Abe’s disturbing lack of focus

By Anatole Kaletsky
April 24, 2014

President Barack Obama’s trip to Asia this week has focused mostly on Japan’s territorial disputes with China. On this issue, Obama seems to be repeating the same mistakes he made in Ukraine.

By creating false expectations of U.S. support for the Japanese position, the president is encouraging Japan to escalate its belligerent rhetoric. That, in turn, makes Chinese military action to seize the disputed islands more likely. Everyone knows that there is no chance of the United States going to war with China to defend Japan’s claim to four uninhabited lumps of rock.

Luckily, a military confrontation in the East China Sea remains highly unlikely because the Beijing government’s top priority is economic and financial reform.  Unfortunately, this seems less true of Japan.

Prime Minister Shinzo Abe’s attention seems to have shifted from economics to diplomacy and military matters — and financial markets have started to notice this disturbing change of focus. The clearest evidence can be seen in the relative performance of the Japanese stock market.

Equities around the world have enjoyed a strong rebound in the past few weeks. While the U.S. and several European stock markets were again challenging record highs this week, the Tokyo market has been by far the world’s worst-performing stock market, down 10 percent so far this year.

Yet Japanese equities are by some measures among the world’s “best value” — or cheapest investments. The Topix index is trading at just 1.1 times book value, according to Bloomberg. U.S. stocks in Standard and Poor’s 500 index, by contrast, are selling at 2.6 times book value, while Europe’s Stoxx 600 index is at 1.9 times.

Despite its relative cheapness, the Tokyo market’s performance has deteriorated further in the past few weeks even as global investors have sought to rotate their money toward better-value assets, as I described here two weeks ago. The upshot is that Japan’s market has  given up all the relative gains it enjoyed in the first half of last year.

Tokyo was then, by far and away, the world’s best-performing stock market — buoyed by enthusiasm for Abe’s economic reform program, known as Abenomics, which seemed ambitious and single-minded. Today, the Japanese stock market is weaker relative to Wall Street and to most European markets than at any time in the past decade.

Why has Japan performed so poorly? I presented the economic case against Japan here a month ago. The key risk was — and still is — last fall’s controversial decision to boost consumption taxes. The move illustrated the sudden shift in Abe’s priorities from accelerating economic growth to the more traditional objectives of conservative Japanese politicians. The higher tax supported the construction industry and, perhaps most important, created the fiscal headroom to boost defense spending.

The consumption tax hike, which went into effect in April, amounts to a fiscal tightening of more than 2 percent of gross domestic product. The contraction more or less guaranteed a slump in the Japanese economy unless offset by very powerful countervailing measures of monetary or fiscal expansion.

But no such initiatives were implemented. Even if some were announced in the next few months, they would come too late to prevent a severe economic contraction.

Why is it that Abe, who early last year seemed willing to “do whatever it takes” to shake his country out of its decades of economic lethargy, has decided to risk pushing Japan back into stagnation by continuously tightening fiscal policy?

Judging by my recent conversations in Tokyo, there are two answers, both connected with the geopolitical issues dominating this week’s Abe-Obama summit.

First, a big fall in output in the current quarter caused by the tax hike will set the stage for a statistical rebound in the third quarter, when consumption returns to something closer to normality. The government and the Bank of Japan are eager to see such a mechanical rebound because the prime minister must make a formal decision in December to proceed with the next stage of fiscal tightening – raising the consumption tax from 8 percent to 10 percent, which would go into effect in October 2015.

A decent rebound in third-quarter GDP figures, due to be released in late November, will provide the pretext that Abe requires for yet another tax hike. The higher tax, in turn, is seen as necessary to create the fiscal headroom for higher military spending in the years ahead.

The second reason for the Abe government’s new-found tolerance for an economic slowdown is directly connected to the rise of China. When Abe was elected in late 2012, his determination to revive the Japanese economy was significantly motivated by fears about China.

The worry was not that China had overtaken Japan as the world’s second-biggest economy and would eventually overtake the United States’ — even the most ardent Japanese nationalists see both these trends as inevitable. More troubling was growing evidence that China’s economic might was shifting the balance of interest in Washington from the traditional postwar friendship with Japan to cultivating better relations with China.

Given Japan’s dependence on U.S. military power, the shift of U.S. attention to China was alarming. Particularly to a fervent nationalist such as Abe, who has always cared passionately about winning Japan’s territorial disputes and rehabilitating its wartime reputation.

But with Obama’s words, the United States has now shown its willingness to antagonize China by promising to defend Japan unconditionally in any territorial disputes. These promises will almost certainly prove false in the event of a genuine military confrontation. But for the moment, they seem to have reassured Japanese politicians that Washington will continue to pay attention to Japan — even if it slides back into economic irrelevance.

 

PHOTO (TOP): Japan’s Prime Minister Shinzo Abe reacts after he rings a bell during a ceremony marking the end of trading in 2013 at the Tokyo Stock Exchange (TSE) in Tokyo, December 30, 2013. REUTERS/Yuya Shino

PHOTO (INSERT 1): President Barack Obama (L) attends a news conference with Japanese Prime Minister Shinzo Abe (R) at the Akasaka guesthouse in Tokyo, April 24, 2014. REUTERS/Junko Kimura-Matsumoto/Pool

PHOTO (INSERT 2): President Barack Obama participates in a joint news conference with Japan’s Prime Minister Shinzo Abe at the Akasaka Palace in Tokyo, April 24, 2014. REUTERS/Larry Downing

PHOTO (INSERT 3): An employee of a foreign exchange trading company looks at monitors as a television set shows Japan’s incoming Prime Minister Shinzo Abe speaking in Tokyo, December 26, 2012. REUTERS/Yuriko Nakao

4 comments

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Anatole, I like your stuff very, very much. But one thing to note is the Japan equity market is surprisingly seasonal, and the winter Japan trade is a classic one.

Posted by rvm3 | Report as abusive

I have to disagree with your opinion that Prime Minister Abe is losing his focus on economic recovery. I don’t know who you are talking to in Tokyo but they are uninformed about the purpose of the consumption tax and why Abe has no choice but to continue with the planned increase to 10%.

In your analysis, you ignore Japan’s most important issue, its aging population. Revenue from the consumption (VAT) tax is earmarked for social welfare programs, primarily public pensions and the national health system. The government’s contribution to the public pension system is the single largest line item in the national budget every year. Everyone in Japan between the ages of 20 and 65 is required to participate in the public pension system. Without a broad-based tax, such as the consumption tax, to support public pensions, the system would soon become unsustainable.

People aged 65 and over are already about 25% of the population. In another 30 years, they will be more than 40% of the population. How do you support a growing number of retirees with a shrinking workforce? You get the retirees to support themselves–to an extent–by paying the consumption tax.

Unless Japan can address the funding of its public pension system, it cannot address the broader issue of government debt. This is the first, necessary step towards the reform of public finance in Japan.

As for Abe’s “militarism,” this is supported by the US. Look at a map of the Chinese coast. You will see that China has no easily defensible access to the open waters of the Western Pacific. China is building a blue water navy but it is bottled up against the Chinese coast.

From China’s perspective, the US Navy is the biggest threat to the security of its shipping lanes. Without access to open water, China cannot defend its shipping.

China is challenging Japan’s sovereignty over the Senkaku Islands as a first step towards challenging Japan’s sovereignty over the southern Ryukyu Islands. If China can successfully assert its claims to the two island groups, it will have created its strategic, defensible opening to the Pacific.

There is a case for China to make to assert its claims over both territories. Personally, I think it is a weak case but it is the only option China has short of outright invasion.

The US and Japan would, of course, prefer to keep the Chinese navy bottled up against the coast.

These are the big issues that Abe is dealing with. I think the economy can handle the tax increases but I doubt that the pension system can survive without the tax increases. As for “militarism” Japan is better off if China cannot project force that threatens Japan’s sea lanes.

Posted by gemmoo | Report as abusive

One word, Fukushima. Much like Chernobyl’s effect in removing Russia as an economic power in the 80′s.

Posted by epockismet | Report as abusive

L.

Posted by 2Borknot2B | Report as abusive