- Nearly two years after launching the aggressive stimulus programme, the Japanese economy is not yet back on its feet. Although deflation threats have receded, economic activity is weak. Authorities need to improve confidence to support the transition to an economy led by private sector demand.
- Downside risks to the Bank of Japan’s inflation forecast, suggest further monetary easing will be necessary, while structural reforms will support the economy’s long-term economic performance.
In December 2012, Japan’s authorities set out a new, more aggressive economic programme. The framework of three components – monetary stimulus, short-term fiscal stimulus followed by long-term fiscal consolidation and structural reforms – is progressing at different paces. Aggressive monetary easing has continued as planned and fiscal stimulus in 2013-2014 was followed by a higher consumption tax. Structural reforms are advancing slowly, but there is more to be done in terms of medium-term fiscal consolidation, as well as measures to revitalise the industry and labour market. Recent economic data suggest that results are still modest. We think that Japan is still around halfway in the process of fighting deflation, which has been largely supported by the yen’s depreciation, while economic activity has been weak. Our GDP growth forecast of 1.5% in 2014 and 1.4% in 2015 is dependent on sustained monetary easing and a depreciation of the yen.
GDP growth contracts after tax hike
Recent data suggest that the economy is struggling after the VAT hike. Indeed, Japan’s first preliminary release of the second-quarter GDP showed a contraction of 1.7% qoq (6.8% qoq annualised), compared to 1.5% qoq (6.1% qoq annualised) in the first quarter. We think the weak data largely mirror the effect of the 3 percentage point VAT hike implemented in April, which disrupted spending patterns. Both consumer and housing spending fell significantly in the second quarter following a pre-tax hike demand surge. In any case, the contraction more than wiped out the earlier gain. As a result in the latest statement on the economy, released yesterday, the BoJ presented a more muted picture than a month ago. Going into the second half of the year, forward-looking indicators – including PMI surveys and business sentiment surveys – point to some improvement, at least in manufacturing-related activities. A more positive sentiment towards the economic environment and credibility in the policies being implemented is essential to improve the growth outlook.
Inflation higher as a result of special factors
Headline and core inflation – excluding food – have increased in the past year as a result of the large depreciation (20% since the Abe administration) and more recently as a result of the effects of the consumption tax. Consumer prices increased by 3.4% yoy in July. Estimates suggest that the year on year change of consumer prices, excluding these effects, to be around 1%. The central bank’s forward guidance under the monetary easing framework specified a target of 2% inflation in or around FY 2015. The Governor of the BoJ has emphasised that the central bank will do whatever it takes to keep the inflation target on track. Further monetary easing will be necessary to move inflation back to 2%, not least through another downward leg in the yen. In the long-term structural reforms are needed to put inflation on a secure upward path. For instance, labour market reforms that support higher wages are important for inflation to become sustainable. Recently, wages have shown improvement. The rise in disposable income can promote consumer spending. Such prospects could induce companies to invest again.
Trade deficit starting to narrow
The authorities also expected that the correction in the overvalued yen would have a major impact on the trade balance. However, export growth slowed at the beginning of the year and has only recently been picking up as global demand strengthens. The limited impact of the currency depreciation could be partly explained by the weak global demand for capital goods, given that machinery and transport equipment account for around 60% of Japanese exports. As the global economy gains strength, the demand for capital goods will likely increase. Japan’s export growth to its major partners China and Europe (18% and 10%, respectively) was volatile in the first part of the year, while export growth to the US (15% of the total) was on a downward trend until recently.
When it comes to imports, the pace of fuel import growth remains high. We expect import growth to slow down, however, once Japan’s nuclear power plants resume operations. All this suggests that the trade deficit will gradually narrow.
Fiscal consolidation and structural reforms a priority
Although authorities have made a good start and Japan’s fiscal balance is expected to improve in the short run, the IMF has already warned that the debt/GDP ratio will continue to increase in the medium term. While the IMF sees the second tax rate hike scheduled for October 2015 as a ‘must do’, we think the authorities will link the feasibility of this measure to the incoming economic data. If the VAT rate hike does not go through, we think that authorities may also put off the reduction in the corporate tax rate announced in its June plans. So there is some uncertainty related to these measures going forward. Meanwhile, as mentioned above, almost everyone agrees that reforms should be continued in order to support the battle against deflation. Analysts expect the next round of reforms to lift labour supply and continue with agricultural and services deregulation. Corporate governance reforms are underway to reduce firm’s preferences for cash holdings. A combination of further fiscal consolidation, higher trend growth and low interest rates will be needed to curb the uptrend in government debt.
Japan’s programme is an ambitious one and it will take an extended period for significant progress to be made. Still, it will already be a real step forward if authorities manage to create confidence and improve the business environment as well as unleash savings and consumer spending. But time is ticking. According to the initial guidelines, the public should be persuaded by next year that deflation is part of the past. We think the risks to the outlook are tilted to the downside. The BoJ will likely react with further monetary stimulus. We think that the yen will underperform against its trade weighted basket of currencies as both domestic growth and real yields lag other economies. Indeed since the start of fiscal year in April, domestic investors have increased their overseas investments in search of higher returns. Furthermore an improvement in global growth and investor sentiment will reduce safe haven demand for the yen.