April 1, 2016, 19:00 JST

Japan Inc. sees shrinkage ahead

The March BoJ Tankan showed that Japanese companies are feeling the chill in their business condition and starting to prepare for continued deteriorations ahead. The business condition DI for large manufacturers deteriorated from 12 in December to 6 in March, bringing the level back to 2013 June. The DI has a close correlation with corporate profits. Deteriorating global economic conditions, especially in the emerging market, must be adversely affecting Japanese manufacturers’ bottom line. 

Business conditions seem to be better on the domestic economy side. Large non-manufacturers and small businesses also saw their business conditions deteriorate, but by smaller margins. 

Perhaps more worryingly, we see that the Japanese companies are now expecting the economy to shrink in the coming year. According to the Tankan survey for their fiscal year 2016 outlook, large companies are planning to see reductions in their sales (by 0.4%), their current profits (by 2.0%) and their capital investment (by 0.9%). They are also expecting their output prices to go down. It seems that they are preparing for a deflationary environment. 

Stagnating economic activities

In our views, the Tankan results should not have surprised policy makers nor the market. There has been plenty of evidences suggesting that the economic activities have been stalling on all sides. The Japanese economy hardly grew in the last three quarters and there is a strong chance that the economy shrunk again in the first quarter of 2016. Industrial production is likely to have shrunk by 1.5% or more in the first quarter of this year. Retail sales have also been plummeting.

It is time to realize that Abenomics have failed

Policy makers should be worried to see these economic news flow. Since 2013, policy makers have been assuming that the fiscal and monetary policy stimulus they are undertaking have succeeded in triggering a virtuous economic cycle where improvements in the corporate profits and asset prices would result in stronger private consumption, capital investment, tighter labor market and higher wages. When the sales tax hike in 2014 seemingly stopped the cycle, the BoJ added a second round of their QQE and assumed that it was enough to revive the cycle. In their pronouncement, all we needed was some patience to see the fruition of the cycle. However, after more than three years since Abenomics started, it is becoming clear that the virtuous cycle is not happening. The March Tankan result suggests that there is even a risk that the newly emerging deflationary mindset could trigger a vicious cycle of deflation and an economic stagnation.     

How will policy makers react?

Policy makers, especially on the government side, have not realized the depth of the problem. They are starting to discuss formulating a fiscal stimulus of 5 to 10 trillion yen. It is sizable, worth 1-2% of the GDP, and should be effective in stimulating the economy if spent efficiently. However, it seems they are planning to spend it in the old fashioned manner. They seem to think it is just another great opportunity to service their constituency. In our view, the construction industry already has orders full and additional infrastructure projects will only lead to higher price tags. In the BoJ Tankan, we see that the construction industry already has the most favorable business condition DI among all 28 industry categories. And the government want to give them more businesses. In our view, they really have not learned why Abenomics has not worked in the last three years. If they go ahead with the 10 trillion yen fiscal stimulus in the old fashioned way, the economy may receive some boost, but it will only be a short term with no lasting impact. The government needs to cast a wider net in trying to stimulate the economy, such as corporate tax cuts, reducing regulatory red tapes. 

Canceling the sales tax hike currently scheduled for April 2017 will be a first good step, but PM Abe is dithering, perhaps waiting for the best opportunity to make a political gain. 

On the monetary policy front, there is a sense of exhaustion and powerlessness of the monetary policy tools. In our view, they can still do more, but the lack of transparency in the monetary policy-making has damaged the effectiveness of the policy. In our view, cost-benefit balance for additional monetary easing is rather discouraging.

Policy actions will probably be too little too late

In our view, the Abenomics policy is no longer working and half-hearted efforts by policy makers to revive the momentum are simply futile. The Japanese economy seems to be heading back toward its deflationary combination of negative growth with falling prices.