Jury still out on Abenomics

Judging by the latest headlines, Japanese Prime Minister Shinzo Abe’s three-pronged strategy to reflate the world’s third-largest economy, dubbed the “Abenomics” programme, is failing.

On Monday, the publication of third quarter gross domestic product data revealed that Japan’s economy slipped back into recession, with output contracting by a worse-than-expected 0.8 per cent. Business investment – a crucial part of Abe’s efforts to revitalise economic growth and end deflation – fell 5 per cent on an annualised basis.

This is the second technical recession – defined as two consecutive quarterly contractions – in the space of two years and the fifth quarter in which Japan’s economy has shrunk since Abe was re-elected prime minister in December 2012.

If capital expenditure is still contracting after three years in which the Bank of Japan has spent an unprecedented ￥80 trillion yen a year purchasing government bonds, the yen has depreciated 50 per cent against the US dollar and when corporate profits in Japan have surged to a record high, then surely there must be something gravely wrong with Abenomics?

The International Monetary Fund (IMF) didn’t pull its punches when it issued its latest assessment of Japan’s economy in late July.

“Abenomics needs to be reloaded so that policy shortcomings do not become a drag on growth and inflation. Risks to [the] outlook are tilted to the downside with the most important risks stemming from weak domestic demand and incomplete policies, particularly with regard to fiscal consolidation and structural reforms,” it warned.

Indeed even the first of Abenomics’ so-called “three arrows” – aggressive monetary easing (the other two are fiscal flexibility and supply-side reforms) – is misfiring.

Late last month, the Bank of Japan slashed its inflation forecast for this year to 0.5 per cent and admitted that its 2 per cent target – which was supposed to have been reached this year – would not be met until the beginning of 2017.

More worryingly, the it has allowed its credibility to be called into question by refusing to provide more stimulus despite having conspicuously failed to meet its 2 per cent target.

Japan’s central bank has even sounded a relatively upbeat note about the state of the economy, stressing that domestic inflation (as opposed to the mainly oil price-driven decline over the last several months) is rising and that a “virtuous circle” between wages and household spending is starting to take hold.

A more convincing interpretation of the Bank of Japan’s reluctance to expand its quantitative easing programme is that it feels the scheme is proving less and less effective. Not only are there serious questions about the pace and sustainability of asset purchases – the Bank of Japan is on course to hold more than half of Japanese government bonds (JGBs) in the next few years – QE has done little for the real economy and has heightened concerns about the monetisation of Japan’s massive stock of government debt, amounting to nearly 250 per cent of GDP.

This begs the question: if even the first arrow of Abenomics – which has fuelled the 132 per cent rise in Japan’s benchmark Nikkei 225 equity index since Abe came to power and is considered to have come closest to hitting its target – is losing momentum, then what hope is there for the second and third ones which are viewed much less favourably by markets?

While there are still major concerns about Abe’s reflationary programme, it would be premature to declare Abenomics a failure.

Firstly, the third quarter GDP data was not as dire as the headline number suggested. If one were to strip out the sharp fall in inventories, private demand grew by a relatively brisk 1.4 per cent year on year, suggesting a modest recovery is under way.

Secondly, an end to further monetary stimulus may be no bad thing.

The QE-driven plunge in the yen has raised the cost of imports significantly at a time when real wages have fallen and private consumption, already weak to start with, was dealt a severe blow by last year’s fateful increase in the consumption tax from 5 per cent to 8 per cent. The government is now readying a sizeable fiscal stimulus package which, while adding to Japan’s massive debt pile, should do more to help underpin the recovery – a crucial prerequisite to implementing the kind of credible medium-term fiscal consolidation programme demanded by the IMF.

Thirdly, some key structural reforms have been carried out. Japan’s highly protected agricultural sector is finally being liberalised, while corporate governance is improving, with Japan’s three largest banks speeding up plans to sell their strategic stakes in some of their corporate clients, known as “cross-shareholdings”, which should encourage domestic investment into riskier assets.

Abenomics is struggling to gain traction but the jury is still out as to whether the programme will produce a meaningful and sustainable recovery.

Nicholas Spiro is managing director of Spiro Sovereign Strategy