Dragon wounded by Abe's arrows

IFR Top 250 2014
12 min read

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The policy initiative of Japan’s prime minister Shinzo Abe to revive the Japanese economy from its two decade-long stagnation and dubbed Abenomics had an immediate impact when it was launched soon after Abe assumed office in 2012.

The yen underwent a sharp depreciation, exports picked up and Japan’s consolidated corporate profits were booming. Now, Abenomics appears to have hit a roadblock. Can it regain its momentum?

Abenomics, as promoted by its proponent in terms of the weaponry of a Samurai warrior, consists of three arrows: monetary, fiscal and structural reform within Japan’s economy. The initial manifestation of Abenomics, however, was achieved mainly through rhetoric: the depreciation of the yen versus its major trading partner currencies, the US dollar and the euro.

Around the time Abe assumed office in December 2012, the yen slid in dramatic fashion against both currencies, shedding 22% against the dollar and 26% against the euro between September 2012 and February 2013.

That was traditional “jawboning” of the currency, with an Abe victory assumed and explaining the currency’s weakness prior to his election as the market discounted his widely flagged view that the yen was overvalued and he would act on it. But the substantive work on the three arrows was to come later and was manifested most dramatically with the appointment of Haruhiko Kuroda to the governorship of the Bank of Japan in March 2013.

Kuroda gave a press conference soon after assuming office and delivered the bombshell that the Bank of Japan would engage in quantitative and qualitative easing in a mirror of the Federal Reserve’s approach with the US economy, but on a more thundering scale. Some US$71bn would be printed by the Bank of Japan every month to purchase Japanese government bonds at multiple tenors.

In addition, Kuroda vowed to double Japan’s monetary base within a year in a bid to drag Japan out of the deflationary mire in which it had been trapped since the early 1990s. He stated an explicit 2% monetary target, one that has yet to be reached, although Japan’s core CPI has picked up since the first arrow was deployed and last registered at plus 1.5% in April versus plus 1.3% in March.

Japan’s GDP growth also picked up in the early stages of Abenomics but has since pulled back, coming in at plus 0.3% in the last quarter of 2013, a shocking print that prompted talk that the prime minister’s grand scheme was unravelling. That poor growth number was accompanied by Japan’s worst trade deficit, which came in at ¥29.7trn (US$27.4bn) as imports surged by 25% versus a gain in exports of just 9%.

Market pundits who cling to the hope that Abenomics will deliver suggested that Japan is caught in a classic “J-curve” scenario in which the initial impact of a weaker currency is felt in painful rising import costs and that the surge in exports expected as the result of a sharply weaker yen will gradually filter through.

Tyres to fit the horsepower

That might be the hope, but for now Abenomics is perhaps beginning to look more and more desperate as Abe and Kuroda tweak the programme in an effort to maintain momentum.

“We have an engine with big horsepower, so it makes sense to have stronger tyres,” said Kuroda soon after he announced the extension of cheap loans to Japan’s banks for another year in February, together with a doubling of the funding size.

This was in the hope that the move would prod them to lend rather than sitting on piles of cash or using the cheap funds to book interest rate carry.

Early in June, Kuroda warned about the risk of discussing the BoJ’s early exit from its monetary stimulus programme, citing the downside volatility caused in US equities and dollar credit markets last year when talk of the Fed withdrawing from QE was first mooted.

He said during a BoJ press conference that the bank would consider withdrawing its stimulus when the 2% inflation target was reached. The Bank of Japan continues to chuck money at Japan’s economy like it is going out of fashion, but it still seems insufficient in relation to the inflation target as well as the country’s long-term growth prospects.

So having deployed as much as the first arrow could seemingly deliver, in early June Abe unveiled a draft plan to boost Japan’s economic growth in what appears to be the firing of the third arrow. This plan, running to 60 pages, involves the speeding up of structural reforms, including a revamp of the country’s bloated and protected agricultural sector, the reform of working hours and a scheme to make broader use of foreign workers.

“The government is working on the details of a corporate tax cut to thrust into a set of revamped basic economic and fiscal policies expected to be adopted later this month. We will lower corporate taxes to internationally competitive levels. We will finalise reform plans by the end of this month. We will review our labour regulations, adjusting them to new ways of working appropriate for the modern era. We must make Japan a place where non-Japanese brimming with ability will find it easier to be more dynamically engaged,” Abe said in a speech in Tokyo on June 3.

He put his money where his mouth was barely two weeks later when on June 13 he announced that Japan’s corporate tax rate would be reduced in stages to below 30%.

Despite this encouraging move, the substantive elements of the third arrow that the market has been so eagerly awaiting since Abenomics was first mooted remain tantalisingly out of reach. Although Abe has announced plans to cut the corporate tax rate, there are numerous critics who believe that with a public debt-to-GDP ratio of 200%, Japan can ill-afford to crimp its tax income, and that deeper structural reform involving revamping Japan’s stodgy labour market and addressing its shaky public finances must be addressed with urgency.. Again, Abe talks of reforming the government pension investment fund (GPIF), which has assets of US$1.2trn-equivalent, but no concrete measures have yet been stated.

The recently appointed chairman of the GPIF, Yasuhiro Yonezawa, suggested on June 1 in an interview with Nikkei Veritas that the fund could reduce its holdings of JBGs to 30%–50% of the portfolio, versus the current 90%, and allocate about 20% to domestic equities. That should in theory have profound implications for both Japanese government bonds and stocks. But the announcement had little noticeable impact on secondary prices of either asset class.

Still, perhaps Abenomics has succeeded in freeing up the slough of the Japanese labour market. The ratio of job offers to seekers is at 1.08 offers for each individual seeking employment, which is the highest level in seven years. In addition, there are signs of wage inflation in Japan, something truly radical, given the propensity over the past 20 years for Japanese corporations to sit on cash and fail to hand any improvement in earnings on to employees. In April, total earnings were up 0.9%, which represented the fastest rate of growth since December 2012.

Nevertheless, regular wages are declining, having dropped 0.2% year on year in April, and the deflationary dynamic still drags.

The pick-up in Japan’s nationwide core CPI in April was attributed in some quarters to a “piggy-backing” of price rises based on the introduction of the consumption tax increase, from 3% to 8%, rather than on the underlying inflationary pressure derived from ordinary economic activity that Abenomics seeks to introduce.

Still, numerous commentators are optimistic and see a range of indicators, including a recovering real estate market after its 20 years in the doldrums as evidence that inflationary psychology is taking hold in Japan.

“It really begins to look as if Abenomics has slayed Japan’s deflationary demon. From where the country was a year ago to where it stands now, you would have to say that the sceptics who viewed Japanese inflation as exclusively a structural phenomenon have been confounded. This time last year only two economies were in deflation – Japan and Switzerland – and whereas, according to Bloomberg data, now about 10 economies worldwide are experiencing deflation, Japan is actually registering inflation,” said Jonathan Allum, chief equity strategist at SMBC Nikko in London.

Jonathan Allum, chief equity strategist at SMBC Nikko in London.This will shift the mindset of Japan’s economic actors and the underlying dynamic of asset price appreciation, principally in real estate, together with earnings inflation should push national inflation towards Abe’s 2% target,” he said.

Allum made the observation that senior Bank of Japan officials, including Kuroda and his deputy Kikuo Iwata, were engaging in a constant dialogue with financial markets, via press conferences and releases, and were perhaps more visible than any central bankers on the global stage.

Iwata has in particular made a strong impression on markets since becoming deputy governor at the BoJ in March last year. A staunch critic of Japanese monetary policy while economics professor at Gakushuin University, he personifies the “poacher turned gamekeeper” that is a familiar phenomenon in the world of central banking.

“Kuroda and Iwata have made an impressive team in turning around the tarnished credibility of the BoJ when it comes to deflation,” said SMBC Nikko’s Allum.

Whether or not Abenomics will prove to have been a vainglorious exercise consisting of a catchy soundbite that failed to achieve its aim in the face of Japan’s notoriously weak demographic, or a turning point in the country’s economic fortunes, only time will tell.

Ironically, some of the improvements in Japan’s economy, such as the job application to offers ratio, were improving in the years prior to Abe’s election.

But that’s often what politicians do: take credit for everything even if it didn’t exactly happen under (or because of) their watch. Still, at least Abe has grasped the nature of the problem and is taking steps to address it. This, together with the perception that the BoJ will throw everything at its disposal until the 2% inflation target is achieved, might well mean that Abenomics will eventually deliver.