Shinzo Abe’s policy programme has started to lift Japan out of its long deflationary slump. But the road ahead is still a long one and political scandals could prevent him from finishing the job.

Progress on structural reform is generally sluggish

Shinzo Abe is no stranger to controversy. But a series of recent scandals have left the Japanese prime minister fighting for his political future. Abe faces allegations he used his influence to force a cut-price sale of government land to a nationalist school; meanwhile his defence ministry stands accused of a cover-up of troop logs dating back to the Iraq War.

In May, Abe’s embattled administration suffered a further blow with the news that Japan’s GDP contracted by an annualised 0.6 per cent over the first three months of 2018. This was the first quarter of negative growth since 2015, bringing an end to the country’s longest period of economic expansion since the boom years of the late 1980s. Analysts blamed extreme winter weather and an accompanying sharp decline in domestic demand for the unexpected slowdown.

Look deeper and Japan’s economy remains in decent shape, with low unemployment, soaring corporate earnings and a stock market touching 26-year highs. By most measures, Japan’s prospects look much rosier than they did in 2012, when Abe’s Liberal Democratic Party (LDP) entered government promising to tackle stagnant growth, low productivity and other deep-rooted structural problems.

But the latest GDP figures show the gains made under ‘Abenomics’ are still fragile, and could yet be reversed. As Abe scrambles to secure his position ahead of a crucial LDP leadership vote in September, thoughts in Japan are turning to issues of succession and legacy. So what more does Abe need to do to complete his task of rejuvenating the Japanese economy; and can Abenomics survive, even if its chief architect falls on his sword?

Three arrows

To properly assess Abe’s record, you need to look at the predicament Japan faced before his second stint as prime minister.

Abe had previously served a brief and undistinguished term in office beginning in July 2006, before resigning due to ill-health the following year.

During his election campaign in 2012, Abe decided to recast himself as a unifying strongman, invoking a well-known parable to muster public support. In the story, a feudal lord demonstrates it is easier to snap a single arrow over one’s knee than to break three arrows tied in a bundle – it’s his way of teaching his heirs they are better off when they stick together.

Styling himself after this wise patriarch, Abe unveiled three ‘arrows’ of his own, a clutch of policies designed to revive Japan’s flagging economy. The first arrow denoted extraordinary monetary easing, intended to banish the threat of deflation; the second, fiscal stimulus to offset the slack in private investment; and the third, structural reforms to spur greater efficiency and productivity.

In 2013, when Abe began to implement these policies, the country’s nominal GDP was the same as it had been in 1991 and the Nikkei had fallen far below its peak level three decades earlier. What’s more, Japan faced dire structural challenges in the form of a rapidly-ageing workforce and a monstrous debt load that exceeded 200 per cent of GDP.

Abe was able to call on support from Bank of Japan (BoJ) governor Haruhiko Kuroda, whom he nominated for the post soon after the election. Kuroda had long been an advocate of monetary easing to stave off deflation. On taking the post in March 2013, he said the BoJ would do “whatever [it] can to lift Japan out of the state of deflation that has sapped spirits and stifled investment for most of the past 15 years”.1

Monetary policy

Kuroda fired the first arrow of Abenomics soon after his appointment. In April 2013, he announced the BoJ planned to double Japan’s monetary base to 270 trillion yen ($2.8 trillion) by December of the following year, mainly by expanding its purchases of long-dated government bonds. But Japan’s deflationary slump was more difficult to shake than expected, and the yen proved stubbornly strong.

“Governor Kuroda and Abe, both of whom initially held a genuine belief that the BoJ’s activist monetary policy would singlehandedly terminate Japan’s deflationary mind-set, were forced to recognise the problem was far deeper and more complex than their original expectations,” says Jin Saito, managing director and co-founder of Observatory Group, a consultancy.

In 2015, volatility in China’s equity market prompted safe-haven flows and the Japanese currency rose in value. Not to be dissuaded, the BoJ doubled down on its easing policies: the following year it introduced negative interest rates; reiterated its commitment to inflation of two per cent; and started a policy of ‘yield curve control’, a method of using QE to hold the 10-year government bond yield at zero per cent.

Unlike its peers in other developed economies, the Japanese central bank has also engaged in large-scale equity purchases. As of March 2018, the BoJ held about three trillion yen in domestic equity exchange-traded funds, an amount equivalent to three per cent of the entire capitalisation of the Tokyo Stock Price Index (Topix), according to estimates from the Nikkei Asian Review.

The BoJ forecasts a median inflation rate of 1.3 per cent for 2018, still far below its target. But the spectre of deflation appears to have been successfully exorcised. As of April, the year-on-year change in consumer prices (excluding more-volatile fresh food items), had remained in positive territory for over 12 months – a notable achievement, according to Jean-François Chambon, fund manager, Japanese equities at Aviva Investors in Paris.

“For a period of about 15 years before Abe became prime minister for the second time, the CPI consistently fell. Families postponed big-ticket purchases in the expectation prices would fall further, and innovation declined as companies were unable to charge higher prices for new products. The reversal of this mindset is very important,” Chambon says.

Figure 1: Japanese equity market performance

Fiscal stimulus

In Abe’s favour, the political opposition is in disarray

After his election, Abe promised trillions of dollars in fiscal stimulus, which would be spent on infrastructure projects to improve productivity and offset high savings rates across corporate Japan. In response, some more hawkish elements in the LDP cautioned against lavish spending, given the country’s record levels of public debt.

Five years on, the loudest voices in the administration are complaining there has been too little stimulus, rather than too much. Taking into account the 2014 hike in consumption tax from five per cent to eight per cent – widely criticised as a misstep – there has in fact been a fiscal contraction during Abe’s tenure.

GDP growth dipped in 2016, sparking concerns the Abenomics project was flagging. Abe launched a new $45 billion round of stimulus, including support for small- and medium-sized enterprises and financing for reconstruction on the earthquake-wracked island, Kyushu. In early 2018, Kozo Yamamoto, minister for regional revitalisation and an influential member of Abe’s cabinet, told the Financial Times he would argue for further aggressive stimulus this year.3

“The country’s fiscal policy has not been consistent: positive from 2013 to early 2014, but negative from the consumption tax hike of 2014 on until late 2016, and once again positive since then,” says Saito, who believes greater coordination in monetary and fiscal policy over the past 18 months may have started to pay dividends in the form of higher employment. According to the latest official figures disclosed in May, the unemployment rate stood at an impressive 2.5 per cent.4

Structural reform

Figure 2: Inflation picks up

Despite these gains, more remains to be done. The disappointing growth figures for the first quarter of 2018 suggest domestic consumption may not be strong enough to constitute the dominant driver of growth. And companies remain reluctant to invest in new products and services, partly because wage growth has yet to pick up.

Last year, Abe called for Japan Inc. to raise wages by three per cent, offering tax incentives for firms that fell into line. But the latest round of Shunto Spring wage negotiations between management and unions failed to produce the desired result; year-on-year wage growth stands at 2.1 per cent, according to the figures from the Ministry of Health, Labour and Welfare disclosed in May.

Ironically, low wage growth may be a consequence of Abe’s successes in another area: structural reform. The LDP has been pushing for a rise in the number of women and retirees in employment and this has put downward pressure on wages. The proportion of women aged 16 to 64 in full employment rose to a record high of 69.4 per cent in February 2018, up from 64.5 per cent in January 2013. Japan’s figure is now higher than that of the US and France, according to the Organisation for Economic Cooperation and Development (OECD).

Over the longer term, widening participation in the workforce should help Japan cope with the effects of its rapidly-ageing population, as should Abe’s tentative liberalisation of visa rules to enable more immigration (the number of foreign workers in Japan has risen – albeit modestly – from 682,000 to more than a million under Abe5). Relaxed visa rules have also boosted tourism, which could prove to be a major investment theme over the coming years (see boxed text).

Corporate governance

Other mooted reforms have fallen by the wayside, however. “Progress on structural reform – to promote higher and sustainable growth – is generally quite sluggish,” says Maulshree Saroliya, macro strategist at Aviva Investors. “While there has been a modest uptick in productivity thanks to better growth last year, Japan needs to go further to prevent a slide in living standards. This requires better credit allocation to boost innovation and investment. Firms need to change their business models to boost profitability.”

Abe has taken steps to reform corporate Japan. By pushing the Government Pension Investment Fund (GPIF), Japan’s gargantuan pension fund, to build its portfolio of domestic stocks – and become an activist shareholder – he has encouraged a greater focus on shareholder returns and corporate efficiency, according to Chambon.

A new corporate governance code, introduced in 2015, compels Japanese banks to significantly reduce so-called ‘cross-shareholdings’ that foster close connections between bankers and their clients. The practice has been identified as one of the reasons why Japanese companies are rarely held to account for failing to deliver higher returns on investment.

Chambon believes these reforms are bringing results. Before Abe, he says, bad economic news tended to beget worse; deflation led to a negative spiral of lower consumption, lower growth and lower wages. But now, with companies more profitable, Japan could be set for a virtuous circle of stronger wage growth and higher consumption – at least for as long as Japan persists with Abenomics.

Abenomics without Abe?

The recent corruption allegations have thrown the future of Abe’s economic programme into doubt. They relate to the cut-price sale of state-owned land to Moritomo Gakuen, a nationalist school with links to the prime minister’s wife, Akie. The news first broke last year but the scandal escalated in March, when the finance ministry admitted removing references to the Abes, along with finance minister Taro Aso, from the sale documents.

In a testimony to the upper house of the Japanese parliament in March, Nobuhisa Sagata, the former finance ministry official at the heart of the scandal, said neither the Abes nor Aso instructed him to falsify the documents. But he refused to answer questions about why his staff doctored the files, citing an ongoing investigation. The prime minister’s political opponents have pressed for Akie Abe to appear in parliament to answer questi6

Abe also faces accusations that he used his position to help a friend open a veterinary school,7 while the government’s handling of historic military troop logs has inflicted further reputational damage.8 A poll conducted by the Asahi Shimbun newspaper in the wake of the Moritomo Gakuen revelations in late March had Abe’s approval ratings down 13 percentage points, at 31 per cent, the lowest they have been during his tenure, although some polls show they had recovered to over 40 per cent by early May.

In Abe’s favour is the fact the opposition remains in disarray after the LDP’s landslide win at the general election in November 2017. “Currently there is nobody in the main opposition party, the Constitutional Democratic Party of Japan (CDP), ready to lead the country,” says Chambon. “Even if the popularity of the LDP is going down, the popularity of the CDP is not going up.”

For now, Abe appears to retain the support of his core constituency. If no hard evidence emerges linking him to the land sale, he may yet survive to fight for re-election as head of the LDP in September. Even if he doesn’t, there are signs Abenomics will live on. Although most of the likely successors to Abe in the LDP – including Fumio Kishida, a former foreign minister, and one-time defence minister Shigeru Ishiba – are equivocal about Abe’s economic policies, they have yet to put forward alternative plans.

In fact, Abe’s successor – should it come to that – may have much to gain from persisting with his policies. The LDP’s victory in November was widely taken as a ringing endorsement of its economic stewardship. According to surveys conducted by the Cabinet Office in Tokyo last year, 73.9 per cent of Japanese people are generally satisfied with their living standards, higher than ever. Just over half said they are satisfied with their income conditions – the first time positive sentiment has outweighed negative for that question since 1996.

Perhaps more importantly, there is the institutional will across the broader policymaking framework to continue deploying the arrows of Abenomics. Kuroda was reappointed for another five-year term as BoJ governor in early March, backed by two new deputies who support his approach.9 Although the bank has started to subtly reduce the rate at which it expands its balance sheet this year, Kuroda has committed to staying the course on QE until Japan definitively emerges from its long economic torpor. In its latest meeting in April, the BoJ said it would keep the yield on 10-year government bonds at near-zero per cent.

Beyond Japan, Abenomics has also won the backing of some influential institutions, including the initially-sceptical International Monetary Fund (IMF), which last year proclaimed the policy programme a ”success“ for banishing deflation. With a growing consensus at home and abroad that Abenomics is working, it could yet prove resilient – even as Abe begins to look less and less like the wise strongman in his favourite story.

References

1 ‘Japanese yen, bonds and stocks in the Abenomics era’, Financial Times, April 2016

‘Bank of Japan unveils aggressive easing’, Financial Times, April 2013

‘Japan’s Abenomics mastermind calls for more aggressive fiscal policy’, Financial Times, January 2018

Observatory Group

Observatory Group

‘Former Japanese finance official Sagawa: no instructions from PM to alter land sale documents’, Reuters, March 2018

‘Abe denies 2015 meeting with Kotaro Kake as opposition pressure mounts over cronyism claims’, The Japan Times, May 2018

‘Japan's Abe faces fresh headache over Iraq troop dispatch logs’, Reuters, April 2018

‘Kuroda’s second chance’, The Diplomat, March 2018

Investment Implications

The latest political developments in Japan will be watched with keen interest by investors, for whom Abenomics has brought significant advantages.

Sunil Krishnan, head of multi-asset funds at Aviva Investors, points to the structural support provided by the BoJ’s ETF-buying programme, for example.

“The Bank of Japan’s willingness to purchase equities as part of its monetary stimulus toolkit places it apart from its major peers. The simple fact of a structural buyer is supportive for the market, but it’s also noticeable the BoJ is a more active purchaser during periods of market weakness. This, together with evidence that monetary stimulus is actually working to deliver a solid domestic recovery, leaves Japanese equities well positioned in a global context,” Krishnan says.

The rising value of the yen could yet erode corporate profits, and continued QE offers little advantage for fixed income investors, given the policies the BoJ uses to hold yields low. “The variation in JGB yields has been minimal since the advent of the yield control policy in 2016,” says Saroliya. “With the yield curve exceptionally flat, the total returns available to investors are very low. There is very little residual QE tailwind for fixed income returns in my view.”

A more pressing hazard facing investors is the potential demise of Abe’s scandal-hit government. The political continuity Abe has offered is a key part of Japan’s recent economic improvements and positive for investor sentiment. “Abe’s successor would need to keep moving forward with the ‘three arrows’, as structural changes are not a luxury but a necessity. But there’s no doubt that effecting these changes will be far more difficult without Shinzo Abe at the head,” says Chambon.

If Abenomics continues, with or without Abe, certain sectors of the economy may benefit more than others. Chambon picks out tourism as an example. A combination of the weaker yen and looser visa regulations has led to a rapid increase in visitors from China under Abe, leading to the phenomenon of Bakugai, or ‘explosive buying’, which can quickly transform consumer sectors.

“Chinese tourists have been spending vast sums on consumer products such as children’s diapers, which are regarded as higher quality than Chinese-made brands. More recently, Chinese spending appears to have shifted towards food and cosmetics supplements. Hotel and restaurant chains are also likely to benefit from a continued rise in visitor numbers from China and elsewhere ahead of the Tokyo Olympics in 2020,” Chambon adds.

Over the longer term, robotics manufacturers and companies that specialise in upgrading production-line efficiency are likely to benefit from the structural shift towards greater automation in Japan as the country’s workforce continues to shrink. Companies with expertise in working with high-end manufacturers to make incremental improvements to efficiency and quality – such as Osaka-based firm Keyence, a specialist in precise, laser-guided automation systems – could reap dividends as firms seek to tool up their facilities.

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