The Bank of Japan’s “Halloween surprise” may have bolstered Abenomics, but the jury is still out on whether the Japanese economy can withstand another consumption tax hike. Ahead of the release of key gross domestic product (GDP) data on November 17, The Diplomat’s Anthony Fensom recently spoke to Dr. Martin Schulz, Senior Research Fellow, Fujitsu Research Institute, on the prospects for Abenomics.
The Bank of Japan’s (BOJ’s) October 31 announcement to expand its quantitative easing (QE) policy greatly surprised markets. Was it necessary?
The Japanese economy was performing quite poorly after the sales tax hike in April. A lot of production and demand was put forward before the 3 percentage point hike, but demand dropped almost as much as the amount of demand brought forward.
So the big question for the summer was how well the economy would recover from this supply-demand shock? What we’ve seen so far is that overall household demand has been dropping, but overall consumption demand has been comparatively stable when we look at necessities and overall demand.
The frustrating part of the picture was production and exports. The big hope of Abenomics was that the lower exchange rate due to much more expansionary policy would increase production and exports from Japan much more than it actually has.
What was positive during the late summer going into fall was that exports were picking up while domestic demand hasn’t been dropping as much as feared beforehand. So the economy was basically bottoming out during the course of the last one to two months, but it wasn’t clear which direction it was actually heading, whether it was going into sustainable recovery or if it remains in a comparatively depressed state.
So what the BOJ decided to do was doubling up on its QE policy from last year, to make sure that demand is increasing, the yen remains weak and exporters that already saw increasing demand and started increasing production would remain happy and increase investment and production to support the overall economy.
The BOJ along with a rather broad coalition of the MOF [Ministry of Finance] and much of Japan’s big industry really want to see an additional VAT [valued-added tax] hike next year. The basis of the decision to do it is the GDP data and overall demand data of this summer. So with this additional monetary expansion, the BOJ wanted to make sure that the government stays on course to rebalance government finances.
There’s a lot of debate over whether Prime Minister Shinzo Abe will go ahead with next year’s sales tax hike. Does this latest move from the BOJ make it more likely?
Yes, quite so. The Abenomics plan for the introduction of the first sales tax hike in April was an extremely expansionary policy that increases demand from overseas because of the weaker yen, and of course pushes domestic demand because of increasing asset prices, hopefully higher wages in the long term increasing domestic demand. Plus a very expansionary fiscal policy to buffer the direct impact of this fiscal drag from the sales tax hike.
The plan for the next sales tax hike has to be basically the same, and for that it was quite important that the BOJ was showing it remained on board with an expansionary monetary policy, and was even willing to double up with its main policy tools if the economy is not performing strongly enough to ensure the next sales tax hike will go through without too much negative impact on the economy.
The government will base its decision on the state of the economy during the recovery after the first sales tax hike, meaning GDP data for the summer [due out November 17].
What we see in the government now is a struggle between two camps. One camp defines Abenomics quite narrowly as a growth policy which puts Japan on a growth trajectory via expansionary policies. To that camp, an additional sales tax hike is a negative that has to be avoided as long as the economy is not performing strongly enough, meaning growing GDP at least by 1.5 or 2 percent [annually].
The other camp defines Abenomics more broadly as not only reflating Japan but also putting it on a more sustainable long-term track, by implementing structural reforms and also reforming government finances, meaning cutting the deficit and putting the huge mountain of debt that has been accumulated at least on a sustainable basis so public debt is not increasing any more. Most people would still define Abenomics in broad terms as overall structural reform to get Japan on a sustainable growth track again, but many politicians are more interested in the short-term growth effects.
Isn’t there a danger that the sales tax hike will negate the benefits of the expansionary monetary policy?
Yes. The direct effect in Japan is comparatively limited; the most important channel of monetary policy right now is the exchange rate channel. Here we have seen a very close correlation and a very strong impact on asset prices, in particular stock prices, that have been driven by a weaker yen. The background reason for that is in Japan the exporters usually provide a very strong positive impact on overall growth and overall production.
The BOJ’s policy board vote was only five-four in favor of additional expansion – is that a concern?
The BOJ remains a very conservative institution which is focusing on long-term sustainability of policy. The board members, as do much as the staff, see the main impact of monetary policy on asset prices and not so much on overall demand. They also see that households are not happy about increasing costs, and even many companies also because so far prices have been going up through increasing import prices, in particular energy, and this is not something that households and companies would see as a positive.
It’s difficult to change mindsets after 20 years of deflation – does Kuroda have a chance of achieving his 2 percent inflation target?
The original plan was to get to 2 percent by next year or next fiscal year, next spring or next summer. This is gradually being pushed back toward a more stretch target. We have about 1 percent inflation in addition to the direct impact of the sales tax hike. Even with the additional monetary action, inflation is not increasing enough to get to 2 percent by next summer. We also have falling oil prices internationally, so the negative cost-push inflation is actually going down a little, and with that the overall price target as well.
But very few in Japan would really push the BOJ to achieve its target on schedule. The reason is households and companies are not totally happy with increasing prices, they have strong concerns, so when there’s a gradual course toward higher inflation expectations that would not necessarily be seen as a negative here. So turning that into a stretch target, let’s say the end of the next fiscal year or even beyond that, as long as expectations remain positive wouldn’t really be a problem.
There is talk of labor shortages in certain sectors – are you seeing any push toward higher wages?
It depends on the sector. We have significant labor shortages in much of construction, transportation, so the situation is not too different from Australia for example a few years ago. In Japan it’s not due to a raw materials boom but to reconstruction in Tohoku after the disaster, and the many fiscal projects, including preparation for the 2020 Olympics and so on.
So in construction and parts of manufacturing we already have labor shortages, and what we’re seeing here is the poor demographics, meaning much fewer younger people, are having a very strong impact here. This will continue and will become much stronger in the future. So prices for temporary staff, young people, particularly in manufacturing will continue to increase.
Abenomics also has its third arrow of structural reform – what concrete reforms are you seeing?
The government has basically decided to focus not on a few headline or core reforms that would make the news like reducing corporate tax, which would have a big impact on incomes of companies and their willingness to increase investment. They’re not focusing on strong labor market reform or a major overhaul of the healthcare sector, which remains almost entirely under government control. Rather, the government decided to do a broad range of reforms, with small steps little by little. Basically they are following most reform demands that have been in high demand by industry in Japan for a very long time, following partially the supply-side reforms of the Koizumi days after 2002, but following them very slowly and in an incremental way so as not to disrupt anything.
It’s probably the right approach in an aging society because resistance to reforms is extremely high wherever you look, from agriculture to construction to healthcare, to insurance which would for example ask for additional private health insurance for additional non-government based treatment in hospitals and doctor clinics. All these are small steps that would help if they continue in the long run. The problem with that is you cannot really fill the newspapers and produce a strong positive news flow because all the small steps are so small that you basically cannot measure them, and they will take a very long time to be implemented.
For example the TPP [Trans-Pacific Partnership], which would be a headline reform, is dragging on with negotiations from pork meat to additional quotas of many other agricultural produce; reforms in finance and incomes of farmers with cooperatives are dragging on. So at all levels these are really small steps which are all important if you put them together, but they don’t produce headline media coverage or strong positive sentiment here.
What are the key reforms you’d like to see implemented?
We do have to recognize that it’s extremely difficult to do effective reforms in an aging society, simply because many of the constituency groups would always face a negative impact from any reform and would have major difficulties to adapt due to their advanced age. Rather than hoping for the government to fix the economy in a structural, comprehensive way, I would rather focus on the easy things, meaning those steps where the government is in direct control and that can be implemented fast and effectively.
One of the simplest ones would be fixing the tax system, which produces huge deficits and sets wrong incentives for growth. Reducing the corporate tax would be a prime example. That would have a strong impact on those companies that are actually performing already positively by paying high income taxes; many Japanese companies are actually not paying corporate taxes because their overall performance is not strong enough, so a very high burden of the overall tax costs is carried by those companies performing comparatively well.
If you want to implement a growth policy, it makes sense to focus on those sectors and those parts that are already performing comparatively well because it’s easy to leverage them and make them grow even faster. So lowering corporate tax would help the well-performing companies.
Another thing you can do is support the growth centers of Japan, and these are the major cities in particular the mega-city of Tokyo. If you have supply-side reforms such as special economic zones as Abenomics is partially planning, you will have a very strong growth impact on those areas that have always been growing.
The flipside is that you get strong distributional effects – when the strong are growing even stronger you have a very effective growth policy, but you have strong distributional effects as others will perform less well. There may even be a strong negative impact on social stability if transfers from the productive city centers into the retiring regions, which are one of Japan’s major drains on economic performance, are cut.
There’s lots of debate around Japan’s high government debt – should markets be concerned?
I think it’s extremely unlikely we’ll see a big bust in Japan due to high government debt. On the other hand, it is already clear that Japan will not be able to repay its government debt – the overall level is simply too high to repay it in any foreseeable future. The difficulty is in between – we will not see Japan’s government go bust simply because most of Japan’s debt is held internally. It would require a huge capital flight for government finances to become unsustainable. The question would be, where would pension funds put all their funds? Into China or the U.S. credit bubble? That doesn’t seem a very attractive solution from a Japan perspective. Retiring debt holders and debtors, namely Japan’s households and the government, are basically captive within Japan.
But on the other hand the high debt level means that if Japan really starts to grow more strongly because of structural reforms for example, the higher interest rates would become and the higher the transfer to the existing debt holders, the old and comparatively rich households. This would have only a very limited positive impact on economic growth while government finances would deteriorate further due to these transfers. So the big issue with the high level of government debt is not that it has become a time bomb already but that it [continues to grow as a] drag on future growth.
It is highly unlikely that Japan will grow in a sustainable way more than 1 to 1.5 percent [per annum], which would already be a very high growth rate for aging Japan. Expecting anything more than that in a sustainable way seems extremely unlikely. The big problem is of course demography – society is already shrinking, so expecting anything more than mildly positive growth on a per capita basis while overall GDP is shrinking would require huge disruptive reforms that might not be appreciated by most.
The weaker yen hasn’t improved the trade balance – how do you see the outlook?
Part of the picture is that many exporters over the last 10 years have focused on building production capacity overseas, because the domestic market is shrinking, they expect labor shortages in the future and face high prices compared to some other countries. So a lower yen doesn’t help them as much as the old days when they were producing more in Japan.
Looking at the yen – what’s your forecast for the exchange rate against the dollar?
Usually when you have a trend in currencies they tend to be strong for a while, so even 120 is possible when carry trades are coming in, meaning investing into the interest rate differential between the US and Japan becomes an important market play. I don’t think the yen on a long-term basis will remain that weak – it should be from a production perspective more around 90 to 100. It’s at one of the weakest points in real terms, and with the economy performing comparatively well I wouldn’t expect the yen will dive to 120 and beyond for an extended period.
Looking at GDP, how are you seeing the outlook for 2015/16?
The economy is growing by close to 1 percent this year, and it will be about 1 percent next year, so not much change. When you look at the long-term perspective, 2016 and so on, there is very little reason to believe that the economy will grow much more than 1 percent even with an extended perspective.
We’re approaching the second anniversary of Abe’s return as leader – how do you rate the success of Abenomics?
Abenomics is in quite a bit of trouble. An important part of Abenomics is to put government finances on a sounder footing and improve the long-term outlook for the economy by structural reforms while achieving strong growth at the same time. So what we’re seeing now is partially a backlash to the very high expectations that could not be achieved on both fronts.
It is make or break time right now, and that is why the government is pushing so hard to be as expansionary and as positive as possible to make the next reform steps, including the sales tax hike next year.
In industry, most people are always skeptical about how much can be achieved by the government – the big monetary push doesn’t really reach industry. Most companies in Japan do not need additional capital and they also do not need banking credit, they are internally financed so they don’t need government finance. And for the household sector the positive impact is also limited because households know that the government is taking money out of their pockets to spend it.
If you look at M2, the major impact on money demand beyond what has been normal has already subsided. The money that the BOJ is printing goes to the government or remains in bank accounts. At the same time, households are still waiting for structural reforms with a significant impact on growth, such as the TPP which could lower import costs and food prices while allowing for more efficient services. So there’s still a lot of catching up to do.
From an industry perspective, the most important effective reform would be lowering corporate taxes, which are very high compared to other countries and remain a detriment to growth for the stronger performers. For companies, too, a fast conclusion of the TPP would be important to better integrate Japan’s high-tech and high-capital but slow-growth market into Asia’s greater high-growth economy.