Is Abenomics working?

So far, so good. The 3 arrows of Abenomics (major monetary easing; active fiscal policy; and structural reform) aim to revive confidence, generate a sustainable recovery and end deflation. And most evidence suggests that the near-term objectives are being met:

• Confidence has been rekindled. Economic sentiment among households and firms (whether manufacturers, services or in the construction sector) is at multi-year highs. Despite recent volatility, Japan’s equity markets remain among the world’s best performers this year. Corporate profits have risen back to their highest level for six years.
• Economic recovery is underway. Japan’s GDP growth in the first half of the year (almost 4% on an annualised basis) was the strongest of all G7 countries, supported by higher household spending, exports and extra public spending. Leading indicators meanwhile suggest the recovery will be sustained – and should broaden out to include higher private investment – through to the first quarter of next year.
• Deflation has eased. Largely due to higher prices of energy and other imported goods on the back of the weaker yen, CPI is now (slightly) positive on a range of measures. In July, the BoJ’s preferred core CPI measure (which excludes fresh food prices) reached 0.7%Y/Y, the highest since 2008. Perhaps more importantly, expectations of future inflation – both in the markets and among households – have risen significantly. And so, real interest rates are now negative, providing firms with further incentive to increase investment.

Will it continue to work?

It remains to be seen whether Abenomics will succeed over the medium term, to ultimately boost potential economic growth, hit the BoJ’s 2% inflation target on a sustained basis, and put the public finances on a sound footing. There is a long way to go to truly transform Japan’s economy. And there remain plenty of uncertainties. For example:

• We await confirmation of Abe’s decision about whether to go ahead with the 3ppt hike in the consumption tax (to 8%) legislated but still not yet confirmed for April 2014. The recovery now looks just about strong enough to withstand the tax hike, which would be a first step towards securing fiscal sustainability. So, we expect it to go ahead, albeit with additional public spending to soften the blow. But assuming the tax rise does proceed, GDP will inevitably contract in Q2 next year. And additional monetary easing will be required to help growth resume thereafter in a sustainable way, not least since further tax and public spending reforms will be required in due course.
• The economic recovery remains in its early stages and there remain significant downside risks. For example, unless the BoJ’s monetary avalanche translates into higher bank lending and private sector investment growth, the recovery will eventually peter out. Moreover, if prices continue to rise at a faster rate than wages, the recovery will likely shift into reverse. And unless above-potential growth can be sustained through to 2015 and beyond to eliminate spare capacity in the economy, the BoJ’s 2% inflation target will not be met, while government debt would also likely continue to rise even if the consumption tax is hiked.
• Abe’s 3rd arrow – structural reforms to boost potential growth – has been a disappointment to many observers. Abe has announced some laudable high-level objectives – e.g. to boost employment and productivity – but few substantive reforms. To some extent this reflects political priorities, notably his aim (successfully achieved) to secure an Upper House majority in July’s elections. And Abe is right to tread carefully, since structural reforms need to be sequenced and implemented in an appropriate manner so not to impair the recovery and/or add to deflationary pressures. But Abe will, in due course, need to make more tangible progress – e.g. via deregulation, labour market reforms and new trade agreements – to offset Japan’s woeful demographics and boost potential GDP growth, which remains among the weakest of all industrialised economies.

But, this is the first concerted effort by the Japanese authorities to try and end almost a decade and a half of below-par economic performance. And the policy approach, in particular “shock and awe” monetary easing, is the textbook response called for by many economists (particularly those outside Japan) for many years. It is arguably Japan’s best hope of reviving its economy since the bursting of the bubble back at the start of the 1990s. And on balance, there is cause to be optimistic that Abenomics will prove ultimately successful at least in ending deflation.

What has Abenomics done to investor sentiment and strategy?

Abenomics has provided a breath of fresh air for Japanese investors, as illustrated by the rise in the Nikkei of roughly 75% from last year’s trough, and the more than 20% depreciation of the yen against the dollar from its peak last year. But after the initial excitement, domestic investors are now waiting to see how effective the various policy initiatives will be.

• For example, will the recovery be sustained or peter out? Will inflation move gracefully towards target, die away, or (most unlikely) get out of control? Investors will need more evidence one way or another to undertake a further major shift in strategy. But if they are eventually convinced that inflation is returning, there will be an increasing shift out of cash into real assets, something that will provide enormous support for asset prices.
• Global factors – not least uncertainty related to the Fed’s moves to taper – also lend themselves to a cautious approach at present. Yet the Fed’s exit should in due course see the yen weaken further against the dollar, supporting Japanese equities.
• JGB yields have been broadly stable (indeed 5-10Y yields have ground steadily lower) since the early summer, a time when most major economy bond yields have taken a marked step higher on talk of Fed tapering and some stronger economic data. That, of course, reflects the BoJ’s buying of more than ¥7trn gross or ¥4.2trn net of JGBs per month.
• Banks have taken advantage of the BoJ’s purchases to reduce their exposure to JGBs, in terms of both the total value of assets held and duration. So far, most of the proceeds of their bond sales to the central bank have been lodged back in their current account balances at the BoJ. They have not yet increased markedly their lending to the real economy, their purchases of risk assets, or their foreign exposures. But there is significant scope for them to do so in due course if and when the economic recovery matures as Abe and the BoJ hope.
• Many insurers and pension companies have also considered gradually reducing their exposures to JGBs and increasing their holdings of riskier domestic assets and foreign assets. But, not least for regulatory reasons, shifts in strategy will be necessarily limited. And so, for example, we expect the longer end of the JGB curve to remain supported even if inflation continues to rise.

Chris Scicluna, Head of Economic Research