Few policymakers have managed to change expectations as dramatically as Japanese Prime Minister Shinzo Abe and his activist central bank governor, Haruhiko Kuroda, have. The bold fiscal and monetary stimulus initiatives they launched last year raised hopes that Japan would finally pull out of its two-decade-long deflationary torpor. Yet less than two years into the effort, many analysts are wondering whether Abenomics, as the policies are known, is running out of steam.
Even before Abe took power at the end of 2012 after a sweeping election victory, his promise of bold action to revive the economy seized investors’ imagination, triggering a major stock market rally. Once in office Abe unveiled a three-pronged strategy of monetary, fiscal and structural policies — three arrows, as he calls them — for invigorating the economy.
The prime minister fired his first arrow in March 2013 by appointing Kuroda, a former top Ministry of Finance official and a critic of Japan’s timid monetary policies, as governor of the Bank of Japan. Within days of taking office, Kuroda declared a goal of boosting inflation to 2 percent — a level Japan hadn’t seen since the end of the bubble economy in 1991 — in a bid to spur consumers and companies to spend and invest. To achieve that target he launched a massive program of quantitative easing that was far bigger in scale, proportionally, than the Federal Reserve Board’s bond buying in the U.S.
The second arrow involved a fresh round of fiscal stimulus, consisting of a large-scale program of infrastructure investment and other public works worth ¥10 trillion ($96 billion), or about 1.6 percent of gross domestic product, over two to three years.
The results were dramatic. Equity investors dazzled by the prospect of a reinvigorated Japan drove up prices on the Tokyo Stock Exchange by a stunning 76 percent between mid-November 2012, when candidate Abe first outlined his plans, and mid-May 2013. Currency markets, impressed by the BoJ’s QE policies and inflation target, proceeded to sell the yen, knocking more than 20 percent off the currency’s value against the dollar in the same period. “Kuroda understood the implications of monetary policy for inflation and the yen better than some of his predecessors,” says Rei Masunaga, former head of the BoJ’s foreign department.
Abe’s third arrow — structural reforms designed to increase the flexibility and productivity of the Japanese economy — has yet to be implemented and will take years to produce its full effect. Nevertheless, the national mood brightened markedly as a result of the can-do attitude of Abe and Kuroda. As long-entrenched deflation psychology gave way to expectations of inflation, consumers opened their wallets and started buying more durable goods rather than waiting for cheaper prices in the future. Corporate profits jumped sharply, and larger companies began raising wages and bonuses. The average basic wage increase agreed to in this spring’s round of wage negotiations, or shunto, was 2 percent, the highest level in years, while bonuses rose by 9 percent, on average.
“Japan is back” trumpeted a headline in Foreign Affairs magazine, a message Abe sought to convey through globe-trotting diplomacy during his first year in office: Japan’s economic might was on the rebound, and the country had fresh ambitions to project itself as a political and even a military power.
Lately, however, Abenomics shows signs of sputtering, presenting the prime minister and Kuroda with perhaps their biggest challenge yet. Last month the Cabinet Office reported that the country’s GDP contracted at a 6.8 percent annual rate in the second quarter — the poorest showing since the first quarter of 2011, when the Tohoku earthquake and tsunami disrupted production and caused household spending to plunge. The latest decline was slightly less than many economists had expected. The government raised the national sales tax by 3 percentage points in April, to 8 percent, prompting many consumers to bring forward purchases into the first quarter. Akira Amari, minister of Economic Revitalization, dismissed the setback as a temporary blip and insisted that the recovery was still intact.
If growth doesn’t recover, however, that could affect the government’s willingness to go ahead with a second increase in the sales tax, to 10 percent, tentatively scheduled to take place in October 2015. The government needs to eliminate its budget deficit and begin bringing down its massive debt, which stands at 243 percent of GDP, to put public finances on a sustainable footing. For Abenomics to truly succeed, it needs to generate strong enough growth to sustain such a virtuous circle.
Abe is expected to decide in October whether to go ahead with the second tax. Amari has said the government might adopt a fresh stimulus package to cushion the impact on the economy.
For now, at least, Kuroda remains confident that the central bank’s easy-money policies are working. “We at the Bank of Japan do not think it is necessary to change our economic forecast for coming years,” he told reporters at the Kansas City Fed’s annual economics conference at Jackson Hole, Wyoming, late last month. “We will continue our current monetary policy, but if there is anything which could derail our course toward 2 percent inflation target, we would not hesitate to change or adjust our monetary policy.”
Many economists believe Japan’s problems go much deeper than the fallout from the sales tax hike. For one thing, exports are not yet responding in the way policymakers had hoped following the sharp depreciation of the yen. The government initially attributed the export softness to global economic weakness. The U.S. economy contracted in the first quarter, much of the euro area stalled in the second quarter, and growth in Southeast Asia has slowed this year.
Lately, however, the Bank of Japan, the Ministry of Finance and other government bodies have begun to acknowledge that structural changes in the Japanese economy are partly to blame for sluggish exports. The biggest factor seems to be the shifting of a significant amount of Japan’s manufacturing capacity to offshore locations by companies struggling to adjust to the yen’s strength in recent years. In its monthly economic survey in August, the BoJ said that automobile and electronics production in particular had migrated from Japan to other parts of Asia and beyond in recent years.
Eisuke Sakakibara, the MoF’s former vice minister for international affairs, attributes the loss of export competitiveness not only to a shift in production by Japanese companies but also to the fact that competitors in countries such as South Korea and China have raised their game in terms of technological prowess and marketing. Manufacturing production is unlikely to come back to Japan, he adds, as long as fears persist that the yen could strengthen again if Abenomics and Kurodanomics stall.
“The structure of the Japanese economy has changed,” Sakakibara — known as Mr. Yen in his ministerial days for his ability to move currency markets — tells Institutional Investor. “Many Japanese companies have outsourced their operations. If you are producing in Japan and then exporting, a cheap yen does benefit you. But if you are producing outside and selling outside, a weak yen does not help much.”
The yen has firmed up a bit since hitting a low of just over 105 to the dollar at the start of this year; it stood at 103.95 in late August.
Renewed strengthening of the yen could force the Bank of Japan to undertake fresh monetary easing, according to Mikio Wakatsuki, a former BoJ executive director who is close to Kuroda. If it has to act, the central bank would prefer to buy more private financial assets, such as corporate bonds, rather than step up purchases of Japanese government bonds, he says, although the government could “exert tremendous pressure” on the BoJ to buy more JGBs if the economy continues to flag.
Acknowledging that the consumption tax hike and weak exports were weighing on the economy, the Cabinet Office in July cut its forecast for real GDP growth to 1.2 percent in the current fiscal year, which ends March 31, 2015, down from 1.4 percent. The International Monetary Fund raised a number of red flags in its latest annual report on the Japanese economy. The report, released at the end of July, warned of the possibility of “faltering growth,” even though it said the world’s third-largest economy still appeared to be on a recovery track. The Fund predicts that Japan’s growth rate will slow to 1.1 percent in 2015 from 1.6 percent this year. “Risks over the medium term are tilted to the downside,” the report stated, adding that if Abenomics does not deliver on its promises of far-reaching structural reform, growth expectations could falter.
Three main concerns — each corresponding to one of Abe’s policy arrows — dominate the attention of financial markets. The first concern centers on whether the Bank of Japan’s monetary easing will succeed in restoring steady inflation that encourages consumption and investment in Japan or whether it will merely trigger damaging rises in costs and prices in a relatively closed economy where supply cannot readily expand to meet demand. Trading deflation for stagflation will do nothing to resolve the economy’s long-term problems.
The second concern revolves around Japan’s fiscal position given the formidable size of the national debt and the prospect of an ever-rising social security burden for the country’s aging population. Although government revenues have risen somewhat on the back of increased corporate profits and the rise in the sales tax should buoy receipts going forward, the government also plans to reduce corporate tax rates to spur domestic investment and attract more foreign investment; this could aggravate the country’s fiscal woes.
In its July report on the Japanese economy, the IMF said Japan should combine any reduction in the basic corporate tax rate with a broadening of the tax base to prevent a drop in revenues.
A third concern is whether Abe’s third arrow — structural reforms and deregulation — can really unlock the productive potential of the economy, allowing the supply of goods and services to keep pace with monetary- and fiscal-policy-induced demand. If not, Japan could end up in a state of relatively high inflation and low growth, or “secular stagnation,” says Wakatsuki.
WHEN KURODA TOOK CHARGE at the BoJ in March 2013, he announced his intention to embark on quantitative easing, with the goal of expanding Japan’s monetary base by ¥60 trillion to ¥70 trillion over two years, to a level of about ¥140 trillion. The central bank currently buys between ¥6 trillion and ¥8 trillion of government bonds a month, or roughly 70 percent of new government issuance.
The aim of the massive intervention is to inject sufficient demand into the economy to support eventual annual GDP growth of at least 2 percent. Kuroda also set a target of raising consumer price inflation to a rate of 2 percent within two years. His goal was not to create inflation for its own sake but rather to stimulate consumption and investment by restoring expectations of rising prices and costs among consumers and the corporate sector. The central bank was “halfway there,” Kuroda announced recently, when the year-over-year rise in the consumer price index hit 1.25 percent after stripping out the one-off impact of the sales tax increase.
Most economists welcome the return of modest inflation after 15 years of almost continuous deflation. Policymakers fear deflation because it renders monetary policy less powerful as a result of the zero lower bound on interest rates. Worries about the risk of deflation prompted former Federal Reserve chairman Ben Bernanke to pursue quantitative easing, and they explain why many economists today are urging the European Central Bank to adopt QE: to prevent the euro area from becoming another Japan.
Analysts attribute the rise in inflation largely to the impact of yen depreciation, which has raised import costs. That’s especially the case for oil and gas, which Japan has been forced to import in huge quantities since idling its 48 nuclear power reactors in the aftermath of the 2011 Fukushima nuclear disaster. The costs of other imported raw materials and of industrial goods also have risen, pushing the trade balance (and even occasionally the wider current-account balance) into steady deficit.
But Japan cannot depend on this kind of one-shot stimulus to prices to achieve sustainable inflation, says Akira Ariyoshi, former head of the IMF’s Asia-Pacific office in Tokyo and now an economics professor at Tokyo’s Hitotsubashi University. “You have to get a more overall inflation that is not dependent on imported price inflation,” he says. It is encouraging, Ariyoshi says, that broad-based inflation is, in fact, appearing, with prices rising on everything from food to clothing. At the same time, he notes, Japanese companies have begun to pass on higher import costs in the form of increased prices while raising wages and bonuses.
Inflation in Japan is now “firmly in positive territory,” the Asian Development Bank said in its July economic outlook report. Japan’s Cabinet Office predicts that consumer price inflation will hit 1.2 percent in the current fiscal year and rise to 1.8 percent in the year ending March 31, 2016. Yet even as data shows a steady uptick in inflation, doubts persist about whether the Bank of Japan can achieve its 2 percent goal by next year. For one thing, some economists point out, the yen appears to have stabilized just above 100 to the dollar; it was trading at about 80 to the dollar before Abe stirred markets with his reflation plans in November 2012. A steady yen means an end to the rising import costs that have stoked inflation until now.
“Under our baseline scenario, inflation will rise toward the 2 percent level over the next several years as the output gap closes and inflation expectations increase,” Jerry Schiff, deputy director of the IMF’s Asia-Pacific department in Washington, said in an e-mail response to questions by II. But “in terms of risks, we’ve been focused much more on the possibility that inflation will not rise to 2 percent, either because the economic reform process disappoints or perhaps because inflation expectations turn out to be much more sticky than we expected.”
Kuroda’s repeated public statements to the effect that the BoJ remains flexible in its approach to the future conduct of monetary policy and that it stands ready to react to whatever situation arises have encouraged the market to believe that further monetary stimulus has not been ruled out. But Ariyoshi believes that “the only thing which could elicit [further easing] by the BoJ would be a turnaround in the depreciation of the yen,” which he says is unlikely.
Exhibit A for skeptics of Kuroda’s inflation policies is the Japanese government bond market, where yields have remained depressed even as consumer prices have risen over the past year. The yield on the benchmark ten-year JGB stood at 0.50 percent late last month, down from 0.77 percent at the start of 2013, just after Abe took office. “That must mean one of two things,” says Paul Sheard, chief global economist at Standard & Poor’s in New York. “Yields are going to go much higher at some point, or Kuroda’s attempt to end deflation is going to fail.”
The outlook for JGB yields has huge implications for government finances, as well as for the wide range of public and private financial institutions whose investment portfolios are replete with Japanese government bond holdings, Sheard says. The yield on the ten-year bond should be nearer 2 percent if inflation is really headed toward the BoJ’s target, he adds. As Tohru Sasaki, chief foreign exchange strategist at JPMorgan Chase & Co. in Tokyo, puts it, “There is a major disconnect between where the current long bond rate is and where it should be.”
The BoJ has become the biggest single holder of JGBs, with ¥201 trillion worth of bonds at the end of March, or 20.1 percent of the overall market. Its holdings eclipse those of domestic insurers, the traditional mainstay of the JGB market, which stood at 19.3 percent in late March. It’s unclear who would absorb potential losses on those holdings if interest rates were to rise. It also remains unclear how the central bank will eventually exit from its quantitative easing policies. All that Kuroda has said so far is that it is “too early” to think about exit strategies and that there are various options available when the time comes. Presumably, he hopes to be able to draw lessons from successful exits by the Fed and the Bank of England.
“The long bond yield will rise as the market realizes that the BoJ is right” about achieving its inflation target, says one central bank official, who spoke on condition of anonymity. He expresses confidence that the BoJ can control the process of catch-up in bond yields by continuing its open-ended purchases of JGBs as long as necessary. Central bank officials contend that stress tests have shown that Japanese banks are able to absorb any possible sudden and sharp shift in bond yields.
The IMF’s Schiff sounds sanguine about the prospect of higher rates. “We do expect bond yields to rise over time, reflecting both higher inflation and faster growth in the economy,” he says. “But such an increase should not be problematic, especially because we expect the Bank of Japan to be in the market over the medium term, which would help to smooth the adjustment of rates.”
Many analysts dispute that optimistic view. S&P’s Sheard, for one, questions whether the central bank can easily control the rate normalization process. “JGB yields have to go up, and go up a lot in the future, if inflation expectations are to rise,” he says. “Yet the BoJ’s quantitative easing is lowering yields. Something has to give.”
Schiff acknowledges that the path to higher interest rates carries risks. If long-term rates spike, “that would probably arise from a loss in confidence by investors in the government’s ability to address its fiscal problems,” the IMF official said in his e-mail to II. “If that were to occur, it would have serious repercussions for Japan for its financial sector, for its growth prospects, and also for the global economy. That is why we have been emphasizing for a number of years now the need to have a credible and concrete medium-term [fiscal consolidation] plan and to implement it.”
To prevent Japan’s debt from spiraling out of control, the government is aiming to balance its budget on a primary basis — that is, excluding interest payments — by 2020. That won’t be easy. The IMF projects that the budget deficit will shrink to 5 percent of GDP on a primary basis in 2015, down from 6.3 percent this year. But Japan’s aging society is boosting social security expenditures at a rate of about ¥1 trillion a year, which will make the goal of a primary balance even more difficult to reach. The Fund has cautioned that the government will likely have to make additional hikes in the consumption tax — beyond the one scheduled for next year — to achieve a primary budget surplus by 2020.
Although most analysts focus on Japan’s fiscal problems and the question of whether the government can restore growth, some economists and officials worry that the Bank of Japan might be too successful in its fight against deflation and spark a fresh round of inflation that exceeds its own target.
“Inflation risks are definitely on the upside now in Japan,” says JPMorgan’s Sasaki. “I really think there will be a large amount of upside pressure on inflation in coming months. The rate may reach 2 percent sooner than even the BoJ expects.”
One MoF official, speaking on condition of anonymity, says concerns about a possible overshooting of inflation are “very valid and need to be monitored very closely.” According to former BoJ executive and Kuroda confidant Wakatsuki, the central bank governor is “becoming concerned” about potential upward pressure on prices.
“The reason why price pressures are rising is that the deflationary gap is quickly narrowing,” according to Wakatsuki. He spoke to II shortly before the central bank’s July announcement that the difference between Japan’s potential output and actual production, known as the output gap, had closed. The output gap had turned positive to the tune of 0.6 percent of GDP in the first quarter of this year, after languishing in negative territory for some six years. A negative output gap indicates an insufficient level of domestic demand compared with production potential and puts downward pressure on prices. The shift to a positive gap indicates that demand exceeds supply, putting upward pressure on prices.
The risk of an inflation overshoot in Japan “cannot be discounted,” says the IMF’s Schiff. “Labor market or other constraints could mean that prices rise to 2 percent before strong growth is achieved. Whether at that stage inflation would rise further would depend on a number of factors, including how the Bank of Japan reacts and how rapidly the needed structural reforms [are] implemented. Measures to raise labor supply and enhance the functioning of labor markets would be critical in making sure that these constraints are not overly binding.”
With Japan’s population and workforce both on the decline, the acceleration of economic growth brought about by monetary and fiscal stimulus has caused the labor market to tighten to a situation of virtual full employment. The unemployment rate stands at just 3.5 percent, the lowest level in 16 years. In many sectors, especially construction, there are more jobs available than candidates willing or able to do them.
Other advanced economies turn to immigration to help plug gaps in their labor markets, but given Japan’s homogeneous — or, as former MoF official Sakakibara puts it, “xenophobic” — society, immigration is a politically sensitive issue that Abe so far has avoided. Instead, he is seeking to increase the participation of women and older people in the workforce, and to find ways of boosting productivity among Japan’s myriad and largely inefficient small and medium-size enterprises.
Tackling such supply-side problems is the main focus of Abe’s third arrow of structural reforms. In June the prime minister unveiled what he calls his new growth strategy, consisting of structural measures such as cutting Japan’s corporate tax, promoting corporate governance reforms, easing employment regulations and boosting female employment and agricultural productivity.
“There will be no taboos and no sacred areas,” Abe promised. But for all his bold talk, the prime minister’s announcement lacked any timetable for implementing reforms or any firm estimate of the impact they are likely to have on Japan’s growth rate. Many of the measures face significant barriers to implementation. The country’s powerful farm lobby opposes most agricultural reforms; industry groups are lining up against the proposed Trans-Pacific Partnership that the U.S. is negotiating with Japan and ten other nations, contending that its import standards are inferior to Japanese standards; and a shortage of day-care facilities is making it harder to increase female employment.
Commenting on the structural measures, Economic Minister Amari said only that “it will take some time before we see the impact.”
Koichi Hamada, an economics professor at Yale University and one of Abe’s principal economic advisers, says the prime minister’s third-arrow measures merit only an E grade — “E for effort,” as he puts it. He gives Kuroda an A grade for the Bank of Japan’s monetary policies and awards the government a B for its fiscal stimulus. But he cautions that Abe’s structural reform package will take “at least five years before its full impact is felt.”
The first and second arrows are already driving up demand and price pressures in a Japanese economy that has long been criticized as being closed to the outside world by a variety of nontariff barriers to trade, but the supply-side reforms that could ease such pressures appear still to be a long way off. “Monetary policy has its limits,” Hamada says. “If you continue printing money when the economy is at full capacity, particularly when certain sectors of the labor market are [experiencing] shortage, that will create inflationary pressures. We could get rid of deflation, which is what we want to do. But we don’t want to start an inflationary phase.”
The recent growth setback, combined with a decline in the prime minister’s popularity rating, has persuaded Abe to return his focus to economic matters and spend less time on his geopolitical agenda items, such as strengthening Japan’s national security policies and reinterpreting its postwar pacifist constitution, according to Chief Cabinet Secretary Yoshihide Suga. Kuroda, meanwhile, is playing the role of cheerleader to boost morale and keep inflation expectations moving upward. But there is no guarantee of success.
As S&P’s Sheard says, Japan has become a “laboratory for unconventional economics.” The world is watching closely to see if Abe and Kuroda can succeed with their experiment. • •
