Japan gambles with shock and awe economics

With the benefit of hindsight, it was evident that the Bank of Japan’s new governor, Haruhiko Kuroda, planned to make seismic policy changes. In his last speech before becoming the BoJ’s 31st governor in March, he emphasised that the Bank’s target of a year-on-year rise in the consumer price index (CPI) of 2% should be achieved “without delay”.

“We need to pursue bold monetary easing both in terms of quantity and quality,” Kuroda added. “Moreover, given that there is little room for the interest rate to decline, it is imperative to work on market expectations in the conduct of monetary policy. Through communication with the market, we need to make clear that we have adopted the uncompromising stance that we will do whatever is necessary to overcome deflation.”

This aggressive commitment to attacking deflation contrasted with the more cautious philosophy of Kuroda’s predecessor, 63 year-old Masaaki Shirakawa, who stood down in March after 39 years at the BoJ, the last five of which he had spent at the helm of the Bank. “There is a need to earnestly discuss what it is that we truly want to achieve when referring to “overcoming deflation”, and what is it that we must carry out in order to accomplish this,” said Shirakawa early this year. “The opportunity is right in front of us now. Once we find what we want, we must take action.”

He may not have said so in so many words, but Kuroda plainly believes that the time has long since passed for earnest and protracted discussions on how to bring Japan’s 15 year battle against deflation to an end. It is a conviction that Kuroda shares with Shinzo Abe, the leader of the Liberal Democratic Party (LDP) who was swept back into power following his victory in the December 2012 election. 

It was the LDP’s landslide victory at the polls that allowed a snappy and highly influential neologism to make its way into the global financial lexicon. Since the beginning of 2013, it has been impossible to keep the word “Abenomics” out of the local or international media.

The momentous BoJ monetary policy meeting (MPM) on April 3-4 may turn out to be one of the most decisive days in the post-war history of the Japanese economy. At the first meeting under his governorship, Kuroda announced a package of quantitative and qualitative monetary easing that went well beyond what almost any economist or strategist had expected.

Perhaps even more striking, it was a package that was approved by a unanimous 9-0 vote by the policy board, which surprised Kenji Yumoto, chief senior economist and vice chairman of the Japan Research Institute (JRI) in Tokyo. He explains that the private sector members of the board had previously been opposed to the implementation of a policy that appears to undermine the independence of Japan’s central bank. After all, the Bank of Japan Act of 1997 says that the BoJ’s “autonomy regarding currency and monetary control shall be respected”.

“I was surprised that there was unanimous support for the policy shift,” says Yumoto. “But I imagine the board members recognised that Japan had crossed the Rubicon and had no choice but to approve the measures.”

For Japan’s economy as well as its capital market, it is hard to overstate the significance of the BoJ’s April announcement. Reporting on the momentous MPM soon afterwards, SMBC Nikko’s bond strategist, Mari Iwashita, described it as “one of the most highly anticipated events in BoJ’s history”. 

Nomura noted soon after the April 4 initiative: “The size and scale of the BoJ’s easing announcement clearly took the market by surprise.” Within 90 minutes of the news, Japanese equities had climbed by 4%, while the yen had weakened against the US dollar by 2.5%, which as Schroders noted soon afterwards was “a huge move for such an actively traded cross-rate”.

The centrepiece of a monetary policy announcement hyperbolically described by some observers as a “shock and awe programme” is the price stability target, which calls for the BoJ to increase the monetary base at an annual rate of about ¥60tr-¥70tr. To put this increase into context, it will lead to a near-doubling of the monetary base from ¥138tr at the end of 2012 to ¥200tr by the end of this year and to ¥270tr at the end of 2014. This will mean that the monetary base, defined as the sum of banknotes and coins in circulation and financial institutions’ current account deposits at the BoJ, will account for 60% of nominal GDP, which is far above the levels of any other advanced country.

To achieve this objective, and to encourage a decline in interest rates across the yield curve, the BoJ also announced that its purchases of Japanese Government Bonds (JGBs) would be increased to about ¥50tr a year. That represents a considerably larger asset-purchasing programme than the market had been anticipating. SMBC Nikko said the general expectation among strategists had been that monthly purchases would rise from around ¥4tr to ¥5tr-¥6tr. So the announcement that the Bank planned to raise the figure to more than ¥7tr was one reason for the collective intake of breath that followed the announcement. 

Kuroda himself recognised the unprecedented scale of the revised asset purchase programme, saying in a speech in April: “The newly planned purchase of JGBs at an annual pace of ¥50tr is massive and goes beyond the conventional knowledge of market participants.”

At the same time, the Bank confirmed that these purchases would extend to the ultra-long end of the curve, which some analysts had feared might not have been practical.

As the BoJ explained at the time: “In addition, JGBs with all maturities including 40 year bonds will be made eligible for purchase, and the average remaining maturity of the Bank’s JGB purchases will be extended from slightly less than three years at present to about seven years — equivalent to the average maturity of the amount outstanding of JGBs issued.”

The equity market also benefitted from the BoJ’s continued munificence, with the already red-hot market for Japanese real estate investment trusts (J-Reits) given yet another stimulus. “With a view to lowering risk premia of asset prices, the Bank will purchase ETFs and J-Reits so that their amounts outstanding will increase at an annual pace of ¥1tr and ¥30bn respectively,” the BoJ announced. 

The BoJ added that it would continue with its programme of quantitative and qualitative easing “as long as… necessary” to achieve the 2% CPI target. In other words, it committed itself to doing whatever it takes for as long as it takes.

Against that background, it is little wonder that the sheer size of the monetary easing programme surprised so many observers. “Relative to the size of Japan’s economy, the size and pace of the BoJ programme is stunning, at 18% of GDP in just one year,” comments a recent update from Morgan Stanley.

Events in Japan in early April had a profound and very rapid effect on the global capital market. By complete coincidence, the currency advisory specialist, Merk Investments, had predicted as much in a bulletin distributed hours before the BoJ’s announcement. “Unsustainable debt. Depression-era fiscal policy. Monetary madness. Welcome to Japan,” Merk advised. “You may not live or invest in Japan, but your investment may well be affected by what is unfolding in the Land of the Rising Sun. Be prepared.”

It was timely advice, for fixed income as well as currency and equity investors. The BoJ’s announcement unleashed a wave of demand for top-rated credits in the international primary market, with a surge in appetite for covered bonds and SSA issuance expected among Japanese investors.

Indeed, the forecast explosion in demand for foreign assets driven by extensive portfolio rebalancing by Japanese insurance companies, pension funds and banks has created a parlour game among analysts aiming to identify the international asset classes likely to benefit most from Japanese liquidity.

For the time being, the expected torrent of Japanese buying of foreign bonds has yet to materialise. “The recent rally in European core and non-core government bond markets has been mainly attributed to an anticipation of Japanese demand, but in the trades we’ve done in the last several weeks we have seen no evidence of any change in demand from Japan,” says Sandeep Dhawan, head of funding for Americas, Asia and Pacific capital markets at the Luxembourg headquarters of the EIB. 

“More broadly, official weekly data on net flows into foreign bonds by Japanese investors is mixed and this shows that there has not yet been any extraordinary buying,” Dhawan adds. “That is not to say it won’t happen, because if Japanese yields keep low, which they have not yet done, and money supply is increased, there will be an incentive for investors to increase their overseas holdings. But it is too early to draw any conclusions yet, and the outlook may be more complicated and nuanced than many people are assuming.”

Over the longer term, however, the indications are that institutions such as life insurance companies — which held just over 19% of the JGB market at the end of 2012 — will look to diversify their portfolios. As Société Générale observed recently: “A number of life insurance companies have in recent days reported on their investment plans for 2013, and these mostly foresee increases in foreign bond investments, but increases in domestic bond holdings as well.”

At JRI, Yumoto points out that of all the institutions within the Japanese investor universe, life insurance companies will be under the most pressure to hunt for improved returns if yields on JGBs fall. “Many life insurance companies have indicated that they need to guarantee returns of at least 1% a year to their policyholders, which they won’t be able to do by buying JGBs at yields significantly below 1%,” he says.

If history repeats itself, lifers are likely to add to their foreign holdings. Deutsche Bank recently pointed out that in the first half of 2003, when JGB yields were on a par with recent levels, Japan’s nine largest life insurance companies were net buyers of foreign bonds to the tune of ¥2.3tr.

Rising Japanese institutional flows into foreign assets will have important ramifications for the Japanese capital market, not least because large-scale buying of non-yen bonds is likely to keep the US dollar/Japanese yen basis swap in negative or deeply negative territory. That may in turn dampen supply of Samurai bonds by international issuers, reducing the options available for local investors in search of diversification and a yield pick-up.

For the time being, however, it is increasingly evident that the wave of economic stimuli collectively known as Abenomics is beginning to have tangible, positive results.

“Since the new administration came to power in last year’s election the atmosphere and the mood in Japan has changed totally,” says Hisato Oiwa, managing director and head of capital markets at SMBC Nikko in Tokyo.

Whether or not this sentiment will be reversed following the sharp correction in the Japanese equity market at the end of May remains to be seen. For now, however, the charismatic Abe has had a remarkable effect on the Japanese economy. “So far, Abenomics has been an amazing success in terms of managing people’s expectations,” says Masayuki Azuma, managing director and head of securities products group at SMBC Nikko. 

It is a telling sign of how profoundly Japan is changing that the rhetoric of two individuals — Abe and Kuroda — should have had such a mesmerising influence on a society known more for collectivism than individualism. Compelling proof that a new-found confidence is coursing through the Japanese economy came with the release of consumer spending figures for the first three months of this year. These came in at a very strong 1.9% in January, 2.2% in February and 2% in March. According to an update published by Lombard Street Research: “For the first quarter as a whole spending on this measure is up by 4.1%, compared with 4Q 2012. This is by far the largest quarterly jump in spending since this series began, albeit not that long ago, in 2000.”

More broadly, as a Daiwa note published in May comments: “The feel-good factor among Japanese consumers looks to have become more pronounced at the start of the second quarter.” Having risen to its highest level in six years at the start of 2013, the headline consumer confidence index rose in April to 44.5, well above its long-term average of 41.5. According to Daiwa, the improvement was broad-based, “with notable increases in the measures of households’ willingness to purchase durable goods and employment conditions. So, having provided solid support over the past two quarters, private consumption should be maintained over coming quarters too”.

Consumer spending, buoyed by the Abe feel-good factor, was an important contributor to the very encouraging economic growth numbers released in May. These indicated that real GDP in the first quarter of 2013 rose by 0.9%, or 3.5% on an annualised basis, according to preliminary estimates. As Nomura points out, this was well above the consensus forecast of 2.7% and comfortably above Nomura’s own projection of 3.1%. “The Japanese economy has clearly moved into a recovery phase after languishing from 2012 Q2.”

It was not just the Japanese consumer that supported the strong showing of the GDP numbers in the first quarter. According to Nomura, economic recovery in Asia ex-Japan also fed through to the robust performance, helping Japanese exports to rise by 3.8% in the first quarter after falling 2.9% in the last quarter of 2012. 

Although Nomura doubts that Japanese exports can continue to grow at a similar pace until the benefits of yen depreciation start to emerge — which it says could at least six months — the first quarter data led it to predict that domestic demand would continue to play a pivotal role in driving the economy in 2013. Soon after the release of the data, Nomura revised its economic outlook for FY2013-14, lifting its forecast for real GDP growth to 2.5%.

A number of other economists have also revised their forecasts upwards, and although this does not necessarily sound a requiem for Japanese deflation, it suggests that the Japanese consumer is responding positively to being advised in numerous advertisements that the time to buy is now.

The sustainability, or otherwise, of the feel-good factor among Japanese consumers into 2014 will be a key to longer term growth prospects. One big test of individuals’ resilience will be the first stage in the doubling of consumption tax planned for April 2014, when it is due to rise from 5% to 8%. In the second stage, in October 2014, the tax will be hiked again to 10%.

“Whether or not the Abe administration decides to go ahead with the tax rise will depend on economic trends, but an increase is essential, given the fiscal deficit,” says JRI’s Yumoto. “So I expect the rise to go ahead unless something disastrous happens to the economy.”

A 1% increase in the tax equates to an increase in revenues of ¥2.5tr, says Yumoto, so the impact of a staged increase of five percentage points will be profound. “I expect the economic recovery will gather pace in the latter half of this fiscal year driven by a surge in demand prior to the tax increase,” he says. “There will then be a backlash in the first quarter of next fiscal year, which is why we at JRI are expecting negative growth in 2014.”

Strategists point out that indications arise to suggest that Japan is faltering in its push towards a 2% CPI level by 2015, the BoJ has plenty of firepower at its disposal to ratchet up its already aggressive asset-purchasing programme. “The next key date is October, when the BoJ releases its second Outlook Report of the year,” says David Bradbury, executive director and head of rates trading at SMBC Nikko in London. “Come October, if the BoJ’s CPI forecasts look as though they’re falling short of the 2% target, we may see another phase of BoJ easing.”

The solid performance of the economy in the first quarter of FY2013 bodes well for the so-called “third arrow” in the Abe quiver, which complements the first two arrows, which are monetary and fiscal stimuli. This is the growth arrow, the details of which were released in early June. “The third arrow will be fundamental to the longer term sustainability of Abenomics,” says Oiwa at SMBC Nikko.

Economists hope that there will be a natural link between the first two arrows and the third, with rising asset prices kick-starting a virtuous cycle. As a note published by Lombard Street Research in April points out: “One effect of faster money growth may be to boost asset prices (in addition to the equity market rally). Higher asset prices, by lifting collateral values, may stimulate private sector credit growth, which would create a virtuous circle, since private sector credit creation would boost bank deposits and broad money.”

While private sector credit growth will play a key role in underpinning longer-term sustainable growth, so too will a range of government-supported initiatives. According to a Goldman Sachs update, the areas likely to be incorporated in the growth strategy include industrial competitiveness, labour reforms, healthcare, energy policy tourism, IT and education. Specific measures to facilitate industrial revitalisation, says the Goldman Sachs report, may range from the creation of special economic zones (tokku) to tax changes and agricultural reforms. Healthcare reforms may include the establishment of a Japanese National Institute of Health, while labour reforms are likely to focus on encouraging increased participation of women in the labour force — which some have dubbed “womenomics”.

The LDP’s energy policy will also be watched very closely, given the urgent need for Japan to explore alternative (chiefly renewable) power sources in the aftermath of the earthquake and tsunami of March 2011. “Last year the government introduced a feed-in tariff for solar power and announced its commitment to buying solar energy at ¥42 per kilowatt hour,” says Yumoto at JRI. “This was important because it encouraged companies like Kyocera and Softbank to enter the market. It is essential that the government continues to promote solar and wind power.”

Trade agreements are also expected to be a big component of the Abe cabinet’s growth strategy. As an update from SumiTrust, released in March, points out, sentiment towards Japanese equities has been supported by Abe’s apparent commitment to Japanese membership of the Trans-Pacific Partnership (TPP), a US-led regional free trade agreement. That, says the SumiTrust update, is viewed by investors as “further evidence of Prime Minister Abe’s strong commitment to boosting economic growth”.

Initiatives such as the TPP, alongside the broader Abe blueprint for inflation and growth, are likely to create a wide range of opportunities for Japanese banks, beyond the jamboree that many of the retail brokers enjoyed in the first quarter as small investors returned to the stock market.

“We are expecting more opportunities to emerge in equity capital markets as well as in the debt market,” says Oiwa at SMBC Nikko in Tokyo. In London, Azuma agrees. “Increased demand for equity and debt products is creating a win-win situation for Japanese banks in terms of product development,” he says.

If banks such as SMBC Nikko are to harness these opportunities, however, they will need to build up their international operations. “We recognise that we are reaching saturation point in our domestic market, and that if we are to grow we will have to do so internationally,” says Antony Yates, president and global head of the derivatives group at SMBC Nikko in London.

The detail of the third arrow in the Abe Growth Strategy is critical, because those who reserve their judgement on Abenomics say that it will do no more than paper over the cracks if it does not tackle some of the structural shortcomings within the Japanese economy.

“Fiscal and monetary policies are just a pain reliever for Japan,” says Yumoto at JRI. “To ensure long term competitiveness, we need comprehensive structural reform.”

More specifically, Yumoto says one of the root causes of Japan’s protracted bout of deflation was an industrial strategy that protected ailing and less-competitive industries. “Long-lasting zero interest rates helped weak companies, and government subsidies which were designed to keep unemployment down meant that the labour market remained rigid and inefficient,” he says.

There are a number of other risks associated with Abenomics. Probably the most serious of these is the danger that monetary easing does not just deliver on its inflation target, but that it does so in spades, with the CPI overshooting its target, creating hyper-inflation in Japan. The apocalyptic scenario is that this would send JGB yields soaring, in turn prompting a stampede out of the market by domestic investors. Given Japan’s debt mountain — gross government debt is 230% of GDP, comfortably the highest in the world — the consequence would be an unthinkable crisis.

This was certainly a risk that former BoJ governor Shirakawa was very aware of. “Shirakawa was always quick to draw attention to the fact that if you create inflation it can be all too easy accidentally create hyper-inflation,” says Bradbury at SMBC Nikko.

For the time being at least, strategists and economists are relaxed on this. “I don’t think there is a real risk of a big sell-off in JGBs, given that inflation is unlikely to accelerate as predicted by the BoJ,” says Kiichi Murashima, managing director of economics and rate strategy at Citi in Tokyo.

At JRI, Yumoto agrees. “It’s important to emphasise how difficult it will be to achieve the inflation target the BoJ has set,” he says. “In the last 30 years, the CPI has only surpassed 2% twice. The first time was in 1997 when the consumption tax was raised, and the second was in 2007 when there was a surge in oil prices.”

He adds: “One of the root causes of deflation is the demand-supply gap, which is minus 3% of nominal GDP at the moment. Theoretically, to increase the CPI to 2% within the next two years it would be necessary to lift the gap by 5% from minus 3% to plus 2%. That is unrealistic, given the real GDP growth projected at 1.4% next fiscal year by BOJ.”

A more workable solution, but one that would risk being unpopular (at home and abroad), would be to encourage an acceleration in the depreciation of the yen. That would stoke a rise in import prices and an increase in flows of payments overseas, which by Yumoto’s calculations would reach ¥5tr over the next year at a yen/dollar rate of 100. “Ideally, to compensate for this increase in import prices and decline in real incomes, wages would rise,” says Yumoto. “But I calculate that there would need to be an annual increase in wages of 4% to achieve the targeted rise in CPI, which is also unrealistic.”

If all this makes the possibility of inflation overshooting into the realms of hyper-inflation vanishingly remote, there are other unwanted complications springing from Abenomics. One of these is that the BoJ’s unprecedented stimulus programme has not been greeted with unconfined joy, either overseas or at home.

The Reserve Bank of New Zealand (RBNZ) is one of a handful to have commented publically on its unease about the likely effect of the dramatic fall in value of the yen on exporters in the Asian-Pacific rim. Japan has insisted that the weakening of its currency is a side-effect, rather than an objective of Abenomics. That is little surprise, given the G20’s stated antipathy towards competitive devaluations, but further longer-term depreciation of the yen is likely to prompt increasingly vocal objections from exporters in Asia (most notably from those in Korea) and beyond.

The weakening yen is also starting to have a damaging effect on a handful of sectors of the domestic economy dependent on imports. It was recently reported, for example, that the rising costs of imported oil have forced some Japanese squid fishing fleets, for example, to reduce the hours they spend at sea. Other areas of the agricultural economy are expected to encounter similar difficulties if the cost of imported oil continues to rise — even though a number of government funds have been set up to assist sectors hit by Abe’s bold monetary initiative.

Companies taking a dim view of Abenomics still appear to be in the minority. “Most Japanese companies welcome the change in the BoJ’s policy,” says Hiroki Shimazu, assistant general manager and bond strategist at SMBC in Tokyo. “But there are risks that inflationary pressures on import prices may reduce Prime Minister Abe’s popularity among some domestic companies over the coming six months.” 

It is not just importers that may have good reason to be uneasy about how they may be affected by Abenomics. As one local banker says, there may also be a backlash against the Abe administration among pensioners if rising inflation begins to erode their purchasing power and therefore their living standards. Following the big wobble in the Nikkei index at the end of May, further falls may also alienate retail investors who were latecomers to the Japanese bull run of early 2013.

The growing recognition that Abenomics will not be able to please all of the people all of the time is perhaps why the Abe cabinet’s approval rating has dipped slightly from unheard-of highs for a Japanese prime minister. The local Yomiuri Shimbun newspaper reported in May that the cabinet’s approval rating had fallen for the first time since last year’s election, slipping by 2% to 72%. It also noted, surprisingly, that only 21% of respondents to its survey indicated that the economy is tangibly improving.

Importantly, however, these polls do not suggest that there will be any meaningful threat to Prime Minister Abe’s Liberal Democratic Party (LDP) in July’s elections for the upper house of the Diet. A majority in both chambers will be welcomed by investors as it will guarantee continuity of a distinctly market-friendly economic policy.

International views on the prospects for the impact of Abenomics on the economy, meanwhile, remain mixed. Equity investors and large sections of the international media seem prepared to give Japan the benefit of the doubt. So, too, do external observers such as the finance ministers in the G20 and analysts at the OECD, which recently gave a guarded thumbs-up to the Abe programme. Its most recent report on Japan describes the government’s tactics in its war against deflation as “most encouraging”, saying that “aggressive monetary easing will boost growth and inflation”. At the same time, however, the OECD repeated the familiar admonition that “stopping and reversing the rise in the debt-to-GDP ratio is crucial”.

Others are less comfortable with the Abe programme. In a note distributed in April, Leigh Skene of Lombard Street Research warned that “Japan can’t grow domestically, its trade balance is in deficit and the structural government deficit is more than 10% of GDP. Shinto Abe’s ‘new’ policy ignores Japan’s real problems.”

The prime minister’s stimulus, Skene cautioned will either “(a) succeed brilliantly or (b) flame out”. His conclusion is unsettling for evangelists of Abenomics. “History is replete with similar policies flaming out, but none were instituted in the conditions that prevail in Japan today, so none are reliable guides,” Skene writes. “However, stories of rescuing broken economies with a single masterful stroke without mending the broken bits are equally rare. My money is on (b).” 

Japan’s squid fishermen will be among the minority hoping he is right.