Japan: Struggling to recover Global Economic Outlook, Q4 2015

The outlook for Japan indicates continued slow economic growth. Inflation is likely to remain low, especially with declining energy prices and a weaker Chinese renminbi. While quantitative easing has been used to address the economic situation, that it is not enough is increasingly clear.

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The state of the economy

Japan’s economy failed to grow in the second quarter of 2015. Moreover, real GDP has fallen in three of the last five quarters—hardly an indication of a rebound in economic performance. Part of the problem is the weakness of the household sector. Household spending has increased only in 3 of the last 20 months—and it continued to fall in July. This reflects a combination of declining wages and virtually no inflation. In 6 of the last 12 months, consumer prices have fallen.1 Meanwhile, consumer spending has not yet recovered from the shock of last year’s increase in the national sales tax. On the other hand, there are indications that the labor market is starting to tighten and, as a consequence, compensation is starting to improve. The unemployment rate is low, and the ratio of job openings to applicants reached a 23-year high in July. Moreover, a relatively large increase in the official minimum wage takes effect in October. Therefore, consumer spending could rebound somewhat in the second half of the year.

Exports to China account for about 20 percent of Japanese exports. Thus, while the weaker yen has helped to boost exports to the United States and Europe, Chinese weakness has hurt Japan’s recovery.

Another problem concerns business investment, which has remained stagnant, reflecting business pessimism as well as the negative effect of weak export demand. However, corporate earnings are rising rapidly, especially due to the impact of a weak Japanese yen on translated earnings from foreign operations. If a boost to wages causes a rebound in consumer demand, this should bode well for the willingness of businesses to invest.

Historically, Japan’s growth has been fueled by exports of manufacturing goods. In 2014, real exports increased 8.4 percent, helping to offset weakness in nearly every other category of spending. However, in 2015, exports have weakened, largely because of the slowdown in China’s economy. Exports to China account for about 20 percent of Japanese exports. Thus, while the weaker yen has helped to boost exports to the United States and Europe, Chinese weakness has hurt Japan’s recovery. Still, the impending change in US monetary policy could lead to a further appreciation of the US dollar. This, in turn, could significantly boost the competitiveness of Japanese exports to the United Sates. Also, trade in services has been a positive factor for the Japanese economy. Tourist arrivals, largely from Greater China and South Korea, soared in both 2014 and 2015. In August of this year, total tourist arrivals were up 64 percent from a year earlier.2 Tourists are attracted, in part, to the low value of the yen.

Overall, the outlook for Japan’s economy indicates continued slow economic growth. Inflation is likely to remain low, especially given the impact of declining energy prices and a weaker Chinese renminbi.

While QE has created some inflation, it remains well below the BOJ’s target; in fact, core inflation is close to zero. Moreover, wages have mostly fallen, thus suppressing consumer spending power.

The policy environment

The principal policy tool that has been used to address the economic situation is the quantitative easing (QE) now underway by the Bank of Japan (BOJ). This involves massive purchases of government bonds, with the intention of boosting inflation (or at least averting deflation), suppressing the value of the yen and borrowing costs, and boosting wealth. All of these things have been accomplished, but it is increasingly clear that QE is not enough. While the drop in the yen has helped exporters, it has hurt domestically oriented businesses by boosting import prices. While QE has created some inflation, it remains well below the BOJ’s target; in fact, core inflation is close to zero. Moreover, wages have mostly fallen, thus suppressing consumer spending power. And while borrowing costs are low, this has not convinced businesses to invest more, especially given both weak external and domestic demand.

The question then is what more can be done to repair Japan’s fragile economy. Recall that the economic policy of Prime Minister Shinzo Abe, popularly dubbed “Abenomics,” involved three “arrows”: monetary stimulus, fiscal stimulus, and structural reform. The monetary stimulus is clearly underway with QE. However, in nearly two years, it has failed to bring inflation close to the desired level. Yet, despite speculation to the contrary, it is not expected that the BOJ will accelerate the pace of asset purchases. As for fiscal stimulus, the opposite has taken place, with a sizable increase in the national sales tax in April 2014 and another one planned for April 2017. Moreover, the government continues to run a large budget deficit (7.7 percent of GDP in 2014) and has one of the highest debt-to-GDP ratios of any advanced industrial country. At the least, this means that any effort to temporarily boost the deficit in order to stimulate the economy (as has been suggested by some) would face severe political resistance and thus is unlikely to happen.

The principal remaining tool is structural reform. More specifically, this would entail legislation meant to remove obstacles to the proper functioning of the market economy. Such obstacles come in the form of labor market regulations, anticompetitive rules in various industries, and trade protection. The idea is that if these rules and regulations are removed, the private sector could become more productive, there would be a greater incentive to invest in those industries that become deregulated, and, consequently, the economy would grow faster.

Yet the pace of reform has been slow. The government has expended its political capital on foreign policy–oriented legislation. In September, the parliament passed controversial legislation to allow the use of Japanese troops in overseas combat. Now that the Trans-Pacific Partnership (TPP) has been completed, it should compel Japan to open various markets to greater competition and implement the kinds of structural reforms that Abenomics promised.