Drawing conclusions from the stock market’s ups and downs can lead to overreactions when things are going well. But when they start to go badly, as they have recently, then everything gets an exclamation point. Even with the drama of China’s economy in the past few weeks, there are plenty of reasons to follow familiar advice and avoid panicking. However, there are also reasons to think of the more troubling scenarios that could result from China’s slowdown.
It’s not hard to create such a scenario: Investors turn to the yen in the search of safer holdings, leading the yen to rise and offset the devalued yen via the Central Bank’s quantitative easing and postponing the goal of two percent inflation even further. Firms remain reluctant to put profits into the Japanese economy, compounded by the stronger yen making Japanese exports less competitive than they were before. Wages stagnate and already-frugal household budgets adjust to the recent (and, for now, forthcoming) consumption tax hike. Japanese voters, frustrated with the stalled economy and with the cabinet’s focus on security legislation relative to economic concerns, let their displeasure show in approval polls, which eventually fall far enough for the government to wonder whether it’s time for a change at the top. The opposition, meanwhile, begins to wonder if it’s time to strike.
This scenario isn’t unlike what happened when Prime Minister Abe resigned in 2007 and is certainly within the realm of possibilities. Its feasibility depends on the answer to three questions: if China’s stock troubles are part of Xi Jinping’s “new normal;” how effective a lower yen will be at reinvigorating the Japanese economy; and how well Prime Minister Abe and his cabinet can adjust to the changing conditions.
The first question depends on how well President Xi and the Chinese government can manage the transition to China’s economic “new normal” by balancing market forces with government manipulation. Some of the results of their attempts have shown that China is on a learning curve in this regard, which shouldn’t be surprising. What’s more troubling is that having the world’s second largest economy on a learning curve will create short-term volatility like that seen in recent weeks as it figures out the right course. On the other hand, what’s encouraging is that China still has many tools available to correct the situation and many advantages like human capital and various reform packages for finance, education, and state-owned enterprises (SOEs) that are encouraging for long-term growth. China’s potential “new normal” isn’t something to worry about; it’s how quickly markets can get used to the attendant volatility that will come with it.
The second question is more complicated. Part of the adjustment markets will make to volatility in China will be look to the yen as a safe haven, something acknowledged by Economy Minister Akira Amari and Bank of Japan Governor Haruhiko Kuroda, as evidence that Japan’s economic fundamentals are sound. But GDP growth has been slower than expected in 2015 as export demand and household consumption both lag and China’s slowdown has shown that its consumers can’t be relied upon as they once were for an export market. That adds more evidence to the argument that economies can’t export their way out of recession as they once did. If Japanese firms see their exports fall even further, the knock-on effects would see wage growth slowed and consumer spending fall further. A cheaper yen might make imports and consumer goods more affordable, but that won’t mean much if wages are stagnant and taxes increase.
The third question is naturally where the Japanese government has the greatest ability to affect outcomes. The security legislation is nearing its conclusion and will almost certainly be ratified in September, giving the cabinet plenty of time to think about economic issues. The future of the Trans-Pacific Partnership (TPP) should also be clearer by October and, assuming the negotiating partners reach an agreement in September, completing TPP will be an important part of Abenomics’s third arrow of structural reform. Japanese lawmakers have begun to call for new fiscal stimulus. But this has its own risks: First, lawmakers will need to resist the temptation to use the stimulus on pet projects and should target low- and middle-income households directly. Second, the additional spending may lead fiscal hawks to issue new warnings about Japan’s debt and make the timing of the next VAT increase more inflexible. The hawks aren’t wrong, but they need to remember how the April 2014 tax increase slammed the brakes on Japanese GDP growth.
The good news is that the scenario for Prime Minister Abe and his cabinet described above is unlikely. The Japanese government still has room to maneuver. Unless things get much worse, the volatility in China’s stock market isn’t going to lead to a recession or to another financial crisis. The bad news is that there is very, very little room for error. The worst mistake the Japanese government could make would be to overreact by forcing down the yen and possibly igniting a currency war or inhibiting economic growth through poorly targeted fiscal stimulus or mistiming future tax increases. Japan’s leaders are correct to preach caution. The risk, however, is that it will be increasingly difficult to do so once elections creep closer.
Paul Nadeau is an independent writer based in Tokyo, Japan.