When the Liberal Democratic Party returned to power in Japan in December last year, Prime Minister Shinzo Abe vowed to restore growth and inflation through what is now known as Abenomics. This comprised three arrows - monetary policy, fiscal policy and structural reforms.
The monetary policy arrow caught the most attention, with the Bank of Japan now aiming to push inflation to 2 per cent per annum through massive quantitative easing.
How big is the stimulus? The balance sheet of the Bank of Japan is already the largest amongst the G4 (reserve currency) central banks, at 35 per cent of gross domestic product. The Bank of Japan aimed to increase base money by 60-70 trillion yen (HK$4.6-5.4 trillion) a year, or roughly US$60 billion monthly, compared with US$85 billion monthly by the US Federal Reserve.
At these levels, the Bank of Japan balance sheet will rise to 60 per cent of GDP by the end of next year. This is unprecedented monetary escalation. So far, the stock market has risen by nearly 40 per cent, and the yen has depreciated to 99 to US$1.
The second arrow of fiscal adjustment is also pretty aggressive, with the intent to increase public spending by 13.1 trillion yen. This would bring the Japanese gross public debt to over 230 per cent of GDP, already the highest among the OECD countries.
The third arrow of structural reforms will be the hardest, because it has been tried for over 20 years. Japan has a highly efficient export sector, but a non-tradeable service and agriculture sector that is protected and rigid. Abe has created two councils to engineer the shift in productivity and competitiveness. Japan has also announced that it will join the Trans-Pacific Partnership in free trade with the US, which will give foreign pressure to force through domestic reforms.
There is general agreement that the three arrows have to work together, with the last being the toughest politically.
The Japanese balance-sheet recession is exactly what the other advanced countries are facing today. Prolonged central bank easing does not necessarily get inflation or growth up when the private sector is busy deleveraging through saving. The risk is that if the central bank gets active, the politicians may not move on the tough structural reforms in the labour market and removing rigidities and inefficiencies in the system.
So quantitative easing buys time for structural adjustment to take place, but if there is a delay in the third arrow, we are back to square one.
Abenomics seeks to change the mindset of the consumer to start spending and businesses to start investing again so that the economy gathers enough steam to get out of the liquidity trap. Initially, I was sceptical, but I think that Abenomics will work, not through more exports, but through the balance-sheet wealth effect.
The devaluation of the yen may not lead to a larger current account surplus, because import costs for such things as energy would increase. The inflation effect may not work if there is still a huge surplus capacity. However, it is true that the cheaper yen would enable Japanese companies to switch production back to Japan, create more employment and also stimulate tourism spending.
The real benefit to Japan comes from the wealth effect of the devaluation, since Japan is the largest net lender to the world, not China. Japan had gross foreign exchange assets of 5.6 trillion yen - 2.5 trillion yen net - at the end of 2010. The devaluation would give Japanese holders of foreign exchange an asset gain equivalent to between 12 per cent (net) and 25 per cent (gross) of GDP. Add that to the 40 per cent increase in the stock market, and it would mean a wealth gain effect in yen of roughly one-third to two-fifths of GDP. No wonder the business community is supporting Abenomics and wealthy people are spending again.
The bottom line is that Abenomics may be able to push Japan out of the liquidity trap, if authorities meet the structural reform challenge. This is good news for Japan, after more than two decades of slow growth.
So far, the rest of Asia has not felt the pressure, because historically, a strong yen has been good for the region (not including Japan), because production is shifted out of Japan and foreign direct investment increases.
Asia's emerging markets will have to adjust to the possibility of more volatile capital flows. Managing this will not be easy, because if you raise interest rates you will attract more inflows. More capital will flow in when you raise exchange rates, which can then push down the economy, property and equity prices.
Japan paid for the higher exchange rates and asset bubbles in the 1990s through low growth. It will be quite a challenge for the rest of Asia if they have to go through the same effect when the reserve currencies begin to depreciate around their strong Asian currencies.
So far, the Nikkei and Dow are heading higher, but risks are building up in the asset markets. Enjoy the recovery while it lasts.
Andrew Sheng is president of the Fung Global Institute