What is Abenomics?

Abenomics refers to the economic policies advocated by the Prime minister of Japan, Shinzo Abe (President of the Liberal Democratic Party, LDP). These policies are built into three main pillars, as follows:

  • Bank of Japan (BOJ) quantitative and qualitative easing;
  • Flexible fiscal policy;
  • Structural economic reforms.

Quantitative & qualitative easing of a massive scale from BoJ

First of all, let’s see in details what the ultra aggressive monetary policy of the Bank of Japan looks like. Quantitative Easing (QE) is not new in Japan: the country has actually conducted 9 similar policies from 2001 to 2006. The goal of easy monetary policy is to reduce real interest rates to boost lending and prop up economic activity. In Japan’s case, it has a significant side effect of weakening the yen, which boosts exports.

Unlike the previous QEs, this quantitative easing has a massive scale. The BoJ plans to:

– Switch the target from the overnight call rate to the monetary base;
– Double bond purchases from ¥3.8trillion to ¥7.5tr;
– Purchase all durations of debt rather than just the shorter-dated issues;
– Increase Exchange Traded Funds (ETFs) purchases by ¥1tr per year and Real Estate Investment Trusts (REITs) by ¥30bn;
– Remove the limit on debt holdings to outstanding currency.

The Bank of Japan currently buys about ¥7tn ($65bn) of government bonds each month using electronically created money, with the aim to push wages, prices and demand. The program, recently announced by the new governor of the Bank of Japan, Haruhiko Kuroda, is for a cash infusion of $1.4 trillion by the end of 2014. The hope is that this new round of QE will transform the economy from a deflationary environment to one with 2% inflation in two years time.

On an annualized basis, this QE10 represents almost 13% of GDP the Japanese GDP. To put things into perspective, the Fed is currently injecting $85bn a month, or 6.5% of GDP. The US QE3 is two times lower than Japanese QE10 in terms of GDP. The first consequences of the BoJ actions have been a drastic depreciation of Yen. The Usd/Yen exchange rate went from ¥80 a dollar to 100. And Japanese stock markets jumped by 40% in just six months, something we will go in further details later on.

Flexible fiscal policy

To support the accommodative fiscal policy, Abe has launched a fiscal stimulus package of ¥10.3 trillion ($116bn). It should bring 0.5 percentage point (pp) growth in 2013 and 0.2 pp growth in 2014.

According to Nomura:

“?Aside from the general account, the government plans to set aside spending for post-quake reconstruction efforts in special accounts,” says Nomura. “The Abe government has decided to boost total spending on the five-year effort (through FY15) to about ¥25 trillion (~ $260 billion), from ¥19 trillion (~ $200 billion) previously.

Moreover Abe has indicated his desire to double Japan’s consumption tax to 10% and achieve a primary budget balance (government revenues minus government expenditures) by 2020. This assumes that government revenue equals outlays, excluding debt-service costs on existing liabilities. Some tax scenario have been made, you can find them here.

Structural economic reforms

According to the Business Insider:

To help design the strategy, Mr Abe had convened a series of reform committees, most notably the Headquarters for Japan’s Economic Revitalisation inside his own Liberal Democratic Party (LDP), and the Industrial Competitiveness Council (ICC). He invited onto them private-sector businesspeople, economists and proponents of reform, including Heizo Takenaka, the former right-hand man of Junichiro Koizumi, who as prime minister between 2001 and 2006 fought against fierce opposition to privatise the postal system.

One area that reformers hoped the committees would tackle is Japan’s labour market. Unless they are going out of business, firms are barred from firing staff employees. That produces perverse results; in January the labour ministry investigated the sad phenomenon of oidashi-beya, or “banishment rooms”. Some well-known firms, it was reported, were sending hundreds of employees into special rooms and leaving them with little or nothing to do all day. Officially, the rooms are to retrain people for new assignments, but the true purpose, many say, is to push workers into leaving. Most companies hang on to their excess workers, so their costs are inflated, leaving them unwilling to take on young employees or to raise salaries. This in turn has contributed to stagnant wages and continued deflation.’

Below is a summary done by Nomura of the growth strategy currently under proposal:

japans economnic revitalization

Mixed results so far

Industrial production and exportations are up

japan ind exp

Source

Japanese industrial production (left chart) has been picking up since the beginning of the year. Japanese exportations (right chart) also seem to have benefited from Abenomics. It helps to increase exportation or at least stop it from falling further. However, both trends have to be confirmed in the next few months/quarters.

Currency devaluation is seen as a necessary and efficient tool. Some analysts see this as a mean to steal demand from your neighbours instead of creating it domestically. Lena Komileva, managing director at G+ Economics Ltd. in London said to Bloomberg:

Japan is exporting deflation risk to Europe, increasing competitive pressures when much of Europe is suffering chronic growth deficiency‘.’

The problem with currency devaluation is that it is only a relative measure, which relies on other currencies not devaluing. Monetary tools have thus a limited efficiency since relying exclusively on them would lead to a worst national and global situation: trade war and protectionism.

Corporate and household confidence at a 2-year high

Since the end of 2012, confidence greatly improved among both Japanese corporate and consumers. This positive dynamic should be be translated in figures by more investment from corporate and more consumption from household in the coming weeks and months. If these two factors play out in a sustainable way then Japan economy would be back on a right track.

japan pmi

 Source

There is a clearly an increase of manufacturing activity since the end of 2012. Combine with Yen depreciation, confidence must have played a role in this production pick up. But again, this trend has be be confirmed in the coming months.

Critical threats

Cost of energy

jcc

yen usd

 Source

The Japan Customs-cleared Crude (JCC) or Japanese Crude Cocktail is the average price of customs-cleared crude oil imports into Japan (formerly the average of the top twenty crude oils by volume). It is a commonly used index in long term Liquid Natural Gas contracts in Japan, Korea and Taiwan, and replaced the Government Selling Price of crude oil as the standard index.

The JCC shows the impact of Abenomics on energy cost. Since commodities are sold in US dollars, a weaker Yen necessarily means that importation costs surge. The JCC went from about ¥8,000 at the end of 2012 to ¥11,000 in March 2013. As these two charts show, a lower Yen has historically meant higher price in energy.

Assets bubble

Like in the U.S., the BOJ’s QE inflates asset’ prices. Huge performance have been observed in real estate market and stock markets, while bond yields remain artificially low due to the BoJ interventions. As of early July 2013, Nikkei 225 and Topix are both up by 40% Year To Date (YTD).

TSE REITsTokyo Stock Exchange – Real Estate Investment Trust

However, since May 2013, Japanese stocks markets have lost 10% from their high (-18% in June) after having rallied more than 75% in six months’ time. The Tokyo Stock Price Index (TOPIX) real estate has greatly benefited from the BoJ actions but the correction engaged since May seems to be under way. At of today, volatility still remains high on both stock and bond markets.

As shown in the following graph, the early year boom in asset prices had nothing to do with fundamentals.

nikkei vs indus prod

Source: Hayman Capital Management

Historically, Nikkei follows industrial production performance. Yet, since the beginning of the year, it seems that the Nikkei keeps increasing regardless of industrial production activity. The stock markets seem to be fueled by ultra accommodative monetary policies rather than fundamentals. Moreover, it is interesting to see that the increase of Nikkei perfectly matches with the Yen depreciation.

Debt sustainability

With a public debt about 250% of GDP (500% all assets included) and a low growth coupled with deflation, the Japanese government has a real underlying solvency issue. A few weeks ago, the 10 years Japanese Government’s Bonds (JGB) reached 1% (early 2012 level). Higher yield directly threaten Japanese debt, since any rise would make the cost of debt unsustainable. The BoJ keeps injecting money to maintain yields low but how long is it going to work?

Until now, Japanese household have been the primary holders of JGBs. As the population gets old, Japanese are reluctant to invest this class of asset, and will eventually sell them in order to get additional earnings to their retirement funds. With less demand for its bonds and faced with a potential (natural) sell-off, the Japanese government will soon be faced with the need to sell its bonds to foreign investors. And given the underlying economic fundamentals, these investors are likely to ask higher yield to hedge against the risk taken.

The success of Abenomics also relies heavily on investors’ trust and confidence in the BoJ and the current government. Indeed a loss of confidence would have a ripple effect on bond yields and push them higher. Shinzo Abe faces timing pressure, as he needs to initiate structural reforms soon in order to keep confidence strong enough to avoid a financial catastrophe.

According to Bloomberg:

Hedge fund manager J. Kyle Bass, whose Hayman Advisors made $500 million during the U.S. subprime crisis, predicts a Japanese fiscal collapse. “Abe and the BOJ face what I call the ‘rational investor paradox.

If JGB investors begin to believe that Abenomics will be successful, they will ‘rationally’ sell JGBs to buy foreign bonds or equities.” That will place upward pressure on Japanese bond yields and government debt-service costs.

As we said previously, Japanese banks and household are heavily exposed to JGBs, holding about 90% of them. Should interest rates rise, they are due to lose an incredible amount of money.

JGBs amount and holders

Source: Ministry of Finance Japan

JGIPF

Source

 

As you can see in those graphs, the Japan’s government investment pension fund has drastically reduced its exposure to domestic bonds. Does Japanese still have faith in their debt sustainability?

Kyle Bass is the founder and principal of Hayman Capital Management and has been folloowing the Japanese situation for a long time. According to him (emphasis mine):

Abe, Kuroda, Nakaso and their staffs are facing a fascinating paradox as they implement the three ”arrows” of their new strategy: i) private sector investment inducing growth strategy ii) flexible fiscal policy, and iii) bold monetary policy. On April 4th, Kuroda announced plans to purchase 60-70 trillion yen of JGBs per year for the next two years which effectively doubles the monetary base for a country that was already moving M3 at a brisk pace of over +3% per year.

The BoJ ”temporarily” abandoned the self-imposed Bank Note Rule and told investors they will extend duration of their purchases which effectively monetizes the curve and allows longer dated purchased. JGB investors responded to the BOJ’s ”shock and awe” plan by immediately reducing their exposure to JGBs, the first real crack in the facade of investor confidence and panglossian beliefs. JGB futures locked limit down (japanese government bond contracts tripped exchange circuit breakers) twice during the day on April 5th, which is technically counterintuitive to the central banking orthodoxy’s expectations.

We are going to need a bigger boat. The financial community’s focus should be on the quadrillion yen of debt. If the Japanese government is going to run the largest fiscal deficit of any developed nation in FY2013 at north of 10% of GDP or roughly 50 trillion yen, the BOJ’s war chest seems to be inadequate.

If 5% of JGB holdings (another 50 trillion yen) are sold due to ”rational” responses to the new monetary plan, the sales will overwehlm the BOJ’s ability to purchase them. If their plan to purchase 60-70 trillion yen, and the cushion will be a paltry 10 trillion yen of additional capacity. It looks to me they need to double the new campaign at the very least if they think they can effectively keep rates from exploding higher.

Conclusion

For the time being we have to acknowledge the fact that Abenomics has helped to improve the Japanese economy. However, these policies might not be enough to offset the critical structural issues: debt, deflation, a rigid labor market and falling demography. It feels like the current government doesn’t know what to do to end the economic malaise which Japan has struggled with over the last 20 years. Instead, Abe seems to be playing his last card, the ultimate option.

The lack of significant and sustainable improvement in the next few months/quarters would push the probability of a government debt default high in the medium term. Will Shinzo Abe be brave enough to actually initiate much needed structural reforms needed in labour market, health care and agriculture?

Written by Maverick with additional contributions from Alash

About Steve Nguyen

Analyst based in China for 4 years, with significant analytical skills in Macroeconomics, Financial Markets and the Chinese economy.