September 1, 2015, 22:30 JST

Abenomics nearing its expiry date

On the surface, our views are little changed from when we last revised our forecast in February 2015. We now forecast Japan to grow by 0.9% in 2015 and by 2.0% in 2016. These figures are moderately weaker than our previous forecast, but hardly a big change.  

However, on the broader issue of Abenomics, the policy mix pursued by Prime Minister Abe, we think it’s chance of success has become much slimmer. In our view, it will not be long before the credibility of Abenomics as a legitimate policy package expires.

A number of factors affected our assessment on Abenomics, but the following three factors stand out. 1) Abenomics policies are reaching its limit 2) Policies are not having their expected economic effects, 3) Policy makers seem to be losing their resolve.

1)    Abenomics policies are reaching its limit

Out of so called three arrows of Abenomics, only the first arrow, the monetary easing, was effectively deployed and still in effect. The Bank of Japan’s massive purchase of JGB successfully flattened its yield curve and yen depreciated to its 40 year low when measured in real term.

 

However, the cost of its monetary policy is showing as a dramatic rise in the central bank’s market share in the JGB market. At the beginning of 2013, the BoJ held slightly over 10% of the whole JGB market. By August 2015, it market share has risen to 30%. At the current pace, it will reach 40% by the end of 2016 and 50% by early 2018. While we think there is no alternative as long as deflation plagues Japan, the higher the market share, the more fragile the JGB market will become against possible future shocks, including the eventual tapering by the BoJ itself. As the 50% mark approaches, we expect that the voice against QE will grow to such extent that the BoJ itself cannot ignore it.

 

The second arrow, the fiscal stimulus, was present in 2013, the first year of Abenomics, but was effectively withdrawn in 2014 when the sales tax was raised.

 

As for the third arrow, structural reforms, it is difficult to make a conclusive argument either way as any reform take time to make a progress and bears fruit. However, when we see all the poster children of their reforms, we see that most of them are issues either trivial or that are unlikely to have any meaningful effects in the near future. Promoting female labor participation is certainly an important issue, but the female labor participation in Japan is already relatively high. At 66% in 2014, it is higher than OECD average of 62.8% and is comparable to 67.1% in US. It is not as if there are million of housewifes idle at home. In order to increase the supply of labor, raising retirement age will be far more effective. Immigration could provide another big potential break. However, these issues are currently shut out from the policy debate. TPP is another poster child, but we see Japan as merely piggybacking on the US’s leadership and we do not see how lowering tariff on meat over many years would have meaningful impact on Japan. On the other hand, the government seem happy to oblige industry lobbies such as taxi drivers and hotel industries, by limiting the new entry into the market.  

Rather than arguing over each policy, we could use the strength of private capital investment as an indirect measure for the effectiveness the third arrow. If the structural reforms are actually working, it should have raised the expectation of future growth, encouraging Japanese companies to increase their investment. However, despite the record profits, their capital investment only saw a moderate increase, unlike the period 2003-2006 when investment grew with profits.

 

To sum up, among the three arrows, only the monetary policy is at work and the sustainability of the current monetary policy is increasingly suspect.

2)   Policies are not having its expected effects

When Abenomics got rolling, the theory was that the monetary easing and the resulting weak yen would spur exports, private investments and private consumption. The high growth should diminish the negative output gap and eventually raise inflation both in consumer price as well as in wages. Almost three years since the advent of Abenomics, the results are rather dismal. Exports never took off. Private investments are growing, but the magnitude of its growth have been disappointing. Private consumption initially lived up to expectation, but the shock of the sales tax rate hike in 2014 seemed to have deprived the life out of it.

 

 

On the inflation front, the consumer price initially rose till early 2014, probably on the back of the rise in import price, but the recent decline in commodity prices seems to have killed off the momentum. Meanwhile, despite the tightening in the labor market, there seems to be no sign of any meaningful wage inflation. The expectation for low inflation among the Japanese population seems quite entrenched and neither corporate managers nor workers seem to feel that any marked rise in wages are in order. 

 

3) Policy makers seem to be losing their resolve.

The following sentence was in one of the first speeches Mr Kuroda made after becoming the BoJ governor.

First, the Bank decided -- as I mentioned earlier -- to convey a strong and clear commitment.  The Bank clearly announced in a statement that "[it] will achieve the price stability target of 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years."  This is the decision of the Bank's Policy Board -- namely, it expresses the will of the Bank as an institution.

(Haruhiko Kuroda, Governor of the Bank of Japan, April 12, 2013)

The end of the time horizon of “about two years” was 4 months ago. Since October 2014, he has maintained that his expectation is that the BoJ will meet its inflation target in the first half of fiscal year 2016. Of course, the juries are still out to see if this delayed commitment would be met, but we must say that it is starting to look unlikely. There is a saying that goes “fool me once, shame on you, fool me twice, shame on me”. At this point, the longer the governor Kuroda maintains that the inflation target will be met in 2016, the lower the market will regard the credibility and the “will of the Bank as an institution”.

Of course, the BoJ is not the only nor the most important institution whose credibility is deteriorating. As we commented earlier, the third arrow misfired or it was not in the quiver in the first place. And since early 2015, Prime Minister Abe seems to have all but lost his interest in the economic agenda, and seem to be spending most of his attention to formulating and passing the security bill, the bill that would enable Japan to engage in collective use of force. The unpopular bill seems to be costing a significant portion of his political capital. In August 2015, his approval rating has dipped below his disapproval rating for the first time since he became PM this time, according to the survey of NHK, Japan’s public national broadcaster.    

 

While his approval rating is yet recoverable, it will take a careful political maneuvering to recover his popularity. With the Upper House election approaching in the summer of 2016, he will probably dislike the idea of risking further decline in his popularity by embarking on structural reforms such as labor market deregulation or pension reforms.

What will follow Abenomics?  

In our view, Abenomics still has some shelf life left, a year, may be a bit longer. As our forecast show, the Japanese economy is likely to do reasonably well till 2016. The BoJ could even inject another monetary stimulus, although their arsenal will be quite depleted once they do. However, it is difficult to see how Abenomics policy mix could go on beyond 2017. The economy, and the inflation, will likely cool down again with the scheduled rise in the sales tax rate. At that point, it will be clear to any economy watchers’ that the Japan’s policies are not sustainable. 

Is there any way out of this conundrum? One possibility is a cancellation of the scheduled sales tax hike in 2017. If the Japanese government decides to postpone the tax rate hike again, it may prolong the shelf life of Abenomics, and it could even help reach the original goal of reflating Japan. The labor market is already tight, and two or three more years of robust growth should be enough to ply upward the entrenched low inflation expectation in Japan. Whether the BoJ could solve the problem of exiting from its QE policy, with over 50% of the JGB market in its balancesheet and in a reflationary environment, is a big if though.

In our view, the time is not yet ripe to declare Abenomics a failure, but we must say that we are getting there.