Japan: off to the races
Japan is off to the races -- but it's going to be an obstacle course
It is early days, but Japan’s Abenomics is off to a good start: first quarter growth surprised on the upside with a robust 3.5% (quarter-on-quarter seasonally adjusted). This gives Japan the strongest start in the new year among G7 economies—admittedly not a particularly fast-growing bunch, but still... The solid growth number is a well-deserved reward for the ambitious policy efforts of the new administration, and will hopefully have a positive psychological impact on policymakers, bolstering their resolve to implement all ”three arrows” of the policy plan. It is also an important down-payment towards the recent performance of the stock market, which has enthusiastically raced ahead to price a better growth performance (as well as stronger liquidity flows).
The acceleration in growth has been driven by private consumption, followed by exports; investment continues to disappoint. What should we make of this mix? I see the strong performance of private consumption as a positive sign: after all, the “big bang” approach of Abenomics was also aimed at shifting consumer expectations and behavior. The fact that consumers have gotten the message and reacted by stepping up spending is a good sign and increases chances that inflation expectations will also gradually move up.
Stronger private consumption seems to have been supported more by a decline in savings than by rising incomes, and this is a reminder that the job is only half-done. Domestic savings have traditionally acted as a captive audience for Japan’s public debt, helping to accommodate a debt-to-GDP ratio in excess of 200% with very low bond yields. As the population ages, savings decline and so will private domestic demand for Japanese Government Bonds (JGB). In the short term this is not a problem: the Bank of Japan is stepping in. But the Bank of Japan cannot support the JGB market forever: beating deflation and boosting real GDP growth will be essential to ensure debt sustainability.
The recent rise in JGB yields is an alarm bell in this respect. Yields on 10Y bonds are back to the levels immediately preceding the launch of Abenomics. This rise is premature and should prove temporary: the fact that Japan is in a liquidity trap suggests that an increase in inflation (once it finally materializes) should initially be reflected in lower real yields and not rising nominal rates; and larger BOJ purchases should also keep rates low. The recent trend however is a reminder that moves in market interest rates are difficult to predict and control.
To boost real growth, structural reforms will be essential.This is the “third arrow” of Abenomics, and the hardest part of the program. It envisions action in key sectors like energy and health care, the tax system, immigration and labor markets, agriculture and the electoral system. Some of the necessary changes are bound to run into tough resistance from vested interests.
In the case of Japan, reforms aimed at boosting female labor market participation and encouraging immigration are especially important. Japan’s growth performance in real per capita terms has not been too far from Germany’s, and recently on a par with the US. This suggests that while Japan has room and strong potential to boost productivity growth further, it still needs to address the fact that a shrinking labor force will struggle to produce the resources needed to match its enormous public debt stock. Measures aimed at bolstering the growth of the labor force are as urgently needed as they are politically controversial.
Japan has strong potential and the best chance in twenty years to break free of deflation—but the real tests are still ahead, printing money will not be enough.