Foreign Developed

Japan at a Cross-Roads

February 13th, 2013 | By Nick Sargen


  • Following two decades of economic stagnation, Japan's new Prime Minister, Shinzo Abe, has pledged to get Japan's economy moving again. The key components of his strategy include prodding the Bank of Japan (BOJ) to set an inflation target of 2% while the government has embarked on a fiscal stimulus program equivalent to about 2.6% of GDP.
  • Investors have reacted to these developments by boosting Japan's stock market by nearly 25% from its lows last autumn, while the yen has depreciated by 15% against the dollar and nearly 25% versus the euro in the past two months.
  • Nonetheless, many observers remain skeptical that these policy measures will succeed. In this blog, we assess the pessimistic case laid out by Martin Wolf of the Financial Times and a more optimistic case based on the views of John Makin of the American Enterprise Institute.
  • Until recently, I had been very pessimistic on Japan's prospects based on the country's poor showing over two decades. However, I am now encouraged that the new government is seizing the initiative to end two decades of deflation and lethargy, and think it may be a good time to increase exposure to Japanese equities. That said, the challenges Japanese policymakers confront are formidable, as old habits rarely are changed easily.

The Case for Skepticism

In a recent FT article (February 5, 2013), Martin Wolf, the paper's chief economic commentator, arrives at the following conclusion about the likely impact of "Abenomics" on Japan's economy:

"Will Shinzo Abe rescue his country's economy from two decades of lassitude? Or has "Abenomics" launched a currency war and pushed Japan closer to hyperinflationary collapse? The plausible answer is: neither. The risk is that the policies of his government will fail to make a difference, in either direction."

Wolf's skepticism, in part, stems from the failure of previous monetary and fiscal programs to turn around Japan's economy. Despite an official interest rate target of 0.5% since mid 1995, the country's GDP deflator – a broad measure of the overall price level– has fallen by 17% in the past 15 years. Moreover, massive fiscal stimulus has had little or no impact on the economy, while gross debt of the central government has risen from 66% of GDP in 1991 to 237% currently. At the same time, Japan has not experienced a debt crisis, as yields on JGBs have fallen from about 8% in the early 1990s to less than 1%. Nor is there a sense of despair among the electorate, as the unemployment rate at 4.1% is low among the developed economies.

Wolf's skepticism also stems from his belief that the thrust of "Abenomics" is directed at ending two decades of deflation in Japan; yet Wolf does not regard deflation as the underlying cause of the country's problems. In his view, the root cause of Japan's problems is "excess private savings" especially in the corporate sector, where there is a huge structural excess of corporate gross retained earnings over investment. While easy money facilitated deleveraging in the post bubble period, it was unable to raise the investment rate, which at 30% of GDP is high for a mature economy.

Nor is it clear that the government is planning on embarking on structural reforms to boost private sector demand, which Wolf favors. They include raising wages, forcing higher distributions to shareholders via changes in corporate governance, and increasing corporate taxation to shift distribution of profits to shareholders and to raise tax revenues. Wolf concludes that the big danger is Japan will persist in treating its long-term structural problems as amenable to monetary and fiscal fixes.


A More Encouraging Assessment

By comparison, John Makin of the American Enterprise Institute, offers a more upbeat assessment in his latest commentary (January 31, 2013). The principal reason is that Makin is a long-time critic of the Bank of Japan's policies, and he is encouraged that the BOJ is about to embark on fundamental reforms that will end the deflationary environment:

"Mr. Abe has threatened the reticent Bank of Japan with a new governing law that would take away much of its cherished independence. The current governor, Masaaki Shirakawa, who as recently as February 2012 promised an aggressive program of reflation and then reneged, citing years of inflation, is in Mr. Abe's sights."

According to Makin, the most likely successor is University of Tokyo Professor Kazumasa Iwata. Mr. Iwata was deputy governor of the BOJ in 2007 when he was the sole policy board member to vote against hiking interest rates at the time – a decision which Makin contends proved to be disastrous, coming just before the global financial crisis. Accordingly, as new board members are brought on to the BOJ's policy committee, it is likely that the BOJ will become proactive in countering deflation.

One of the main challenges for Japan's policymakers will be to steer a course where inflation expectations rise gradually, but do not spike above the targeted rate of 2%. This is especially critical given the high level of central government debt in relation to GDP. Note: Because interest rates have fallen so low, Japan's government interest expense as a share of GDP has actually declined from a high of 3% in 1985 when the net debt/GDP ratio was about 25% to about 2% today with the net debt/GDP ratio at 140%. Makin envisions that as Japanese inflation approaches the 2% rate in the U.S., yields on 5-year JGBs would rise from 0.25% to 0.8% (roughly the same level as in the U.S.) If so, the cost of financing Japan's debt would increase nearly four-fold. However, because Japan's economy would be growing at a faster rate, its debt/GDP ratio would slow over time and become more sustainable.

In assessing Japan's outlook, Makin is generally complimentary of the approach Prime Minister Abe is taking. Makin acknowledges that the aim of the BOJ's money printing and foreign bond purchases is to depress the value of the yen, but he counters that Abe can point out to critics that a Japanese economy growing at a 3% annual rate in nominal terms, is "a better trading partner than a stagnant, deflationary Japan with a stronger yen."

Makin concludes his assessment by observing that most global portfolio managers have long since given up on Japan as a viable investment, having been burned by trying to predict recovery in Japan. (According to Goldman Sachs they are underweighting Japanese assets in global portfolios by at least $60 billion.) Makin feels this skepticism was reinforced by the BOJ's decision to back off of its reflation stance a year ago, which was accompanied by a stock market slide of 15%. However, he is now more optimistic about the prospects for the Japanese stock market: "It is likely, given the determination of the Abe government to pursue expansionary fiscal and monetary policies even in the face of foreign criticism that Japan's stock market will rise further, perhaps even doubling in value over the coming year."


Investment Implications

One of the biggest calls for investors to make in 2013 is whether to increase exposure to Japanese equities and to hedge yen exposure in light of the policies of the new Japanese government is pursuing. Since Japan's real estate and stock market bubbles burst in the early 1990s I have been reluctant to add to Japanese equity exposure on grounds that the country's policymakers lacked both the will and the means to end Japan's stagnation. With Japan's new prime minister having campaigned on the need to have new leadership at the BOJ to tackle deflation, I believe Japan is now committed to address one of its principal economic problems.

Ending the cycle of deflation is important to overcome the current psychology in which consumers believe there is no imperative to spend because prices will be lower tomorrow. It is also vital to ensure that investors are not content to hold bonds that barely have a positive yield, because the return is higher after adjusting for deflation. In this respect, I will be closely monitoring how effective the BOJ is in altering inflation expectations. If its policies are successful, there are grounds for expecting the Japanese stock market to post further significant gains, as valuations are compelling.

At the same time, I believe addressing deflation is necessary, but not sufficient, to alter Japan's long-term growth trajectory. For three decades now, Japan has struggled to find a strategy in which economic growth is led by domestic forces and not by its once powerful export engine. This is a key component that Japan's new government needs to address to convince investors that it has finally turned the corner.