By Anthony Rowley
Japan’s economic future remains gloomy. But policy options are limited as reform becomes a dirty word
The R word is looming large over Japan as the world’s second-largest economy threatens to follow America into an expected recession later this year. To complicate matters, Japan has faced a political crisis since the start of 2008 that has deadlocked the parliament and could bring down prime minister Yasuo Fukuda – along with his government.
The economy first started to slip into lethargy after reformist prime minister Junichiro Koizumi left office in 2006. His five years in charge brought the longest economic recovery in Japan’s post-war history and a dramatic revival in the fortunes of the governing Liberal Democratic Party (LDP).
Yet policy-makers now say reform has become a dirty word – and the economy is stagnating. The political fortunes of the LDP have also plummeted, depriving the country of clear economic leadership when it is most needed.
Growth still appears to be healthy – it grew at an annualized 3.7% in the last quarter of 2007, but it was driven by strong exports and corporate capital investment, both of which have diminished as the overall outlook worsened. “The Japanese economy will go through a period of substantial slowdown, if not recession,” the former vice finance minister for international affairs Eisuke Sakakibara tells Emerging Markets. “The economy has been expanding for the past five years, but this is ending now.”
Sakakibara says one immediate threat is endaka – a period of strengthening yen. “Within a matter of six months or so, I think the yen will probably break 90 to the dollar,” he says. Known as Mr Yen during his time in office, Sakakibara could return to power if the opposition Democratic Party of Japan defeats the liberals at the next election, expected to be next year.
“The cause of the cheap yen was low interest rates,” he says. “Japanese individuals and institutions invested money outside the country, and that created the yen carry trade. Since the surfacing of the subprime crisis, interest differentials have started to go down quite significantly, and that wipes out the cause of the cheap yen. A stronger yen will hit corporate profits, which in turn will impact equity prices. At least in the short term, that will have a negative impact on the Japanese economy.”
Successive Japanese governments have pressed the Bank of Japan not to raise interest rates. This is partly to protect the economic recovery, but also because they fear the damaging impact of higher rates on the cost of servicing the government’s colossal burden of outstanding debt – the highest among OECD countries. “In the past, when the government has said something that is not so optimistic [about the Japanese economy], it has been an excuse to exert pressure on the Bank of Japan,” says Mikio Wakatsuki, a former deputy governor for international relations at the BoJ.
Bank vacancy
In recent months it has been particularly vulnerable. When the bank’s governor, Toshihiko Fukui, retired in March after five years in charge, the government was unable to appoint his successor for several weeks. Under Japanese law, the governor and two deputy governors of the bank must be approved by both chambers of the parliament.
The upper chamber, now controlled by the opposition DPJ, blocked both of Fukuda’s initial nominees on the grounds that they were former fiscal policy chiefs at the finance ministry. The opposition said their backgrounds would compromise the independence of the central bank and monetary policy – notions enshrined in the 1998 Bank of Japan Act.
The embarrassing hiatus eventually ended when Masaaki Shirakawa (a BoJ career official) was elevated to the governorship from his position as deputy governor. A compromise candidate, he is believed to be malleable to political influence, but still has the bank’s interests at heart. The prospect of a more independent bank, emerging with support from opposition, is alarming to the liberal party.
The political group has for years been accustomed to dealing with a compliant central bank that will buy government debt and keep interest rates low enough for that debt to be serviced. Under Fukui, the bank had in 2006 managed to raise short-term policy lending rates to 0.5% – ending six years of “zero” interest rates. It is unclear whether Shirakawa will succeed in attaining the bank’s long-term goal of “normalizing” rates.
After embarrassing Fukuda in a year when Japan is chair of the Group of Seven (G7), and when the prime minister is due to host the group’s annual summit in July, the opposition attacked on several other fronts. It blocked tax legislation, forcing the price of gasoline down in Japan, just when it was rising elsewhere, and repeatedly forced the government to use an unpopular veto over parliamentary voting.
Election calls
By April, Fukuda’s personal popularity rating with Japanese voters had collapsed from 60% when he took office in September last year to less than 30% – the minimum figure for a prime minister who hopes to avoid being ditched by his party. He not only faces danger from fellow liberals (the former foreign minister, Taro Aso, is said to want his job), but also from the opposition, which has surged ahead of the government in the polls.
With the political crisis further weakening economic confidence, the government faces calls for an election. “The best resolution is to dissolve the Diet,” Sakakibara says. “But the government will probably not do that until September 2009 because the LDP will likely lose the next election. So, they will try to postpone it for as long as possible. That is very bad because economic conditions will deteriorate, and political confrontation will probably intensify.”
An annual Organization for Economic Cooperation & Development (OECD) report on the economy, published in April, warned that the stronger yen would slow Japanese exports, now the driving force of economic growth. The organization’s secretary-general Angel Gurria also says growth is at risk from lower domestic consumption, hurt by “soaring prices of energy and food [that] are squeezing household income”.
“The ominous outlook raises questions about what policy-makers in Japan can do to support economic expansion,” he says. “In the area of fiscal policy, there is little room for manoeuvre,” and likewise in monetary policy. “The top priority is to reduce the government budget deficit and to stabilize the ratio of public debt, which soared to around 180% in 2007, the highest level ever recorded in the OECD area. Further cuts in government spending will be difficult he said, so consumption tax must be raised and the tax base broadened.
Warnings
Gurria warns that Japan’s economy “will lose opportunities” and competitiveness unless it changes key policies, including a reform of its tax structure. It also needs to raise productivity in its services sector, which accounts for 70% of national output, he says. But the climate for economic reform in Japan is acknowledged to have deteriorated since Koizumi left office, largely because of a popular backlash against income inequalities that reforms are perceived to have generated.
“For the time being, the government is back pedalling on reforms, although you hear about continuation of efforts in rhetorical terms,” says Wakatsuki. “Reform is something like a dirty word now, because some say that the Koizumi reforms have created inequality.”
Sakakibara is also pessimistic about reform prospects in Japan, especially the outlook for increasing business investment from overseas. “The perception of the Japanese economy is not good,” he says. “This is not a place to invest, many investors feel.”
Meanwhile, economic projections are also unpromising. The OECD forecast that Japan’s GDP should continue to grow at a rate of 1.5–2% through 2009. But Gurria admitted on his visit to Tokyo in April that since the report was prepared, the OECD had revised downwards, by half a percentage point, its growth projections for all major economies including Japan’s. The BoJ’s most recent survey of business conditions in Japan (the tankan) added to the gloom when it reported in March that Japanese business sentiment had plunged to a four-year low.
The index measuring sentiment among major manufacturers slumped from a level of 19 last December, when the previous tankan survey was made, to 11 at the time of the most recent survey in March. This was its weakest showing since the final quarter of 2003, and manufacturers said they expected conditions to worsen by June when the next tankan survey is due.
Larger manufacturers say they intend to cut capital spending this financial year to 1.6%, the lowest level in six years. Smaller companies expect to cut capital spending still further – by 24%, which would represent the largest decline since 1999. With consumer and government spending low, corporate spending was one of the few engines still driving growth.
In its absence, the focus will increasingly fall on exports – particularly to China. But with exporters reportedly caught off guard by the surge of the yen, government ministers are concerned. “I am very worried about declines in capital spending plans,” said economic and fiscal policy minister Hiroko Ota. “Particularly for big manufacturers.”