Japan: Continued weakness in yen may boost growth Global Economic Outlook, Q1 2017

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​The Japanese economy performed better than expected in recent months. While the weakness in the yen should boost growth, consumer spending could remain weak, given low wage gains. Thus economic growth is likely to remain modest in the coming year.

Good news on growth

The Japanese economy grew at an annualized rate of 2.2 percent in the third quarter.1 This was far better than many analysts had expected. The strength of GDP growth was largely due to trade. The growth of exports combined with shrinking imports contributed 1.8 percentage points of the 2.2 percent growth. Export strength is attributed to the revival of the US economy and the stabilization of the Chinese economy. Business investment did not grow at all. It should be noted, however, that the first estimate of Japanese GDP in each quarter is often significantly revised in later months. Thus the latest report ought to be taken with a pinch of salt.

Going forward, the weakness in the value of the Japanese yen should enable further export growth. This will be helped by an acceleration in global economic growth. Stronger export growth might lead businesses to accelerate the growth of investment. Also, the expected government fiscal stimulus is likely to provide a boost to growth. On the other hand, consumer spending could remain weak, given low wage gains. The lagged effect of a strong yen could also boost imports, thus subtracting from economic growth. Therefore, a reasonable scenario is that economic growth remains modest at best in the coming year.

The lagged effect of a strong yen could also boost imports, thus subtracting from economic growth.

Monetary policy remains hopeful

The Bank of Japan (BOJ) left monetary policy unchanged at its latest meeting, with the benchmark interest rate at -0.1 percent, the 10-year bond yield capped at 0 percent, and the pace of asset purchases (known as quantitative easing) unchanged. Investors expect the BOJ to leave policy unchanged in the months ahead. Meanwhile, the value of the yen has fallen sharply since the US presidential election. BOJ Governor Haruhiko Kuroda said that the drop in the yen was “not yen weakness, but dollar strength. I don’t think the level it’s at is surprising.”2 Indeed, the US dollar has strengthened against most major currencies due to market expectations that the new US administration will pursue an expansionary fiscal policy. Whatever the reason, the drop in the yen should help boost Japanese inflation, which remains dormant. The BOJ is optimistic that this will change. It said that “the year-on-year rate of change in the consumer price index is likely to be slightly negative or about 0 percent for the time being. As the output gap improves and medium- to long-term inflation expectations rise, it is expected to increase towards 2 percent.”3

The BOJ has been expecting a reversion to higher inflation for the past several years, so its latest expectations might not appear credible to investors. Indeed, during the period when the BOJ kept expecting price rises to accelerate, inflation remained close to zero. Part of the problem is simple demographics. A declining population is exacerbating the problem of excess capacity. On the other hand, the recent rebound in oil prices might raise Japanese inflation, at least temporarily. As for the yen, if the new US administration follows through with fiscal stimulus, it is possible that the dollar will rise more, thus pushing the yen down further. This would help boost Japanese inflation as well as improve the competitiveness of Japan’s exports. On the other hand, a more protectionist US policy could damage Japan’s massive trade sector and lead to slower growth of exports. That, in turn, could further damage business investment.

One interesting aspect of Japan’s monetary policy is that the BOJ is accumulating a very large share of the government’s debt. Currently, the BOJ holds about 37 percent of government debt, a figure that will continue growing as the BOJ purchases debt faster than it is issued by the government. As intended, this will keep bond yields very low. Meanwhile, as bond yields in the United States rise, the gap between the two should contribute to further downward pressure on the value of the yen, which is the BOJ’s intention.

Wages disappoint

One of Prime Minister Shinzo Abe’s biggest frustrations is that, despite low unemployment and rising inflation, wages have barely budged. This means that real incomes are actually declining, leading to very weak growth of consumer spending. Abe has been encouraging businesses to accelerate wage gains. In a meeting with business leaders, he said that he expects them to boost wages in 2017 by at least the same rate as in 2016.4 In the Japanese system, there is a national negotiation each year in which management and unions set wage goals. Businesses are not required to follow suit, but many of the big ones do so. Abe has attempted to influence these negotiations and is doing so again. In the past year, the yen has appreciated, and deflation reared its ugly head. Abe evidently fears that market conditions will hurt prospects for significant wage gains. Yet now that the US dollar is once again rising, and, given the tightening of Japan’s job market, he hopes to push wages higher, thus boosting prospects for consumer spending growth.

External risks

As discussed in the last edition of this report, the Japanese government implementing structural reforms would offer the best hope for a sustained improvement in the rate of economic growth. 5 This last “arrow” of Abenomics is the most difficult because it is the most politically controversial. Yet Abe had hoped that implementation of the Trans-Pacific Partnership (TPP), a free-trade agreement between Japan, the United States, and 10 other Pacific Rim nations, would provide him with the political cover necessary to obtain structural reforms.6 The TPP would have required Japan to do many of the tough things that would open markets and encourage greater productivity. However, following the US election, it is clear that the TPP is dead. Thus Abe, who had expended some political capital in order to obtain parliamentary approval of the TPP, will now face a substantially changed and more challenging political environment. Moreover, with an increasing likelihood of a trade conflict between the United States and China, Japan stands to suffer collateral damage. Japan’s manufacturers play a critical role in China’s manufacturing supply chain, contributing high-tech inputs to products that are assembled in China for export to the United States and elsewhere. A decline in Chinese trade with the United States would, therefore, be detrimental for Japan. Thus it is no surprise that Abe was the first foreign leader to meet in person with Donald Trump following the election. He likely made the case that changes in the trading regime should be undertaken with care.

Following the US election, it is clear that the TPP is dead. Thus Abe, who had expended some political capital in order to obtain parliamentary approval of the TPP, will now face a substantially changed and more challenging political environment.