Japan's Economy Going Forward

A word of caution to those thinking Japan's economy has turned the corner because of its efforts to drop the value of the yen by about 17 percent since mid-November. On July 29th BBC reported that industrial output fell 3.3% in June, from the previous month. Compared with the same month a year ago it fell 4.8%. More surprising was the 0.4% decline in household spending from a year earlier. Analysts had expected growth of 1.0%. Japan has been trying to boost domestic consumption in an attempt to revive its stagnant economy. While the data was weak and highlighted the challenges faced by the government, it was not a cause for immediate concern that Japan has again turned downward.

The thought is while falling consumer prices may sound good, they tend to hurt the economy as consumers and businesses put off big purchases in the hope of getting a better deal later on. In response Prime Minister Shinzo Abe's government has unveiled a series of aggressive measures to boost domestic demand and end deflation, many policymakers and analysts have said that ending the deflationary cycle is key to reviving Japan's economy. Even with a falling yen analysts said it was too early to declare the end of deflation. If you look at a narrower basket of goods without energy a clear rising trend isn't there. Koichi Fujishiro, from Dai-ichi Life Research Institute in Tokyo said "Only when wages start going up will we be able to say that it's a more sustainable and meaningful trend. So far, it can still end on a short blip up."

Meanwhile data showed that consumer prices, excluding food recently jumped by 0.4% - the biggest increase for five years. The rise was mainly due to higher energy bills rather than increased domestic demand. Japan has suffered a shortage of energy since the closing of almost all the country's nuclear reactors, which followed the earthquake and tsunami in 2011. As a result, it has been importing much of the energy it needs. Since becoming prime minister late last year, Mr. Abe has looked to decrease the value of the yen with government spending and ultra-loose monetary policy, in order to help boost exporters' earnings. However, the weaker yen means it is more costly to import fuel and other commodities into the resource poor country.

Prime Minister Shinzo Abe has introduced a set of policies called “Abenomics”. These policies focus in three key areas: massive fiscal stimulus, aggressive monetary policy similar to that of America's Federal Reserve’s QE’s 1-3, and improving the competitiveness of the Japanese economy. It will take many years to greatly improve the competitiveness of the Japanese economy, so for the next few years Abenomics has to rely mainly on fiscal stimulus and aggressive monetary policy. Will Abenomics, with its main focus in more aggressive buying of assets by the Bank of Japan (BOJ) and expanding the money supply be successful in increasing the economy’s growth rate?

With this program Japan has pulled a page from Ben Bernanke's playbook and plans to copy the Fed’s large-scale asset purchases in an effort to get the economy rolling again. QE1 was  introduced during the early days of the crisis as the Fed attempted to prevent the American economy from slipping into a very serious depression. While most economists  believe that QE1 was extremely important in providing liquidity to the American banking system at a time when liquidity was in scarce supply many have doubts about the efficacy of QE2 and QE3 that further increased bank reserves, and lowered long-term interest rates even further.

Despite the aggressive action of the Fed the recovery of the American economy has been slower than in any previous recession. More than four years after the crisis erupted, unemployment is still much higher then when the crisis began and the growth rate of GDP is still far below its long-term growth path. Japan is not in a financial crisis, so the success of QE1 in providing liquidity to banks is not very relevant. Expansive monetary policy by Japan is likely to end its deflation and lead to price increases. That is the good news, the bad news is that the evidence so far on QE2 and QE3 is not reassuring and it is questionable if Abenomics’ monetary loosening will significantly raise the long term growth rate of Japan’s real GDP, as in America such a monetary policy carries substantial risk and side effects.

When you introduce demography into the picture the water gets incredibly muddied. Japan is stuck with a shrinking population, neither monetary nor fiscal policy will adequately solve the problem. Continuing to run fiscal deficits in a deflationary environment will only means that government debt is pushed onward and upwards leading to a variety of possible scenarios as to what the end game will finally be. Cutting the deficit and raising consumption tax would only make deflation worse. The current BOJ policy while effectively driving down the yen is producing very little in the way of visible inflation. What it is doing is systematically distorting financial markets across the planet, Italian ten year government bond yields for example recently hit their lowest level since November 2010 based on the idea that at the end of the day, even if the country’s debt (currently at 127% of GDP) does continue to rise Japan style, it doesn’t matter that much since the ECB will be there to back them up. Italy is in fact the EU country most similar to Japan in terms of growth and demographic issues.

It was reported recently that Sumitomo Mitsui Financial Group Inc.’s lending unit almost halved its JGB holdings to 11.5 trillion yen in the three months through June, this was confirmed according to the company’s  earnings presentation. Mitsubishi UFJ Financial Group Inc. also pared its holdings by 17 percent over the quarter to 40.3 trillion yen and Mizuho Financial Group Inc. reduced the amount by 20 percent to 24.6 trillion yen. “As we can see from the megabanks that are drastically reducing their Japan Government Bond (JGB) holdings, there are some company managers with a reasonable mind,” said Fujimaki.a former Soros adviser “The risk of a default is shifting from the private sector to the public as the BOJ splurges on JGBs. If we continue down this path the credibility of the BOJ will be lost and the yen will plunge.”

Bottom-line, if investors in Japan's government bonds begin to believe that Abenomics will be successful in dropping the value of the yen and in bringing back inflation it would be logical for owners of  JGBs to move out of the securities and buy foreign bonds or equities. That would place upward pressure on Japanese bond yields and raise the cost of government to service its massive debt. With the BOJ  set to absorb half of the government bonds planned for sale this fiscal year, domestic investors have already started venturing overseas for higher yielding assets. Japanese were net buyers of foreign debt for a fourth straight week, according to figures released yesterday by the Ministry of Finance in Tokyo. If this turns in to a tsunami of  money fleeing Japan it will constitute the end of the line for those holding both JGBs and the yen.


Footnote; Your comments are welcome and encouraged. If you have time check out the archives for other post that may be of interest such as the post below,
                                http://brucewilds.blogspot.com/2013/04/japans-yen-is-in-play.html