Worries abound about future recession Made in Japan

May 20, 2016

A woman looks at items at a discount drug store at a shopping district in Tokyo March 26, 2015. Japan's annual core consumer inflation ground to a halt in February when excluding the effect of last year's tax hike, the first time it has stopped rising in nearly two years, keeping the central bank under pressure to expand monetary stimulus further. Picture taken March 26, 2015. REUTERS/Yuya Shino  - RTR4V28D

Asia’s second-largest economy may have expanded a lot quicker than expected in the first three months of the year, but past experience suggests an economic contraction isn’t far off if Prime Minister Shinzo Abe moves ahead with a second sales tax hike in April 2017.

Economic forecasters are so sure of the likely result, they’ve already factored one in.

For G7 finance leaders meeting in Japan on May 20-21, differing views on fiscal and currency policy will likely not yield any coordinated action.  So any concerns about manufacturing a recession through a possible tax hike, something Japan has done at least twice in the past two decades, may not even come up.

Value-added tax (VAT) hikes are part of Abe’s ambitious reflationary programme, called Abenomics, that punches together monetary and fiscal stimulus and economic reforms aiming to end years of deflation and boost growth.

The trouble is, while tax hikes are the most effective temporary way for a government to boost stubbornly low inflation, they aren’t stimulative or inflationary in the longer-term at all. The next attempt to run the experiment is not expected to yield any different results.

Economists polled by Reuters over the past week forecast Japan gross domestic product will contract 5 percent on an annualised basis in Q2 2017, just after a scheduled VAT hike in April 2017. That’s a huge deterioration from 2.8 percent growth forecast for Q1.


The last time, Abe raised sales tax to 8 percent from 5 percent in April 2014, core inflation more than doubled to 3.4 percent, above the Bank of Japan’s target. But that led to a 6.8 percent contraction in the same quarter. Inflation then quickly fell back to below where it was before the tax hike. By then, the BOJ had to ramp up its already-massive asset purchase programme once more.

Japan inflation

So far, expectations in markets and among investors is that the sales tax hike next April will be delayed. It has already been pushed a couple of years out from an original planned date of April 2015 due to recession by other means. That also appears to be the official view in Tokyo.

Kazuhiko Ogata, chief Japan economist at CA-CIB in Tokyo, expects Abe to announce sometime ahead of the July upper house elections that the next hike will be postponed.

“In the short-term, Japan’s economic outlook remains fragile and if VAT is raised as planned (in April 2017), it could prompt another recession.  That’s a clear risk. So it’s going to be very challenging for Abe to raise VAT without first making plans to offset the impact on consumer sentiment through fiscal or monetary stimulus or a supplementary budget.”

The fact that economists are predicting a sudden and deep contraction in GDP a year from now suggests their central view is the hike will proceed as scheduled.

Less recent history also suggests deferring or taking a pass on the hike altogether might be a more prudent move.

In 1997, value added tax was raised to 5 percent from 3 percent in order to increase government earnings and shrink the country’s debt, at that time half the size of the economy.

But consumption stumbled, followed by a deep recession and deflationary spiral that Japan has struggled to put behind it.

Soon afterward, the BOJ became the first central bank in modern times to conduct a massive asset purchase programme as policy stimulus and has been doing so for the vast bulk of the time since.

Consumption (C in the chart below) also slumped quite a bit after the last sales tax hike.


Since the start of Abenomics, the fastest annualised growth rate reached was 5.9 percent in Q1 2014, just before the last VAT hike. The economy has contracted in nearly half of the 12 quarters since April 2013. Only the BOJ printing truckloads of money to buy everything from government bonds to Nikkei index funds helped cushion the economic outlook slightly.

Private forecasters also agree that the current exchange rate is too strong for an economy so heavily reliant on exporting high-quality manufactured goods to the world market.

The latest consensus in Reuters polls shows the economy growing just 0.80 percent this fiscal year, and flat in the fiscal year to April 2018.

That is hardly the kind of growth rate that can be expected to generate inflation that will meet the BOJ’s 2 percent target.

(With reporting by Shrutee Sarkar)

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