Japan: A Fragile Economic Recovery Should Gradually Gain Traction

Japanese GDP growth and inflation should pick-up through 2018, with the former averaging around 1% in the next two years; but the latter will likely fall short of the central bank’s 1.5 to 1.7% forecasts and its 2% inflation objective. Despite steady progress across a wide range of structural and institutional reforms as well as a forthcoming boost from fiscal stimulus and firmer global demand, a faster pickup in growth or inflation will remain somewhat constrained. This is because of the presence of entrenched backward looking inflation expectations, an almost flat Philips curve, low fiscal multipliers, and the 16% nominal appreciation of the Yen in the year-to-date.

Adverse demographics and institutional rigidities underpin most of these structural shortcomings. As a result, these also imply outsized reliance on a continuation of accommodative policies even as structural reforms are undertaken. Moreover, the risk of “de-globalization” and falling trade pose additional risks.

Market participants’ impatience with the accomplishment of the key goals of “Abenomics” belies the structural reform progress which is already underway. It is true that the Bank of Japan’s 2% inflation goal has had to be repeatedly postponed. In fact, the BOJ now no longer even expects to reach this target by the end of its governor’s current tenure, in FY2018. What’s more, the goal of sustaining 3% nominal GDP growth also remains distant.

Nonetheless, it is worth highlighting that a wide range of structural reforms have indeed been gaining traction. Alongside monetary accommodation, these have begun: raising labor force participation and tightening labor markets, liberalizing protected sectors of the economy and boosting competition, and improving corporate governance and raising overall productivity and innovation. They have also raised price levels, and should keep them from relapsing back into deflation for a sustained period of time.

However, many of these reform efforts are time consuming, require corporate restructuring, broader political consensus, and rub against deeply ingrained socio-cultural norms. They also reduce costs and generate labor savings and, hence, are slow in accomplishing key macro goals -such as the 2% inflation objective. These shortcomings are evident from the lack of sustained increases in domestic demand or wages, despite tightening labor markets and high corporate profits.

Hence, as structural reforms take more time, our cautious optimism about the near-term outlook is predicated on the forthcoming fiscal stimulus. The government will directly spend around JPY 13.5 tln as part of a larger JPY 28.5tln package to raise resilience against external shocks, build out infrastructure and address structural demographic challenges. We estimate that the incremental amount of the pick-up in government spending could amount to around 1% of Japan’s GDP, spread out over 1.5 years. Additionally, the postponement of the consumption tax hike to 2019 or later will keep contractionary fiscal impulses at bay. That said, the growth benefits of the fiscal stimulus could begin fading by late 2018 or early 2019. But by that time, the effects of further reform deepening and a pick-up in construction activity in the run up to the 2020 Tokyo Olympics should sustain a
reasonably robust rate of domestic demand.

Another glimmer of near-term optimism is the slow healing of global demand. Amid the rising possibility of world-wide reflation led by infrastructure activity in the US and in China, global demand conditions could be a touch stronger in 2017, than it has been so far this year. This should provide a boost, at the margin, for demand-constrained economies such as Japan.

The modest brightening of the macro outlook should remain supported by the Bank of Japan’s highly accommodative monetary policy stance. In particular, the shift in the central bank’s policy framework from an open ended commitment to broadening its asset base to maintaining negative interest rates with yield curve targeting improves, in theory, the sustainability of monetary policy. This allows it to exploit negative real interest rates, out till 10 year tenors, to try and spark domestic activity and credit demand whilst also having an indirect influence on capital flows and exchange rate expectations. A gradual claw-back of monetary policy credibility alongside a slow pickup in economic growth should result in a leveling off of FX hedging demand by domestic institutional investors –of assets held abroad, in higher yielding instruments. That should limit further appreciation pressure on the Yen. This is important as the 16% appreciation of the Yen, in the yearto-date, alongside the collapse in oil prices, has delayed the hoped for pick-up in inflation.

All told, the outlook and the stance of policy are not without its drawbacks. For one, banks’ margins have come under pressure as credit spreads have eased relatively more than funding costs --and as, both, lending appetite and credit demand have remained scarce. Negative yields and the dearth of fees and charges on large deposits are also hurting banks’ profitability and have left them vulnerable to a further reduction in the interest on excess reserves. Further reform, could boost credit activity and the banks’ revenues and margins. These could include measures which discourage banks to insist on loan collateral or encourage them to levy fees on underutilized large value deposits, or an acceleration of labor market reform which raises the share of fulltime workers –who are typically regarded as more “creditworthy” than their part-time equivalents. But these do not seem imminent just yet.

Another drawback is that the government’s fiscal stimulus plans, and postponement of the VAT rate hike, imply a slowdown in fiscal consolidation. Efforts to stabilize the government debt burden at around 250% of GDP will be challenged by low nominal GDP growth (of less than 2% per annum) and still sizable primary fiscal deficits (of around 3-4% of GDP).

Finally, rising BOJ bond purchases are weighing on bond market liquidity. As BOJ purchases of JGBs are on course to rise toward nearly 40% of the outstanding bonds in 2017, and as nearly 70% of the government debt stock is at zero or negative yields, there are increasing concerns about tapering and the impact on bond yields. Amid thinning turnover, underlying bond market (or currency) volatility could magnify --should inflation expectations or resident portfolio preferences begin turning more decisively, and not be accompanied by soundly communicated BOJ policy and liquidity management responses.

In this context, in our view, there’s not much else for the BOJ to do for catalyzing growth or inflation, as the drivers are shifting to fiscal spending and external sources of demand. If undertaken, deeper negative interest rates –could hurt the banks even more, and is likely to be eschewed unless adverse external shocks (or large “risk off” episodes) materialize. Moreover, any tapering of asset purchases –given the yield targeting framework of the central bank will also be gradual, so as to avoid signaling any shift in the stance of policy and for limiting financial market volatility.

The main risk to the outlook is geopolitical in nature, and medium-term. We are now doubtful of the implementation of the Trans-Pacific Partnership (TPP) agreement –which would have provided a small boost to Japan’s long-term potential growth. However, over the course of the coming year, any scaling back of trade and, especially, the strategic relationship between the US and Japan could prove more damaging. Although these trends are not a given or a baseline in our view, a more isolated Japan could encounter much greater headwinds to its reform and reflation efforts. In such circumstances, Japan’s political authorities would also have to countenance deeper strategic shifts in its external relations and national security paradigms.


The comments provided herein are a general market overview and do not constitute investment advice, are not predictive of any future market performance, are not provided as a sales or advertising communication, and do not represent an offer to sell or a solicitation of an offer to buy any security.  Similarly, this information is not intended to provide specific advice, recommendations or projected returns of any particular product of Standish Mellon Asset Management Company LLC (Standish).  These views are current as of the date of this communication and are subject to rapid change as economic and market conditions dictate. Though these views may be informed by information from publicly available sources that we believe to be accurate, we can make no representation as to the accuracy of such sources nor the completeness of such information.  Please contact Standish for current information about our views of the economy and the markets.  Portfolio composition is subject to change, and past performance is no indication of future performance.
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