After two “lost decades,” Japan has begun a risky monetary gamble. Abenomics has the potential to make or break Japanese savings, Asian century, and global recovery.
When the Bank of Japan (BOJ) concluded its highly-anticipated two-day policy meeting on April 4, 2013, a new era began in Japan.
As the conservative caution of the previous BOJ governor Masaaki Shirakawa faded into history, his successor Haruhiko Kuroda, an establishment veteran but longtime critic of the BOJ, pledged to do “whatever it takes” to achieve the 2 percent inflation target.
The great gamble has begun.
A platform of changes
Last December, the Liberal Democratic Party (LDP) returned to leadership, with Shinzo Abe as its prime minister.
The LDP campaigned on a three-pillar platform of renewed fiscal stimulus, aggressive monetary easing from the BOJ, and structural reforms to boost Japan’s competitiveness.
In turn, these pillars were coupled with the proposed Trans‐Pacific Partnership (TPP) agreement, which Abe hopes to use to achieve liberalization in more sheltered industries. The U.S.-led TPP excludes Japan’s trade partner China, which supports the Comprehensive Economic Partnership for East ASIA (CEPEA) – which does include Japan.
The sheer anticipation of change in Japan has resulted in a sharp depreciation of the yen and equally steep rise in stock prices. The consensus forecast for GDP growth in 2013 and 2014 is now around 1.5 percent.
Recently, the BOJ also pledged to begin open-ended asset buying, seeking to inject $1.4 trillion into the economy within two years. It hopes to double the monetary base to $2.9 trillion by the end of 2014.
In relative terms, the goal would be comparable to the Fed purchasing $8 trillion of sovereign debt in less than two years.
Financial markets responded with exuberance. After the BOJ announcement, Goldman Sachs upgraded its 12-month target for both Japanese benchmarks – the Nikkei and Topix – by almost 20 percent.
However, by targeting the monetary base, the BOJ has effectively abandoned interest rates as a target.
As tax revenues have failed to cover for government expenditures in Japan, life support has become a way of life. Economic activity is sustained through excessive deficit spending.
In the process, Japanese governments have piled up debt valued at $14.6 trillion, which translates to a whopping 230 percent of annual GDP. Yet, Japan pays less than 1 percent interest – less than Germany.
Unlike Europe’s indebted southern periphery, Japan borrows most of its money from its own people. Domestic banks and insurers have purchased 95 percent of the sovereign debt using the savings deposits of the population.
Only a decade ago, Americans used their subprime apartments as ATM cash machines, which created a semblance of real economic activity. Japan relies on the confidence of its people that the nation can one day pay off its debts.
In the U.S., the subprime machines collapsed in 2008. Japan’s sovereign debt could have been sustained only another decade – until Abe’s reforms.
In addition to the massive monetary stimulus, Abe’s reformers have resorted to a large fiscal stimulus valued at 2 percent of the GDP, to jump-start growth and to foster aggregate demand. That could raise the deficit to 11.5 percent, while public debt may soar to 245 percent of GDP by the year-end.
The assumption is that the aging Japan will still opt for lower-risk, highly liquid assets.
Abe critically needs the BOJ to boost nominal growth and a growth environment, to pursue fiscal consolidation in a growth environment.
After monetary expansion and fiscal stimulus, the success of Abe’s reforms depends on the proposed structural reforms and the overall effectiveness of the new policy thrust.
In Japan, the opposition is concerned that, if jobs and salaries increase only marginally, the new monetary policy could result in a plunge of real wages.
In Asia, Japanese reforms translate to South Korea’s losses because the two compete directly in machinery, cars, electronics and other industries. As the value of yen plunges, the won has surged.
The soaring optimism in Tokyo has gone hand in hand with heightened international concern over “currency wars.” Yet, the latter were left unmentioned in the G20 joint statement in last February. In Tokyo, that was seen as a green light for the reform program.
Washington’s position seems to be that policies to strengthen domestic demand are desirable and should be encouraged, whereas beggar-thy-neighbor policies, such as deliberate devaluation, are to be discouraged.
Unfortunately, the line between the two is often drawn in waters.
In China, Japanese reforms are seen as effective devaluations and the BOJ decision to double the monetary base as “blackmail” to open the liquidity floodgates. Japan’s equity markets have already seen $60 billion in foreign investment inflows since mid-November, which has pushed the Nikkei to record highs.
As the BOJ is pumping liquidity in the global economy, the threat of “hot money” – speculative short-term portfolio investment – will increase in Asia. That could reignite the carry trade, in which investors borrow in low-interest yen and invest in high-interest markets.
Risks escalate toward 2014
If the Japanese conclude that the decline of the yen will continue and decide to move their assets abroad, the outflow could turn into an avalanche, as the investor George Soros has warned.
But another risk involves timing. The current goal is to implement the fiscal stimulus in 2013, while fiscal consolidation is to follow in 2014 and beyond.
In their zeal to take advantage of the Japanese fiscal stimulus and monetary expansion, global financial markets have ignored the stated second phase of the Abe reforms.
Tokyo’s dramatic expansionary moves will accelerate in 2013, but reverse equally dramatically in 2014 – amidst economic erosion and political friction in the Eurozone, impending U.S. fiscal consolidation, and solid but reduced growth prospects in China.
If Abe’s gamble succeeds, it could reverse Japan´s decline, support Asian expansion and global recovery. If it fails, it could shrink Japanese savings, slow down the proposed “Asian century” and undermine the nascent global recovery.
Whatever the final outcome, the colossal gamble will speed up history.
A shorter version of this commentary first appeared in the South China Morning Post print edition on Apr 22, 2013 as “Timing is the key in Japan’s massive gamble to revive its moribund economy”