Abenomics and the Japanese Economy (December 2013)

8/13/2019 Abenomics and the Japanese Economy (December 2013)

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worlds third largest economy, which had seen seven

of its leaders come and go over the previous six years.

Following his victory, Abe outlined a bold economic

plan aimed at growing the economy, boosting private

investment and combating Japans chronic

deflationary problem the continued decrease in theprice of goods, services and real estate that had been

plaguing the country since the 1990s. The plan

announced by Abe, popularly refered to as

Abenomics, is best understood by examining its three

inidividual components (or three arrows, as the

prime minister labeled them):

Aggressive monetary easing by the Bank of Japan

(BoJ): this involves keeping interest rates at or near

0% in order to stimulate corporate and consumer

borrowing and in turn promote spending and

investment. The BoJ also started a program ofquantitative easing, or QE. Under this program the

bank has commited to purchase $1.4 trillion in

financial assets (bonds and other credit linked

securities) from commercial banks and other private

institutions over the next two years. By purchasing

these assets, the BoJ is effectively increasing the

monetary base1 and lowering the yield on those

credit linked securities. Furthermore, by promoting

spending and increasing the monetary base it is trying

to create inflation (the target has been set at an

annualized 2% rate).

Massive fiscal stimulus: the second arrow implies

significant short-term fiscal expenditures, especially

investment in public works and renovation of

infrastructure. The government also plans to give tax

incentives to companies that invest in research &

development, hire more employees, pay higher

salaries and purchase new equipment.

Structural reforms: These measures include the

enactment of de-regulatory laws and the inclusion of

Japan into international trade agreements such as the

Trans-Pacific Partnership (TPP). They aim to liberalizeJapans traditionally protective corporate sector and

force it to compete with international corporations in

the domestic market. Some of the reforms will be

directed at flexibilizing Japans strict employment

1The monetary base is defined as the portion of the commercial banks reserves that are maintained in accounts with their central bankplus

the total currency circulating in the public (cash). When the Bank of Japan engages in QE it is effectively crediting money into the commercial

banks accounts held in the BoJ.

laws and promoting the integration of more women

into the workforce. Because of the intrinsic ambiguity

of this section of Abes plan, along with the difficult

political negotiations that will be required to carry it

out, many believe it will be the hardest to implement.

Abenomics was received with great interest within

Japan and throughout the international business

community. The stock market began an impressive

upward trend that continues until today and there

was a sense that the plan might finally end the

economic stagnation and deflation of the past 20

years. In order to better understand the

aggresiveness of the policies and the enthusiasm they

generated domestically and internationally, it is

useful to quickly review Japans recent economic

past.

The Rise of a Superpower

Japans spectacular rise as an economic power

started in the second half of the 19thcentury with the

policies enacted during the Meiji Restoration the

period that restored imperial rule after the last

shogunate was overthrown in the 1860s. During this

time the country began an era of westernization,

applying a number of political, social and economic

reforms that ended the feudal system and catapulted

an industrial revolution.

The end of the feudal system transformed the

structure of Japanese society, fomenting socialmobility and education across all classes. A young,

dynamic and educated workforce emerged. Coupled

with the governments fiscal policies of investing in

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JPY(intrillions)

BoJ Asset Purchase Program (outstanding current total)

Source: Bloomberg.


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US and other industrialized nations during this time

period.

What occurred was a sharp decline in stock market

and real estate prices from the historic levels they had

reached in the late 1980s. The reason they had

reached such levels in the first place was an excess ofliquidity in the system that resulted from a

combination of years of economic prosperity,

protectionist policies promoted by the government

and an ever increasing aging population that was

looking to save money for retirement and therefore

causing high deposit rates in banks.

High deposit rates enticed banks to lend more money

so credit became easier to obtain. As a result, many

corporations started borrowing directly from banks

(they are a cheaper source of capital than issuing

bonds or equity in the markets). This low cost of

capital, coupled with a weak yen, increased Japanese

corporations competitiveness in the international

markets and amplified the countrys trade surplus.

The ease of obtaining capital fueled speculation,

especially in real estate assets and the stock market.

The Nikkei index traded at all-time highs in 1989 and

real estate prices skyrocketed to the point where

retail properties in Ginza, one of Tokyos most

exclusive neighborhoods, reached $200,000 per

square meter. The ensuing wealth effect prompted

many people to take mortgages on their homes and

encouraged excessive borrowing by corporations.

The BoJs decision to raise interest rates to combat

the asset bubble that had formed, combined with the

excessive leverage that existed in the system, led to a

2Most of Japans debt is denominated in yen. Because deflation increases the value of a currency, it has actually increased the value of

Japanese debt and made it more difficult for the country to pay its interest obligations.

domestic debt crisis. Unable to meet interest

payments, many firms declared bankruptcy, a wave

of consolidation took place and the government was

forced to make significant capital infusions to a large

percentage of the financial institutions.

Although GDP and unemployment never reacheddepression levels and many corporations quickly

returned to profitability, the bursting of the bubble

unraveled a series of issues that Japan is still dealing

with today. One of the most critical is that the major

capital infusions and the stimulus put into place to

prevent an economic collapse made the government

incur massive amounts of debt and run a budget

deficit starting in 1996. For a country with a

decreasing population and long-term deflation,

dealing with a prospective debt crisis in the future

might prove catastrophic2. This is why so much hope

and enthusiasm has been put into Shinzo Abes

program to overhaul the economy.

Abenomics so far

Since its announcement on December of last year,

only the first two arrows of the plan have been

implemented. Haruhiko Kuroda, the governor of the

BoJ, has led the execution of a very aggressive form

of QE and committed the bank to buying some 50

trillion (~$485 billion) of Japanese Government Bonds

per year. If this rate is maintained, the countrys

monetary base will double by the end of 2014. A 10trillion (~$100 billion) fiscal stimulus package has also

been put into place, with investments being made in

large scale infrastructure, construction and

transportation projects.

The result has been economic growth at an

annualized rate of roughly 4% (nominal GDP) during

the first three quarters of 2013 the highest within

the G7 nations. There has been a modest decrease in

unemployment from 4.3% to 4.0%. The massive

easing by the BoJ has caused the yen to depreciate by

over 20% vs. the dollar, boosting the profits ofJapanese industrial giants like Toyota and Sony

(cheap debt has also helped their margins). The Tokyo

Stock Exchange has been the big winner, with the

index up almost 50% since December of last year.

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Indexed price of major market-cap weighted indices (December

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Tokyo SE S&P 500 FTSE 100

Source: Bloomberg.


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Structural reforms, however, have still not been

implemented. Abes push for Japan to join the Trans-

Pacific Partnership3 has been met by strong

resistance from sectors within the national business

community. Skeptics argue that important reductions

in tariffs on Japanese exports should be made, a

concession that the US, the TPPs most powerful

member, has so far been unwilling to make.

Changes to the countrys strict employment laws

have not been carried out either. It is still very difficult

for companies to lay off workers (the concept of at-

will employment4 does not exist in Japan) which

makes them hesitant about hiring people in the first

place. Many companies say they are waiting for more

permanent signs of an economic recovery before

taking on additional employees. The process of

integrating more women into the workforce has alsobeen hard, and faced with a declining population and

a dire need to increase birth rates, it will probably be

an increasingly difficult issue for the country to tackle.

Although inflation has started to pick up, much of the

rise in prices has come from an increase in import cost

due to the yens decline (since the yen is worth less,

Japan now has to spend more yen to import the same

amount of goods) and a hike in electricity rates due to

the Fukushima nuclear accident. Sustainable inflation

requires that wages start to rise too not just prices.

Another headwind to sustained inflation has been the

fact that domestic investment by large corporations

has not been as significant as expected. After years of

deflation, companies are skeptical about investing

3A proposed trade agreement between 12 nations including Japan, Vietnam, Malaysia, Singapore, Brunei, Australia, New Zealand, Canada, USA,

Mexico, Peru and Chile.4A contractual relationship in which an employee can be dismissed by an employer for any reason without having to establish just cause for

termination.

locally in factories, machinery and real estate (big

fixed costs) that might decrease in value if the BoJs

policies are not effective. Furthermore, a key element

that has been hurting the banks ability to spur

inflation, and that has its roots in a much deeper

structural problem of Japanese society, has been a

lack in the velocity of money.

Velocity of money is the number of times one unit of

currency is spent to buy goods and services per unit

of time. An increase in the velocity of money points

to an increase in the number of transactions that are

taking place between individuals in an economy. The

BoJ hoped that by expanding the monetary base (by

way of QE) and keeping interest rates low, banks

would be enticed to lend and consumers to borrow.

Ideally this would drive domestic consumption and

create inflation.

The issue is that by lowering interest rates in a

country where one third of the population is over 60

years old, the BoJ created another problem. As

people get closer to the age of retirement they tend

to increasingly rely on the interest income that is

generated by their savings. Therefore, reduced

interest income further reduced the likelihood of

increased spending and borrowing in this segment of

the population.

With interest rates being so low and the expectation

of inflation, investors started re-allocating capital to

the equity markets in search of yield and protection.

This fueled the sharp rise in the Japanese stock

market to the point that its valuation has become

divorced from the economic reality. Having placed so

much hope in Abenomics, and with the feasibility of

structural reform still unclear, the expectation is that

the BoJ and the government will continue to engage

in quantitative easing and fiscal stimulus (they

basically have no alternative until the economy and

inflation show continued signs of recovery).

Consequently, stock market outperformance and adecline in the value of the yen will probably continue

in the short to medium term.

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Nikkei225Index

Ind

ustrialProduction(Value)(JPY,Millions)

Value of Japanese Industrial Production vs. S tock Market Performance

Industrial Production (Value) Nikkei 225 Index

Source: Bloomberg.


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While supporters of Abenomics point to market

performance and GDP growth as evidence of the

programs success, the truth is that without

important structural reforms it is unlikely that the

efforts will lead to secular changes in the economy.

On the contrary, continued quantitative easing and

fiscal stimulus that adds to Japans massive fiscal

deficit and debt burden might create problems that

will be extremely hard for a country with a rapidly

decreasing population to tackle.

The debt problem

Regardless of whether or not Abenomics has been

positive for Japans economy so far, the unescapable

reality is that it faces a major structural challenge in

the form of population decline. It peaked at almost

128 million people in 2010 and is currently hovering

around 125 million. One third of the population isover the age of 60 and one fourth over the age of 65.

The country has arguably the most homogenized

society among developed nations (less than 3 million

of its citizens are non-Japanese). This makes it

unlikely for it to adopt progressive immigration laws

like the ones implemented in Europe to combat its

population problem.

At approximately 250% of GDP, Japan currently has

the biggest public debt balance in the developed

world. Over 90% of this debt (Japanese Government

Bonds or JGBs) is held by Japanese financial

institutions on behalf of Japanese citizens. Some

economists like Eamonn Fingleton point to Japanese

social cohesion and the fact that such a big proportion

of Japanese debt is held by its own citizens as a sign

of strength and stability in the countrys sovereign

debt market.

The problem is that once inflation starts to kick in, the

value of the JGBs will be affected. Inflation decreases

the value of a currency and therefore the value of

debt that is denominated in that currency. While this

makes it easier for countrys to pay their debts

(assuming the debt is denominated in their national

currency), it also erodes the capital of individuals and

institutions that have invested in that debt. The fixed

income they receive is gradually worth less (this is

5The sum of the balance of trade (i.e., net revenue on exports minus payments for imports), factor income (earnings on foreign investments

minus payments made to foreign investors) and cash transfers.

why fixed income instruments are generally not

considered good hedges against inflation). As fund

manager Kyle Bass of Hayman Capital points out,

even in a population with a very high degree of social

cohesion it is unlikely that socio-cultural norms will

precede human nature. An individual close to or at

retirement age who sees the value of his savings in

JGBs erode will most likely be enticed to sell them, in

turn creating a sharp rise in yields.

A sharp rise in yields would pose a major threat for a

country so heavily indebted and running a massive

fiscal deficit, making it difficult for it to keep up with

interest payments. Until recently, economists from

Japans Ministry of Finance argued that the deficit

was not a major problem as long as Japans current

account5was positive. The problem is that the recent

pickup in inflation has dramatically increased Japans

import costs, especially in the case of energy imports,

and as of last month the country was running a

negative current account.

Being an island-nation, it is unlikely that Japan can

implement any effective solutions to reduce its

reliance on imported energy and food products. It can

try to boost productivity to increase exports, but even

some of these efforts have come under threat lately.

Almost 20% of Japans exports are to China. These

have been in decline recently and increased political

tensions have not contributed to the situation. In

September of last year, as the Senkaku Islands conflictwas unfolding, Japanese auto sales to China fell by as

much as 63%. Fiscal stimulus has added to the

countrys debt but industrial production has

continued to be on decline. The TPP seems like a good

alternative to enhance trade, but at the moment it is

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Source: Bloomberg.


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unclear whether parliament and Japans powerful

agricultural lobbies will provide support.

Adding to the debt problem is the massive fiscal

deficit, currently at ~10% of GDP. Parliament recently

approved a measure to increase the sales tax from 5%

to 8% starting in April of 2014. However, the taxincrease comes with a 5 trillion stimulus package of

its own (to help the economy from slowing down)

which will add to the deficit in the short term.

A negative current account is not making the situation

any easier. Industrial production needs to grow, and

so far, the increase in corporate profits is probably

more correlated to the monetary landscape than to

secular long-term trends. Another worrying sign is the

fact that many companies are using excess funds to

carry out share buybacks which, although boosting

share prices in the short-term, have little effect onlong-term productivity improvement. To make

matters worse, a declining population means a

declining tax base. Faced with these facts, it is hard to

be optimistic about the future.

The future

On April 4thof this year the BoJ announced its shock-

and-awe campaign to double the monetary base in

the next two years by purchasing government debt.

Economic theory suggests that such an

announcement should have led to rising bond prices

and falling yields. Instead, the 10-year JGB yield sky

rocketed and prices dropped. The bonds futures

opened limit down6 and trading had to be halted

twice throughout the day to stabilize prices. It took

several months, reiterated promises to keep interest

rates at or near 0% and trillions of yen in QE for the

BoJ to reduce yields and trading volatility.

6The maximum amount by which the price of a futures contract or stock may decline in one trading day. If the maximum decline is surpassed,

trading on the security is usually halted. These limits were introduced to counter unusual market volatility and prevent panic-driven selling.

In his book Antifragile, scholar Nassim Taleb points to

the fact that when you suppress volatility long

enough, the volatility event that ends up happening

is much greater than the sum of all the volatility that

you tried to suppress. Whether in the form of

neurotically overprotective parents or the former Fed

chairman Alan Greenspan trying to smooth out

economic fluctuations by injecting cheap money into

the system, you usually end up making things more

fragile, not less. Assuming Talebs argument is

correct, the longer aggressive quantitative easing is

implemented in Japan, the graver the potential debt

crisis that could unravel.

This is not to say that a crisis is inevitable. Japan still

has an impressive industrial infrastructure and counts

with world-leading corporations and a highly-skilled

workforce. Even though its population is declining, its

cutting edge technology and standards of education

are assets that boost its competitiveness in the world

economy. Over the course of history its population

has proved to be resilient. It successfully rebuilt itself

from the ashes after WWII and went on to become

the worlds second largest economy until it was

overtaken by China in 2010.

However, if it is to succeed, monetary policy and fiscal

stimulus will not be enough. Measures must be taken

in order to combat the basic problem of population

decline. Prime Minister Abe must fire his third arrow

without significant structural reform Japan could

very well have a major debt crisis in its hands. If thiswere to happen, the damage that took place during

the lost decades would pale in comparison.

Juan Andres Jacobus-Avila

Registered Investment Adviser

[email protected]

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Japanesepopulation

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Evolution of Japan's population

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Source: United Nations Department of Economics and Social Affairs.

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GovernmentDebt(JP

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IndustrialProduction(Value)(JPY,

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Value of Japanese Industrial Production vs. Government Debt

Industrial Production (Value) Government Debt

Source: Bloomberg.

Abenomics and the Japanese Economy (December 2013)

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