If Abenomics is to succeed

If Abenomics is to succeed

The Bank of Japan’s quantitative easing program cannot by itself guarantee success of Abenomics. So, what additional developments should we look out for?

It is obvious to anyone who pays attention to financial news that great things are afoot in Japan. Prime Minister Shinzō Abe’s commitment to achieving an inflation target of 2% has buoyed the Nikkei 225 stock index by over 40% since November 2012. Let us straight away put aside the issue of a currency war: if anything, Japan’s deflationary nightmare arguably entitles it more than any other country to make use of intensive expansionary monetary policy. Furthermore, weakening of the yen is but an ancillary benefit of the country’s bond buying programme, not its main aim. The bigger question is whether the gains in its stock market are sustainable.

Japan's Prime Minister, Shinzo Abe

Prime Minister Shinzo Abe is walking a tightrope, but seems happy.

The recent increased quantitative easing in Japan has provided the banking sector and corporates with much additional cash. The intention is of course for this to be invested in Japan and boost the economy. However, recent yield decreases in world bond markets seem to indicate instead that Japanese companies and banks are happy to find returns on their cash savings abroad. In order to promote investment in Japan, Abe’s government must provide fiscal incentives as well as nurture structural changes to deregulate the stagnant Japanese economy.

From a fiscal point of view, incentives need to be put into place to encourage fixed capital investment and R&D investment. Japanese companies are notorious for sitting on piles of retained earnings, a buffer which fosters corporate inefficiency. These need to be put to better use. A solution recently proposed by Martin Wolf of the Financial Times is to introduce punitive taxes on non-invested retained earnings. Although potentially too extreme a measure to be embraced by Abe, this kind of solution sets the fiscal tone, which Japan must follow. One thing it definitely should not do is increase taxes on consumption, as the government is currently planning to do with a VAT increase. Combining an expansionary monetary policy with higher taxes on consumption can only be self-defeating in the quest for inflation.

As noted earlier, Japan’s deflation problem cannot be solved solely through the use of monetary and fiscal means. There are deeper structural and social issues within Japan, which hold back economic growth. Protectionist and monopolistic areas such as the farming, medical and energy sectors need to be deregulated and opened to more competition. Abe also must push forward in taking Japan into the Trans-Pacific Partnership, a free-trade zone, in order to further boost exports. Furthermore, insofar as corporate regulation is concerned, there is a need for increased shareholder power to lead to more competitive and efficient companies. Finally, labour practices need to be changed to encourage female participation in the labour force, as well as promote immigration to make up for a rapidly aging population. Of added note, further investment in the teaching of English, the lingua franca of world business, can only aid Japan to cement itself in the global marketplace. It might not be necessary or even possible to implement every single one of these changes, however Abe should capitalize on his currently high popularity to bring about as many possible.

A final word of caution on how Abenomics can affect the issue of government debt in Japan. With the government debt ratio about 230% of GDP, it is important that any government action does not substantially add to this burden. The fiscal measures mentioned above need to be carefully balanced since a purely expansionary fiscal policy is not a viable one. Additionally, if Japan successfully attains inflation, there is still a very real risk that government debt repayment on new JGB issues could quickly become unsustainable. This is because new issues would have to suddenly offer much higher coupons than they do now, if they are to offer real positive returns in an inflationary environment. The result could be particularly painful if there is a significant time gap between inflation and wages rising, leading government income to lag behind the inflation rate. Japan must closely manage its debt during the implementation of Abenomics or face replacing a deflation crisis with a debt quandary.

Japan is currently performing a very dangerous tightrope act. Over the next few years Mr. Abe will have to successfully address all the issues raised above if Japan is to emerge unscathed. Moreover, this will likely be the last chance to save the country’s economy without a crash. Nevertheless, if Japan does in fact succeed, it will have all the tools to become one of the more successful advanced economies. The combination of strong institutions, a highly educated workforce as well as its key position within the world’s most dynamic region will be in very good standing post-Abenomics.

Categories: Asia Pacific, Economics

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