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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
20
30
40
50
60
70
80
Aug-10 Feb-11 Sep-11 Apr-12 Oct-12 May-13 Nov-13
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.
-57%
+15%
+4%
40
60
80
100
120
140
Dec-89 Jul-90 Feb-91 Aug-91 Mar-92
Indexed price of major market-cap weighted indices (December
'89 to June '92)
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.
0
4000
8000
12000
16000
20000
50000
120000
190000
260000
330000
Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13
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
-1000
-500
0
500
1000
1500
2000
2500
3000
3500
Current Account (JPY, Billions)
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
80
90
100
110
120
130
Japanesepopulation
(millions)
Evolution of Japan's population
A ct ua l P rojec ted
Source: United Nations Department of Economics and Social Affairs.
600
700
800
900
1000
50000
120000
190000
260000
330000
GovernmentDebt(JP
Y,Trillions)
IndustrialProduction(Value)(JPY,
Millions)
Value of Japanese Industrial Production vs. Government Debt
Industrial Production (Value) Government Debt
Source: Bloomberg.
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