Japan: Gauging the Stimulus Response

The Japanese patient seems to be responding well to Prime Minister Shinzo Abe's attentions. Equities have rallied strongly. The yen, as the government desires, has retreated from export-crushing highs. The economy has shown signs of a genuine cyclical pickup. The good news has buoyed spirits in Japan. It will likely continue for a while longer, too. But the picture for the country is not yet all joy, because Abe's policies fail to address the country's significant, longer-term, fundamental problems. Unless he amends them to include solutions on these basic levels, the pattern of economic improvement will eventually run into trouble.

Abe took office late last year on the strength of an aggressive policy agenda. He wants to shock Japan out of its deflationary malaise, create new jobs, and stimulate exports by driving down the foreign exchange value of the yen. He would achieve these goals with a three-pronged strategy: First, the government will pursue a massive stimulus spending program of ¥20.2 trillion ($210 billion) or about 3.5% of the economy.1In this, some ¥10.3 trillion ($108 billion) is earmarked for spending on new infrastructure. Second, the Bank of Japan will raise its inflation target from 1.0% a year to 2.0% and engage in quantitative easing on a huge scale along the lines adopted by the U.S. Federal Reserve.2Haruhiko Kuroda, the new governor of the Bank of Japan, aims to double the country's monetary base over the next two years, expanding the central bank's balance sheet by 1.0% of Japan's gross domestic product (GDP) a month until well into 2014. And third, Japan will make structural changes that should enable it to cope better with the rising average age of its population, including efforts to bring more women into the work force and overhaul regulations on energy, environment, and health care.

Japanese investors, businesspeople, and households have responded enthusiastically. Japanese stock prices have risen in excess of 40% since Abe took office while the yen, obedient to his policy objectives, has fallen about 20% against the U.S. dollar. Exports, in response to the cheaper yen, turned up at an annual rate of almost 9.0% in February and March (the most recent period for which there are data). Industrial production, no doubt in support of the exports growth, has turned from decline to rise for four consecutive months through March. Orders for new machinery have also turned from decline last January to make gains in February and March, sufficient enough to bring them up to a 20-month high.3Japan's consumer sentiment gauge hit a six-year high this spring. Most important to policy objectives, core price measures, recently in decline, showed modest increases in February and March. Though the changed inflation-deflation picture has occurred too soon to ascribe it to the policy shift, the deflationary relief, nonetheless, will help sustain the public's enthusiastic response.

The policy, and the remarkably positive responses to it, will almost certainly carry on for a while longer. In all probability, the good news will last at least long enough to boost the election prospects for Prime Minister Abe and his Liberal Democratic Party (LDP) as they contest the upper house of Japan's diet (parliament) later this year and the more powerful lower house next year. But beyond this happy intermediate-term prospect, more sustainable gains depend on new policies to deal with Japan's still debilitating structural problems. Abe's agenda still lacks this element.4

Primary among these concerns is the matter of public finance. Japan has tried for so long, so ineffectively, to stimulate its economy that it has amassed an unconscionable amount of public debt. Outstanding government obligations at last count amounted to some 220% of Japan's GDP. As the new, massive stimulus measures add to the already-large ongoing budget deficits, public debt will likely rise to 240% of GDP. There is much quibbling these days about how much debt will harm an economy's growth prospects. But Japan's astronomical levels leave little room for cavil. The nation's finances are and will become increasingly burdensome. Until now, high personal savings rates have made government financing relatively easy. But as the Japanese public has aged, savings rates have fallen from double digits 10 years ago to 3.0% or less of income more recently. Now, the outstanding debt is so great that even a small rise in interest rates could absorb all tax revenue just to meet the government's interest obligations.5The growth-constraining burdens implicit in this picture may wait a while longer to have their effect, allowing matters to continue for a while as benignly as in the past, but this kind of debt overhang asks when rather than if financial strains ultimately will hold back Japan's growth potential.

From a slightly shorter-term perspective, other troubling questions surround Japan's impending sales tax hike. The legislation, put in place earlier in 2012, before Mr. Abe took office, to help the country deal with its budget deficits, will hike sales taxes from 5% at present to 8% in 2014 and then to 10% in 2015. When Japan last raised sales taxes, in 1997, from 3% to 5%, the country immediately suffered a recession. The impeding tax hike is so unpopular that many political analysts credit Abe's victory with the sponsorship his opponent, former prime minister Yoshihiko Noda, gave the bill. But Abe has not repudiated the tax. Instead, he has left the legislation in place, telling Japan that he will decide whether to go ahead when second-quarter economic data become available later this summer. It remains, then, a threat to the economy. In fact, it may well be that a desire to make purchases ahead of the sales tax hike may have done more than Abe's policies to drive up recent consumer spending. If this is so, or even partly so, much of today's spending has borrowed from the future and will likely dip in 2014, even if Abe postpones the tax hike and especially he allows it to go into effect.6

Doubts even arise about the recently introduced massive infrastructure spending. Japan, after all, has tried such stimulus for years, decades in fact, to little or no avail. The LDP particularly has a reputation for using lavish infrastructure spending to dole out contracts to supporters in favored regions and industries. Because historically the party, and so the government, has geared such spending to political instead of economic parameters, it often failed to have lasting economic effects. This latest, massive effort may deviate from the unfortunate historical pattern. It might take a truly economic focus and create an economic follow through. But the record of such policies in the past, particularly with the LDP, leaves many questions. If some 18 months from now, after the elections, it turns out that, as so many times in the past, the stimulus was not spent effectively, the Japanese recovery could suddenly lose momentum.

And then there is the matter of Japan's demographic imperatives. With the rising average age of Japan's population, a huge overhang of retirees will increasingly burden an even-smaller working aged population. In Japan's case, matters go beyond a relative shift in the numbers of workers and retirees. There, the number of working-aged people has declined absolutely, by 6.1% over the last 10 years, leaving Japan with dramatically fewer producers to provide for a large group—almost 23% of the population—that continues to consume, but that has ceased active in production. This circumstance demands that Japan alter its basic economic model, accept its need to import more, particularly of labor-intensive goods, and turn its economy from its dependence on an export-driven to a reliance on a consumer-driven growth engine.

Abe's policies only gesture at a response. He wants to fill the labor shortage by encouraging more women to participate in the work force. That has potential, since, for cultural reasons, Japan's women have a notoriously low rate of participation in gainful employment. But it will take a lot to overcome such cultural biases. Abe also wants Japan to join the Trans-Pacific (Trade) Partnership. But his reasons have less to do with changing the country's economic model than to continue with the promotion of Japan's exports. In fact, most of Abe's policies continue the export push, and so work against the needed basic shift in Japan's economic emphasis. Further, Abe's plans do not encourage the economic flexibility needed to make the adjustment. On the contrary, his approach continues the top-down, directed economic model that has long favored established industries and practices. He does, though, speak of easing regulations on select industries, but these also would aim at established sectors. They would do little or nothing to encourage the innovation clearly needed to accommodate the country's demographic imperatives.7

Until Japan can demonstrate that it will deal with these fundamental structural issues, the great enthusiasm of the present, the economic resurgence, and the market gains will in time face limitations. The stagnation and the disappointment will eventually return. The hope is that in the interim, while the immediate policies generate growth and gains, Abe and his team in Tokyo can craft policies that deal with more lasting, fundamental, demographic, economic, and financial matters. If they do, then the economic and market gains may well persist. But until they do, likelihoods will continue to suggest that the economy will eventually lose momentum, as it has in the past, probably after the elections.8

1Beina Xu, "Abenomics and the Japanese Economy," Council on Foreign Relations, April 5, 2013.

2Wieland Wagner, "Can Japan Jumpstart Its Economy?"Spiegel(online), April 18, 2013.


4Charlie Metcalfe, "Japan's New Economics and Reforms Underpin Dynamics,"Pensions & Investments, April 15, 2013.

5"Don't Mention the Debt,"The Economist, May 4, 2013.

6Tko Sekiguchi, "Japan Parliament Passes Sales Tax Increase,"The Wall Street Journal, August 10, 2012; and Tajashi Hirokawa, "Abe Says Japan Sales Tax Increase Depends on April-June Economy," Bloomberg, December 8, 2012.

7Milton Ezrati, "Japan: Another Season of Downturn Abe?"Economic Insights, January 22, 2013.

8The Ministry of Finance (Japan) website.

Milton Ezrati, Partner and Senior Economist and Market Strategist, has been widely published in a wide variety of magazines, scholarly journals, and newspapers, including The New York Times, Financial Times, The Wall Street Journal, The Christian Science Monitor, and Foreign Affairs, on a broad spectrum of investment management topics. Prior to joining Lord Abbett, Mr. Ezrati was Senior Vice President and head of investing in the Americas for Nomura Asset Management, where he helped direct investment strategies for both equity and fixed-income investment management.

The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

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