Interview: Naomi Fink on the Japanese Economy

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Interview: Naomi Fink on the Japanese Economy

Analyst Naomi Fink on the Japanese economy and the outlook for Abenomics.

Interview: Naomi Fink on the Japanese Economy
Credit: Naomi Fink

Japan’s economy limped out of recession in the December quarter, having posted zero growth for 2014 after a consumption tax hike hit spending. With consumer inflation recently falling back to zero and international forecasters seeing only modest growth this year, can the world’s third-biggest economy get its groove back?

The Diplomat’s Anthony Fensom spoke to Japan analyst Naomi Fink, chief executive of Europacifica Consulting, about the latest growth figures and Abenomics’ prospects of overcoming deflation.

Japan has just emerged from recession with a modest expansion. What are you expecting for the rest of this year?

Partially because the slump in domestic demand was greater and more prolonged than expected and the recovery in the December quarter was anemic, I think there might be a lot of latent demand this year. One of the reasons is corporate profitability, which zoomed in 2014, and the Nikkei’s performance reflected that. Of course stockmarkets aren’t a perfect forward indicator, but they’re one in relation to corporate profits. We’ve also seen wages increase which is relevant to consumption and wages expectations. So after the greater than expected slump we saw last year, we should see a pretty good year.

Over the first half of this year, we will be doing some catching up, especially with better profitability figures and better wage expectations, so I would expect growth to be above the 2 percent mark on an annualized basis. Even over the second half, I can easily see it staying above 1.5 percent.

Prime Minister Shinzo Abe and the Bank of Japan (BOJ) have declared war on deflation – what can we expect from the BOJ in terms of achieving its stated 2 percent inflation target?

What the BOJ and Japan want to achieve is sustainable reflation, so a sustainable recovery in demand, not inflation for inflation’s sake. If domestic demand stays where it is and commodities rallied again, that wouldn’t be a good inflation profile. So the most important thing above and beyond the 2 percent target is whether inflation stays positive and whether it’s driven by domestic demand.

On the 2 percent target, the BOJ probably wouldn’t be happy to hear this, but in my mind the 2 percent target is much more important as a symbol than as a number. This is because 2 percent is actually a pretty high inflation rate in recent history in Japan. If anything, it symbolizes the BOJ’s aggressive commitment to continued easing until it achieves stable reflation, so it’s set on the high side.

Is it achievable? Yes – you look at the amount of liquidity in the system, all we need is for price rises to start accelerating a bit more. Whether this target will be achieved this year or not is still uncertain. On one hand, cheaper fuel and commodity input prices are keeping overall prices subdued, which is one delaying factor, yet on balance a good thing for real income and household demand. On the other hand, you look at unemployment, we’re very near levels historically where prices have started accelerating. So maybe it’s just a matter of time. Maybe it’s a little bit later than we might have expected in another country such as the U.S. with this type of aggressive easing, but more important is what happens when we get nearer there.

All types of inflation were not created equal – if we start moving from demand-related inflation to cost-push inflation, we start running into a situation where the BOJ might have to move quickly from aggressive easing to tightening.

Given the latest data, will the BOJ have to do more?

If we do have a dip in inflation (more widespread than in fuel and commodity prices) and more importantly, inflation expectations, then we can’t rule out easing. They’ve eased so much, they have such an inflated balance sheet that they want to realize the impact of what they’ve done, that would be ideal but you can’t guarantee that.

If you’ve promised aggressive easing and you think inflation and inflation expectations are going in an opposite direction to your target, then it’s hard to get away from that easing. I wouldn’t rule easing out, but keep in mind that the BOJ has quite a lot already – it has one of the most aggressive policies around, so the best thing in the BOJ’s mind would probably be to wait until the effects of that easing to kick in and boost the economy. But given they have an explicit target, should oil and commodity price declines prove a greater force than inflationary forces such as rising wages, then they may not have the luxury of waiting too long.

Some analysts have even speculated about the risk of hyperinflation, given the level of monetary stimulus in Japan.

I would put into the risk category not hyperinflation but stagflation, which is much more closely tied to the risk of fiscal crisis. If you start seeing cost-push inflation, we would need to see an offsetting rise in domestic demand for tax revenues to increase, in order to successfully inflate away debt. If that growth isn’t there, and even if inflation doesn’t go to hyperinflation but is eroding away real growth, then it’s a bad fiscal situation and we get closer to a crisis.

It might have been the necessary complement to the reflationary policy, by delaying the consumption tax hike due this year. Still, from the moment when the government delayed the hike to 2017, it came at a price of undermining the credibility of the government’s fiscal policy to some degree. We might say that the tail risk of crisis has already risen since that point. About the tax hike in April 2017, any signal that it will be delayed further, then the risk increases again.

Hopefully the growth will stay around for long enough for the government to start inflating away debt and then make those hard structural decisions that you can only make when the economy is doing well and people accept it. Otherwise, the risk is we never get to a place where the recovery is strong enough so the government can take decisive action and do things like cut spending in a certain area, such as social security, or amalgamate the general and special accounts so there’s a different structure for regional payouts, to make regions accountable for a larger portion of their revenue as well as spending. If we never get to that point, then the structural portion of Japan’s fiscal balance won’t improve and we’re left worse off than before as the debt levels are bigger.

Looking at Abenomics, there’s been much debate over the third arrow of structural reform. What reforms are you expecting and what do you see as a priority?

I came up with a specific framework to analyze structural reform in a quantitative sense, yet those results don’t appear to have been addressed by the Abe government, and that worries me. For instance, one of the quantitative results that came from my study is what we really need long term is improving total factor productivity, but where’s total factor productivity weakest? It’s not the manufacturing sector, so every time we hear something about improving productivity in the manufacturing sector, it’s off target. The manufacturing sector is already efficient; it’s the services sector that needs to be improved.

We see things like the privatization of Japan Post; that’s one small part, but the structure of the privatization isn’t such that the government cedes its exposure fully to market forces – it’s keeping a large portion and they don’t seem to be creating a level playing field. And that has implications for the insurance and financial sectors, in which productivity is exceptionally low. It does not seem like an effective structural reform, if we look at it from the basis of the quantitative study.

Also, I did some econometric studies on regulation and structural reform to reinforce my point on manufacturing earlier. I broke down regulation into manufacturing and non-manufacturing, and the striking result was that in non-manufacturing and services, when you decrease regulation it’s consistent with a rise in productivity. That’s not the case with manufacturing, where the coefficient is inverse. This means if you decrease regulation it’s consistent with a decrease in productivity.

The long and short of it is if you start looking at special economic zones for manufacturing, they’re targeting many of the wrong industries, and they’re not putting enough emphasis on structural reform in the industries that really need it.

On wages, Toyota is leading the way on proposed pay hikes, but will it be enough to spur consumer spending?

Expectations of continued wage rises are probably more important than just one wage rise itself. If you have a one-off wage rise and you know it’s never going to reoccur, what are you going to do? You’re going to save most of it.

Japan’s trade balance has improved recently, but how much of an effect can we expect from a weak yen?

For years on end, Japan’s trade balances have diminished; even when the current account was in surplus before the Tohoku disaster, investment income, not trade, was a greater component. Capital flows, not trade, dominate the current account, and these flows consist of companies’ direct investment overseas as well as portfolio investment, the larger portion. So I would be inclined to agree when people downplay the effect of the weak yen on exports. That said, the yen plays a larger-than-life role in the Japanese economy, not only trade but also capital.

Every year you have a weak yen, then results of sales overseas improve (all else being equal), and if you are a corporate, and don’t think the weak yen is going to last for much longer then you repatriate more. From an investor perspective it means greater capital gains in yen terms; and on top of that, we also have a decent interest rate differential, so you have higher currency adjusted gains, and that will persist so long at the BOJ remains aggressive to other economies especially the U.S.

Currencies are affected by that rate differential as well, so in many ways the weak yen reflects the rate differential now and expectations for some widening in the future. Of course, with regard to importers, the weak yen is not a desirable development, but on the other hand commodity prices have been declining and that has offset a lot of the losses from importers exposed to rising dollar prices.

“Womenomics” aims to boost female participation in the workforce, but can it overcome existing barriers?

I will have to be a bit skeptical. Europacifica presented recommendations for Roundtable Japan that are presumably going to Japanese parliament, but from what I can tell a lot of the recommendations fell on deaf ears. If you come up with a new economic policy, one of the things you do is to survey intensely, gather as much observational data as possible, then you start thinking about incentives. Nobody has done this. You’ll have to pardon me for being skeptical, but it sounds very glib for the government to declare a new policy but do none of the groundwork for it.

For example, received wisdom says it’s due to a lack of childcare facilities. It is highly probable that this is one driver, but so far an unsubstantiated one, particularly for those who claim it is the main driver. I’m sure it’s a driver, but the way you design economic incentives is to pinpoint as accurately as possible the various (and sometimes conflicting) drivers of the behavior you are trying to change. The process is not as complicated as it is made out to be – you survey, then you analyze, then you tax behavior you want to discourage, and subsidize behavior you wish to encourage.

So we are still behind on step one – there remain many different analyses that can be done but are not. Perhaps the analysis is being done somewhere in the bureaucracy, but the process whereby such analysis influences policy is not transparent. As far as we can tell, no such studies have been commissioned by the Cabinet Office, and the absence of this basic step heavily undermines the credibility at all to whatever Womenomics is meant to be.

Another way of boosting the labor market is immigration – are you expecting any developments in this area?

My worry here is that the plans for increasing immigration still seem below that of the natural attrition rate from the labor force due to retirement, etc. We’re not in a situation of excessive wage inflation or labor capacity issues, but if reflation continues we might get there, and if we have an immigration policy below the natural attrition rate the question is how do we keep productivity going by increasing participation in the workforce?

Part of this is female participation, but that alone is not enough. There’s probably politics behind this – the vested interests are in regional Japan, which historically has been and remains politically conservative, and we can’t see them giving up their power for any kind of inclusive policy.

Japan is still a market economy and you don’t just tell people to hire more women or raise wages and it happens – you need to give economic incentives, and I don’t see any evidence of anything but poor design of these incentives. Immigration is also one of these cases – politics are standing in the way of the best economic policymaking and as long as that’s the case it’s hard to find a lot of credibility in that type of policy.

Finally, Japan’s recent experience is often cited as a prelude for other countries, such as Europe and even China in terms of aging and deflation. Is that fair and is there still potential for Japan to get out of this current cycle?

I don’t think the two things (Japan escaping its deflationary doldrums and other countries learning from Japan’s mistakes) are mutually exclusive. Taking a look at the lost decades, quantitative easing, and an aging population, there are many things that countries, particularly developed countries, should be watching out for. This is neither to say that Japan will be in the doldrums forever or that other countries will perfectly mimic Japan’s fate.

But there are many commonalities in the questions raised by economies all over the world over design of pension systems; worldwide there’s been a lot of questioning over whether current pension and social security systems in the U.S. or Europe are sustainable. Even in Australia, some question the sustainability of the superannuation scheme (so far viewed as largely successful).

Given the advanced age of the Japanese populace combined with the amount of pension outlays and massive debt burden, it is possible that Japan may be one of the first to experience problems that will become more widespread in the large economies of the world. How Japan deals with this burden in the future will undoubtedly attract global attention. Japan’s predicament is an extreme that provides an example (but hopefully not a roadmap) for every developed economy with an aging population.