By Mitsuru Misawa
In order to catalyse economic activity and pull Japan from its two-decade period of deflationary recession, new Prime Minister Shinzo Abe has enacted a bold recovery strategy. Thus far, his programs have not yet yielded the dramatic shift that he hoped for. Below, Mitsuru Misawa explores and rates the projects, and outlines possible future courses.
Abenomics- What is it?
When Japanese Prime Minister Shinzo Abe was re-elected in December of 2012, he stated that he would see Japan through its economic problems which included deflationary recession and stagnating exports. Then he promoted a strategy focusing on “bold monetary policy, flexible fiscal policy and a growth strategy that encourages private investment.” Dubbed “Abenomics” by the media, his strategies target a 2% annual inflation rate and involve large-scale public works projects, yen depreciation to spur exports, quantitative easing, incentives for public investment, and the buying of Japanese government bonds (JGB) by the Bank of Japan (BOJ).
For almost two decades, Japan has suffered from a deflationary spiral. It began with deflation caused by a fall in overall demand. Consumers, noticing the continuing trend of decreasing prices, reasoned that future prices would be lower than current prices, therefore electing to postpone their purchases in an effort to get the best prices. On the production side, consumers’ lack of involvement led to idle capacity. When the market failed to absorb producers’ output, investment sources also dried up, compounding the dearth of aggregate demand. In an effort to rectify these alarming trends and jump-start the economy, the extreme measure of a zero-interest-rate policy was enacted by Japan in February 1999. However, ten years elapsed and still the policy did not yield sufficient economic expansion. The next tactic used to stimulate the economy was that of expanding the monetary base, enacted by former governor Shirakawa of the BOJ for the period of August, 2008 to March, 2013. Changing expectations of deflation to expectations of inflation in consumers was not easy. This was the path that the Japanese economy had walked in the previous 20 years before Abenomics was initiated in April, 2013.
Abenomics, initiated in April 2013, has so far yielded positive returns, and has the potential to surpass the previous, ineffectual programs. After the April enactment, the yen sharply decreased in value, crossing the ¥100/$ boundary. It has since hovered in that area, and currently sits at ¥102.88/$ (as of December 2, 2013). This depreciation in value has promoted export profitability, which in turn has led to rising stock prices. While these gains are certainly welcome, critical concerns nonetheless remain. For one, exports account for only roughly 15% of the Japanese GDP. Despite success in this sector, the collective power of the Japanese economy is decreasing, indicated by the rapidly-shrinking total monetary value in dollars. Another issue on the horizon that must be addressed is the long-term projection of interest rates. While devising strategies to combat these problems is certainly necessary, the real end to Japanese national deflation and economic resurgence will come with a restoration of confidence and spending domestically.
Monetary Easing
The first thrust of Prime Minister Abe’s revitalisation campaign sought to raise expectations with a bold declaration: double the monetary base and double the purchase of JGB and exchange-traded funds. Haruhiko Kuroda, who had been confirmed on April 4, 2013 as the BOJ’s governor, announced this intention in a new BOJ program called “Quantitative and Qualitative Monetary Easing.” The plan would create a bolder central bank that would be more active in the marketplace in the hopes of buoying corporate investment and fostering consumer spending. Specifically, the central bank would effect the monetary base doubling plan by dramatically increasing its holdings of JGB bonds over two years. Japan’s monetary base includes financial institutions’ account deposits at the BOJ and cash circulating throughout the market. By purchasing banks’ JGB holdings, Kuroda sought to re-distribute money into business and households. The new “easy money” policy is projected to grow the monetary supply by 60 to 70 trillion yen per year. With a starting monetary base of 138 trillion yen as of year-end 2012, it is expected to reach 200 trillion yen by end of year 2013 and 270 trillion yen by end of year 2014.
“Abenomics, initiated in April 2013, has so far yielded positive returns, and has the potential to surpass the previous, ineffectual programs”
A critical parameter of this policy’s success rests on the degree to which the BOJ can reverse inflation expectations. Currently, the population of Japan on the whole expects continuing deflation, an assumption buttressed by a consumer price index that has been often negative since 1994, as well as persistently negative expectations of future inflation. Assuming efficient and open markets:
r = i – π
where r is the real interest rate, i is the nominal interest rate, and π is the expected inflation rate. As the equation implies, the real interest rate can be decreased by a decrease in i or an increase in π. As the nominal yields on Japanese government bonds have been consistently low for quite some time, it is thought that to decrease r, an increase in π (because the current value of π in Japan is negative) to the real governmental target of 2% is necessary. Then, once real interest rates decrease, capital spending and housing investment will increase, ushering in economic growth.
In order to measure the expected inflation rate, markets often employ the Break-even inflation rate (BEI), which is a market-based gauge measuring the difference between the nominal rate on a fixed-rate investment (R) and the real yield on an inflation-linked investment (r) of similar maturity and credit quality. In the case of Japan, the nominal rate for treasury bonds is used for R and the real yield for treasury inflation-protected bonds (JGBI) is used for r. These substitutions and a simplification allow us to represent the Break-even inflation rate as:
BEI= (R-r)/(1+r) ≒ R-r
As the exhibit shows, the expected rate of inflation has risen from its low starting value since Abe was elected, but has now leveled off, and actually regressed from its high of about 1.9%. The trend of the expected inflation rate had a high correlation with those of the exchange rate. As the expected rate of inflation has risen, the yen sharply decreased in value, crossing the ¥100/$ boundary.
Though the BOJ’s target of a 2% inflation rate is an admirable goal, it will likely be very difficult to realise. Starting from deflation, as Japan has, is a daunting task, and there is no way to adequately predict how large of a monetary base is necessary to accomplish the goal. In fact, the goal of doubling likely represents just an estimate of the worst-case scenario. In Japan, faster economic growth will help get this money flowing, but this poses the question of which comes first. It is the point of balance that Kuroda will have to identify if he wishes to be successful.
For this problem, it is useful to look at two other economies that have attempted similar programs. In the United States and Europe, Fed Chairman Ben Bernanke and European Central Bank President Mario Draghi, respectively, adopted a “whatever it takes” stance. Now, the United States has created an enormous base of money but it is currently under-used and primarily resting idle in the government’s own accounts. Kuroda’s predecessor also tried to increase the inflation rate, but was chastised for being too conservative. There is little doubt that Kuroda will be more aggressive, but there is still much doubt surrounding the outcome.
Fiscal Spending
The second part of Abe’s three-pronged plan to pull Japan out of its economic woes centers on implementing large-scale public works projects. However, given Japan’s two decade period of economic lethargy, and the associated debt that goes with the nation’s underperformance, this prospect will almost certainly prove difficult, and perhaps even irresponsible if not reigned in. Currently, Japan’s public debt ratio stands firmly above 200% of GDP, which is worst among major developed economies. This massive debt was in part caused by its third recession in five years during the worldwide financial crisis of the 2000s, as well as the tsunami-earthquake disaster that struck the Tohoku area in March 2011.
Initially, Abe’s government stated that their aim was to cut the primary balance deficit to 3.2% of the country’s GDP by fiscal year 2015, and, more ambitiously, reach surplus by 2020, whichwould enable them to finance government projects without issuing new bonds. This, however, seems an unattainable goal in light of the most recent projections. In February 2013, the Cabinet Office released a report indicating that Japan could log a deficit of 33.9 trillion yen, or 6.9% of nominal GDP, a 1.7% increase over the previous estimate. Going forward, it would seem a prudent choice for Abe’s government to set out a more realistic and detailed plan, one that itemises spending goals by category and lays out a timetable for the upcoming 3% sales tax increase.
Growth Strategies
The third focus of Abe’s strategy will lean on social, political, and regulatory reform to usher in growth. Specifically, Abe seeks to create an atmosphere more conducive to women as earners. He will also raise the pension eligibility age (it currently stands at 60 years old) to account for Japan’s high life expectancy and low birth rate. Together, these two measures will enable a larger portion of the population to be productive. In addition, Abe hopes to lure overseas companies to Japanese soil by enacting regulations and incentives. Specifically, he will erect “special economic zones” in three of the nation’s prefectures.
“If jobs commanding higher incomes are not created, the forced inflation will serve only to erode purchasing power and diminish consumer confidence.”
Of the three courses for improvement mentioned above, the relaxed business relations aimed at making Japan appealing to foreign interests is likely the most difficult to implement. Big business is strongly entrenched in Japan, and such proposed shifts in regulations will almost certainly meet staunch opposition. In addition, energy- and environment-related concerns continue to grow more pressing, and therefore make compliance more expensive. Though there have been positive signs such as Japan’s facilitation of induced pluripotent stem cell basic research, (commonly abbreviated as iPS) for which Japan is leading the world, in general Abe’s attack has not been powerful enough. Thus far, the measures have been limited to rhetoric and bold proclamations, not effectual policy changes. Specific examples of the government stopping short of what was necessary were: not cutting the effective corporate tax rate and not allowing patients to combine the use of publicly insured and uninsured medical treatments. Also, Abe’s government could not lift the ban on the online sale of over-the-counter medicine. All in all, this area of Abe’s program has been marked by inconsistency.
Going Forward
The first two components of Abenomics, monetary easing and increased fiscal spending, are likely to be met with public support. The third component, growth strategies, will be seen as a shuffling of the deck for entrenched, so-called protected businesses, and thus will be more difficult. However, it is imperative that these regulatory and structural reforms happen because they are undeniably what Japan needs most. The opportunities for newcomers to the market will present consumers with more options and in the process revitalise the economy.
History has shown time and again that reflationary tactics carry with them large risks. Of special concern to Japan is the appearance of a bubble, which is what occurred in the 1980s. To protect against this possibility, the Abe government is monetising debt. By printing money to buy government bonds, they are in effect leveraging future income to protect the present. This has long been eschewed by the Japanese government, as there are two severe dangers looming if the policies are not employed effectively. The first danger is that too aggressive a push might steer the Japanese bond market to fear inflation, sparking a hike in long-term borrowing costs and slowing recovery. The second danger is a phenomenon that would specifically target households. If jobs commanding higher incomes are not created, the forced inflation will serve only to erode purchasing power and diminish consumer confidence, perpetuating the status quo of consumer spending as a negative force on the economy.
Another cause for concern is Japan’s falling national economic power. Though the depreciation of the yen has promoted indirect foreign investments, it has also had the effect of significantly shrinking national GDP. The IMF global economic outlook of April 2013 reported that Japan’s GDP in terms of dollars fell from $5.96 trillion in 2012 to $5.14 trillion in 2013, a nearly 14% drop. This number will place Japan’s national worth at roughly half of China’s. In order to buttress the economy as the yen depreciates, Japan needs to make direct investment more accessible to foreign firms. Currently, foreign investment is exceedingly low in terms of both flow and stock. It is in Japan’s best interests to open its market to the outside. This tactic, aimed at the third of Abe’s three pillars, is the most important because it has the best chance to ensure growth in the future.
About the Author
Mitsuru Misawa is Professor of Finance and Director of the Centre for Japanese Global Investment and Finance at the University of Hawaii at Manoa. During his time as an executive officer at the Industrial Bank of Japan (now Mizuho Corporate Bank) for the period of 1960-1996, he acted as an international investment banker in charge of various industries in Japan. He has considerable knowledge of issues of Japanese economy and finance.
References
1. Bank of Japan Statistics, (http://www.boj.or.jp/en/statistics/index.htm/) (accessed of November 1, 2013)
2. International Monetary Fund (July 9, 2013) “World Economic Outlook Update,” (http://www.imf.org/external/pubs/ft/weo/2013/update/02/) (accessed November 1, 2013).
3. Misawa, Mitsuru (2013). Abenomics of Japan: What Was it? Could This Conquer Japan’s Decade-Long Deflation?, Harvard Business Publishing (http://cb.hbsp.harvard.edu/cb/web/search_results.seam?Ntt=MISAWA&searchButton.x=25&searchButton.y=13&N=0) (accessed November 1, 2013).
4. Misawa, Mitsuru. (2013). Bank of Japan (2): Meeting on April 4, 2013 (Doubling Monetary Base Via Government Bond Purchases), Harvard Business Publishing (http://cb.hbsp.harvard.edu/cb/web/search_results.seam?Ntt=MISAWA&searchButton.x=25&searchButton.y=13&N=0) (accessed November 1, 2013)
5. The Statistics Bureau of Japan, Consumer Price Index (www.stat.go.jp/english/data/cpi/) (accessed November 1, 2013)
6. Yahoo, Finance, http://finance.yahoo.com/currencconverter/#from=USD;to=EUR;amt=1 (as of November 1, 2013).