February 27, 2015

Japan to enjoy robust growth in 2015-2016

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Our outlook for the Japanese economy has substantially changed since we last revised our economic forecast in mid-November 2014. We now see the Japanese economy growing by more than 1% year on year in 2015, and by more than 2% year on year in 2016. The change is most pronounced for 2016 where we are revising up our forecast from 1.2% to 2.1%.

We would list the following three as important factors for the upward revision in our economic outlook. (1) Declines in international commodity prices, (2) Signs of robust expansion in exports, (3) Signs of pronounced tightening in the labor market. 

(1) Declines in international commodity prices

Since the summer of 2014, prices of international commodities, most notably that of crude oil, have fallen significantly. Between September 2014 and January 2015, the price of imported energy has fallen by 27% on contract currency basis and by 21% on yen basis.   

It is not only the price of energy but also of other type of commodities such as iron ore that have fallen. Between September 2014 and January 2015, the price of imported metal and metal products has fallen by 13% on contract currency basis and by 5% on yen basis.

The declines in commodity prices are hugely beneficial for Japan. In 2014, Japan spent 28 trillion yen, about 6% of its GDP on imported energy. Together with other commodities such as lumber and iron ore, commodity imports account for about 7% of the Japanese GDP. Assuming that commodity prices declines by between 10 and 20% on average between 2014 and 2015, it cuts the import cost for Japan by between 0.7 and 1.4% of GDP. The benefit will be shared by Japanese consumers through lower consumer prices and by Japanese corporates through wider profit margins. If we assume 80% of the saving to go to corporates, as historically been the case, declines in commodity prices should raise corporate profits by between 4 to 8%. In reality, the impact should be larger as lower commodity prices should boost the overall economic activities in Japan.  

(2)   Sign of robust expansion in exports

Promoting Japanese exports has been one of the core strategy of Abenomics. A weaker yen was supposed to encourage larger exports from Japan and that in turn was supposed to add jobs as private capital investment in Japan. For a while, the strategy was seen not to be working. Both exports and industrial production remained stagnant despite the significant weakening in yen between 2012-2014. However, the strategy seems to be finally starting to work. Since August 2014, there has been a notable pick up in export volume. The real export index, estimated by the Bank of Japan, grew by more than 12% between August 2014 and January 2015. 

Correspondingly, manufacturers are expanding their production in Japan. The industrial production has expanded by 8% between August and January. 

The recent expansion in export volume is particularly encouraging, as it negates the view that Japan has lost of its competitive edge in manufacturing. Pessimists have argud that Japanese manufacturers have irreversibly moved their production facilities to overseas location to be closer to their markets and also to escape high labor cost in Japan. However, it seems that the apparent high profitability of exporting from Japan is starting to lure some manufacturers to bring their production back to Japan. The expansion in exports will have positive ripple effects as it results in larger demand for labor as well as an increase in capital investment in Japan to support higher production.  

(3)   Sign of tightening in the labor market

Japanese labor market has been tightening consistently since mid-2009 when the unemployment rate peaked at 5.5%. The sales tax hike in April 2014 halted the improvement, but fortunately for Japan, the effect was only transitory. The unemployment rose from 3.5% in May 2014 to 3.8% in July 2014, but then started to fall again. By January 2015, the rate has fallen to 3.6% and we expect the rate to continue to fall to 3.0% by the end of 2015.


What we are less certain though is what would happen to wage growth and inflation. Despite the ongoing tightening in the labor market and rising inflation, we have hardly seen any sign of wage inflation. 

However, as we observe what happened in the past, wage inflation tends to lag behind economic activities and inflation. Such was the case in the oil shock incident in 1970s and also in the bubble years through 1989-91. 

More than 2 years since Abenomics started, Japanese populations should be starting to adjust their inflation expectation by now. With the visible tightening in the labor market, it is our prediction that we will see a visible wage inflation through the course of this year. 

2% inflation target to be achieved in 2016

In our estimation, the so called NAIRU (Non-Accelerating Inflation Rate of Unemployment) for Japan is 3.5%. As we forecast the unemployment rate to fall to 3.0% by the end of 2015, we expect a stronger wage inflation to surface in the Japanese labor market. Our outlook for GDP gap, the difference between potential GDP and actual GDP, tells similar story. In our estimation, the GDP gap was already marginally positive at the end of 2014 and the 1% growth in 2015 we expect will bring the GDP gap into a clearly positive territory, giving rise to further inflationary pressure on the GDP deflator. 2015 is likely to be the year when Japan kisses good-bye to deflation. We expect wage inflation to accelerate to 1% by the end of 2015 and to 2% by the end of 2016. With a moderate rise in commodity prices, chances are that the CPI inflation will hit the 2% target in mid 2016. 

No more monetary stimulus needed in 2015

Some pundits argue that the BoJ should add an additional stimulus to accelerate inflation to meet the inflation target as soon as possible. We do not agree with them. As we think that the inflation target is already within its reach in a reasonable time frame, it is time for the BoJ to think about how to achieve a sustained and stable inflation. In our view, there is now as much upside risk to inflation as downside and there is no need to push down on accelerator.

We do not see any need for the BoJ to take policy actions, other than subtly trying to control the market expectation about its future course of its policies.