Japan’s economic reform has stalled. But can Prime Minister Shinzo Abe restore confidence?
It’s been a tough few months for those who expected Japan’s economy to pull away strongly under the radical leadership of Shinzo Abe. A bold quantitative easing programme combined with ambitious structural changes seemed to promise so much last summer. But the sharp stock market fluctuations since December have disappointed the Tokyo bulls.
The 1.9% third quarter recession was worse than expected, and the battle against deflation has fallen short. The sales tax reform has had to be postponed, which means no relief for the Treasury. So where do our panel of experts think things are going now?
Many thanks to our panel:
Michael Wood-Martin, manager of the Japanese portfolio for The Bankers Investment Trust PL
John Redwood, Chairman of the Investment Committee, Charles Stanley Pan Asset
Tom Elliott, International Investment Strategist at deVere Group
Will we see a resumption of confidence in 2015, and where will it come from?
The economy has performed poorly since the introduction of the increase in VAT last April and is one of the reasons why the proposed second hike in the VAT charge has been postponed for a couple of years. Inflation too has been trending lower than what the authorities might have expected but this is a global trend with inflation rates slipping elsewhere. The fall in the oil price will only serve to flatten inflation further.
But this is not to say that the authorities in Japan have failed – far from it. Both Kuroda-san of the Bank of Japan and Prime Minister Abe-san remain committed to rejuvenate the Japanese economy. Whilst 2014 was hampered by an increase in VAT the outlook for 2015 should see a recovery in consumption as the benefits of improved profitability feeds through to higher wages and increased corporate spending.
A weaker yen is likely to boost exporters’ earnings and those of their suppliers, but there is a large part of domestic economy that is not benefiting from the falling yen as inflation eats into near-stagnant wages. Certainly valuations are attractive, perhaps over-sold in recent years relative to history and to those of other industrialised nations. But markets can remain miss-priced for a long time. If a sustained rally is to take root, I think it will be as a result of clear political victories in the Diet by Prime Minister Abe, in the area of structural economic reforms.
Japan so far has defied all the rules about public finance and economic progress. Mr Abe’s three arrows meant carrying on with the policies of large budget deficits and money printing that had characterised the previous two decades. His decision to allow the consumption tax hike from 5% to 8% as part of a gradual policy of curbing the large public deficit is credited with setting the economy back, and has narrowed his options further. He now seems keener on growth than cutting the deficit.
Japan borrows more than 40% of the state budget each year. Its total state debts are now more than 240% of GDP, way above the levels of other advanced countries who are trying to get their deficits down. So far Japan has got away with this, as all the money borrowed is borrowed at home, safe from negative effects from a falling yen. The state now owns such a large share of this debt that interest rates have been driven lower despite all the extra borrowing.
2015 is likely to see more of the same. The government forecasts a resumption of growth in 2015-16. They are seeking to persuade larger exporting companies to put up wages, as they are benefitting from a weaker yen and doing well in world markets. They are reluctant to do this, and the government has only limited influence. Meanwhile the large state social welfare budget is directing spending money to consumers.
Prime Minister Shinzo Abe’s “Three Arrows” policy was intended to stimulate business on the tacit understanding that employers would redistribute some of the windfall through bigger dividends and higher wages. But businesses have been slow to fulfil their part of the deal. Why is this, and can Abe do anything about it?
While the First (monetary) and Second (fiscal) arrows of Prime Minister Abe’s “Three Arrows” were easy to dispatch, the Third arrow (structural change) was always going to be the most difficult to implement and measure. Despite some scepticism a number of changes are taking place including a proposed cut in corporation tax, the introduction of a corporate governance code and the promotion of women in the workplace – all changes for the good which should improve corporate profitability.
Wages are increasing but were trumped by the increase in VAT in 2014 – whereas 2015 should witness an increase in real wages. Businesses are fulfilling their role although the Abe administration will ensure that the corporate sector does not slacken off.
Mr Abe’s third arrow of supply side reform has been slow to travel from his bow. Labour market changes and reducing the number of obstacles to competition in sectors like health and agriculture will help. Meanwhile as we wait more progress the markets are likely to respond favourably to yet more official buying of shares as well as bonds, as Japan enters another year when it defies the logic of deficit control and sound finance. The overall tax burden in Japan remains low, with tax cuts for corporations as part of the Abe policy mix.
Political pressure has resulted in the larger companies sharing strong profit growth with workers, through higher wages. This has helped mitigate the effect of inflation and a rise last spring in consumption tax. However, the many more private sector workers that are employed by smaller companies, that can escape government pressure, have seen little or no wage growth and rising inflation and consumption taxes have led to a decrease in living standards.
The link between unemployment levels and wage growth, which is a strong feature in western macroeconomics, does not appear to apply to Japan where unemployment is at a 15 year low of 3.5%.
‘So what?’ an optimist might say. “Japan’s involvement in developing markets, especially China, will carry the day even if the country’s own domestic economy doesn’t improve as hoped.” Is there anything in this argument?
Yes, and it is this that has enabled Japanese manufacturing companies to remain world class. They have kept manufacturing costs down by outsourcing the production to neighbouring Asian countries, enabling continued investment in R&D and in future projects. Meanwhile, high value-added jobs with good salaries have been kept in Japan. Japanese exporters are leveraged plays on global demand.
With the yen so weak, the outlook for exports has greatly improved and exports remain an important driver of the Japanese economy. However with the change in political landscape in recent years the focus has shifted from one of overseas reliance to the regeneration of domestic demand to power the economy.
So, while a cheaper yen should feed through to higher exports and an improved level of profitability for the corporate sector, the main emphasis is on breaking the mind-set of deflation within Japan and creating an environment where the domestic economy enters a period of secular expansion.
The Bank of Japan stepped up its fiscal stimulus last October, but the BoJ governor faced heavy opposition from his own board about the negative impact on the yen. Sure, a cheaper yen helps exporters, but it also makes life harder for consumers who want imports. How can Abe square the circle?
The last quarter of 2014 witnessed a number of surprises from the unexpected move by the Bank of Japan to loosen policy to the snap election (and subsequent victory) by the ruling coalition. Whilst it is true that the weaker yen can be something of a drag for consumers, the prospect of higher wages as a result of a higher level of corporate profitability more than offsets such disadvantage. The drop in the oil price will help consumers too while thepostponement in the VAT hike will also improve the prospects for consumption over the coming year.
It was not only other board members at the BoJ who complained about the weak yen. Taro Aso, Abe’s finance minister, has also complained that a weak yen was counter-productive as it reduced households’ spending power. This reflects a broader global discussion, which is whether quantitative easing is ultimately divisive in a society. It helps to raise asset prices, benefiting those with Japanese stocks and property in recent years (ie the rich and those who have built up some savings).
But, insofar as it suppresses the value of the yen and causes import prices to rise, it hurts the spending power of the young and the poor who consume a greater proportion of their income than the old and rich. Abe is trying to square the circle through moral suasion, asking employees to raise wages ahead of inflation, but with only limited success.
The fall in oil price makes generating inflation as the government wants that much more difficult. Were inflation to take off, of course, the government might find that was worse for Japan and her irregular finances than this long period of price stability and very low interest rates.