Japan – Indefinite easing to fight deflation

by: Maritza Cabezas

Japan - Indefinite easing to fight deflation.pdf ()

The centrepiece of Prime Minister Abe’s economic programme is to achieve an inflation rate of around 2% as soon as possible, with a horizon of about two years. But this does not appear to be an easy fix. Although early efforts proved a good start in terms of reviving growth and inflation, Japan seems to have taken a step back since the consumption tax hike in April. At the last Monetary Policy Meeting in October, the Bank of Japan (BOJ) countered deflation concerns by increasing its asset purchase programme to Y80tn. On top of this Prime Minister Abe announced snap elections for December and plans to delay the second sales tax hike. Should this all not be enough to achieve the inflation target as scheduled, we expect the BOJ to intensify monetary easing. We forecast GDP growth of 1.4% in FY 2015 and FY 2016, while inflation should increase modestly to 1.6% in 2015 and 1.8% in 2016. Meanwhile, the divergence in growth between the US and Japan should push the USD/JPY higher, to 125 in 2015 and 135 in 2016.

Consumption tax hike greater impact than expected…

April’s value added tax hike, from 5% to 8%, has had a far greater impact on Japan’s real economy than anyone anticipated. Consumption had been performing fairly well before the tax hike and was in fact one of the main drivers of the recovery. Consumer spending fell significantly in the second quarter after demand surged in the run-up to the hike. This weakness did not spare the third quarter GDP growth. The preliminary estimate for the third quarter declined by 1.6% qoq annualized (was -7.3% qoq in April-June). Consumption which accounts for 60% of GDP remains sluggish. Going forward, we expect only modest growth in 2015 and 2016, while consumption should firm on the back of improving employment and higher purchasing power from lower energy prices, along with the rise in household wealth.



…puts fiscal consolidation at risk

Although fiscal consolidation is one of the commitments made by Prime Minister Abe, the second consumption rate hike has now been postponed. The Prime Minister’s decision to call for an early general election and delay the second increase in the value added tax until April 2017 has sufficient ground, but it also means that Japan’s fiscal viability will be put in question again. The problem is that given Japan’s debt/GDP ratio of 244%, this measure is basically seen as a goodwill gesture for investors and the international community, indicating that Japan is committed to solving its debt problem. Indeed, the IMF and rating agencies see the second tax rate hike as a ‘must do’.

Weaker yen has not helped exports

So far, the effects of a weaker yen on export growth have been disappointing. Authorities anticipated that a weaker yen would fuel export volumes, improve corporate earnings, increase fixed investment as well as wage growth. But up to now, the weaker yen has not managed to revive export volumes. There are several reasons for this. Some export firms are not likely to benefit from a weaker yen since they have to contend with a rising import bill at the same time. This is the case for chemical firms, for instance. Meanwhile, other firms have decided to take this opportunity to restore profit margins, rather than translating gains into lower export prices.



Moreover, structural issues could be behind the weaker exports. Japan’s car manufacturers, for instance, have moved their production overseas, resulting in weaker exports to the US. Our view is that despite the modest impact in this early phase, the yen’s increasing weakness will gradually benefit more firms, resulting in a moderate boost to overall export growth in the coming years.

Reviving inflation a difficult task

Concerns have increased that consumer prices could return to their deflationary path, mainly as a result of the sharp decline in oil prices but also due to weak growth expectations. Indeed, investors marked down their inflation forecasts and even the Bank of Japan signalled a downgrade following the 31 October meeting to 1.7% yoy (ex VAT) from the previous 1.9%. Meanwhile, the BOJ still believes that core CPI inflation will reach 2% in 2H FY2015. We had revised our inflation forecast (without VAT impact) to 1.3% in 2014, which combines the upside of monetary easing, the weaker yen and the downside of lower oil prices. Inflation should increase modestly to 1.6% in FY 2015 and 1.8% in FY 2016.

Further easing to calm deflation concerns

To revive inflation, Japan’s authorities unexpectedly announced in October a two-pronged approach to restore confidence. The BOJ announced further monetary easing in the form of an increase in the targeted annual monetary base growth (from Y60-70 tn to Y80 tn), an increase in yearly JGB (Japanese Government Bond) purchases (to Y80tn from Y50tn), as well as an extension of the average maturity of the BOJ’s JGB purchases to 7-10 years from 7 years. The BOJ governor, Mr Kuroda, surprised markets with the size and timing of the programme. We had only forecasted another round of easing in November or December, while consensus was for the beginning of 2015.

This decision was complemented by the GPIF’s (government pension investment fund) announcement that it plans to increase both domestic and foreign equity portions to 25% from the previous 12%, increase foreign bonds to 15% from 11%, and reduce domestic bonds to 35% from 60%. This will free up the amount of outstanding Japanese government bonds, facilitating the purchase of bonds by the central bank, while allowing the government pension fund to investment in more risky assets. The Japanese injection relative to the size of the economy is far larger than that announced by other central banks. The BOJ will now increase its balance sheet by 15 percent of GDP per annum. Japan is therefore making a significant gamble, relying mainly on monetary policy to break deflation fears.



Market reactions positive, more easing expected

These shock measures were received positively by markets and resulted in a weaker yen and a rebound in stock prices. We expect these measures to improve inflation expectations in the coming period, which is critical. But Japanese authorities will still need to announce a number of reforms and fiscal measures, which will likely cause some uncertainty as we move forward. Even with a further weakening of the yen, core CPI inflation will remain below target in 2015. Consequently further easing will be needed to anchor inflation at around 2%, particularly in 2016. We then expect further purchases in JGB and other assets.

Japanese yen to weaken further

Further BOJ monetary stimulus will exert additional downward pressure on the yen. Moreover, the market is underestimating the pace of US rate hikes next year. We think an adjustment in short-term yields in the US will materialise in the coming months. As interest rate differentials between US and Japan widen, the US dollar is expected to appreciate against the yen. We think that the JPY to decline to 125 against the USD in 2015 and 135 in 2016.