Try finding a developed economy where, virtually overnight, most economists have hiked their estimates for GDP growth over the next year. It’s difficult, but that is precisely what many of those following Japan have done.
"We’ve revised our growth forecast for the coming fiscal year by more than 1%, to 2.7%," says Chris Scicluna, head of economic research at Daiwa Capital Markets in London. "I can’t think of any other major economy or large emerging market where we’re likely to make a similar upward revision."
Daiwa’s forecast is by no means an outlier. The government itself has lifted its projection for 2013 growth from 1.7% to 2.5%, while other analysts have made even more dramatic revisions to their forecasts. Morgan Stanley, for example, said in January that it was raising its real GDP forecasts from 0.4% to 1.6% for calendar 2013, and from 1.1% to 2.4% for the fiscal year.
It is not difficult to see why there has been a sea change in economists’ forecasts since December’s general election, which returned the Liberal Democratic Party (LDP) to power. The landslide victory has handed prime minister Shinzo Abe the political room for manoeuvre he needed to push through a far-reaching stimulus package. By tragic happenstance, the catalyst for the so-called "super majority" that the election gave to the LDP was in part the earthquake and tsunami of March 2011 and the fierce public debate about nuclear energy that followed. The result, for now at least, has been an end to the political stalemate, which, as Moody’s puts it, "made it difficult to reach agreement on comprehensive fiscal and supply-side measures to rein in the budget deficit."
Described by Abe as "a clear commitment to economic revitalisation", his ¥10.3tr ($116bn) package is designed to add 2% to annual GDP, create at least 600,000 new jobs and put an end to the pernicious deflationary cycle that has blighted the Japanese economy and depressed consumer sentiment for at least two decades. Forget yes we Kan; think Abenomics.
While analysts are upbeat about the prospects that this ambitious package has created for growth and investment in 2013, they are equally uniform about sounding a warning note for 2014. This is in part because Japan still plans to double its consumption tax to 10% by October 2015 from its current level of 5%, which is very low by international standards, with an intermediate step-up to 8% in April 2014.
Lifting the consumption tax, economists agree, is essential if Japan is to address the issue of its super-sized debt. But doing their bit to chip away at the debt mountain will not do much to strengthen confidence among consumers.
"The problem is that the current plans suggest that fiscal policy will be contractionary in 2014 and 2015," says Scicluna. "First, because the base effects of the extra public works spending mean that lower public investment will subtract as much as 1% from growth in fiscal year 2014. Second, because the impact of the consumption tax, which will bring consumer spending forward to the fourth quarter of 2013 and first quarter of 2014, will lead to a sharp drop in domestic demand in subsequent quarters of 2014."
The growth path, therefore, will be choppy and distorted, he adds. "This raises the issue of whether Abe will look to provide yet more in the way of a stimulus at the start of 2014 to provide an extra cushion to the economy."
The hope — or, more accurately, the gamble — is that over the longer term the main features of the stimulus package will create a virtuous and self-sustaining economic circle, as higher growth and higher inflation feed through to rising confidence and greater tax revenues.
While the stimulus package is clearly positive for corporate profits and equities, its likely impact on the Japanese Government Bond (JGB) market is less straightforward. So too are its long term implications for foreign holdings of JGBs, which by September 2012 had crept up to a multi-year high of 9.1%. This increase, say strategists, reflected international investors’ search for safe haven credits, alongside the pursuit of diversification opportunities, the appeal of a strong currency and the reassurance of the support given to the JGB market by the domestic investor base.
Against the backdrop of the appetite for risk that prevailed in global markets throughout most of 2012, those attractions apparently outweighed the negatives associated with the JGB market. Foremost among those were its famously low yields and the conundrum of Japan’s debt mountain, which at about 230% of GDP — and rising — makes government debt in some European economies look like pocket money.
In a number of ways, the stimulus package and Abenomics in general appear to change the dynamic in the JGB market at a stroke. First, they inevitably increase the supply of Japanese public debt, with market issuance projected to rise in FY2013 to ¥156.6tr, from ¥7.2tr in FY2012.
Second, by strengthening the prospects for rising inflation, and therefore for higher rates, they erode the appeal of longer dated bonds for investors. Koji Shimamoto, head of research at Société Générale in Tokyo, says that he already detects evidence of this dynamic. "The 10 year JGB yield is holding steady at between 0.7% and 0.8%, so on the surface there has been no impact of the stimulus package on the market," he says. "But in the 20 year maturity, the yield has already climbed to more than 1.8%, compared with below 1.7% before the election, so the curve is already steepening at the super long end."
Credit Suisse appears to be relaxed about the outlook for demand at the very long end of the curve. In a recent update, it points out that the ¥1.2tr increase in the issuance of 30 year JGBs should be "easily absorbed", given the rise in insurance companies’ assets of about ¥2tr per quarter. "However," it adds, "absorption of 20 year JGBs may pose a challenge."
Third, by reversing the strengthening trajectory of the yen, which became something that investors could almost set their watches by, it potentially eroded one of the attractions of JGBs to some foreign investors.
Fourth, by stoking expectations of a long-term revival in the Japanese equity market, it may engender a reallocation among some domestic investors away from JGBs and into riskier asset classes. This may be no more than a marginal issue among retail investors, who in any case account for a very small share of total holdings. Even after an advertising campaign designed to bolster retail investors’ participation in JGBs, their share of the market was only 2.7% as of September 2012.
More risk, please
More general shifts in attitudes to risk are potentially a much more serious issue among some of Japan’s giant institutional investors. The Government Pension Investment Fund (GPIF), for example, which is the world’s largest retirement fund, with total assets of ¥107.7tr, has publicly indicated that it plans to reduce its 67% target allocation to JGBs and to increase its holdings in riskier assets. That is likely to mean that the GPIF will add to its modest holdings of ¥9.6tr in international bonds.
Bankers say that the process of adding to their international portfolios has already gathered momentum among Japanese institutional investors in recent months.
"There has been a shift back into selected eurozone government bonds among Japanese investors since the middle of 2012," says Morven Jones, managing director and head of corporate and SSA debt capital markets at Nomura. He says that although many investors remained buyers of the most liquid core European government bond markets throughout the year, there was some retrenchment from the semi-core in late 2011 which began to reverse last summer.
Some Japanese institutions, says Jones, are now branching into less liquid markets in search of a yield pick-up — with Belgium and Austria two examples of higher yielding eurozone sovereigns that have been capturing the attention of yield-starved Japanese institutions.
There is, of course, a barricade in place to shore up the JGB market against selling pressure in the form of Japan’s asset-purchase programme, the scope of which has recently been expanded. "The BoJ’s recent decision to make its asset purchase programme open-ended and continue to buy securities throughout 2014 suggests that it is even more committed to its programme than the Fed is," says Scicluna. "That should keep yields pinned down at the short end of the curve and contribute to further yen weakening."
Less certain is the outlook for yields at the longer end of the JGB market, which was not brought within the scope of the BoJ’s asset purchase programme under the tenure of the hawkish Masaaki Shirakawa, whose five year tenure as BoJ governor has just come to an end. His successor, former Asian Development Bank (ADB) head Haruhiko Kuroda, has reassured markets with his very public commitment to the 2% inflation target, and with his insistence that this is an objective that the BoJ can deliver.
Kuroda is a popular choice as BoJ governor among Tokyo-based bankers not just because of his commitment to Abe’s recipe for recovery. Tetsuya Kodama, vice chairman of Barclays in Japan, says the new governor is known to be a skilled communicator and negotiator, with numerous contacts with key personnel in the international financial community, the so-called "inner circle".
Balance sheet expansion
Irrespective of who stepped into Shirakawa’s shoes at the BoJ, the expectation within the market was that the Bank would bolster its asset purchasing programme.
In a recent economic update, Citi commented that "whoever becomes the next governor is likely to expand the BoJ’s balance sheet aggressively." As well as expanding the asset purchase programme, that implies extending the maximum maturity of the BoJ’s JGB purchases.
At Société Générale, however, Shimamoto cautions against assuming that the BoJ will be able to extend its asset purchase programme to cover the entire yield curve. "Domestic investors are very optimistic that the BoJ will increase the extend the maturity of the programme," he says. "Of course the BoJ will need to move away from its focus on the short end of the curve, so I expect it to add 10 year JGBs to the asset purchase programme. But it will be much more difficult for the BoJ to buy 30 year JGBs because it is unclear what its exit policy would be."
Some would argue that if the Abe stimulus package does lead to some selling pressure in the JGB market, the risk is one that is well worth taking if it is accompanied by a broader move towards increased risk-taking among consumers and within Japanese society at large.
The performance of the Japanese equity market since the election certainly suggests that there is rising confidence that corporate Japan will recover some of its risk appetite. The return of retail investors to the equity market also implies that Japan is rediscovering some of the risk tolerance that has been conspicuous by its absence for two decades.
This is critical, because if Japan is to manage the delicate balance of achieving fiscal consolidation and reviving its economy on a sustainable basis, it will need to encourage the more efficient allocation of its very substantial resources.
Speaking at the Japan Summit in London in January, Tokio Morita, Deputy Commissioner for International Affairs at the Japanese FSA, conceded that the savings culture in Japan remains very "bank-centric". The numbers speak for themselves. Of total household assets of $19.7tr, 55.6% sat idly in bank deposits in the third quarter of 2012, with just 9.5% in equities and 2.2% in bonds. By vivid contrast, of the $53.6tr of household assets in the US, only 14.3% was in bank deposits, with 45.3% and 8.7% more productively invested in equities and bonds respectively.
Unsurprisingly, these figures are mirrored in the funding distribution of the two economies. In Japan, of the $14.4tr of funding in the non-financial sector, 33% is in bank lending, with 34.8% in equity and 7.7% in bond financing. In the US, of the total of $43.7tr, a relatively minor 14% is accounted for by bank lending, with 55% in equity finance and 13.8% in bonds. The balance in the UK is similar. In other words, the capital market in Japan is very underdeveloped in comparison with its counterparts both in the US and the UK.
From a capital market perspective, however, there are a number of risks associated with the pursuit of a weaker yen beyond its possible effect on the JGB market. Some are concerned, for example, about its potential impact on outbound M&A, with a weaker yen perhaps leading Japanese companies to pull their horns in.
A bigger concern is that Abe may now be enjoying a honeymoon period, and that over the medium term some of his targets may be unachievable and his reforms unsustainable.
There are several potentially stiff tests ahead for the Abe administration, with Citi’s latest economic update identifying a number of challenges that may arise in 2014. One is that in the absence of another supplementary budget, public works spending is likely to decrease sharply in 2014.
"Declining public works spending, along with the planned consumption tax hike in April 2014, will probably depress economic activity significantly," cautions Kiichi Murashima, managing director of economics and rate strategy at Citi in Tokyo. "Deflationary pressure could increase again."
"A splurge in fiscal spending could result in sovereign downgrades by ratings agencies," he adds. "For instance, another substantial supplementary budget might lead to downgrades. While not our base-case scenario, significantly higher JGB yields and/or sovereign downgrades may start to take Mr Abe’s hands off the fiscal pump some time in 2013."
Super-majority or no super-majority, Abe is no miracle worker, nor are his refreshingly bold policies a magic pill that will alleviate the vista of economic and social headaches that would beset any Japanese government. There is nothing that his economic reform programme can do, for example, to address the dilemma of the ageing of the Japanese population, which shrank in 2012 for the sixth year in a row, to 128m, and is expected to decline by 30% by 2060.
More immediately, the new prime minister is faced with several risks way beyond the control of his new administration and the Bank of Japan, some of which will call for Abe-diplomacy rather than Abenomics.
Globally, these inevitably include the situation in Europe, continued anxiety about the US fiscal cliff and murmurings overseas about a currency war.
Closer to home, at the forefront of the uncertain geopolitical outlook is the dispute with China over ownership of a cluster of islands in the East China Sea, known as Senkaku in Japan and Diaoyu in China.
Speaking at the Japan Securities Summit in London in January, Yusuke Kawamura, deputy chairman of the Daiwa Institute of Research, was relaxed about the economic impact of the spat with China. He pointed out that at the peak of the crisis, at the end of November, Daiwa had been appointed as one of the arrangers for the PICC IPO, which indicated that Sino-Japanese commercial relationships in the private sector remained cordial.
That may be, but it would be unwise to dismiss the dispute over the islands as a little local difficulty. As Daiwa’s Scicluna points out, at the height of the row, sales of Japanese cars in China plummeted by more than 40% year-on-year in October 2012 alone.
"In January, China’s imports from Japan were still down on a YoY basis by 16%, compared to a rise of more than 15% in China’s total imports," he says. "Although the YoY decline in auto sales eased to about 20% in December, it was still very significant and was one reason why the US overtook China as Japan’s number one trading partner last year."