Is Japan's Economic Rebound For Real?

The two phrases “Abenomics” and the “BOJ’s Shock and Awe Monetary Easing” are all over the headlines about Japan. Prime Minister Abe unveiled his economic policy late last year calling for a 3% annual nominal gross domestic product (GDP) growth target and an aggressive monetary easing by the BOJ (The Bank of Japan) to achieve 2% inflation. The BOJ unleashed the world’s most intense burst of monetary stimulus last month promising to double the monetary base to 270 trillion yen ($2.7 trillion) by the end of 2014 to defeat deflation.

How effective so far?

Both “Abenomics” and “Shock and Awe Easing” have had a positive effect in that the bold monetary easing has resulted in a shift in sentiment that the Japanese economy will finally come out of the long, dark tunnel (see chart). First quarter GDP came in ahead of market expectations at an annualized rate of 3.5%. However, the demand deflator (the amount of GDP growth attributed to price changes) suggests that inflation is still conspicuously absent. Despite weak indications of current inflation, the April consumer confidence survey showed a big jump in the proportion of households expecting inflation to be 2% or even higher in a year’s time. This is exactly what Yale Professor Hamada, a special economic advisor to Abe, means when he says that current policies “work upon people’s expectations,” or in other words, change the deflationary mindset to an inflationary one.

What is supposed to happen next? Our on the ground research suggests that there may be a modest boost to real income in coming months, a welcome change to Japanese wage earners who have seen their incomes declining faster than consumer price inflation (CPI) since 1998. The expectation is that higher real wages will translate into increased

consumer spending. In an effort to evaluate what the policy implications are for the longer term, the “Takahashi policy” (1932-36) may provide a useful template. Korekiyo Takahashi held positions such as the Governor of the BOJ in 1911, the Prime Minister from 1921 to 1922 and the Ministry of Finance multiple times. We find this period relevant because there are many similarities in the economic and social backdrop between now and then: 1) the combination of long-standing deflation and a strong yen (Showa Depression in 1927 vs. Japan’s Lost Decade), 2) damage from a major earthquake (Great Kanto Earthquake in 1932 vs. Tohoku Earthquake in 2011) and 3) global depression triggered by a U.S. financial crisis (Great Depression vs. Lehman Crisis).

Further, there are similarities in the policies themselves. “Abenomics” consists of three arrows: 1) bold monetary easing, 2) fiscal stimulus and 3) reforms to stimulate private investment. Takahashi’s policy was similar in the sense it carried out an aggressive stimulus both on the monetary and fiscal front. Takahashi suspended the gold standard and ordered a gold embargo on his very first day in office, which significantly increased the flexibility of financial policies. Subsequently, he adopted his monetary policy allowing the BOJ to purchase bonds issued by the government, a practice which went on 14 years. These measures catalyzed the yen to devalue by almost 50% against the U.S. dollar (about 30% yen decline in the past six months) followed by increases in import prices, and eventually the price increases translated from wholesale prices to consumer prices, resulting in mild inflation. He also allocated significant amount of government budgets to public investments, which increased the level of dependence of government revenues on public bond issuance to about 70% (about 50% currently). Eventually real Gross National Product (GNP) grew at an annual rate of 5.8% after Takahashi’s Policy was implemented (GNP growth 0.5% in 1929, 1.1% in 1930 and 0.4% in 1931), initially driven by exports and later by consumption and capex. Employment improved in 1933 and nominal wages started to go up with about a 12 month lag. It seems clear that “Abenomics” and “BOJ’s Shock and Awe Easing” are modeled on Takahashi’s policy and therefore we can use the outcome of the Takahashi experience to inform our current expectations.

What to do from here?

Since we wrote our view on Japan in November 2012 (declining yen driven by aggressive monetary policy leading to market appreciation), the Nikkei index has soared about 70% and the yen has declined about 30%. We wouldn’t be surprised if the Japanese equity market takes a breather in the near-term, but this would create a good entry for people who have missed the rally. We are looking for the following catalysts to produce the next move higher in the stock market: 1) growth initiatives from the government to be announced next month which include putting together a policy to address the financial imbalances among the government sector, corporate sector and household sector, 2) reinforcement of popular support for the government’s mandate (The Liberal Demographic Party’s presumed victory in the upper house election in July), 3) decision of government pension funds to increase equity exposure in their long-term strategic asset allocation, 4) setting up special economic zones for foreign companies as a part of future growth initiatives coupled with relaxing visa requirements to foreigners (prelude to easing of immigration policy), 5) decision on the 2020-Olympic host city (Tokyo, Istanbul or Madrid) in fall 2013 and 6) other themes include passage of casino registration, a policy to raise women’s labor participation to address the issue of the structural decline of labor force, etc.

We need to keep watching the Japanese government bond market where yields have spiked up in the last few days, but so far it seems like a “benign yield spike” (yield pick-up driven by economic recovery, not by renewed expectation of deflation), which we guess is exactly what the BOJ Governor Kuroda has been envisioning.


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