Japan took an important step in starting the long process of repairing its government finances by increasing the sales tax rate at the beginning of April. In the run-up to the increase, domestic demand boomed. It is therefore expected that demand will fall temporarily in the second quarter. Profits are high and access to bank credit has been eased for companies. The elevated investment activity will lead to a further improvement in the labour market. This props up disposable income, despite the increased price pressures. The Bank of Japan (BoJ) is making progress in turning the deflationary tide. Yet, a stepping up of monetary easing is likely. Exceptionally loose monetary policy will keep interest rates low and put pressure on the yen.
Milestone in history
Japan took an important step to restore order to its government finances. As of April, the sales tax rate increased from 5% to 8%. The next adjustment, to 10%, is planned for October next year. The OECD estimates that each increase of 1 percentage point generates 0.5% of GDP tax revenue. Hence, the planned adjustment to 10% will help structurally improve the budget by 2.5 percentage points.
The adjustment of the sales tax rate marks a milestone. The sales tax has been an agenda item since the 1970s, but tariff increases have continuously been postponed. Back in 1997, policymakers actually did agree to raise the tariff. However, their timing couldn’t have been worse as it coincided with spending cuts, the Asian financial crisis and a domestic banking crisis. The ensuing recession was so deep that plans to raise the sales tax rate were shelved for a long time.
On this occasion, history will likely not repeat itself. The international environment is far more favourable for Japan than in 1997 and the domestic economy is far stronger. GDP growth reached 2.5% in the final quarter of last year. The growth was completely due to domestic demand. The most important contributions were made by consumption and investment, which respectively added 1.3 and 1.2 percentage points to growth. The government made a positive contribution of 0.4 percentage points. Meanwhile, the external sector and stocks reduced output growth by 0.2 and 0.1 percentage points, respectively.
Consumption rising in run-up to tax increase
As mentioned above, the strong rise in consumption is partly related to the increase in the sales tax. In anticipation of the rise, households brought forward purchases of durable goods. For example, the number of car registrations rose by 20% yoy and flat screen TV sales have gone up. Apart from these purchases, households also spent more on home maintenance. Consumption will probably drop temporarily in the second quarter due to the increased sales tax rate, all the more so as households brought forward purchases. However, in the third quarter consumption growth may again record a small gain.
A foreshadowing of the temporary spending dip is clear from the recent decline in consumer confidence. After hitting a high in September, consumer sentiment has continuously fallen. An important cause is the rise in inflation. Consumers are increasingly convinced that inflation will continue to increase. The rise in the output gap, which measures the differential between actual and potential production, confirms their belief.
The increased price pressure, and expectation that inflation will continue to increase, are actually positive developments and evidence that the Bank of Japan’s aim to turn the deflationary tide is succeeding. Inflation is currently at 1.5%, a major change compared to the beginning of 2013, when prices were still declining. It should be noted, however, that the increase in inflation is mainly the result of the lower exchange rate of the yen and the increase in energy prices. To ultimately quell deflation, the BoJ will have to step up its aggressive stance with an extension of its asset purchase programme. This will keep capital market interest rates low and pressure the yen even further.
Wages continue to rise
An opposite development to the loss in purchasing power as a result of higher inflation, is the improvement in the labour market. Last year, employment rose by 0.7%, while the labour force only increased by 0.3%. As a result, unemployment declined from 4.2% of the labour force in January 2013 to 3.6% in February 2014. The ratio between vacancies and job seekers has reached the level of 2007, when the economy was at full steam. The low unemployment rate increases employees’ negotiation power in wage settlements. This is confirmed by the fact that wages are rising again. Last year, wages increased by 0.2% after having declined by 0.6% in the year before This helped to prop up disposable income, which rose by 0.3%.
Wages are also set to rise in 2014, not least because many major employers have responded to the government’s call to compensate their employees for the increased tax burden. Employers have room to do so, as company profitability has improved strongly. Corporate profits increased in 2013 by 20%. The 1.9% increase in productivity helped lower unit labour costs as well as boost profits.
The improvement in profitability gives companies the scope to invest. Extra financial means are available now that credit conditions have become more lenient and banks are keener to extend credit. Outstanding credit increased last year by 1.8%. The more favourable credit conditions are related to the BoJ’s massive bond-buying scheme. The resulting liquidity is increasingly being used by banks to extend credit.
Producer sentiment high
Producer sentiment has improved considerably thanks to the favourable profitability trend and more lenient financing conditions. The PMI indices of both the services sector and the manufacturing industry are far above 50, which hints at a further increase in activity. The All Industries Index is approaching the record level of 2007 and the Tankan Survey is at its highest point since 1992. In this leading survey, entrepreneurs have indicated that they are more optimistic about the future. Domestic demand and profitability are perceived as encouraging. And companies are indicating that they plan to hire more workers in the future, although they are somewhat hesitant on the outlook for the second quarter.
The restraint regarding the prospects for the second quarter are also reflected in the Economic Watchers Survey, which declined sharply last month. The outcome for February was a first signal that industrial production growth will temporarily fall back. Production increased that month by 7% yoy, which is rather good, but much lower than in January when production reached its peak with an increase of 10.4%. The extra production of cars and construction materials accounted for the increase. In anticipation of a temporary recoil in demand, companies are using their stocks.
Meanwhile, the corporate sector needs to improve its competitiveness. While Japan ranks 9th on the Global Competitiveness Index of the World Economic Forum, its companies increasingly have difficulty competing with their foreign peers. The continued deterioration of the terms of trade might be a sign of a lack of innovation. Even the strong depreciation of the yen hasn’t turned the tide. As a consequence, export growth lags import growth and the deficit on the trade account is continuing to increase. The current account also turned negative in the first two months of 2014. However, this outcome is related to the temporary rise in domestic demand. Soon the current account will be in positive territory again.