As Abenomics shows signs of strain, will Japan unlock growth potential?

The phantoms of stagnation still haunt Japan despite prime minister Shinzo Abe’s efforts to devise a comprehensive action plan to reignite growth and dispel deflation, commonly known as 'Abenomics'. 

After assuming office in December 2012 for a second stint as head of the government (he first served as prime minister between 2006 and 2007), Mr Abe emphasised his inflationary, pro-growth strategy built around three main areas: expansionary monetary policy and budget spending, combined with structural reforms.

In its first two years, Abenomics rebuilt some confidence among local businesses and consumers as a 2% inflation target seemed within reach and GDP growth accelerated. That initial boost has gradually waned as China’s slowdown, the drop in oil prices and political occurrences such as Brexit and the election of Donald Trump as US president-elect have dented Japan’s export potential, cooled inflationary forces and partly frustrated Mr Abe’s policies.

Today, Japan is facing falling consumer prices and economic growth close to zero. A new package of reforms aimed at, among other things, opening up the job market to qualified migrants to counter an ageing and shrinking working population is expected in the coming months.

Additionally, a long-awaited interest rate hike by the US Federal Reserve should turn the tide on the yen appreciation in the currency market, gaining Abenomics more time to trigger the virtuous circle of growing wages, consumer spending and investment that the country needs to reverse its decade-long stagnation.

Sluggish economic performance

Economic growth in Japan remained flat in the second quarter of 2016, while GDP did not expand beyond an annual 0.7%, according to government figures. Private consumption, which makes up about 60% of Japan’s GDP, was unchanged at 0.2%.

“The business environment is still uncertain,” says Thomas Östergren, a long-time expat in Tokyo and country manager for Atlas Copco, a Swedish manufacturer of industrial tools and equipment.

“You felt an improvement after Mr Abe came into power with the yen being weak, but still [the economy] has not taken off, and remained rather fragile. And today, as the yen has been strengthening after Brexit, expectations for the future are still uncertain. Of course, that will delay investment decisions.”

The flat sentiment of the local business community was captured in the third-quarter 2016 Tankan survey, where the Bank of Japan (BOJ) surveys the expectations of businesses across the country. The index tracking the mood of big manufacturers remained unchanged from the previous two quarters, while the services sector showed deteriorating sentiment.

External observers such as the IMF have also issued a sober outlook on the country's economy. “Japan’s growth is projected to remain weak, in line with potential, at 0.5% in 2016, before rising to 0.6% in 2017,” the IMF said in the October update of the World Economic Outlook.

“Postponement of the consumption tax hike, the recently announced growth-enhancing measures, including the supplementary budget, and additional monetary easing will support private consumption in the near term, offsetting some of the drag from the increase in uncertainty, the recent appreciation of the yen and weak global growth. Japan’s medium-term prospects remain weak, primarily reflecting a shrinking population,” it added.

Abe’s renewed support

Japanese voters have twice reiterated their confidence in Mr Abe’s reform agenda, first in the early general elections of December 2014, when the coalition led by his Liberal Democratic Party (LDP) maintained a two-thirds majority in the lower house of the Diet and renewed his mandate as the head of the government.

The second occasion was in July, when the LDP coalition won a two-thirds majority in the upper house too, securing him plenty of political room to continue with Abenomics policies to shore up economic growth and wrest the country from its decade-long deflationary pattern.

Mr Abe beefed up public expenditure immediately after elections through a supplementary budget entailing about Y4110bn ($38.4bn) in extra spending that the Diet passed in October, bringing the total budgeted expenditure for the fiscal year ending in March 2017 to Y100,010bn, slightly above the Y100,000bn mark achieved in the first three years of the Abenomics programme. Almost one-third of the budgeted spending will go towards a Y28,000bn economic stimulus package including infrastructure investment and strengthened welfare service approved by the cabinet in August.

Central bank plans

The government’s expansionary budget goes hand in hand with the BOJ’s repeated efforts to defeat deflationary pressures through an aggressive round of quantitative and qualitative monetary easing (QQE) to defeat deflation and generate a 2% inflation rate. 

The bank has pumped liquidity into the Japanese economy through massive bond-buying programmes since Mr Abe took office in 2012. The overall monetary base, including cash in circulation and the balance of current account deposits held by financial institutions at the bank, stood at more than Y417,600bn at the end of October, from Y130,600bn at the end of 2012, according to BOJ figures.

The BOJ board even decided to follow in the steps of the European Central Bank when it agreed to negative interest rates on banks’ excess funds held on deposit at the central bank in January, in an effort to encourage commercial banks to increase loans.

However, the BOJ’s QQE, widely considered the most aggressive easing ever attempted by a central bank, is not translating into fast-growing credit lending as banks are hoarding cash to strengthen their own balance sheets rather than passing on to the real economy the massive flow of cheap money offered by the central bank.

As a result, despite years of aggressive monetary expansion resulting in a booming monetary base, deflation remains a tangible reality across the country, with consumer prices falling by 0.5% in August 2016 from a year earlier.

In acknowledgment of the limited results achieved with the last round of QQE, the BOJ abandoned its goal of increasing the monetary base in September to focus on controlling the 10-year yield curve and thus keep mid-term interest rates at about zero in a renewed effort to push banks to lend.

Structural reforms

Mr Abe’s third strategic area of focus, structural reforms and deregulation, has probably proceeded at the slowest pace so far.

“In Japan there are a number of rules and regulations that are very specific to the country, which makes it more complicated to bring in international development because we have to adjust to tight Japanese standards. That may prove a bit difficult, and eventually slow down the pace of investment,” says Alan Combier, vice-president for the north-east Asia cluster of French industrial gases producer Air Liquide.

The government reduced the corporate tax rate by 2.51% in 2015, and then by another 2.14% in April 2016, bringing it down to 29.97%. It also pushed through an overhaul of the corporate governance of listed companies to make room for independent board members. However, much has yet to be done in key areas such as deregulation and labour.

With an ageing population and shrinking workforce, combined with little immigration and foreign investment, many are calling for the country to introduce measures to boost wages and productivity to support consumption and increase the profit margins of its companies.

“Whether Japan’s economy will grow in the long run depends on whether the country’s labour market can successfully adapt to this changing environment,” said BOJ governor Haruhiko Kuroda in a speech in October.

“Indeed, labour market reform is a vital part of the current government’s policy agenda. As for the long-term economic outlook, given Japan’s ageing population and low birth rate, an increase in labour force participation and a further rise in labour productivity are both essential if Japan is to lift sustainable long-run growth; in other words, to raise its growth potential,” he added.

Changing the workforce?

In September, Mr Abe established a panel to examine possible solutions for pay gaps between 'regular' and growing 'non-regular' workers, to cut extreme working hours, and to help older people get back to work. The panel will also address ways for the country to better engage with foreign workers to cover the current demographic shortages.

The government is already working on a green card system for skilled foreign workers (see interview with Jetro CEO on page 12), but any measure to allow in foreign, low-skilled labour remains highly sensitive in a country that has seen very little immigration in recent years. The panel is expected to file its final proposals in March 2017.

Japan’s ageing population poses a great fiscal challenge, demanding massive welfare spending. This has led to a deficit that has been gradually falling over recent years, but remained at 5% of GDP in 2015. Besides this, the country has the world’s largest outstanding public debt, which is expected to hit 250.4% of GDP at the end of 2016, according to IMF estimates.

Mr Abe’s reform ambitions, particularly fiscal, inevitably need to acknowledge this widening double deficit. He increased the consumption tax to 8% from 5% in 2014, but eventually decided to delay to 2019 another hike to 10%, which was originally due in June.

Despite the current uncertainties over the effectiveness of his strategy, the prime minister remains defiant over his next steps. “We’ll further accelerate Abenomics and maximise the pace of moving out of deflation,” he said in September during the opening of the autumn parliamentary session.

He has two years left of this term to ensure that Abenomics gains some traction and finally revitilises the Japanese economy.