RaboResearch - Economic Research

Country Report Japan

Country Report


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We believe Abenomics -consisting of fiscal, monetary and structural measures- is a unique opportunity to end deflation and spur growth. However, political reality shows that Abenomics is incomplete as structural reforms are clearly lagging.

Strengths (+) and weaknesses (-)

(+) Competitive private sector

Based on Japan’s competitive and innovative corporate sector, the country ranks 9th in the Global Competitiveness Index 2013/14.

(+) High private savings

In contrast to Japan’s precarious public finances, the private sector (especially households) is financially very sound. As a result, the country has a robust positive NIIP (57% of GDP).

(-) Ageing

Japan’s working age population has declined steadily since 1995 and is expected to shrink at the same pace until at least 2050.

(-) High public debt

Several years of low nominal growth and continuous fiscal stimulus (high deficits) have resulted in a very high gross public debt ratio of 243% of GDP in 2013. Net debt equals 140% of GDP.

Key developments

1. Gauging the progress of Abenomics

We believe Abenomics -consisting of the three ‘arrows’ of fiscal, monetary and structural measures- is a unique opportunity to end deflation and spur growth. Fiscal and monetary stimulus measures are welcome to boost actual growth, while structural reforms are necessary to ensure long-term fiscal sustainability and to increase potential growth (currently estimated between ½% and 1% by the IMF, OECD and the BoJ). However, the government seems to have missed the opportunity to launch the third arrow of structural reforms during the short-term growth revival. With the growth momentum expected to fade, it will become harder to announce sweeping reforms due to their negative economic and social impact in the short term.

Regarding a long-term fiscal plan, the IMF has estimated that a structural fiscal consolidation of 11% of GDP in the coming decade will be needed to stop the gradual debt accumulation. Proposed policy measures -an increase in the consumption tax to 10% in 2015 and several spending restrictions- account for around 5.5% of GDP, so an equally robust effort will be needed in the years beyond 2015. Please note Japan has some room to increase the tax burden, especially on households, as its government revenues (31.5% of GDP in 2013) are quite low from an international perspective (G20 average equals 36.3% of GDP). On the spending side, policy should focus on health expenditures. Without further reforms, the government’s contribution on health care and long-term care will rise from 3.8% of GDP in 2010 to 6.5% of GDP in 2030. Regarding structural reforms, Japan’s rigid labour market should be a priority. Especially given the declining population, high labour force participation is needed to increase Japan’s potential growth rate. While the male participation rate is already high (84.3% in the age of 15-64, in 2012), the female participation rate is clearly lagging (63.4%, albeit still slightly higher than the OECD average of 62.3%).

2. Short-term stimulus effects are fading

The pickup in growth in 2013 (1.6%) can be highly attributed to direct and indirect effects of the stimulus measures under Abenomics (figure 1). Despite last year’s momentum, we expect growth to fall back significantly in 2014, possibly even towards 1%. In contrast to 2013, both this year and next year there will be a significant fiscal withdrawal which will inevitably weigh on growth. More specifically, the Bank of Japan estimated that the planned hike of the consumption tax (from 5% to 8% in April) might subtract around 0.7%-points from growth in 2014. In addition, real disposable income of households will come under pressure as inflation rose to 1.5% in December 2013 (core inflation to 0.7%), its highest level since 2008 (figure 2). Until now, nominal wage growth did not keep track with rising inflation. At this stage, it is hard to assess whether the rise of inflation is temporary or structural, as the strong depreciation of the yen since end 2012 (-20% in effective terms) and the short-term stimulus might have pushed up prices. Only when inflation expectations increase structurally, it might spur future wage growth, although the wage setting process remains to be tested given Japan’s limited experience with rising inflation in recent years.

Figure 1: Growth performance compared
Figure 1: Growth performance comparedSource: Reuters EcoWin
Figure 2: Remarkable rise of inflation
Figure 2: Remarkable rise of inflationSource: Reuters EcoWin

We expect the BoJ to step up its quantitative easing program in the course of the year, although it is unlikely this will prevent a growth slowdown amid the fiscal withdrawal. That said, further easing will put more pressure on the yen, which already seems to be ‘moderately undervalued’, according to the IMF. A further depreciation, together with the expectation of a gradual pick up of world trade, underpins our view that Japan will benefit from higher external demand going forward.

3. No impact on government bond yields yet

Abenomics did not have an impact on government bond yields until now. A substantial rise in long-term interest rates would pose an economic and financial risk as it would result in 1) higher funding cost for the government and 2) a large loss for domestic banks and pension funds on their government bond portfolios. Given that headline inflation recently rose to 1.5%, it is remarkable that the nominal yield on 10-year government bonds remained extremely low (around 0.6%). Japan’s low interest rate is often attributed to ageing (which leads to low growth potential and low inflation) and its stable investor base (around 90% is domestically held). These factors seem to outweigh the country’s fiscal metrics. Besides that, a possible underlying upward pressure on yields might be masked by BoJ purchases, which holds around 12% of total public debt. For 2014, our base case scenario shows a very gradual and modest rise in government bond yields on the back of rising global bond yields due to US tapering. In addition, in the coming years, upward pressure on yields might possibly derive from higher inflation compared to previous years and a gradual decline of the domestic investor base due to a lower saving ratio as a result of ageing. A tail risk exists in a sudden change in investors’ risk perception, since it would lead to a stronger rise in yields. In such a scenario, the BoJ will likely further step up its purchases, at the cost of market volatility and a further weakening of the yen. In the end, only structural reforms are able to lower the probability and impact of such a scenario, therefore they cannot be postponed forever.

Factsheet of Japan
Factsheet of JapanSource: EIU, CIA World Factbook, UN, Heritage Foundation, Transparency International, Reporters Without Borders, World Bank.

Background information

The recent history of the Japanese economy is often characterized by its ‘deflation era’; since 1995 there have been almost two decades of very low inflation or even mild deflation. The phenomenon of deflation arose in the aftermath of the huge real estate and financial crisis of the early 90’s; large negative wealth effects alongside bank deleveraging and a rising yen put downward pressure on domestic prices. That said, the fact that deflation persisted well beyond the recovery of the financial sector shows there is also a more structural factor suppressing domestic demand: ageing. Japan’s working age population has declined steadily since 1995 and is expected to shrink at the same pace until at least 2050. Owing to a period of low nominal growth combined with a steady fiscal stimulus, Japan’s gross public debt ratio has ballooned from 91% of GDP in 1995 to 243% of GDP in 2013. The weakness of the public sector is compensated by a financially sound and competitive private sector: Japan ranks ninth in the Global Competitiveness Index 2013/14. A history of current account surpluses has resulted in a robust positive net international investment position (57% of GDP). In this light, it should be noted that the trade balance turned negative during 2011 amid structurally higher energy imports after the earthquake and resulting tsunami. Despite the strength of the private sector, maintaining public debt sustainability in a low nominal growth environment remains a key challenge. The policy response has moved away from the ‘gradualism’ seen in previous years –which consisted of a steady, incremental policy stimulus- towards a more aggressive stimulus experiment launched by Prime Minister Abe. Success will likely depend on vigorous implementation of structural reforms, but it should be noted there is little policy experience in how to escape from a period of sustained deflation like in Japan.

Economic indicators of Japan
Economic indicators of JapanSource: EIU


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