Although international opinion on the prospects for Prime Minister Shinzo Abe’s economic reform package has been mixed, the domestic electorate appeared to give his administration a resounding thumbs-up in the Upper House election in July.
Abe’s Liberal Democrats (LDP) won more than 50% of the seats contested, with its coalition ally, New Komeito, gaining a higher than expected 11, meaning that the government now holds majorities in Japan’s Upper and Lower Houses for the first time since 2007.
The result, as Daiwa noted in an update published soon after the election, is that “hopes are high that Sunday’s election will put an end to the political paralysis that has plagued Japan in recent years.”
The government’s landslide victory, and the devastating rebuff given by the electorate to the main opposition party, the Democratic Party of Japan (DPJ), hands the prime minister a strong mandate to push ahead with a bold economic agenda aimed at calling time on Japan’s two-decade long deflationary cycle.
His formula for long term economic revival is based on a cocktail of monetary easing and fiscal stimulus, laced with proposals on long-overdue structural reforms aimed at stoking economic growth.
The scope of the stimulus, outlined at the start of April by new Bank of Japan (BoJ) Governor Haruhiko Kuroda, is unprecedented in scope and took virtually everybody — locally as well as internationally — by surprise. “The policy package BoJ decided was much bolder than expected,” said Nomura in an update published soon after the “historic” BoJ meeting. “Not only [did the] Bank deliver almost all policy options the market expected in one go, but it exceeded market expectations in some areas: quantity and quality of asset purchases, communication strategy, and Governor Kuroda’s stronger leadership.”
Collectively known as Abenomics, the potential ramifications of the prime minister’s three-arrowed initiative spread well beyond Japan. As the IMF observed following a visit to Tokyo in May, “the rewards of a complete package of reforms are potentially large. Successful implementation would not only benefit Japan, but also strengthen growth and stability of the global economy.”
The broad consensus among analysts in the immediate aftermath of July’s election was that it would be positive both for the Japanese economy and for its capital market. Commenting on the election results, Morgan Stanley identified a number of key implications that were likely to be welcomed by investors. With Japan’s Diet no longer split or twisted, legislation can now be passed more quickly, the bargaining power of vested interests has been weakened, and the process of economic reform can be accelerated. “On balance,” said the Morgan Stanley note, “we believe the election result will likely raise confidence in exit from deflation, and in acceleration of economic growth.”
Nomura reached a similar conclusion in its assessment of the market impact of the Upper House election, describing the ending of the split Diet as being of most significance for economic policy. “The split Diet had in many cases been responsible for holding up policy decisions in Japan, and we think the ending of this situation should make it easier for the government to push ahead with Abenomics and its growth strategies,” Nomura advised.
Three arrows; four barometers
Perhaps the outcome of the Upper House election, and even the influence of Prime Minister Abe himself, should not be overegged. Some argue that Abe — and the ambitious reform programme named after him — has acted as a catalyst for a revival that had already begun long before last year’s election, rather than as an alchemist responsible for an overnight transformation of the Japanese economy. “There is a popular misunderstanding that Abenomics has been the only driver of Japan’s economic recovery,” says Takuji Aida, chief economist at Société Générale in Tokyo. “People forget the importance of the reconstruction after the disaster of March 2011. Japan’s biggest economic problem is its excess corporate savings, and the cyclical recovery began when those savings started to decline. This began to happen before Abenomics, which strengthened the recovery.”
Many would argue that there are at least four barometers suggesting that the Abe-Kuroda plan is already delivering on at least some of its pledges. Equities may have lost some of the fizz that they enjoyed in the first six months following Abe’s victory in the general election of December 2012. But the explosive performance of the Nikkei-225 and Topix indices up until the end of May suggested that investors were prepared to reassess their views of the prospects for Japanese growth. More specifically, it suggested that they were prepared to buy into the story of a longer term weakening of the yen — which is the second key by-product of the LDP’s economic agenda.
The slide in the value of the Japanese currency, down about 25% since last year’s election, feeds straight through to the bottom line of Japanese exporters, with each one yen decline against the dollar adding an estimated $350m to the earnings of the car manufacturers alone. Its influence on inflation is less striking, with Citi estimating that a 10% depreciation in the value of the yen versus the dollar adds 0.37% to headline CPI in the first year and 0.42% in the second. But every little helps.
A more controversial barometer of the impact of Abenomics has been the performance of Japanese government bond (JGB) yields since the announcement of the central bank’s initiative on quantitative and qualitative easing (QQE). The intense volatility in the market in the wake of the QQE announcement was understandably greeted with concern, given the banks’ mountainous exposure to the JGB market.
But rising JGB yields were also taken by some strategists as proof positive that the market was expecting Abenomics to deliver on its objective of conquering deflation and achieving an annual inflation rate of 2%. After all, as a recent update from Lombard Street Research observes, “the 2% inflation target, if deemed credible by investors, should lead over time to the convergence of bond yields to at least the inflation rate.”
More to rising yields than meets the eye
Others argue that to attribute rising bond yields to the expectation of rising inflation is an over-simplification. Tetsuya Miura, head of the fixed income research department at Mizuho Securities in Tokyo, says that the surge in bond yields that unnerved investors in May was due principally to a failure on Kuroda’s part to communicate the Bank of Japan’s strategy for controlling long term interest rates. That miscommunication prompted an apology from Governor Kuroda, since when stability has returned to the JGB market. “We don’t believe JGB yields will skyrocket again, as they did in May,” says Miura. “We expect the 10 year yield to remain below 1%.” That, he says, is because rising yields in the government bond market will be kept in check by the BoJ’s open-ended asset purchase programme.
Koji Shimamoto, branch manager at Société Générale in Tokyo, agrees. “I expect the yield on the 10 year JGB to remain range-bound at 0.7%-0.9%,” he says. “If yields rise higher than this the market will be supported not just by the BoJ, but also by regional banks and life insurers.”
The fourth and most fundamental measure of the effect of the Abe blueprint has been the macroeconomic indicators published in the last six months. To date, the indications are that consumer and business confidence has been given a much-need fillip, with inflation jumping by almost a full percentage point in a May and June combined. “For now at least, data continue to provide evidence that, helped by Abenomics, Japan’s recovery gathered momentum at the end of the second quarter,” Daiwa commented at the end of July.
The release of second quarter growth figures in August, which came in below most economists’ forecasts, at an annualised 2.5%, was taken by some market-watchers as a signal that Abenomics was faltering. That is an unduly premature judgement on a long term programme that will inevitably have plenty of ups and downs. As Lombard Street Research commented after the release of the numbers, “stocks fell on the news. But this is because expectations were unreasonably high.”
Besides, irrespective of short term fluctuations in macroeconomic indicators and financial markets, there is now a spring in the step of Japanese consumers which has been conspicuous by its absence for well over a decade. “Whatever you believe about the motives for Abenomics, the fact that it has created a feel-good factor in Japan suggests that it is working,” says Dr Seijiro Takeshita, director at Mizuho International in London.
Even Japan’s corporate sector, famous (or infamous) for building up vast stacks of unproductive cash, is starting to feel good about the prospects for investment. “Business sentiment is improving,” says Kiichi Murashima, economist at Citi in Tokyo. “In the first quarter of this year, only business investment dropped, while all other components, including exports, private consumption, residential investment and public investment, posted growth. We’re now also starting to see signs that capex is recovering, and we expect it to grow this fiscal year.”
If Abenomics is being given the thumbs-up by domestic consumers and companies, it has also been given cautious approval overseas. Among international observers, the IMF, for one, has welcomed the initial steps in the Abe programme. “We fully endorse the BoJ’s sweeping enhancements to its monetary policy framework,” the Fund reported after a visit to Tokyo at the end of May. “By setting a clear time frame for achieving 2% inflation underpinned by a large-scale expansion of asset purchases, the BoJ has taken an important step for raising growth and inflation.”
Let’s twist again?
So far, so good. But the general consensus appears to be that the Abenomics agenda is now entering into its most challenging phase. “The first two arrows are working, but I’m doubtful about the third, which is creating a foundation for sustainable long term growth,” says Takeshita at Mizuho International.
Others share this concern, but appear prepared to give Prime Minister Abe and his team the benefit of the doubt. “It is impossible to be completely confident about Abenomics as we do not yet have enough details about the third arrow and what truly counts as success will be debatable,” says Jonathan Allum, executive director at SMBC Nikko in London. “However, a number of negative trends that have been a brake on Japanese growth for many years now seem to be reversing. I would highlight the property market, which seems to be coming out of a 25 year bear market, corporate capex, which peaked in 1991, and the fertility rate, which bottomed in 2005.”
A timely warning on the importance of generating long term growth was issued by Moody’s in August. Advising that failure to achieve growth would potentially be the “tipping point” for Japan’s creditworthiness, the Moody’s update cautioned that growth is “a necessary (but not sufficient) condition for reducing Japan’s heavy level of government indebtedness.” Long term government debt is more than 200% of GDP and annual debt refinancing needs are “the highest among mature economies,” according to Moody’s.
Delivering growth will be easier said than done, however, because it calls for an attack on deeply vested interests that are well supported not only across society at large, but within Prime Minister Abe’s LDP. “There are plenty of protectionists within the LDP,” says Shimamoto at Société Générale. “The Diet may no longer be twisted but in some ways the LDP is.”
Creeping expenditure reductions in areas such as medical costs can probably be introduced without provoking too much public discontent as the government sets about its objective of halving the primary balance deficit to GDP between FY2010 and FY2015 and posting a surplus by 2020.
Far more delicate, but urgently required, will be much-needed reforms elsewhere in the economy. These are described by Mizuho International’s Takeshita as the “bitter pills” that Japanese society must swallow if the country is to generate the sustainable growth it needs.
One of these is labour reform. As Lombard Street explains, although unemployment is relatively low — at around 4% — “a dysfunctional labour market is one of the key weaknesses that must be addressed if Japan is to boost competitiveness and its sustainable rate of growth.” Citi’s Murashima agrees, but says that the government’s indecisiveness on labour reform is a good example of an area where Abe’s growth strategy lacks punch. The corporate sector, says Murashima, urgently needs more freedom to adjust labour costs by reducing payrolls rather than relying on so-called non-regular workers, as many companies do today. “This would make it easier to enhance labour productivity over the longer term, which would lead to a rise in per-capita wages,” he says. Little has been achieved so far, Murashima adds, because the government appears to be more concerned about potential short term pressure on unemployment.
The acid test of Prime Minister Abe’s resolve, however, will be his management of Japan’s consumption tax, which at 5% is far lower than its equivalent in most developed nations. Under a schedule originally hammered out by the previous government, Japan plans to increase this tax to 8% in April 2014 and to 10% in October 2015. At the end of July, however, it was reported that Prime Minister Abe had instructed his advisers to re-examine the impact that the tax hike would have on Japan’s economic revival. Since then, speculation has mounted that instead of increasing the consumption tax as planned, the Abe administration may be tempted to back-pedal on the rise, either postponing it altogether or introducing it in a series of pigeon-steps. Citi’s Murashima says he puts the chances of the tax increasing as originally planned at 70%.
|Tokyo 2020 — a gold medal for public confidence|
| For a horrible week or so, it looked as though Fukushima was returning to haunt Japan again. At the end of August, it was reported that contaminated water seemed to be seeping out of the nuclear power station, 145 miles north of Tokyo, that was damaged during the 2011 tsunami. |
That briefly threatened to derail Tokyo’s bid to host the summer Olympics in 2020 — a threat that was serious enough to prompt Prime Minister Abe to cut short his participation at the G20 meeting in Moscow and hot-foot it to Buenos Aires to support the Japanese bid. It was probably an unnecessary trip. Although Madrid gave Tokyo a decent run for it money, Japan had been the bookmakers’ favourite for months.
For an economy where confidence remains fragile, the stakes are high. According to research published by Mizuho, the Tokyo 2020 Bid Committee has estimated that the city’s winning bid is expected to boost GDP by 0.6% (¥3tr) over the next seven years. But as Mizuho’s research adds, this number does not take into account a range of other fiscal, tax and regulatory initiatives included in the government’s so-called “special zone” proposals which will run parallel to the build-up to the Olympics. These, says Mizuho, “could produce an economic impact without much in the way of government expenditure”.
For all the number-crunching that some equity analysts have done on the quantifiable impact of the Games on everything ranging from public spending to equity valuations, the most important by-product may be on public confidence.
“In the same way that the 1964 Tokyo Olympics showed that Japan had entered the ranks of modern industrialised nations, we expect that the 2020 Tokyo Olympics will show that ‘Japan is back’,” Nomura commented soon after the announcement. True enough. But this time around, this is a message that may need to be trumpeted more forcefully at home than overseas. s
That spooks international observers such as the IMF, which has strongly urged the Abe administration to stick to this timetable, arguing that it is “an essential first step to contain fiscal vulnerabilities.” It adds that “the scheduled tax increases… should proceed as planned as they are critical to maintain confidence in the ability of the government to address the fiscal problem.”
That’s easy enough to say if you’re sitting in Washington. It is likely to be less easy to accept if you’re sitting in the Japanese Diet and attempting to orchestrate a sustained economic recovery in which consumer confidence has been fragile for well over a decade. Analysts say that it is especially sensitive as there are no exemptions to Japan’s consumption tax, as there are to Britain’s value added tax (VAT), for example.
Unpalatable though an increase in the consumption tax may be, analysts say that the government simply has no choice but to push ahead with the rise if is to retain international credibility. “Even the opponents of an increase within the LDP understand that if the consumption tax is not raised, it will be a clear trigger for a JGB downgrade,” says Tomochika Kitaoka, senior economist in the equity research department at Mizuho Securities in Tokyo.