Japan as the crisis next time

By Anatole Kaletsky
March 14, 2014

Which major economy is most likely to disappoint expectations this year, and perhaps even cause a financial crisis big enough to break the momentum of global economic recovery? The usual suspects are China and southern Europe. But in my view the most likely culprit will be Japan.

While Japan no longer attracts much attention these days, it is still the world’s third-largest economy, with a gross domestic product equal to France, Italy, Spain, and Portugal combined. Its industries still pose the main competitive challenge to U.S., European and Korean manufacturers, and its regional weight is still sufficient to trigger financial crises across the whole of Asia — as it did in 1997.

To make matters worse, the Japanese government bond market is in an enormous financial bubble that could burst catastrophically if Prime Minister Shinzo Abe’s audacious economic program is seen to have failed.

I was an early enthusiast for Abenomics, but I became alarmed about Japan’s prospects last October, when Abe decided to impose a massive tax hike on consumers beginning in April this year. With this crunch point now approaching, I travelled to Japan to get a firsthand feel for economic conditions. What I saw and heard from financiers, businesses and officials has heightened my concerns.

Abenomics was initially a promising program because it seemed to pierce the complacency of previous governments with its “three arrows” of radical economic policy — monetary expansion, fiscal stimulus, and structural reform.

By last October, however, two of these three arrows were veering off course. Structural reforms in labor regulation, corporate governance, competition policy and pension management had already been abandoned or delayed sine die in the summer. When Abe bowed to the longstanding demand from Japan’s powerful Ministry of Finance for a doubling of Japan’s consumption tax, his fiscal “arrow” was transformed into a boomerang, threatening the hopes of economic acceleration in 2014 and 2015.

This boomerang will hit Japan on April 1, when the consumption tax jumps from 5 percent to 8 percent, and again in October 2015, when it will rise again, to 10 percent. The result will be a fiscal tightening worth roughly 2.5 percent of GDP this year, plus another worth 1 percent in 2015, according to IMF estimates confirmed by unpublished projections from the Ministry of Finance. This fiscal squeeze — almost exactly equal to those in Britain in 2011 (2.4 percent) and Italy in 2012 (2.2 percent) — will cut Japan’s economic growth from 2.5 percent in 2013 to 1.4 percent, according to official forecasts.

The reality, however, could be much worse. Private sector forecasts collated by the ministry point to just 0.8 percent growth this year. Even that is probably over-optimistic, since many private forecasts still reflect hopes of various growth-promoting measures that could, in theory, be implemented to offset April’s tax hikes.

Such hopes can be divided into six broad categories, all of which now seem quite forlorn:

  1. 1. Structural reforms to stimulate investment, productivity, and hiring. Although there are more than 30 reform bills on structural issues now going through the Diet, ranging from mild encouragements for women in the workforce to rationalizing rice farming, most of these have disappointed expectations and none will likely have any significant impact on growth in the next year or two.
  2. 2. Pay increases of 3 percent or more could, in principle, have compensated workers for higher taxes. This week, however, the annual pay deals at Toyota and Hitachi showed basic wages rising less than 1 percent, even in the most profitable companies. While many Japanese workers can expect substantial bonuses and seniority payments, experience suggests that basic wages are the main determinant of consumer spending and these will be declining in real terms once the higher consumption tax bites.
  3. 3. Corporate tax cuts were widely mooted last year to encourage investment and to offset fiscal drag. But they have been rejected for two reasons. First, because reducing corporate taxes would defeat the purpose of the consumption tax hike, which is to expand the government’s long-term revenues. Second, and less creditably, because the Ministry of Finance and the ruling Liberal Democratic Party both have a natural institutional bias to maximizing taxes, and then offsetting the deflationary economic effects by spending money on public works, which increases the ministry’s bureaucratic influence and the LDP’s political patronage powers.
  4. Additional public works spending has been announced to the tune of 5 trillion yen. But this only maintains the increased levels of investment already implemented in 2013. Although further supplementary budgets are likely if growth suffers after the tax hike, the government’s ability to spend more money on public works is already constrained by lack of suitable projects, shortages of construction workers, and bottlenecks in materials such as cement.
  5. Regulatory measures could be attempted to pump up the Tokyo stock market in the hope of boosting consumer confidence, but the scope is limited by the disappointing review last November of the $1 trillion Government Pension and Investment Fund. This was expected to recommend a big shift from bonds into equities, producing a surge of demand for Japanese shares. But bureaucratic resistance within the GPIF resulted in only a marginal shift in asset allocation — and no further reviews are now planned until 2015.
  6. More aggressive monetary expansion will be the final recourse, if the Japanese economy suffers a serious slowdown. But the Bank of Japan is already committed to doubling its balance sheet by the end of 2014, and it is far from clear that simply expanding bond purchases would have much effect on growth. An alternative might be for the Bank of Japan to try to boost the stock market by buying shares instead of bonds. But would pumping up share prices really do much for growth?

In short, Japan seems to have no convincing options if next month’s tax hike precipitates an economic slump. Of course, everyone hopes that this will not happen.

But hope is not a strategy.

PHOTOS: A man walks past an electronic board displaying Japan’s Nikkei average outside a brokerage in Tokyo March 14, 2014. REUTERS/Toru Hanai 

Japan’s Prime Minister Shinzo Abe bows at the end of a news conference at his official residence in Tokyo June 26, 2013, to mark the end of the ordinary parliamentary session. REUTERS/Toru Hanai

 

6 comments

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He thought He is American but he is not. What an dumbass.

Posted by veethevee | Report as abusive

Bond buying to “pump up” stalk markets only appears to be a effective strategy at this time, but like all illusions they are eventually dispelled. L.

Posted by 2Borknot2B | Report as abusive

I completely agree that the next financial crisis will originate in Japan. Sometimes, one can get the best indication of how things stand on the ground by walking the streets of a city.

I live in Tokyo and walking around the city, I am struck almost on a daily basis by the huge construction boom in residential properties which I started noticing about a year ago. While old homes in Japan often have to be replaced every 30-40 years in Japan, this construction boom seems quite different. In many of these cases older residents living in large homes sold them to developers, who demolished these and then constructed two or three smaller homes on the same piece of land. This scenario has been repeated thousands of times all around Japan, in order for real estate companies and buyers to beat the tax increase scheduled to go into effect on April 1.

In effect, the planned tax increase has acted as a catalyst to accelerate and pull forward this construction for new homes, that would otherwise have taken place over the next 3-5 years. This has created a spike in construction jobs, demand for construction supplies, as well as, all the things people need when they move to new homes (appliances, electronics and furniture, etc.).

We are now at the tail end of this boom, since the higher tax will kick starting in a couple of weeks. I am quite scared and very concerned that the pulling forward of demand will actually result inmuch slower growth for the Japanese economy over the next several years.

Posted by JSCD | Report as abusive

Some of your arguments or contingency-invoking conditions are effectively counted here twice! For example, the shortage of construction workers and bottlenecks in materials such as cement would be substantially alleviated if the Japanese private economy was to substantially contract as you are suggesting it will. In this scenario, if Mr. Shinzo Abe plays his political cards right and enlists proper support early enough from universities and research groups in identifying appropriate projects; he will be able to use a monetary expansion to fund an expansion in public infrastructure works which would boost the Japanese economy. (Perhaps though, it is more likely in the recession scenario, that he would simply use monetary expansion to fund sham “public infrastructure” works in politically supportive areas or in marginal constituencies. Japan is not alone in this behavior: the USA’s infamous “bridges to nowhere” are case-in-point that political patronage knows no boundaries, it is not exclusive to Japan, Africa, Eastern Europe or other politically underdeveloped parts of the world! I wish that other nations than China and Germany would play a long economic game with proper Keynesian anti-cyclical medicine, instead of just engaging in “monetary expansion” and “quantitative easing”, leaning on banks to lend and hoping for the best!)

I believe your overall thesis that there is substantial risk in many foreign markets (characterized perhaps more particularly by the structural non-payment of taxes, and the pervasive infiltration of corruption, cronyism & political patronage, and mafia gangsterism into the system); but for the reason given above, I think your thesis might be unfairly biased against Japan. The market and the risk are both global.

Posted by matthewslyman | Report as abusive

Yes! Please try. I make good trade, again. Short is nothing comparing to earthquakes. We don’t afraid short, but we do afraid long. We have around 1750 local government body like Detroit floating only by LDP politics. Yes, they are Liberal Democratic. We have NO Republicans nor conservatives. So, all companies are running on union base.
Technically Japan is socialist or cooperative productive communist country. So, every workers holding assets and some cash to play. And Japanese worker don’t allow any workers waiting order for too long. They are expected to find work and do voluntary. I joined worker class for few years after decades of consulting and business runner.
It was quite interesting experience for me learning how the system working from inside. From cultural basic knowledge I can understand but from free market view points, they are aliens. Money does not drive, but most system depend on emotional attachment to work, pride on work competition and love for creation as product of people.
In easy word for Americans, they are running all system including high technology and finance in method of farmer’s community competing, say pumpkin or water melon. They have no mentality for profit at all. Democrat GHQ designed this society. It is really interesting. And I start analyse why same methods does not work in other places.
I give you clue easy to study for you. 1st oversea case was Dutsun factory as Nissan in Ayutaya, Thailand. 2nd good case is Honda in Ohio. I do believe Japanese are focusing on creation of middle class community. And R128, Detroit and Wall st. can’t take loss of assets value.
I do believe nobody jump in except Italy to a location like Detroit. (Look at Ital-Thai project. They smell support funds from government since WW2, nature don’t change.) Automobile is quite a commodity products so production should be local in at least in every state because demand is different by environment and density of traffic.
LDP is quite famous not doing anything right for companies and industries in Japan. So, try your good luck. Japanese Banks and security companies have too much money from people, nobody to rent, and afraid to take risk. So, they will increase volume, not price of asset value to cover long time sponsors’ loss.
For example, instead of higher real estate, they expand city on ocean like Ariake and retail sales for condo is going on along coast. Same time, they expel many government facilities and jobs to middle of no where like Tsukuba, and Saitama.
Baby boomer and flower children will keep losing their benefit. And younger generation start receiving benefit. We start having 85%+ job rate for high school graduate (which is known to be stupid because of easier education policy by teachers’ union for another 10- years) this is first wave of new middle class replacing baby boomers.
This is re-distribution period of youth and companies both domestic and global. Thanks for pushing us on TPP. Finally, a rice farmers’ JV went Vietnam. This will be good start for cutting farmers’ benefit and move into oversea production, not only buying. Farmers given land by GHQ and doctors given demands by GHQ as social securities are 2 last biggest union support bodies making LDP to decide wrong preventing competitions and lost any strength.
Anyway, Japanese Banks have no choice than making money on short covering JGB to generate cash flow for base strategy. Because all local governments body bond will fail otherwise. In US market company junk bonds are junk bonds. In Japan, municipal junk bonds are junk bonds which went bad by corrupted managements. So, your stock index is quite dangerous to short. In Japan, interest rate are quite dangerous to long, as they are united to print, anytime. They rather drop from BIS and isolate because nobody in Japan will win. Instead, bankers will be sentenced in jail, and the bank will lose license.

Posted by yellowjap | Report as abusive

One of my biggest concerns for Japan’s future is the triple melt-down at Fukushima, an event about which little is said and less is done. Imagine the impact of turning a large portion of the country into a contaminated ‘Exclusion Zone’ zone, like that surrounding the destroyed plant in Chernobyl. Unlike the Ukraine, Japan has yet to do anything to effectively contain, or even slow, the spread of radioactive contamination. Manipulating data and willfully lying to the public as cancer cases skyrocket is obviously not a long-term solution. In other words, the good people of Japan have bigger concerns than higher taxes or a growing bond bubble.

Posted by h5mind | Report as abusive