The Japanese Economy: Abe and Ability

“Stagnant” is a commonly used word to define the state of the Japanese economy. The economy is characterised by low growth (less than 1%) in GDP, an impending problem of deflation and an enormously indebted government.

The Japanese economy has had two decades of slow growth. Image courtesy The Guardian

One side of macro-economic trends you have a lot of hustle and bustle around countries like USA (increase in interest rates on the bonds), India (implementation of the GST), Britain (Brexit), China (causing a commodity collapse, devaluation of the currency) and OPEC countries (decisions on whether or not to cut oil supply to prop up prices). However, on the other end of the spectrum, you have Japan which has consistently failed to prove its mettle. Even a “snail’s pace” cannot be used to draw an analogy as the nation just doesn’t seem to progress. If you study the “Japanese economic problem” from a theoretical stand point or watch experts give their views in research papers and interviews, it is a challenging task to connect the dots of intricate problems and eventually draw conclusion on “what went wrong” and “why hasn’t the government been able to revive the economy”. This article seeks to simplify matters into 3 broad questions, the answers to which will help you take a stronger stance on this issue. The following are the questions put into context:

  1. What were the tipping points after which the growth trajectory went downhill?
  2. What measures have been adopted in the past and why have they failed to pull Japan out of this conundrum?
  3. What are the evaluated solutions on the table which provide credence for a more likely Japanese recovery?

# Tipping Points

Firstly, the tipping point for Japan could be called “de-industrialization”. This refers to a phenomenon wherein manufacturing activity declines which in turn leads to low output, decline in price levels and high unemployment. De-industrialization occurred in 2 phases in Japan. The first phase occurred in 1973 due to an “oil shock” wherein the Arab Petroleum Exporting countries proclaimed an oil embargo. This implied that the there was a hold on oil supply which in turn pushed up the oil prices. The Japanese economy was highly dependent on import of oil and as a result had to pay a higher price for each barrel of oil. This went on for a decade and the Japanese economy plunged into a deficit as they paid more for their raw materials (oil) but could not increase the prices of their final products in the same proportion in order to maintain export competitiveness. Thus the government was compelled to issue bonds in order to finance its deficit (it could not increase taxes as domestic aggregate demand was down 10% as well). The total borrowing at the onset of the 1980’s was over 15trillion yen. Managing such imbalances shifted the focus of the government away from growth and the Japanese economy with a lack of government stimulus went into recession.

The second phase occurred in the 1990’s when Japanese firms began to relocate to ASEAN countries and China on account of lower aggregate demand in the domestic economy and lower production costs incurred outside. Of the remaining firms in Japan, less than 50% survived for another 10 years. Thus by 2003 the state of industrial output had shrunk more than 40% subsequently causing high unemployment (shrinking of the labour force). Thus there are 2 key takeaways from the above timeline of events:

  1. Japan was in a state of recession and high unemployment.
  2. The phase of de-industrialization left the Japanese government with a high level of debt.

# Failure of reforms

The most notable reform undertaken in Japan is known as “Abenomics” deriving its name from the ideology of the current Prime Minister of Japan-Shinzo Abe. The reform essentially seeks to depreciate the currency which in turn will make exports competitive and thereby increase output contributed by Japanese exports. The impact on the Japanese Economy was expected to help. On the other hand a depreciating currency will also make import of goods costlier causing an inflationary impact on the domestic economy (since producers will have to increase their prices in order to maintain profit margin). This ideally should solve the problem of stagnancy as output will increase and price levels will increase (solving the problem of deflation). However, this theoretical notion isn’t the case in reality.

Has Abenomics failed? Image courtesy the Guardian

For example, reduction in interest rates is a key tenet of Abenomics. The interest rate in Japan has been kept at a near zero level and recently been pushed into negative territory by the Central Bank of Japan. A low interest rate relative to interest rates in other nations should typically lead to capital outflows (reducing demand for Japanese yen) and depreciate the currency. However, contradicting the notional belief, foreign investors have been investing more and more in Japanese government bonds framing the yen as a haven currency. The rationale behind this move is that to lend foreign currency, foreign investors charge a fee and this very fee income outweighs the cost of holding negative yield bearing Japanese bonds. Thus instead of depreciation and inflation, the macro-economic trend has been reversed in Japan. A foreign investor would not want to invest in American markets where a possible “Fed Hike” in interest rates could drive down prices on US bonds and lay out huge capital losses.

Another wrong assumption made in the case of Abenomics is that a reduction in interest rates will reduce borrowing costs for firms and give them an impetus to borrow, invest and increase capital expenditures. This assumption has been proven to be wrong as “core machinery orders” which is a proxy for capital expenditures in the Japanese Economy has been declining 8% year on year. Incontrovertibly, low interest rates should cause more and more firms to borrow and invest in their business but one needs to ask another fundamental question-“Who are the borrowers in my country?”. That’s where the catch lies. Japan has an approximate 4.7 million firms registered. 90% of them are SME’s and banks in Japan don’t have the risk capacity/tolerance to lend to firms which don’t have the credibility on risk and credit scorecards (lack of collateral and problem of cash flows).

Taking the case of a more recent measure (2015-2016), negative interest rates are also paving way for yet another structural failure instead of a ray of hope. This policy implies that banks will have to pay interest rates to deposit money in the Central Bank of Japan (instead of the quintessential case of Central banks paying interest rates on the commercial banks’ deposits). Thus it is a push from the central bank for commercial banks to park lesser funds in deposits and lend more. Firstly, the case of SME’s non-credibility reappears as an obstacle for this chain reaction. Secondly, 63.2% of the Japanese population is dependent on interest income. Therefore, reduction in interest rates on the lending side will also lead to a reduction in interest come for those from whom the banks are borrowing (depositors). Thus the dependent population will have to cut back on expenditures which will reduce aggregate demand and increase deflation (instead of lower interest rate increasing aggregate demand and inflation).

 

# Evaluated solutions

Japan’s insurmountable level of debt (Debt/GDP=229) is an area of concern. It could undertake 2 policies to inoculate itself against such concerns:

  1. It could exchange its debt for perpetuity bonds- a bond that is never repaid (in principal terms) and only an interest payment is made each year. This would shift the risk off the government books and could entail an inflationary impact as well.
  2. It could monetize its debt. It is a highly understated fact that although Japan has a high level of debt, it owes most of it to itself(70% is domestically owned)! The main stakeholders in Japanese debt are Japan Post Bank, Japan Central Bank and Japan Post Insurance. An increase in money supply to finance this debt poses yet another extension of an inflationary impact, a feature that Japan exactly needs right now.

Lastly, it is imperative to keep a quantitative target in mind. It must be taken into cognizance that the deficit level of the government is currently 3.3%, its growth rates are less than 1% and its price levels are plummeting (inflation = 0%). Making sense of these numbers, deficit> growth rate + inflation which is unsustainable in the long run (can further lead to unemployment and low output). Thus the government must strive to reduce its deficit either by spending cuts or increasing taxes. Given an aging population, spending cuts will have an impact on pension and other transfer payments accruing to the old. Thus tax hikes seems a more plausible solution for the Japanese government, although it will have to overcome the political impediments of doing so.

Ayush Banerjee

Ayush Banerjee

Policy Intern at InPRA
Ayush Banerjee has completed his bachelor's in economics from Narsee Monjee Institute of Management Studies. He has been associated with several NGO's (Round Table India, Make a Difference, Save the Children etc.) in the past and is committed to making a positive difference. An avid follower of activist investing and Buffetology, he aspires to become a successful value investor in the Indian equity markets.
Participating in debates and MUN's has motivated him to research on international law and change the public perception about the prevalent laws by conducting a deep dive analysis of policies and it's ramifications. He hopes to do the same by writing for InPRA.
Ayush Banerjee