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Despite a set of gloomy data that showed widespread declines in output across the advanced economies in Q4, financial markets have remained resilient, and the Bull Run that began in the New Year continues. Japanese equities have been a prime beneficiary of this increasingly risk-on attitude, with the Nikkei up 30% since November. The Yen, meanwhile, has fallen by 15% against the dollar over this period. Much of this movement has reflected the policy agenda of Japanese PM, Shinzo Abe, who has promised a three-pronged toolkit to revive his country’s ailing economy: fiscal stimulus; monetary stimulus; and a bold new leadership team at the Bank of Japan (BOJ). Despite the apparent vote of approval from global investors, we question whether this really marks such a dramatic shift in policy. The BoJ was, of course, the first central bank to undertake QE. And Japan’s debt-to-GDP ratio has already surpassed 200%, largely on the back of repeated attempts at fiscal stimulus. Past efforts providing monetary and fiscal support have proved ineffective. But that does not mean that just one final push will do the trick. Rather, we would argue that much of Japan’s economic problems stem from its broken banking system. Unless and until this is addressed, its current blend of stimulus measures will, at best, provide only a temporary boost to growth.
Japanese GDP fell unexpectedly, and by an annualised 0.4%, in Q4. The consensus had been for a 0.4% gain. The fall should not have come as a great surprise; Japan has been bumping along the bottom for a very long time now. Over the past 20 years, almost 2 quarters in every 5 has seen a drop in output – these are the areas shaded in grey on the chart below. Against this weak backdrop, Shinzo Abe was elected on an ambitious policy agenda to engineer an economic turnaround. These measures, collectively dubbed Abenomics, have three main pillars: 1) expansionary fiscal policy, as evidenced by a JPY 10 trillion stimulus package; 2) an end to deflation, which can be seen in the new 2% target for CPI; and 3) and the appointment of a less orthodox leadership team at the BoJ.
A cursory glance at the data suggests that investors have high hopes that Abenomics will work. Japanese equities have been on a tear, with the headline Nikkei 225 up almost 30% since November. Meanwhile, the BoJ’s more aggressive stance towards fighting deflation appears to be gaining traction. Inflation expectations have increased, especially following the announcement of a new 2% target for CPI. On closer inspection, however, the apparent faith of global investors in Mr Abe and his new policies may have been overstated.
The Japanese equity Bull Run that has taken up space in many financial newspapers may be more apparent than real. Yes, the Nikkei has risen sharply, but much of this reflects the impact of a weaker currency. In US dollar terms, the Nikkei has risen just 10%, almost the same as its major counterparts in Europe and in the US. On that basis, it would be unfair to suggest that investors have reassessed their fundamental outlook for growth and earnings in Japan.
Despite rising inflation expectations, there remains substantial uncertainty about whether the BoJ will be able to meet its 2% target – something that is surely a prerequisite for a weakened currency over the medium term. A recent poll, conducted by Reuters, found that 12 out of 20 economists do not believe it achieve this goal over the next five years. This chimes well with market pricing. The five-year breakeven rate has risen quite substantially over the past year or so, but remains some distance below 2%. Nevertheless, the data are at least moving in the right direction. Moreover, they appear to reflect the BoJ’s stated policy aims; rising expectations have coincided with the announcement of specific inflation targets – initially 1% in February last year, and 2% this January. It remains unclear, however, whether the impact on households and businesses will be as pronounced.
January’s trade data highlight that a weakened Yen is not necessarily a panacea. Sure, a falling currency helps exporters, especially those with a large foreign presence – of which Japan has many. At the same time, however, it makes imports more expensive. For an increasingly energy-dependent nation like Japan, it is unclear what the eventual net impact will be. While exports rose by 6% in the year to January, the first positive reading in eight months, imports grew faster, in part due to an increase in the Yen price of imported energy. The result was a deterioration in Japan’s trade balance. Indeed, its trade deficit rose to JPY 1.6 trillion – the largest on record. As long as Japan remains reliant on imports for energy, a substantial portion of any weak-Yen-induced increase in competitiveness will be lost to higher energy costs.
So if Abenomics is more talk than action, what can policymakers do to revive their moribund economy? In our view, the remedy for Japan is much the same as it is for the UK. Japan must fix its broken banking system. Specifically, it needs to recognise the bad assets that continue to clog balance sheets. In practice, this means accepting losses, and recapitalising ailing lenders where appropriate. In a recent policy paper, we argued that the failure of UK policy makers to introduce a version of the US Troubled Asset Relief Program back in late 2008 may cumulatively have cost the UK around £120 billion in lost output. We based this conclusion on recent Bank of England research, which in our view suggests that a prolonged banking crisis could reduce labour productivity growth by up to 0.9 percentage points for each year that it is in place. Japan’s banking crisis began in earnest in 1997, when the spread on interbank interest rates rose to what were then all-time highs. As our chart shows, this is precisely the point at which labour productivity growth in Japan began to fall behind that in the US. By the end of last year, as our chart shows, a gap of some 18% had opened up. On our calculations, much if not all of this could reflect the failure of Japanese policy makers to deal with their own banking crisis.