Strategy Bulletin  

18/03/2014

ABENOMICS. THE EASY PART IS OVER

While Japanese Prime Minister Shinzo Abe’s economic program, “Abenomics”, has clearly been acknowledged by the domestic economy and markets since its launch in Dec. 2012, the question of its definite success and sustainability remains open. In that respect, the sales tax hike from 5% to 8%, scheduled to take effect in April, will test the robustness of Abenomics’ achievements so far, and might well re-emphasize the urgency of taking it to the next level : the implementation of structural reforms.

To break free from twenty years of economic stagnation and deflation, Mr. Abe put together an aggressive threefold plan. The first “arrow” aimed at doubling the monetary base over two years, to weaken the yen and thus boost exports while creating inflation. Although the yen’s devaluation was indeed impressive (18% drop against the USD last year) and the country exited deflation (core inflation runs at 0.7% on an annual basis and headline inflation at 1.4%), one goal has been missed so far : imports have been rising faster than exports, due to higher costs and weak overseas demand, especially from Japan’s main export partners (China and the rest of Asia). As a result, the trade deficit has surged to its largest level on record (upper chart). Simultaneously, the second arrow, fiscal stimulus, has admittedly boosted demand, but it has also increased the huge stock of public debt while obviously not helping to reduce the deep fiscal deficits (middle chart).

In that context, it is now vital that trend growth move higher in a sustainable manner. Unfortunately, the recent pick-up in growth appears transitory. Net trade has dragged growth down since mid-2013 (lower chart), and is expected to remain sluggish, even though import growth could slow down after the tax hike, as lower Chinese demand prevents a sharp acceleration in exports. On the other hand, private demand has been the largest contributor to growth over the period, with higher consumption in anticipation of the tax hike. This does not bode well for future consumption, especially given weak consumer confidence and poor real income growth. This is where the third arrow, structural reforms, is supposed to kick-in, to engineer – as described by the Japanese Ministry of Finance – a virtuous cycle, whereby increased capital investment generates better productivity and earnings, which, in turn, leads to higher salaries and consumption, kick-starting the economy into healthy inflationary growth. While this plan looks well-oiled, uncertainties lie at almost every juncture. Will corporates use the proceeds from lower taxes to invest more – as the latest business outlook survey for Q31 lets us hope – or to raise real wages – as suggested recently by some key wage hike announcements? Will it trigger a new consumption wave? Will social security and pension fund restructuring overcome the huge demographics challenges faced by the eldest population in the world?

The first two arrows may have generated some growth and inflation, but they are designed to have a lasting effect only in conjunction with the third – structural – arrow. Without the final part of the trilogy, the country is left with lower private consumption, deteriorating net trade and worsening fiscal ratios, as public bonds are issued to compensate for shortages of national revenues. Expect more public spending and Japanese government bonds’ buying by the Bank of Japan to compensate for slower growth. This could support fairly valued equity markets for some quarters, but investors should also be more vigilant than last year, as the easy gains are over and 2014 might well be the ultimate test of Abenomics’ “raison d’être”.

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