2015 has been a year full of twists and turns for Japan. The Federal Reserve’s decision to hike interest rates by 0.25% has reinforced the divergence in monetary policy between the USA and other advanced economies in Europe and Asia. The Bank of Japan’s sudden decision to add to its asset purchasing scheme further confused Asian markets, which are still reeling from the Chinese slowdown and stock market sell-off over the summer. Prime Minister Shinzo Abe’s masterplan for economic revitalisation is still not producing the desired effects, and as a result the country’s fate seems to be hanging in the balance.
Japan’s economic expansion suffered a slight setback in Q3 2015 due to weak Chinese and emerging market data, but end-of-year GDP growth is expected to be around 1.0% overall with 2016 projections ranging from 1.1-1.8% (based on a series of Long-Term OECD, IMF and World Bank estimates). Headline consumer price inflation is still close to 0%, but overall signs remain positive as an overwhelming proportion of the decline can be attributed to the plunge in oil prices, and growth/inflation measures could be scaled up further as consumer spending picks up in line with real wages.
This article focuses on the three key topics of discussion surrounding Japan’s economic future. The first of these is the much-hyped “Abenomics”, which has come under criticism of late – the major point of concern appears to be the nation’s deep-rooted cultural customs, which are acting as barriers to reforms. The second point explores the markets and establishes links between the Yen currency, monetary policy and economic projections for 2016. Lastly, we look at a new dynamic for Japan as a whole, where structural reforms give rise to adaptive measures, and where the nation has the opportunity to fashion a new development paradigm based on the one so-called “weakness” it possesses: an ageing population.
Abenomics: From 1.0 to 2.0
Prime Minister Abe celebrated his September re-election as head of the ruling Liberal Democratic Party (LDP) by announcing the second stage of his Abenomics resuscitation program. The first stage comprised a three-pronged approach of loose monetary policy, fiscal stimulus and fundamental structural reform, with the aim of rescuing Japan from depression and seeking to permanently end the era of deflation. Of these, it appears that only the first arrow, monetary policy, has been effective thus far.
Since 2009, the Bank of Japan (BOJ) has undertaken Quantitative Easing measures involving purchases of ¥80 trillion in government bonds to support market liquidity and overall consumption/investment demand. QE has helped to flatten the yield curve by pushing down long-term interest rates and has assisted in the depreciation of the Yen to its 40-year low, though the true extent of policy effects is unknown as the BOJ is only forecasting inflation to reach the 2% target sometime towards the end of 2017. However, there are still two key issues to resolve: potential bond market fragility and the waning credibility of the BOJ itself in its implementation of “Abe’s Blueprint”. Analysts at Japan Macro Advisors have expressed concern at the BOJ’s large and growing share of the Japanese Government Bond market – the share currently stands at 32% and is forecasted to expand to 40% by the end of 2016 as the Bank forges ahead with its asset purchasing scheme. With such a high share, this could increase the JGB market’s exposure risk to future shocks, including the eventual QE tapering by the Bank itself.
There was a surprising twist in the week leading up to Christmas 2015 when the BOJ announced that it would supplement its bond buying program with ¥300 billion in annual purchases of exchange-traded funds (ETFs) to track the JPX-Nikkei Index 400 (which is focused on companies that meet outlined criteria for corporate governance). The scheme has already been rendered ineffective due to the small scale of purchases relative to the actual QE program; the Wall Street Journal was particularly critical of Governor Harohiko Kuroda and the BOJ, stating that,
“The new measures raise concerns about political interference in business decision making…[and this type of action]…sets a precedent that could undermine the Bank’s independence.”
Fiscal stimulus attempts have been countered by the sales tax hike in mid-2014. This latest consumption tax increase from 5% to 8% led Japan into a mini-recession with 2 consecutive quarters of contraction, and with another tax hike scheduled for April 2017 it is unlikely that this “arrow” will be of much use going forward. The Government has allocated a spending budget of ¥96.8 trillion for the next fiscal year, but despite the anticipated rise in tax revenues to ¥57.6 trillion the fiscal deficit is expected to remain relatively large thanks to ballooning social security costs. Social security spending is a crucial part of the budget given Japan’s ageing society and the need to finance safety/security measures, but this means Japan may need to continue to resort to borrowing, thereby raising its National Debt to over 240% of GDP.
Meanwhile, Japan’s population demographic poses arguably its greatest structural problem. Around 25% of the total population is aged 64 and over, and this figure is projected to increase to over 35% by 2050. A study on spending patterns in Japan revealed that people entering their mid-fifties start to save more and thus spend less by building up a stock of assets and creating value which they can pass on to the younger generations. Another issue running side-by-side with the older population is that of apparent female underrepresentation in the workforce and low fertility rates. Certainly in the past, the lack of women in professional/senior corporate roles meant that relatively fewer people were able to contribute directly to increasing output. There exists the possibility of raising the retirement age or supporting businesses which cater to senior citizens in order to extract as much value as possible in the short-term, but a more durable solution is also required.
Abe’s “Womenomics” initiative aims to fill 30% of “socially leading positions” in Japan with women by 2020, and with an overall female labour participation rate of 66% (higher than the OECD average of 62.8%) this seems like an achievable target. In Abe’s second stage, a fertility rate of 1.8 has been set as a target to maintain until 2020 (up from the current rate of 1.4 per woman), which would ensure Japan’s total population stays above 100 million and be the key to providing long-term sustainable growth by enhancing the country’s productive potential. In order to achieve this, he plans to provide free preschool education, support for infertility treatments, greater assistance for single-parent families and a host of other incentives to make people feel more comfortable about bringing up children as future labour force participants. Another way to stay competitive on the global stage would involve attracting foreign skills and talent (i.e. giving young, skilled migrants with fresh ideas the right to work in Japan and contribute directly to the economy). However, immigration is “a contentious topic in a [Japanese] society where many pride themselves on cultural and ethnic homogeneity” – the main obstacles for anyone looking to move to Japan involve language barriers and working styles which could be difficult to overcome.
The Markets: Year of the Yen?
As previously mentioned, there may be some volatility in the Japanese government bond market considering the extent of the BOJ’s holdings, which exceeds the holdings of all commercial banks. In the short-term, foreign investors (typically from Europe) will account for 10% of JGB holdings, although this is more an instinctive reaction to the ECB’s negative rate policy relative to the BOJ’s actions and may not persist for very long.
“Growth may have disappointed but improving corporate earnings continue to drive market sentiment.”
The analysis points to Japan’s tight labour market (with unemployment at a 20-year low of 3.1%) along with hints of growth in real wages and solid long-term growth forecasts relative to its main European competitors. Corporate earnings and shareholder returns, particularly for renewable energy and tech companies, are likely to receive a boost in 2016 as the nation maintains its commitment to investing in “clean” renewable energy sources and electronic developments across all major towns. Involvement in the landmark Trans-Pacific Partnership (TPP) could realise further benefits through export-oriented growth, although this may take a lot longer to feed into the economy.
The “Big Story” for 2016, however, is likely to centre on the fate of the Yen – the official currency of Japan, and one of five IMF main reserve currencies in its lending facility. The prevailing view amongst several analysts seems to be that the Yen will continue to weaken against the Dollar in light of further policy stimulus from the Bank of Japan. Themos Fiotakis, co-head of FX & Rates Research at US, firmly believes that the current USD/JPY rate is consistent with an inflation rate of close to 1% rather than the 2% target – so as the effectiveness of monetary policy increases over the next 18-24 months, the Yen should adjust accordingly by weakening to between 125 and 135 to the Dollar. Morgan Stanley, on the other hand, remains bullish on the Yen, and believes
“The Yen will outshine the Dollar as next year’s star performer in the $5.3 trillion-a-day global currency market.”
This prediction stems from the view that the Yen is fundamentally undervalued and will be supported in the long run as Japanese investor look to repatriate money once the situation stabilises.
Another premise for this bullish sentiment is the idea that the BOJ had been adopting a reluctant stance on monetary easing in 2016, but the end-of-year surprise announcement on asset purchases has thrown a spanner into the works. It seems improbable that the Yen will strengthen to 110 (or even 115) by the end of next year, and so these movements should depend largely on the behaviour of investors. Key corporate investors, including major pension funds and life insurance companies, have been investing up to ¥1.5 trillion equivalent in USD-denominated securities. The Fed’s interest rate hike (by 0.25%) has supported the possibility of higher offered rates (thereby enticing continued flow of funds from Japanese investors) and a stronger Dollar against the Yen. The Nikkei 225 Index rose 1.6% after the Fed’s announcement, and this exuberance in Japanese markets reflects the view that the Fed is practically doing the BOJ’s job for it, and could help “save” Abenomics 2.0. The theory is that monetary easing and a weak Yen help boost competitiveness of exports and drive private investment and consumption. Japan needs higher growth to diminish its persistent negative output gap and eventually raise inflation in both consumer prices and wages.
New Opportunities for “Greying Japan”
Taking all observable factors into consideration, Prime Minister Abe’s resuscitation program does appear to be economically sound in terms of its basic principles, but there has been no solid evidence to indicate increasing exports or consumption since the scheme was initially introduced. Although corporate tax is meant to be reduced from 32% to 30% next fiscal year, the next sales tax hike is still scheduled to go ahead and despite boosts to tax revenue this course of action can only create further doubts in the minds of consumers. The BOJ’s latest, highly-questionable episode has unfortunately jolted an otherwise relatively successful monetary policy arrow.
Consequently, a high proportion of the burden is shifted onto the performance of the Yen as well as all the arrows for structural reform. Regarding the latter, the logical conclusion at this stage would be that tightening monetary policy in the US coupled with pension funds’ appetite for overseas investments and current inflation expectations should marginally outweigh potential reversal of capital flows back into Japan (i.e. repatriation) and “uncertainty factors”, resulting in a weaker Yen next year. Hence, although the popular macro view is that Abenomics policies are entering their final stages, Japan has fostered the “right conditions” for growth and economists and financiers can still hold out hope for 2016.
Regarding underlying structural issues, Japan effectively has two options: “Reform” or “Adapt”. Abe’s Womenomics, for instance, falls in the Reform category, as do other possible measures including means-tested pension schemes, retirement laws and immigration. Some serious discussions on immigration policy are needed next year to see how the country can increase the size and strength of its workforce. Unlike some competitor nations, Japan’s unique standing in the world of institutional asset management and technology means that it is equipped with a Plan B (“Adapt”). It is worth noting that Japan is host to “some of the largest pools of institutional investment assets in the world.” The sheer scale of the largest pension funds has meant that retirement assets currently total ¥182.4 trillion. The prominence of these funds, and other institutions such as life insurance companies, is down to corporate Japan adapting to the demographics and needs of clients, who have up to ¥1,500 trillion in savings. Japan’s elderly are the products of healthy and fit lifestyles, with emphasis on good diets and on preventive care in its national medical system resulting in one of the highest global average life expectancies. In order to extend working lives, Japan’s “silver market” consists of elderly consumers “drawing down savings from a lifetime of hard work and thrift” as well as new technologies (advanced robotics) to help offset the physical deficiencies of senior workers in some industries (e.g. automotive/manufacturing).
Encouraging the elderly to spend on catered sectors can certainly be conducive to increasing future consumption, particularly since those over the age of 64 are in control of more than 60% of Japan’s household assets and already account for 50% of total spending. The New Arrows of reform can also be solved through adaptation and through the old arrows. In 2016, Abe is expected to announce concrete measures for attracting foreign tourists and enhancements to childcare services to boost the fertility rate – all in his quest to meet the ultimate target of ¥600 trillion in GDP by 2020. This figure implies a real annual growth rate of 1.5-2% and, on reflection, may not be entirely unrealistic. In a 2013 speech, Abe told the world:
“I will bring back a strong Japan, strong enough to do even more good for the betterment of the world.”
Perhaps 2016 will be the defining year that confirms the Great Japanese Revival.