Behind the generally upbeat note sounded by the world’s financial bigwigs about Japan’s economic turnaround, concerns are emerging about the sustainability of recovery in the world’s second largest economy. Beyond the obvious worries about high oil prices, there are fears over whether the Japanese government can handle its massive burden of public debt, and whether the Bank of Japan might abort recovery by raising interest rates too rapidly.
Financial markets are expecting the central bank to go slow on hiking rates now that it has ended its six-years-old zero interest rate policy. But some economists think the markets could be in for a shock.
“It looks as though interest rates will rise more rapidly than previously expected, and higher interest rates mean lower growth,” says chief economist Richard Jerram at Macquarie Securities in Tokyo.
This is not the consensus view among economists, and expectations are that Japan’s current economic recovery, which began in February 2002, is set to exceed the record set by the so-called Izanagi Boom, which lasted from October 1965 to July 1970. Confidence took a bit of a knock in mid August, however, when the Japanese cabinet office announced the GDP figures for the second quarter of 2006, showing that real growth in the period slowed dramatically to just 0.2%, or 0.8% at an annualized rate.
But markets have grown accustomed to good news from Japan, where the economy has expanded for eight consecutive quarters on the back of buoyant export demand, revived consumer spending and strong corporate capital spending. Deflation has declined to the point where nominal growth has edged ahead of real (in Japan’s case, deflation-adjusted) growth, and unemployment has declined. Consumer prices are expected to rise by up to 1% this year.
Lending
Corporate profits have enjoyed two years of double digit expansion, cash flows have improved, and the mountain of corporate bad debt left behind in the wake of the collapse of the bubble economy has reduced dramatically. Meanwhile, Japan’s leading banks have slashed their non-performing loans from 8.8% of total lending to nearer 2%, and bank lending has begun expanding for the first time in six years, which augurs well for growth, some say.
Economics and fiscal affairs minister Kaoru Yosano insists that Japan’s economy is still on track for a 2.1% real growth in the current fiscal year, despite the second quarter slowdown. The OECD in its annual Economic Survey of Japan published in August predicted that the economy would achieve real growth of 2.8% in calendar 2006 and 2.2% in 2007. Macquarie’s Jerram has revised down his forecast for fiscal 2006 growth but is still looking for 3.2%.
Tensions
Beneath the surface, however, signs of strains are increasing. In July, the Bank of Japan took what elsewhere might have been seen as a minor decision, but which for Japan’s central bank was momentous, to raise its overnight secured call lending rate by 0.25%. This was not just one of many US Federal Reserve-type increments but instead the first time that Japan had experienced positive official short-term interest rates in six years.
It was a momentous decision because at the time when the BoJ implemented its zero interest rate policy (following this up shortly afterwards with “quantitative” monetary easing, whereby the Japanese banking system was flooded with excess liquidity), Japan was on the brink of a deflationary spiral and of systemic financial problems. When the BoJ had tried to reverse zero rates before, the economy plunged into recession.
BoJ governor Toshihiko Fukui decided to resist intense political pressure and ended first the quantitative easing regime, and then the zero interest rate policy. He has come in for a barrage of criticism since. OECD chief Angel Gurria warned in Tokyo that Japan could slide back into deflation if interest rates rise too fast, and suggested that it was better for the BoJ to err on the side of raising rates too slowly (risking inflation) than too fast (risking deflation). IMF managing director Rodrigo de Rato delivered a similar message to Fukui when he was in town in August.
It is not so much fear of deflation that worries Japan’s finance minister, Sadakazu Tanigaki, however, as the implications of rising interest rates for the government bond market [see interview]. Gurria noted during his visit to Tokyo that Japan’s outstanding general government debt has now reached an all-time record high for any OECD member country equal to 170% of GDP, and both he and de Rato insisted that the problem must be tackled urgently.
But this is going to take a combination of further cuts in government spending, a broadening of the nation’s tax base and a hike in the national consumption tax as well as other government levies. This in turn means that Japan can expect to be flying with one engine – public spending – out of action for some considerable time, and the export engine could falter too, some economists say. If so, monetary tightening could spell the end of Japan’s economic recovery. “What we are worried about is that interest rates in Japan could go up too early and too fast,” says OECD economist Randall Jones.