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Japan Chair Platform: The Japanese Economy at Risk: Why Does Japan Need Structural Reform?
Abenomics: Still Fragile
Abenomics, the three-point economic revival strategy of Prime Minister Shinzo Abe, was introduced when he started his second term in November 2012. The strategy is based on the so-called three arrows consisting of the Bank of Japan (the Bank) making a massive purchase of Japanese government bonds (JGBs), agile government spending, and structural reform.1 The Bank increased its holdings of JGBs by 100.2 percent to ¥178.6 trillion ($1.72 trillion) by the end of August 2014,2 and the 2014 government expenditures budget was up 6 percent to ¥95.8 trillion ($922.9 billion).3 Both the stock and foreign exchange markets welcomed Abe’s policy. By the end of August 2014, the Nikkei Index had climbed 72 percent to ¥15,424 and the yen depreciated 31 percent to ¥103.8 per dollar in the Tokyo Market. Other economic indicators also reflect the near-term impact of Abenomics. The business conditions diffusion index (DI) in the March 2014 Tankan survey by the Bank improved to plus 12, signaling optimism about the economy.4 The ratio of job openings to applicants in June 2014 reached 1.1, the highest since June 1992. Further, real business fixed investment increased for four consecutive quarters since the second quarter of 2013, and increased a substantial 7.6 percent in the first quarter of this year.5
However, less encouraging macroeconomic data has appeared since the government increased the consumption tax from 5 to 8 percent in April 2014. Japan’s gross domestic product (GDP) came in at minus 7.1 percent per annum in the second quarter.6 Japan’s trade deficit for the first half of 2014 was ¥7.59 trillion ($73 billion), which increased 57.9 percent from a year earlier, the worst showing since 1979 when the statistics were first published, and in July 2014 the government reported the 25th consecutive monthly trade deficit.7 The business conditions DI in June 2014 was plus 7, down from plus 12 but at the same level as in June 2007 before the global economic crisis.
The consumption tax hike caused a temporary lull in the economic recovery and Abenomics now stands at a turning point. Many economists have urged Abe to shoot the third arrow, structural reform, as soon as possible, and some have suggested that the second stage of the consumption tax hike, from 8 to 10 percent, scheduled to take effect in October 2015, should be postponed. This is because there are real limitations for both financial policy and government spending. Importantly, the success of the first two arrows only gives Abe time to prepare for the start of structural reform in Japan.
Two Limitations of the Bank of Japan
The Bank’s mechanism of quantitative and qualitative easing (QQE) consists of four elements (two actions and two spread effects).8 First, with a strong and clear commitment to raise the consumer price index (CPI) to 2 percent, the Bank will be able to erase the public’s deflationary mindset and raise inflation expectations. Second, the massive purchase of JGBs will place downward pressure on the entire yield curve.9 Third, those two steps would lower the real interest rate and provide a strong stimulus to the economy.10 Fourth, with the resulting recovery, prices would rise and, as a result, inflation expectations would rise further.
The Bank acted on the first two elements last year and the second two elements consequently came to the stage. The year-on-year rate of change in the CPI (excluding fresh food) was 1.3 percent in June 2014, compared to minus 0.4 percent in April last year, and was in line with the Bank’s projections. Based on the logic of the mechanism of QQE, we should be able to observe inflation, expected to rise steadily to 2 percent in the future if the recovery continues.
However, all that the Bank, as a central bank, can do is intervene in the market and wait for the self-sustaining economic recovery. Once the economy recovers, the Bank must withdraw the money from the market. This is similar to what the Federal Reserve Board in the United States has done.11
At the same time, there is another limitation for the Bank. The Japanese government issued JGBs totaling ¥13.8 trillion ($132 billion) in 2013, an 8 percent increase from a year earlier. Outstanding JGBs totaled ¥821.9 trillion ($7.9 trillion) in July 2014, an increase of 4.6 percent. The ratio of national debt to GDP of Japan is more than 200 percent and has continued to increase under the Abe administration.
Even though the Bank’s purchases were not connected to the increase in the outstanding amount of JGBs, it is obvious the Bank made space for the government to issue more JGBs. In the meantime, the government has continued to shoot the second arrow of government spending. The Bank needs to consider the negative impact of tapering, which is similar to what the United States’ Federal Reserve Board has faced recently.
Therefore, the Bank may have to consider purchasing other assets from the private market if it should introduce another round of QQE.12 Prime Minister Abe should shoot the third arrow as soon as possible.
Economic Policy: Less Effective in Transforming Japanese Companies
In the past, the weaker yen helped spur Japan’s exports of cars, electronics, and other products,13 but that trend has been largely absent this time. Why hasn’t this happened? Does this mean Japanese corporations have lost their competitive edge to compete in the global market?
One reason for the absence of a surge in exports by Japan is the slower growth of Asian economies since last year. But more importantly, Japanese companies make many of their products in factories outside Japan and have increased imports of parts for production inside Japan, which is not expected to increase. Japanese companies will keep the current production structure and can assimilate foreign exchange income into a consolidated financial result. Hence, the recent depreciation of the yen has done less to increase net exports in Japan. The success of internal reforms pursued by Japanese companies over three decades of yen appreciation has helped.
Japanese businesses changed the simple export-driven business model after the rapid appreciation of the yen that began with the 1985 Plaza Accord.14 They began to source more of their intermediate goods and components from Association of Southeast Asian Nation (ASEAN) countries. Some of them have given up labor-intensive and low-cost assembly operations such as home appliances, shipbuilding, and mobile phones when they found they had lost the competitive edge. Korean, Taiwanese, and Chinese companies replaced these operations. Over time, these practices contributed to the development of extensive regional production networks (RPNs) for manufacturers.15 Japanese corporations chose to take the core position of RPNs and some of them became electronic parts makers or fabric makers.16
The number of employees of Japanese companies in foreign countries was 55.8 million in 2012, having doubled over the last 15 years.17 The ratio of foreign assets to total assets of Japanese companies in 2013 was 19.3 percent, compared to 3.3 percent in 1990.18 Companies operating globally have not chosen to increase production in Japan because they question how long Prime Minister Abe can remain in office and how long the current trend of a weaker yen will last.19 Therefore, the current trend of Japan’s trade deficit under the Abe administration has not changed.20 Japan is not an unemployment exporting country any more. Rather, it is an employment exporting country. But this also means Japan’s economic and financial policy might be less effective than before.
What Prime Minister Abe Should Do under the Third Arrow: Implications of Structural Reform by Koizumi in 2001
The markets were familiar with the term “structural reform” more than 10 years ago when Prime Minister Junichiro Koizumi took office.21 At the time, structural reform mainly meant privatization of government businesses in order to reduce the huge national debt. Koizumi had strong charisma and appeared to succeed at reform during his term. But it took several years to produce a bill to privatize government businesses and the practical process of privatization began in the last few years of the Koizumi era.22
His structural reform agenda slowed down after his resignation in 2006 and was almost stopped when the Democratic Party of Japan (DPJ), a rival of the ruling Liberal Democratic Party (LDP), took power in 2009. The first challenge of structural reform in Japan in the 21st century came and left with Koizumi. No real structural reform has appeared since then.
Koizumi’s experience with structural reform suggested that the Japanese people might not like to change the business model that, for almost half a century, protected them with lifetime employment and don’t want to change the social system in general. Prime Minister Abe therefore chose a more moderate approach to structural reform. His main challenges for structural reform are to (1) reduce the corporate tax rate to the 20-plus-percent range,23 (2) promote women and the education of young people in order to raise productivity, and (3) reform the agricultural and medical sectors. The reduction of the corporate tax rate has already been approved in a cabinet meeting in June. The other two challenges could prove more difficult but Abe’s efforts could end up more successful than Koizumi’s if he can overcome opposition within the LDP and among the public.
Japan Cannot Stop Structural Reform This Time
Prime Minister Abe is the first Japanese leader to face a mixture of globally operating or newer-model firms and the export-led or older-model firms. He should understand that economic policy is less effective with the newer-model firms, which know that the good financial results from Abenomics in 2013 stem from a weaker yen, which is an artificial and temporary boost.
On the other hand, Japanese consumers now recognize the value of regional production networks (RPNs) and don’t necessarily prefer goods made in Japan, which has a positive impact on globally operating firms. This supports the decision of those firms to watch the Japanese economy and see how serious this latest attempt at structural reform is, and if steps such as reduced corporate tax rates create more comfortable business conditions.
Japan cannot exit the current economic slump in the long run if Prime Minister Abe does not shoot the third arrow. The impact of the first two arrows so far is similar to previous economic policies. More importantly, Japan has crossed the Rubicon: the Bank purchased a huge amount of JGBs and will need to return to the market in the future, so Japan cannot return the government balance sheet to a normal position without the success of Abenomics.
The Japanese economy is at risk because globally operating firms will not come back to Japan easily. Structural reform is therefore critical if the government wants them to increase production at home.
Yoshihiro Sakai is an adjunct fellow with the CSIS Japan Chair and senior fellow at Tsinghua University. He was a senior official of the Bank of Japan and a senior economist of the Development Bank of Japan.
1 Prime Minister Abe announced a “growth strategy to enhance private investment,” including a reduction of the corporate tax rate, which is understood to entail structural reform. Prime Minister of Japan and His Cabinet, “The Three Arrows of ‘Abenomics’: Growth Strategy,” http://japan.kantei.go.jp/letters/message/abenomics/asean1.html.
2 This is the number of ordinary government bonds.
3 Highlight of the Budget for FY 2014: Ministry of Finance, http://www.mof.go.jp/english/budget/budget/fy2014/01.pdf.
4 The Tankan is the short-term economic survey of enterprises in Japan. The DI was minus 8 in the March 2013 Tankan survey, http://www.dir.co.jp/english/research/report/jsothers/20140402_008390.pdf.
5 The increase of business fixed investment was attributable to renewed demand for construction machinery ahead of expected regulations limiting emissions. Increased demand for personal computer software was due to support for Windows XP ending in March.
6 There is an opinion that minus 7.1 percent is a recoil reduction of 6.0 percent growth per annum in the first quarter. If we look at seasonally adjusted quarterly GDP numbers compared with the previous quarter, we find plus 1.5 percent in the first quarter and minus 1.8 percent in the second quarter. See http://www.esri.cao.go.jp/jp/sna/data/data_list/sokuhou/gaiyou/pdf/main_1.pdf.
7 The government also reported on September 5 that the trade deficit in the first 20 days of August increased by 8.2 percent to ¥902 billion from a year earlier. See http://www.customs.go.jp/toukei/shinbun/trade-st/2014/201408b.xml.
8 Speech by BOJ Governor Haruhiko Kuroda at the London School of Economics and Political Science, How to Overcome Deflation, March 21, 2014, http://www.boj.or.jp/en/announcements/press/koen_2014/data/ko140322a.pdf.
9 The Bank also extended the remaining maturity of the Bank’s JGB purchases from nearly three years to about seven years, which is almost equivalent to the remaining maturity of the outstanding JGBs issued. Thus, the increase in JGB purchases and their maturity extension represent QQE.
10 The real interest rate is the nominal interest rates minus the expected rate of inflation.
11 The Federal Reserve Board in the United States has aggressively purchased treasury bonds in recent years, but it has started to taper down.
12 The Bank included the decision to expand the purchase of exchange traded funds (ETFs) and Japan real estate investment trusts (J-REITs) as part of QQE when it was announced in April last year.
13 Intervention by the Bank of Japan to purchase dollars was a regular formula to stop appreciation or push depreciation in the past.
14 See William W. Grimes, “Japan and Asia-Pacific Economic Integration: Looking beyond TPP,” CSIS Japan Chair Platform, August 27, 2014, http://csis.org/publication/japan-chair-platform-japan-and-asia-pacific-economic-integration-looking-beyond-tpp; also Yoshihiro Sakai, “Japan should focus on China, not the Yuan,” International Herald Tribune, January 11, 2004, http://www.nytimes.com/2004/01/10/opinion/10iht-edsakai_ed3_.html.
15 According to Credit Lyonnais Securities Asia (CLSA), a brokerage and investment firm in Asia, the number of cars produced in the rest of Asia will soon exceed production in Japan.
16 For example, Panasonic focuses on making batteries for electric cars and total management of home electronics. Sony sold its personal computer operation and focuses on audiovisual equipment, smart phones, and other electronic devices. Sharp focuses on liquid crystal panels.
17 Kaigai Jigyo Katsudo Kihon Chosa [Basic Survey on Overseas Activities], Ministry of Economy, Trade and Industry, April 25, 2014, http://www.meti.go.jp/english/statistics/tyo/kaigaizi/pdf/h2c406je.pdf.
18 “Japan’s Fund of Flow Accounts,” Bank of Japan, June 18, 2014, https://www.boj.or.jp/en/statistics/sj/sj.htm/.
19 The average term for Japanese prime ministers after World War II is 26 months, the second shortest after Italy at 19 months in the Organization for Economic Cooperation and Development (OECD) countries. Since Junichiro Koizumi left office in 2006 after five years, the average term is almost one year.
20 Japan’s persistent trade surplus from the late 1980s to early 2000s was the subject of a political battle with the United States.
21 Heizo Takenaka, Koizumi Kouzou Kaikakuno Shinjitsu [The Reality of Koizumi’s Structural Reforms] (Tokyo, Nikkei Publishing, December 2006).
22 For example, the privatization process for Japan Post started in 2007 and for Nippon Expressway Company in 2005.
23 On January 22, 2014, at the World Economic Forum, Abe announced plans to reduce the corporate tax rate to the 20-plus-percent range in a several years. The current tax rate in Tokyo is 35.64 percent. “Prime Minister’s Remarks at the World Economic Forum,” January 22, 2014, Council on Foreign Relations, http://www.cfr.org/japan/prime-minister-abes-remarks-world-economic-forum/p32286.
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