This guest blog is a summary of remarks made by Professor Shumpei Takemori at a seminar held at Daiwa Capital Markets Europe Ltd. on 16th January 2014. 

A prevalent opinion about Abenomics can be summarized as follows:

“Increased BoJ bond-buying was the easiest of Abe’s three arrows to shoot. But now that the positive results of that policy have been realized, the Japanese government needs to shoot the third, and most difficult, arrow, namely structural reform. Otherwise, the Tokyo stock market will soon lose steam…”

Thus, a wide number of possible Japanese structural reforms are currently being discussed. But just as in 1997, when most of the structural reforms advocated by the IMF and US for resolving Asia’s financial crisis were unnecessary, I do not expect the new policies to emerge from Abe’s third arrow expert committees to cure Japan’s low-growth syndrome once and for all. Indeed, in my opinion, more important than that witches’ soup of committees are the answers to the following questions:

• What is wrong with our system? In particular, what are the main problems of our political system which obstruct economic growth?
• Does Mr. Abe’s reform plan really have the potential to cure the main problems of our system?

1. What is wrong with the Japanese system?

Japan’s economic problem, in my view, resides principally in its skewed electoral system: One vote in densely populated areas has, at worst, between one quarter and one third of the weight of one vote in scarcely-populated and depopulating areas. This skewed political representation has created at least two major economic problems.

• First, public investment and other resources are diverted from productive use in densely populated areas, like Tokyo, Yokohama, and Nagoya, to unproductive use in scarcely populated or depopulating areas, like Tohoku (see Figures 1 and 2 below). Contrast this with China, where the government has promoted urbanization as a key element of its domestically-oriented growth strategy, helping the economy to weather the storm of the global economic crisis.
• Second, despite Japan’s relatively small rural population, the agricultural lobby is still strong. This has created a huge obstacle for Japan to conclude Free Trade Agreements with other countries.

2. Does Abenomics have a coherent plan to cure the problem?

Shifting resources to highly-populated areas

To some extent, Abenomics offers opportunities to help shift resources to more productive use. For example, Abe can use the 2020 Tokyo Olympic Games as a pretext to divert public investment away from less productive projects to promote developments in the Tokyo metropolitan area. And the BoJ’s monetary easing policy translates into low mortgage interest rates which, in turn, will encourage residential construction in the most densely populated areas.  

An export-led growth strategy

More fundamentally, at the heart of Abenomics lies an export-driven growth strategy, similar to that pursued when Mr. Abe served as Chief of Staff to P.M. Koizumi. Throughout that period, Japan’s export dependency doubled (see Figure 3 below) thanks to stronger US consumption on the back of ultra-loose Fed policy and the MoF’s epic (¥35 trillion) currency intervention initiated by then-Vice Minister Mr. Haruhiko Kuroda. Perhaps now we can see what Mr. Abe is aiming to achieve through his appointment of Mr. Kuroda as Governor of the BoJ! And the fact that Mr. Abe has also embarked on the Trans-Pacific Partnership (TPP) negotiation is further proof that promoting exports is central to his growth strategy.

It is hardly uncommon for a country hit by economic crisis to recover through export growth. The puzzle in this case is why – not least after the Korean economy transformed itself into a formidable Export Machine post-1997 – it has taken so long for Japan to pursue this course. Of course, what inhibited a Korean-style export-driven recovery was the curious movement of the Yen-Dollar exchange rate. Whereas Korea benefited from marked Won depreciation against the Dollar in the immediate aftermath of its crisis, the Yen kept rising throughout the 1990s. Indeed, since Japan is a major capital-exporting country, every time it has experienced a crisis the Yen has appreciated, with the Yen reaching a record high immediately after the 2011 earthquake.

The Koizuimi/Kuroda strategy a decade ago, focusing on export-driven growth, was wise in the context of that time. Unfortunately, the experience ended in tears due to the eruption of the US sub-prime crisis in 2007. But this was not a fault of the Koizumi-Kuroda team. And this time around, not least through its impact on the Yen, the Abe/Kuroda strategy may well put our economy into a higher growth trajectory based on export growth as long as the US economy sees continued recovery.

A greater role for Leveraged Buy-Outs

Critics have argued that Japanese firms have little scope to increase investment, even in the presence of the current low interest rate environment, because their profitability is low. I disagree. The true puzzle for me is the fact that Japanese firms are relying more and more on higher-cost equity finance rather than debt, despite the fact that the costs of the latter are getting lower and lower thanks to the BoJ. In fact, one key to the success of Abenomics is that Japanese firms eventually realize the cost advantage of debt financing to boost profits.

Some Japanese firms, e.g. technologically competitive medium- and small-scale manufacturing companies which currently rely on borrowing, can already enjoy the benefits of new low-cost debt financing. And a simple way to trigger the shift on a wider scale is via Leveraged Buy-Outs (LBOs). In fact, an environment in which (a) the Yen is weak, (b) interest rates are low, and (c) stock prices are on the rise, should be ideal for LBO activities. This should provide strong incentives to managers, since companies that keep stockpiling cash rather than investing them will be targeted for LBOs. So, the Japanese government should make clear that it will take a neutral or even favorable stance in the event of an LBO boom. And I urge European investors to start considering LBOs of Japanese firms.

In conclusion…

If Mr. Abe promotes just one particular measure – the reform of our electoral system – I will buy Japanese stocks right away. He should make efforts to ensure that one vote has an equal weight everywhere in our country. Lacking the necessary political courage and, in particular, fearful of an escalation of fighting inside the LDP, however, he seems unlikely to do this. Nevertheless, Mr. Abe is at least trying to simulate the solution via other politically less demanding measures on the back of his first arrow. That, however, means that a steady US economic recovery, rather than any structural reform proposals coming from the witches’ soup, is likely to be the real third arrow of Abenomics.

The full article can be found here

A response to the article can be found here 

Fig 1: Regional distribution of Japanese central government investment

Source: Ministry of Internal Affairs and Communications (MIC)

Fig 2: Regional distribution of Japanese local government investment

Source: Ministry of Internal Affairs and Communications (MIC)

Fig 3: Japanese Trade Dependency

Source: IFS

Key contact: Chris Scicluna, Head of Economic Research

chris.scicluna@uk.daiwacm.com