Japan – So far, a poor score card for Abenomics

by: Maritza Cabezas

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We expect GDP growth to increase to 1% in 2016, slowing to 0.6% in 2017
We maintain our view that inflation will rise in the coming quarters, but that the BoJ will undershoot its 2% inflation target
We expect further monetary stimulus, complemented with fiscal measures to prepare the economy for another consumption tax hike in 2017

Japan in a technical recession

Japan’s economy remains weak and progress appears to have stalled. Indeed, the economy contracted in Q2 (-0.7%) and in Q3 (-0.8%). Household spending has been volatile, while the corporate sector has been restrained, despite high profits. Indeed, third quarter data showed that corporate investment was a drag on growth due to weak capital expenditure and the fact that the contribution of inventories turned sharply negative. On top of this, the contribution of export growth is still lacklustre. Meanwhile, the growth slowdown in emerging markets, particularly China, is affecting foreign demand. Looking ahead, we think that in order for the economy to grow above trend (0.4%) in 2016, Japan’s policymakers will have to announce a comprehensive fiscal stimulus programme alongside additional monetary easing. This should unlock increased household spending and trigger firms to boost business spending. This will result in a more resilient economy, paving the way for the consumption tax hike in 2017.

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Japan’s war against deflation is ongoing

The BoJ’s war against deflation has not yet come to an end. In January 2013, the BoJ said it wanted to lift inflation to 2% within two years. The problem is that the BoJ’s traditional inflation measure, has been negative in the past three months (average -0.1%) and there is growing uncertainty as to whether Japan can meet its2% goal. This, despite the ongoing QQE and the central bank’s commitment to continue with QQE as long as necessary to maintain this target. The BoJ has responded by delaying the timing for reaching the inflation target to the second half of FY 2016. It has also introduced a new preferred measure of inflation, which excludes food and energy. This core-core inflation has been slowly rising, but we expect it to only move closer to the 2% target in 2017. Clearly, this justifies additional monetary easing.

Wage growth slower than expected

One of the factors that continues to hold down inflation is modest wage growth, despite the record high corporate profits and low unemployment rates. Wage growth for full time employment has been slow, while growth of wages for part-time employment has been higher. The BoJ explains this discrepancy by indicating that firms are trying to meet the increase in labour demand by hiring fewer regular workers until the recovery becomes firm. On top of this, the government is likely to lower the corporate tax in 2016, hoping that the tax savings will encourage firms to further increase wage growth. We think that actions such as this will support investment and wage growth in 2016. Mr Kuroda has said that he will be watching wage growth closely after the 2016 spring negotiations. This will be the most likely trigger for additional easing in 2016.

Export growth remains disappointing

The strong depreciation of the yen is one of the most visible outcomes of the BoJ’s QQE programme. However, this has not given export growth the expected impulse. Japanese firms have been expanding abroad and according to IMF estimates, around 25% of total manufacturing is produced by Japanese firms outside the country. On top of this, lacklustre global trade and the moderate growth in China have also been suppressing export growth. Since the start of the year, exports to China have dropped considerably, mainly in the area of chemical products, business machinery, transportation equipment and metal products, which are closely related to the slowdown in China’s industrial sector. We think that global growth will show some improvement next year, which will benefit Japan’s foreign demand.

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Additional monetary easing may not be enough

The divergence in monetary policy across central banks, will leave its mark on the yen. The yen will likely weaken due to the Fed’s monetary tightening. At the same time, it will strengthen against the euro as we expect more monetary easing from the ECB. Given that we anticipate the US rate hike cycle to be one of the weakest, we still expect the BoJ to ease further in 2016, likely around the spring wage negotiations. This will give the economy, and particularly inflation, an additional impulse. However, there are a number of concerns. The government has been cautious about the pace of yen depreciation, which has been putting pressure on food prices and this could affect consumer sentiment. Moreover, the expansion of QQE is not unlimited. The slower pace of selling of bond holdings among pension funds and insurers places restrictions on the BoJ’s bond purchase programme. As a result, although our base scenario is for additional QQE, we think that negative interest rates are a growing possibility. However, it is likely that monetary policy alone will not be able to lift the economy. We hence expect it to be complemented with some fiscal stimulus.

Fiscal policy to the rescue

Given Japan’s weak fiscal position, the contribution of fiscal policy to growth in recent years has been meagre. Indeed, government consumption has added very little to GDP growth in the past quarter. Japan’s debt-to-GDP ratio remains high, but the government’s borrowing costs continue to be low. Looking ahead, we think there will be a more proactive fiscal policy in 2016, which will likely go hand in hand with monetary policy easing. This should give some boost to economic activity, providing the necessary conditions for the consumption tax increase planned for April 2017. If the results of this tax hike in any way resemble those of the previous hike, the effects will be front-loaded and there will probably be a decline in demand thereafter. If Japan makes good on this commitment, growth should slow down again in 2017.

More and deeper structural reforms needed

Of the three arrows of Abenomics, the expansion of QQE has been effective in boosting the Japanese stock market and the yen’s depreciation. In contrast, there is little to see from the fiscal stimulus arrow. Fiscal policy has been at best neutral after the implementation of the consumption tax hike. As mentioned above this could change. Meanwhile, progress made in the third arrow, which includes structural reforms, has been insufficient to convince households and companies to spend. So far, reforms have been passed to make the farming industry more dynamic, to liberalise Japan’s electricity market, to provide companies better governance, and to foster trade (Transpacific Trade Pact). It will take some time before implementation of this Pact, but it will give the services industry more access to foreign markets. Other measures aimed at tackling demographic problems, including a higher female labour participation, lifetime employment at large firms and immigration, remain a challenge.

This article is part of the “Global View” of 25 November 2015.