Published in Newsweek Japan 11/6/2013
Who is the strongest political leader in the world today? Six months ago the answer might have been Angela Merkel or Vladimir Putin. Few would have imagined that a candidate might emerge from the “everyone-takes-a-turn” karaoke club of Japanese politics.
Yet in a world where leaders of both developed and emerging nations appear to be struggling helplessly against the economic tide, Japanese Prime Minister Shinzo Abe has seized the initiative. In Japan, uniquely, policy changes are driving the financial markets, not the other way around.
Abenomics is a bold attempt to reflate Japan – which means to put an end to fifteen years of deflation, stagnation and increasing irrelevance. If all goes well, the benefits will be broad and long-lasting. Yet to turn around an economy which has experienced no top-line growth for so long is not an easy matter. It requires changing the expectations of everyone – investors, savers, managements, workers, bankers, entrepreneurs and, not least, the ordinary man and woman at the ramen shop counter.
For that to happen, Japan’s usual softly, softly approach will not work. Only dramatic, even shocking change stands a chance of success. So if nobody complains, if everyone carries on just as before, as comfortable as ever in the lukewarm bath of managed decline, then it would be a sure bet that Abenomics was failing.
Dramatic regime shifts in policy must create new winners and losers. And as is always the case the voices of the losers will be loudest, while the winners will tend to keep their heads down and carry on winning. It’s no surprise that recent volatility in the financial markets has brought out the gloomsters and doomsters and deflation-lovers.
“The stock market fell sharply at the end of May and mortgage rates are rising. That must mean Abenomics is a big mistake!”
“Japan is going the same way as Greece. The bond market is going to collapse. The yen is going to collapse. Everything is going to collapse.”
“This weak yen is no good. I was going to book a holiday to Europe, but the hotel prices are ridiculous. Even worse, I went to Disneyland instead and it was full of Chinese tourists!”
“Luxury spending? You must be joking! The stock market may have soared, but I’m a hard-working salaryman, not a speculator. I keep my money in the bank and shop at one hundred yen stores. I don’t fancy two percent inflation.”
Such complaints are inevitable during the first phase of Abenomics, when the most visible changes are the wild movements of the financial markets. The second phase, general economic recovery, takes time to appear. In the case of monetary policy the lag is usually nine months to a year.
The usual sign of imminent recovery is a rise in market interest rates. Despite Mr. Kuroda’s unhappiness with the timing, everyone knows this must happen if reflation is to succeed and wages and consumer prices and real estate values are to move higher. The super-low interest rates to which people have become accustomed are only compatible with perpetual recession.
In fact, upward pressure on interest rates is a sign that the markets are already taking Mr. Kuroda’s commitment to reflation seriously.
Likewise, stocks cannot go on rising by 10% every month without a correction, not even in the magic kingdom of Abenomics. Bull markets feed on scepticism and worry. It’s when everyone is confident and relaxed that markets are most dangerous.
What the recent burst of volatility tells us is that the stock market too is foreshadowing the next phase. The real estate and financial stocks, which led the rally have started to perform badly – just as happened in early 1987 when Japan emerged from the endaka recession. As happened then, market leadership should be taken over by the stocks of the companies experiencing the strongest improvements to profitability.
From an investment standpoint, the recent financial market turbulence is a healthy, indeed necessary phenomenon.
As Friedrich Nietzsche might have put it, had he been long of Japanese equities, that which does not kill us makes us stronger.
So far the main beneficiaries of Abenomics may appear to be Chinese tourists and rich old ladies shopping at department stores, but the fundamentals of corporate Japan are already turning decisively for the better.
To see why, we need to go back to the start of Japan’s deflationary disaster, the bursting of the bubble economy in 1990.
Incredible as it may seem now, such was the cast-iron confidence of Japan’s establishment at the time, that it was widely believed that collapsing asset prices would have no effect on real economic activity. The ministry of finance, the Bank of Japan and most business leaders were united in the view that it would be possible to crack down on speculative excesses in the “symbol economy” of real estate and the stock market while preserving Japan’s industrial competitiveness.
They couldn’t have been more wrong. What they missed was the complex two-way relationship that exists between asset markets and real economic activity. The stock market and real estate markets collapsed, but the debt behind them remained unchanged – resulting in huge holes in the balance sheets of companies and households.
In order to generate cash and repay borrowings, companies cut back on capital investment and consumers delayed their purchases. That led to feeble economic growth, which in turn led to collapsing profits and rental income – which then set off further declines in stock and real estate prices. It became a long, lingering vicious cycle.
None of this was helped by the strong yen which the Japanese authorities passively accepted. When the bubble burst in 1990, the yen-dollar rate was 150. Under the Noda administration, despite Japan’s lack of growth, it rose as far as 77. The result was not just to reduce Japan’s competitiveness, but also to wreak further damage on the national balance sheet. The value of Japan’s huge stock of overseas assets was in continuous decline in yen terms – which meant repeated write-offs and special losses.
If Abenomics works, it will ram this entire cycle into reverse gear. Higher asset prices will lead to stronger growth which will drive asset prices still higher – putting Japan into a virtuous cycle that will ultimately take it from balance sheet recession to balance sheet boom .
So far the progress has spectacular. In six months, the stock market has risen by some 70%, increasing its total value by about 150 trillion yen. Relative to that, the recent correction has been minor.
Japan has a mountain of foreign assets, the largest in the world by some distance – one reason why comparisons with Greece are absurd. If the yen declines, the value of this treasure trove increases in yen terms. A 30% drop in the yen – such has just been experienced – raises the value of Japan’s net foreign assets by an amount equivalent to about 70 trillion yen..
That’s not all. By far the largest pool of wealth in Japan is the real estate market, which is worth roughly three times as much as the stock market, with most of the value concentrated in the big urban areas. A rise in real estate prices of 15% would result in a further increase of some 180 trillion.
These are rough numbers, but altogether they add up to around 90% of Japanese GDP. If Abenomics, could generate a sustainable improvement to Japan’s national “shareholder’s equity” on this scale, the change in the economic and social climate would be dramatic.
A confident, well-capitalized corporate sector would be more dynamic. It would invest more, make more acquisitions, reward workers with higher wages, perhaps even reward shareholders with higher dividends. Banks would lend more and take more risk. Consumers would open their wallets and stop favouring price over quality. The labour market would tighten, especially for young workers, who are in short supply.
An optimistic, assertive Japan would emerge from the long tunnel of deflationary stagnation. Over time, economic recovery would enhance Japan’s status and bring huge strategic benefits.
But the key word is sustainable. Whether any move in asset market is sustainable or not is a question that only time can answer. If Japanese asset prices were fundamentally overvalued today, this would be a dangerous manoeuvre. But even now, Japanese stock prices are no higher than they were twenty eight years ago. And according to a recent study by the OECD, Japanese house prices are the cheapest* amongst the twenty seven countries it covers. Anyone worrying about bubbles is looking in the wrong place.
There is another risk, though – one that has become very familiar in Japan over the past fifteen years. Could the Japanese government make another policy mistake by tightening before the economy is strong enough to bear it?
Of the famous three arrows, the first – monetary policy – has already been deployed with success, as the action in the financial markets has shown.
The third arrow, structural reform, by its nature takes time to produce results. The reaction of commentators to Mr. Abe proposals has been generally critical, but in reality he has raised a dizzying number of issues. Entry into the TPP, doubling FDI, liberalization of casinos and online sales of medicines, better childcare, restructuring the electric power industry and agriculture, increasing the number of students studying overseas, creating special low tax zones – a year ago action on any of these fronts would have been unthinkable. If the government managed to produce concrete proposals for just one quarter of them, it would constitute huge progress.
It is the second arrow, fiscal policy, which is the most problematic. The planned rise in the consumption tax could easily derail the recovery, just as happened in 1997. For a more recent example of how the negative impact of fiscal tightening can overwhelm the positive impact of loose monetary policy, you need only look at the UK economy over the past few years.
Why sacrifice the huge increase in asset values for a tax increase worth just 2% of GDP? The great Korekiyo Takahashi would never contemplate such a thing after just one year of reflation! As in the 1930s, the risks of tightening too early are much greater than the risks of being too late.
There are international implications too. The Abe administration had done a superb job diplomatically. After a few early uncertainties, Japan’s key trading partners have given the thumbs up to Abenomics, as have international institutions such as the G7 and the IMF. The assumption has been that a revived Japanese economy would be good not just for Japan, but for the world too, as stronger domestic demand boosts world trade.
Squeezing Japanese consumption would make this story much harder to sell. If world economic conditions are still depressed at the time, as is all too likely, Japan could stand accused of sucking growth from the rest of the world and stoking the flames of currency wars.
For Prime Minister Abe to retain his unique hold on events, he needs to deploy all three arrows consistently – until several years of 3% nominal growth have been safely achieved. If he does that, the future will look promising indeed and Japan’s political karaoke club will remain closed for a long time to come.