Abenomics Could Light A Fire Under The Japan Trade Again

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Shinzo Abe

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Japan's Prime Minister Shinzo Abe (L) and Myanmar's President Thein Sein toast during lunch at the Myanmar International Convention Centre in Naypyitaw May 26, 2013.

On Wednesday, Japanese Prime Minister  Shinzō Abe will unveil the much awaited "third arrow" of the experimental "Abenomics" program of economic stimulus that has captured the imagination of observers around the world.

The success of this experiment depends in its entirety on the details and implementation of this third component of the Japanese stimulus package: actual structural reform.

The first two "arrows" of Abenomics have already been launched and are fully in play.

On the fiscal stimulus front, the government has increased expenditures on public works programs. On the monetary stimulus front, the Bank of Japan has launched a quantitative easing program unprecedented in size and scale.

Of course, monetary and fiscal stimulus are designed to provide a short-term boost and, taken by themselves, will not be enough to lift Japan out of the economic malaise that has plagued the country for more than a decade.

That's why the details of the structural reforms to be announced Wednesday in Japan are so important.

The Japanese stock market had for months been one of the hottest equity markets in the world – up until May 22, that is, when the market crashed 7.3% in a single day. Adding up losses from the subsequent sell-off, the Japanese Nikkei 225 is now 15% below its peak from just two weeks ago.

And the Japanese yen, which weakened dramatically against the dollar as Japanese stocks rose, has halted its devaluation for now. (The Abe government wants the yen to continue weakening, hoping that it will induce higher exports to the world from Japanese companies, boosting profits and creating something of a virtuous cycle for financial markets and the economy.)

As Nomura economist Richard Koo puts it, investors' "honeymoon" with the long Nikkei/short yen trade appears to be over.

" I think the virtuous cycle for Abenomics in evidence since late last year is at a critical juncture," writes Koo in a note to clients today. " This means further gains in equities will require stronger corporate earnings and a recovery in the economy."

Again, crucially, both the continuation of the rally in Japanese share prices and the success of Abenomics in stimulating economic growth in Japan hinges on the strength of the structural reforms that are the "third arrow."

Here, Abenomics may prove to be fatally lacking.

In a recent report, Mitsubishi UFJ Morgan Stanley Chief Economist Noboyuki Saji highlighted a major challenge facing the Japanese economy that really drives home why structural reform is the most important component of Abenomics:

We think Japan lacks two things in particular. One is world-class products and services with high value-added and high price tags. The other is companies and individuals capable of driving economic growth. The US economy, in contrast, would appear to have both these things. First, it dominates the process of standardization in the field of information and communications technology (ICT).

The US-based Institute of Electrical and Electronics Engineers (IEEE) plays a leading role in developing standards in this field and easily overshadows the United Nation’s International Telecommunication Union (ITU). US ICT firms gather at the IEEE, and rivals in other countries closely watch for new developments. The large US vendors seek to further advance global standardization by acquiring competitors. NTT set up an R&D and information-gathering center in Silicon Valley this April called NTT I3 in response to this trend. Meanwhile, US income disparities are approaching all-time highs.

An Abe government panel on industrial competitiveness discussed a sweeping range of topics at its ninth meeting on May 22, including healthcare, tourism, science and technology, the revitalization of Japan’s education system, and the “cool Japan” cultural initiative. The panel hopes to come to some conclusions in time for the government’s early June unveiling of a national growth strategy.

The average household spent ¥10,984 a month on telecommunications in 2012, up from ¥8,196 in 2000, ¥5,429 in 1990, and ¥4,075 in 1980.  Whereas spending on telephones doubled between 1990 and 2012, households spent an average of just ¥310 a month on television in 2012, less than half the ¥782 figure recorded in 1990 (although the depressed expenditures were partly in reaction to an earlier surge under the Eco-Point subsidy program).

The telephone-related profits flow to companies possessing global standards. These firms are able to collect big data and acquire companies developing software for the analysis of unstructured data, leading to a new cycle of global standardization.

In the materials distributed at the nine meetings of the aforementioned industrial competitiveness panel, there is not a single mention of “global standardization.” A company that cannot develop global standards will eventually see its products commoditized. Although the yen’s decline since last December has enabled Japanese firms to recoup some of their lost earnings, a more important issue in our view is whether Japan’s economy can resume growing.

We intend to focus less on the government’s wide-ranging discussions than on the ability of a new generation of Japanese executives to demonstrate a sophisticated business sensibility, strong powers of observation, and the power to act. 

In light of the above, the problem for investors is that there really isn't any visibility on what the "third arrow" entails just yet.

Perhaps we could assert that Wednesday, with the announcement of Abe's structural reform program, observers will finally find out whether or not Abenomics is actually "for real."

Unfortunately, we won't get the full details Wednesday. The plan isn't expected to be finalized until sometime later this month, ahead of the elections in the Upper House of Japan's bicameral legislature scheduled in July.

And that brings us to the Upper House elections.

Briefly, some background: Shinzō Abe is, if there ever were one, a career politician.

His grandfather, Nobusuke Kishi , served as Japanese Prime Minister from 1957 to 1960.  His father, Shintaro Abe, was another major politician who served as Japan's foreign minister from 1981 to 1986.

Even forgetting that Abe has grown up in a political family his entire life, he himself has been in politics virtually ever since graduating from college, save for a brief three-year stint at Kobe Steel in between.

And the economy does not really appear to be a big priority for Abe, irrespective of the merits of Abenomics.

A recent special report by Reuters correspondents Linda Sieg, Yuko Yoshikawa and Tetsushi Kajimoto revealed an important insight: Abe may have been elected to the premiership in December because of Abenomics, but it was, in fact, a late addition to his campaign platform.

Sieg, Yoshikawa, and Tetsushi report (emphasis added):

Less than six years after his humiliating departure, Abe, 58, is back in office for a rare second term. He is riding a wave of popularity spurred mainly by voters' hopes that his prescription for fixing the  economy  will end two decades of stagnation. The policy, known as "Abenomics", is a mix of monetary easing, stimulative spending and growth-inducing steps including deregulation in sectors such as energy.

But interviews with some two dozen allies and insiders show "Abenomics" was a late addition to his platform.

Abe's unlikely comeback was engineered by a corps of politicians who called themselves the "True Conservatives," many of whom share his commitment to loosening constitutional constraints on the military and restoring traditional values such as group harmony and pride in Japanese culture and history.

While the cultural-political agenda is what drove them, Abe and his backers also came to realize that voters cared most about the  economy , so this time, they made it the top priority.

"Mr. Abe in his first term put more priority on revising the constitution than on the economy," said Yoichi Takahashi, a former finance ministry official who is an adviser to Abe. "Even now, I think that is the case. But I think he realized that in terms of order of priority, he had to work on the economy first."

(Sieg, Yoshikawa, and Tetsushi's report is an absolute must-read. Find it here.)

The Reuters report highlights Abe and his band of cultural conservative politicians' true agenda: revising the Japanese constitution in order to remilitarize Japan, which has been a pacifist nation since its defeat in World War Two.

Abe's political party, LDP, already controls the Lower House and, of course, the Administration.

In July, he gets a shot at the Upper House. If LDP wins, they will control the legislature and the executive branch, and it will ostensibly make Abe's constitutional priorities a lot easier to push through.

Credit Suisse 's Henry Russell recently expressed skepticism, citing fears of a "s hift from structural reform to constitutional reform," writing to clients that "Abe appears more focused on the long term Abe family/LDP goal of constitutional reform, rather than industrial revitalization and social reform."

So, is Abenomics for real?

The "third arrow" to be announced Wednesday is the preview.

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