Japan: Abenomics is working, but for how long?

by: Philip Bokeloh

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The Japanese economy has been improving. GDP growth reached 2.3% yoy in the third quarter, boosted by government spending, consumption and investment. Meanwhile inflation picked up to 1.6% yoy. However, the pick up in inflation is partly attributable to the depreciation of yen and the rise in fuel prices. For inflation to become sustainable it is important that wages increase and that the rise in disposable income promotes consumer spending. Such a prospect might induce companies to invest again. Yet companies remain reluctant to share potential profits by structural wage increases and rather rely on one-off bonuses. If the coming wage agreements prove disappointing the likelihood of additional monetary stimulus will increase. Further accommodative measures will create ongoing downward pressure on the yen. The widening trade deficit is also pressuring the currency. However, the deficit is set to decline again once domestic demand softens following April’s sales tax rise.

Reforms are on the agenda

The authorities have been trying to break the deflationary spiral through monetary and fiscal stimulus, and structural reforms. The Bank of Japan hopes to push up inflation expectations with the help of an inflation target of 2% and accommodative monetary policies. The recent increase in inflation suggests this programme is on the right path. The same is true for the fiscal stimulus measures. Additional government spending has boosted growth but doubts prevail with regard to structural reforms.


The government wants to liberalise the energy sector. As soon as power generation and power distribution are separated, electricity costs should fall. Health care is also slated for reform and scale increases should boost efficiency. In addition, new entrants and innovations will have a chance to break through when barriers of entry in agriculture are lifted. The flexibilisation of labour markets should ease the transfer of employees from old to new industries. Once the women’s participation rate starts to rise, the talent pool will be enlarged. A key adjustment role is played by the international trade negotiations and the free traffic of goods, people, knowledge and capital, which should boost productivity.

Though ambitious, it is far from clear whether the current reform intentions will bring about the intended productivity improvement. For starters, the reforms require stamina. It will take years before the adjustments in the energy sector have been passed. Continuing political support is therefore required. But recent surveys reveal that the government is losing popularity now that people are starting to feel the pinch from some of the reforms. More importantly, the intended reforms don’t resolve the problem of the underlying financial imbalances. While the private sector is saving, the government is dissaving and its financial deficits are mirrored by the surpluses in the corporate sector. These imbalances are set to increase when corporate taxes are lowered by 2.4 percentage points in April.

Government wants firms to invest

The government is implementing the tax reduction in an effort to stimulate investment and the latest confidence indicators suggest that companies are indeed investing again. The Bank of Japan’s Tankan survey has showed an improvement in business sentiment. The large manufacturers’ index increased from +12 in Q3 to +16 in Q4 and the improvement is broad-based. Meanwhile, small manufacturers are also becoming more upbeat. At +1, small manufacturers recorded the first positive outcome since December 2007. The improvement in sentiment can be attributed to the weakening of the yen and the increase in sales and profits.

Still, businesses remain cautious. This can be seen from the downward adjustment in capital investment plans from 5.1% in Q3 to 4.6% in Q4. Businesses are keeping a wary eye on what will happen after April’s sales tax hike. The housing construction and durable goods sectors experienced an increase in demand after the tax hike was approved in October. But demand might soften once the measure has been implemented; the increase in confidence during the run-up to the previous tax hike in 1997 was followed by a drop after the hike took effect. It is, however, unlikely that the 1997 scenario will be repeated. The timing of the measure was quite unfortunate as it coincided with the Asia crisis and spending cuts that were already severe.

Hence, it remains to be seen whether the penchant to invest will experience a sustainable increase. Export-oriented companies have been taking advantage of the weaker yen but the benefits of the depreciation have turned out to be somewhat smaller than expected. Many companies transferred their production facilities abroad during the years that the yen was strong and there are very few signals that they plan to move production capacity back to Japan. It is often more effective to produce and sell locally than to serve foreign markets from Japan. On top of this, knowledge and skills have gotten lost in the meantime.

Wage increases crucial for future spending

The investment decisions of the corporate sector are closely correlated with consumer spending. Long-term prospects are rather weak given a future of population decline. However, a favourable income development could act as a counterweight. As disposable incomes have lagged behind for years, the government is striving for wage increases. Still, companies remain reluctant and would rather share potential profits through one-off bonuses than structural wage increases. Recent remarks by the top management of Toyota and Hitachi indicate some shift in the position of large corporates. But it is premature to conclude that wages at large firms are set to rise or even that other companies will follow suit. Smaller businesses have benefited less from the government policies and are facing a rise in costs due to elevated import prices resulting from the depreciation of the yen.

Downward pressure on yen

If wage agreements prove disappointing, the likelihood of additional monetary stimulus will increase. Spending power will be pressured when the sales tax is raised in April. That could constrain consumption growth and moderate inflation. This risk is far from imaginary, given that the recent increase in inflation is largely attributable to cost-push rather than demand-pull factors. Additional accommodative measures by the Bank of Japan will be required to finally exorcise the deflationary ghost.

The prospect of further accommodative measures will create ongoing downward pressure on the yen. This pressure is heightened by the deteriorating trade balance. While Japan used to have large surpluses, this has changed. In November, the trade balance recorded a deficit of more than Yen 1,000 bn. The deficit is attributable to increased imports, which are expected to soften once the sales tax tariff has been raised. However, the trade balance is unlikely to return to a comfortable surplus again when the rise in domestic demand wanes. Firstly, the fuel import bill increased following the closure of nuclear power plants in response to the Fukushima disaster in 2011. And secondly, it remains to be seen whether Japan can become the export powerhouse it once was, as companies have transferred production facilities overseas.


As the surplus on the income account could not compensate for the trade deficit, the current account recorded a deficit in November for the second consecutive month. For now, Japan’s reliance on foreign investor funding does not pose a problem, notwithstanding its weak government finances. The current account will likely turn positive again once domestic demand softens. This could change, however, if the current account deficit becomes structural. But that may take years, given the substantial income flows from the large saving surpluses abroad.

This publication is part of the Quarterly publication “Global Market View 2014Q1”

Deze publicatie is onderdeel van de kwartaal publicatie “Macro Visie 1e kwartaal 2014”