Japan’s new leader, Shinzo Abe, has the toughest job in the world right now. Not only does he face another recession, near-zero interest rates, falling wages, deflation and the highest debt-to-GDP ratio (220%) in the world—he’s also vowed to reverse these trends. His approach has so far involved mainly bravado and the bullying of anything that stands in his way, including the country’s central bank, which he recently threatened to relieve of its independence.
Markets are thrilled—the Nikkei is up over 20% since mid-November, buoyed by what investors call the “Abe trade“(paywall). Western commentators seem similarly enamored of Abenomics. But though a key part of Abe’s heroic narrative is the broad popular mandate that he won in a “landslide,” that was mainly due to the crumbling of its opposition. In fact, if the record post-war low in December’s election turnout is anything to go by, the Japanese people have largely given up hoping for a reversal of fortune. And who could blame them? Japan’s churning cast of prime ministers have tried it all, and to little avail.
But what they haven’t tried is everything all at once. That’s exactly what Abe’s now gearing up to do.
Among Abe’s plans:
- A ¥12 trillion ($136 billion) infrastructure-focused stimulus, to end March 31, including:
- Lending ¥150 billion to businesses with new technologies
- Investing ¥5 trillion-6 trillion in public works
- Creating a ¥200-billion fund for foreign mergers and acquisitions
- Earmarking ¥83 billion for loan guarantees and credit for small businesses
- Lifting the ¥44 trillion ($520 billion) cap on debt
- Making asset-purchases “unlimited” to target a 2% inflation target and likely either 3% growth for nominal GDP or a job-growth target
- Cheapening the yen to boost Japan’s declining exports
- Spending ¥1 trillion to buy and lease back ailing industrial plants to encourage investment
Abe’s aggressive strategy seems smart—after all that Japan has been through, why not go all out? The problem is that these tools might work for run-of-the-mill business cycle recessions, but Japan has made many of them ineffective through years of misuse, to the point that Abe’s effort risks exhausting fiscal and monetary resuscitation altogether.
The three pillars of monetary unwisdom
Even Abe’s relatively straightforward plans for stimulating growth have pitfalls. Take his effort to weaken the yen. This will likely involve a combination of printing money and strategic buying of foreign assets, and it should be a boon to Japan’s long-suffering exporters. The historically strong yen has steadily winnowed down the country’s trade surplus as exporters became less competitive and moved factories abroad. In December, exports were down more than 19% over last year, while the trade deficit widened by over 280%.
But even with a cheaper yen, countries aren’t exactly lining up to buy Japan’s cars and electronics—just look at the state of Europe’s consumer demand. And a weakened yen carries risks. Chief among them is due to the fact that Japan imports almost all of its energy. As this gets more expensive it could crimp corporate margins even further, especially in the industrial and manufacturing sectors that Abe is angling to revive with fiscal stimulus. So much for bolstering the economy through trade.
In theory, monetary stimulus should also give Abe real firepower in creating investment-led growth. But Japan’s chronic deflation suggests that decades of debt-fueled investment and loose money haven’t been productive. One key reason, as ING’s Tanweer Akram points out, is that credit hasn’t grown along with the expanding monetary base, despite the fact that Japan is largely out of its deleveraging cycle. While bank lending has shown signs of pick-up, the sluggish economy means there’s little demand for credit from small- and medium-sized businesses. Abe’s recent plan to set aside ¥83 billion in funding for these struggling businesses bodes well for generating productive investment. But given anemic global and domestic demand, some corporations say there’s little worth investing in, even with rates so low.
An even bigger impediment to investment-led growth is excess capacity. As Akram argues, the large output gap has been the core problem throughout Japan’s lost decade, making investment—even trillions of yen worth of it—wasteful. And some of this overcapacity is deeply entrenched. For one thing, there’s the government’s support of “welfare society,” whereby it loans to private companies to avoid shouldering the burden of unemployment benefits. Then there are the bailouts of banks and, more recently, an electric utility. There’s little to suggest that this is changing.
So if both foreign trade and investment are unsure bets, then what about the third traditional pillar for boosting growth: consumption? That looks similarly bleak. Private consumption has been dropping year-on-year for the last two quarters (pdf). This is due to deflation, but also because wages growth is largely flat.
All this suggests that there’s little demand for the excess money, from either businesses or consumers. As for government-led spending, Abe’s wallop-packing stimulus should spur demand through the first quarter of 2013, but whether it can sustain growth will depend on how much of the investment flows into wasteful projects and overcapacity-saddled sectors.
Inflation at all costs?
Excess money that isn’t channelled into productive growth is likely to bring about inflation sooner. Along with higher energy import prices, monetary expansion and stimulus spending should help put a stake in the heart of deflation—something Abe has rightly made a core objective.
But the trick to playing with Keynesian fire is the ability to douse inflationary bursts. Rising inflation will induce interest-rate hikes, which means higher borrowing costs. With the Bank of Japan (BoJ) already shelling out 4.5% of Japan’s GDP on servicing its debt each year, an inflation spike could mean Japan suddenly owes bondholders much, much more than it’s used to paying. The current yields on two-year bonds are a mere 0.1%; Barclays calculates that paying interest rates of 2.0% would cost the government all of its annual tax revenue.
Even if inflation remains under control, Abe’s funding gush could prove problematic. As of late September, the BoJ held a record ¥105 trillion ($1.2 trillion) in Japanese government debt, 11.1% of the outstanding total. It plans to buy more, and that’s not counting the open-ended asset-purchasing that Abe has pressured the BoJ to take on. Aside from the sheer quantity of government debt this will saddle the bank with, there is a more serious problem, argues Tim Duy, an economist at the University of Oregon: that in caving to Abe’s pressure the bank will in effect find itself monetizing the government’s debt—i.e., printing money to pay it off—and thus becoming a handmaiden of the government’s fiscal excess instead of, as central banks are meant to be, a check against it.
As long as the bank keeps soaking up new government debt, yields will stay low. But what happens when it’s time to wean the economy off its bond-fuelled spending spree? Once investors see that coming, expect a bond selloff and rising yields. That would put an extra burden on the government’s debt-servicing, but also on Japan’s banks, due to the sizable share of government bonds on their balance sheets.
Two ways this could go
The key question, therefore, is what might spark panic. Here are some possibilities:
- High inflation: Abe’s guns-a-blazing approach will probably achieve its goal: inflation. But if prices then rise at more than about 2%, can he and his captive central bank tame them? Higher prices will drive up interest rates, raising the specter of fiscal insolvency, which could in turn prompt a larger selloff in bonds and equities—a classic vicious circle.
- Rising yields: The risk of Abe’s all-out assault on Japan’s economic woes is that if it doesn’t seem to be working, investors may wonder if Japan can ever grow at all. That could prompt a fear-driven bond sell-off, leading to a similar vicious circle.
- The fiscal solvency tipping point: Though this is a longer-term risk, the debt market relies to a large extent on household demand. That demand shrinks as the population ages and wages fall. As government debt eclipses household financial assets, the nation becomes insolvent as a whole.
Despite these risks, there’s a chance things could turn out well. Some signs to watch out for:
- Open-ended asset-purchases from the BoJ: If the bank does commit to buy enough assets to reverse deflation it will quell fears about more economic decay and boosting confidence, even if there are long-term risks.
- Low-level inflation, and expectations thereof: A pick-up in consumers’ price expectations would suggest they are thinking about spending more. Rising core inflation, below 2%, would signal a genuine rebound in consumption. As long as the rise is gradual, it would suggest the monetary stimulus is having a productive effect.
- Depreciating yen/growing global demand: If the yen reaches Abe’s target of ¥90:$1 it should stoke confidence. Steady growth and debt reduction in the EU and US would mean more demand from two of Japan’s biggest export markets (pdf). If Japan can improve relations with China, that would help too (though so far, Abe has shown signs of belligerence.) Export orders should be a leading indicator of overall economic revival.
- Growth in private-sector credit: More demand for credit in the private sector, particularly from small- and medium-sized businesses, would be a sign of businesses spending. Rising mortgage loans (along with rising housing starts) and loans on durable goods should hint at a revival of consumer confidence.
It won’t be easy to tell how well things are going, at least not straight away. Improvement on one front could come at the expense of another—for instance, rising bond yields would be bad news for the government but good for exporters. And good news on inflation could quickly sour if the inflation gets out of hand. Perhaps only one thing is at all clear: that Shinzo Abe is arming Japan for a showdown, and it’s fixing to be epic.
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