Japan cover story

This is the main text of my recent Fund Strategy cover story on Japan’s experiment with “Abenomics”. Note that I had to be a guarded in expressing my own opinion as my brief was to write a feature based on the views of others.

Three arrows held together cannot be broken, according to a Japanese folk tale. That is the inspiration behind ‘Abenomics’, Shinzo Abe’s radical three-pronged reform policyfor the country’s economy. A year on from its launch, how well is the policy working?

Perhaps the most striking figure illustrating the recent plight of Japan is 38,957. That was the record high for the Nikkei 225 stockmarket index achieved way back on the last trading day of 1989. In contrast, at the time of writing, nearly a quarter-century later, the index stood at only about 15,000.

To be sure, the steepest falls were in the early 1990s, with the Nikkei already trading at about its current level in 1992. Since then the index has risen above 22,000 at its height and just topped 7,000 at its lowest. So those investors who have bought and sold at the right time have made a lot of money while others have suffered heavy losses. However, the market has not enjoyed a clear upward trend for almost 25 years.

Of course, equity prices do not translate directly into economic performance. But in Japan’s case the economy has performed relatively poorly from the 1990s onwards. Japan’s nominal GDP this year is at about the same level as it was in the mid-1990s.

Japan remains a relatively rich country despite more than two lost decades. In terms of GDP per head, it is at about the same level as Britainf. But if Japan’s stellar growth rate of the 1980s had continued the country would by now have the largest economy in the world by far. It is all too easy for observers today to forget that until the 1990s Japan was considered easily the most dynamic of the large economic powers. As events have turned out, it is not only smaller than America in economic terms but China has overtaken it.

This extended period of economic stagnation provides the backdrop for what has become known as ‘Abenomics’. That is the policy of ambitious economic reform pursued by Shinzo Abe, the Japanese prime minister, since late 2012. In his favoured term the programme consists of three ‘arrows’: monetary policy, fiscal policy and structural reform.

The terminology comes from a Japanese folk tale in which a father shows his sons that three arrows held together cannot be broken. In other words, the three arrows represent complementary components of a strong reform package.

This article will examine the impact of Abenomics on the economy and asset prices with the benefit of more than a year’s worth of hindsight. It will start by examining the forces driving Japan towards radical economic reform. Then it will consider the impact of the three arrows of Abenomics. In conclusion, it will consider the likely impact of the strategy over the coming years.

Driving force

More than two decades of economic stagnation provide the context for the introduction of Abenomics. The Abe government is intent on wrenching Japan’s economy out of its deflationary spiral and bolstering asset prices in the process.

This raises the question: why now? Japan’s leaders could have taken decisive action five, 10 or even 15 years ago. Instead, they waited till the end of 2012 before committing to the move.

One possible answer to this puzzle is that Japanese governments have not had strong mandates until recently. The country had five prime ministers between September 2007, when Abe ended a year in office, and late 2012. For just over three years of that time the Democratic Party of Japan was in office. Then, in 2012, Abe’s Liberal Democratic Party (LDP) was elected with a substantial majority. Its rule was further consolidated when it won elections to the upper house in July 2013. Barring any dramatic developments, the LDP looks set to dominate Japanese politics for several years.

For some observers this political shift is sufficient to explain Abenomics. The government is finally introducing radical reforms because it is in a position to do so.

However, others have argued that there is another element at work. Japan has finally got round to implementing a decisive economic programme because of the perceived threat from China. For Japan’s leaders the country needs to be strong enough both to weather Chinese economic competition and to deter any potential military confrontation. In that sense the programme is said to be a return to the Fukoku kyohei (rich country, strong army) policy of the late 19th century.

From that perspective, Abe’s hawkish attitude to history (see box on tensions with Asia) is closely tied to Abenomics. Both are designed to ensure that Japan maintains what it regards as its rightful place in the world.

Three arrows

The first of Abe’s arrows is aimed at monetary policy. Both the government and the Bank of Japan are intent on substantially increasing the money supply in an effort to head off the deflation that has plagued Japan for many years.

Behind this policy is the idea that Japan is stuck in a liquidity trap. In other words, falling prices create a disincentive for Japanese consumers to spend. Why pay, say, a million yen today for something that will cost less tomorrow and even less the day after?

The idea that this is Japan’s main challenge goes back at least to 1999 when Paul Krugman, a US economist, who has since won a Nobel prize, published a book called The Return of Depression Economics. In his view, Japan needed to avoid deflation by pursuing a monetary stimulus. It has taken the Japanese authorities 14 years to embrace his ideas, but now they are pursuing them in earnest.

Judging by the headline figures, the policy seems to be successful. Core inflation in 2013, which excludes fresh food, was up 1.3%. Japan seems to be moving towards its recently declared 2% inflation target.

However, on closer examination the result is not so clear cut. Part of the rise is the result of a one-off increase in energy prices. Since the yen has fallen sharply, the local cost of energy, of which Japan imports most of its requirements, has surged. But the increase is not likely to be sustained in the years ahead. In other words, its contribution to overall inflation looks set to fall.

Andrew Rose, a Japan fund manager at Schroders, says a rise in people’s earnings is vital to the success of Abe’s monetary policy.

“The key is for that inflation to be more embedded,” he says. “That comes down to whether wages will pick up”.

Asset prices have enjoyed an indisputable surge as a result of monetary expansion. The Nikkei 225 performed remarkably strongly in local currency terms in 2013 although, with the falling yen, not nearly as well when expressed in terms of foreign currency. Much of the rise happened in the first half of the year, when Abenomics enjoyed its great impetus. Meanwhile, yields on Japanese government bonds (JGBs) are remarkably low, with 10-year yields at only about 0.6% at the time of writing.

If the monetary policy is relatively straightforward, at least in principle, the fiscal policy is the opposite. In its initial phase the idea is to bolster public spending as a way of complementing the monetary boost. That is why Japan implemented two supplementary budgets in 2013.

However, over the slightly longer term the idea is to rein back the fiscal stimulus. That is because Japan has an enormously high level of public debt that dwarfs even the levels in Greece. The comparison is not exact because domestic investors hold most JGBs whereas foreigners own a lot of Greek debt. Nevertheless, the Japanese authorities are intent on reducing government debt levels over the medium-term.

This reverse course in fiscal policy is scheduled to start in April with an increase in Japan’s equivalent of VAT. For investors, the reaction to this move will be particularly important to watch. If the economy or markets get spooked, the authorities could well take counteracting measures such as introducing a new stimulus package.

Perhaps the most difficult arrow of the three to gauge is structural reform. That is because it includes a hotchpotch of policies, including measures relating to agriculture, energy supply, immigration and the labour market.

John-Paul Temperley, a Japan fund manager at Martin Currie, describes it as “a very disparate collection of other policies”. The idea is that these reforms will help make the Japanese economy more productive.

It is widely accepted that, so far at least, Abe has not gone far in putting these structural reforms into action. Abenomics in this area consists more of a statement of intent than practical measures.

Optimistic observers take the view that such reforms take time to implement. Schroder’s Rose says: “Structural reform doesn’t happen over night.” He points to the example of Margaret Thatcher’s reforms in Britain in the 1980s to show that such change can take time.

Nicholas Weindling, a Japan fund manager at JP Morgan in Tokyo, takes a similar view. “Taken overall, it’s going much better than anybody would ever credit.” From such a perspective, it is far too early to judge Abenomics either a success or a failure.

For the pessimists, in contrast, the reforms are either long overdue or they miss the point.

Charles Dumas, the chief economist at Lombard Street Research, argues that Japan has steadily lost competitiveness in recent decades. “Thirty years ago, what did you buy? It would have been a Honda Accord, a Nintendo Game-Boy, a Sony Walkman, a Sharp fax machine or any number of Japanese hi-fi makes. Now, you do not buy Japanese things unless they price their way into the market by being cheaper.” (Daily Note, 20 December 2013).

In Dumas’s view, Abenomics is likely to make Japan’s plight worse rather than better, only perpetuating the featherbedding of Japanese companies. Cash-rich corporates are already enjoying further benefits, he notes, while cash-strapped households are being squeezed even harder.

Prognosis

As time goes by, it will no doubt become easier to assess the success or otherwise of Abenomics. At this point those who accept that a liquidity trap is Japan’s main economic challenge are likely to be upbeat. It is hard to believe the Japanese authorities cannot stoke up inflation if they really put their minds to it.

As Willem Verhagen, a senior economist at ING Investment Management, says: “If you want to end deflation, at least in theory you can always do so.” The challenge could be keeping inflation under control if they take such drastic measures.

Those who emphasise the importance of structural reform are likely to be more downbeat. Judging by their record, the Japanese authorities look set to move extremely cautiously in this area.

Equities are likely to benefit from the continuing monetary boost in the immediate future. The Japanese authorities are also taking measures that should help shore up equity prices. They have already introduced the Nippon Individual Savings Account, or Nisa, based on Britain’s Isa. Millions of Nisa accounts have been opened since the start of the year. Soon an Individual Retirement Account (IRA), designed to encourage longer-term savings, will be introduced.

Of course, some opportunities will be more attractive then others. JP Morgan’s Weindling points out that consumer electronics brands such as Panasonic, Sony and Toshiba have lost out to foreign competitors such as Apple and Samsung. In contrast, Japan is a world leader in robotics, while the ageing population also provides a theme that investors can play.

Overall, those fund managers who are willing to brave the Japanese stockmarket are guardedly optimistic about its prospects for the next year or two. Although they do not expect a repeat of the stellar performance of 2013, they see the potential for significant gains.

Global fund managers are heavily committed to Japanese equities, according the Bank of America Merrill Lynch. A net 30% were overweight Japan in January.

Whether or not the stockmarket fulfils its expected potential over the coming months, the economic impact of Abenomics remains far from certain.