keen to maintain the status quo, and avoid grappling with the profound challenges the country is facing. For all his optimism, Abe himself has said that this may be Japan’s one chance to finally get this right.

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