Japan as the crisis next time
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roughly 2.5 percent of GDP this year, plus another worth 1 percent in 2015, according to IMF estimates confirmed by unpublished projections from the Ministry of Finance.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. 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. 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. 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.
- 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.
- 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.
- 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