- authored by www.HedgedEquity.com
Japan has witnessed a very unusual economic trajectory of any developed nation in the last 25 years. Suffering from a combination of excess debt, the deflation of a giant real estate and stock market boom, and adverse demographics, the Japanese economy shrunk by almost 20% in nominal terms over the 1995-2007 period. Consumer prices in 2017 remain at the same level as in the early nineties, while nominal wages (black) have stagnated together with GDP (yellow):
After recurrent recessions and periods of deflation through the 90s and 00s, Japan seems to have turned page at the start of this decade. The election of Shinzo Abe as prime minister in December 2012 inaugurated the beginning of a new economic policy, coined “Abenomics”, and aimed at reflating the economy, using government spending to stimulate GDP growth and reforms to render Japanese businesses more competitive. The economy nevertheless proceeded to grow only 1.4% in 2013, below the figure of 1.7% for 2012, and by Q3 2015 had returned to recession. Although manifesting modest growth in 2016, with GDP increasing 1%, Q4 2016 marked a slowdown in growth compared to Q3.
The year 2017 seems to again give hope of a turnaround. Japanese GDP increased by 1%YOY in Q1 2017 and 0.3% QOQ:
The economy is now on its longest expansion streak since 2005. Despite these positive signs, there are still doubts about the sustainability of Japan’s rebound. Several elements need to looked at to assess what will driving or hindering growth in 2017 and beyond. These include the lack of inflation still permeating the economy, anaemic wage growth and consumer spending, trade, and how these factors reverberate to dampen sustainable GDP growth.
The Japanese Trade Sector
Japan continues to be a global trade powerhouse. It is both the 4th largest exporter and importer in the world after China, the USA and Germany. Exports reached $645.2 BLN in 2016, up 3.2% YOY, while imports fell to $607.1 BLN, down 2.9% YOY. In 2016 Japan achieved its first trade surplus in 6 years with a figure of ¥4.1 TLN, as the value of imports fell primarily on account of low oil prices. This compares to a ¥2.79 TLN deficit for 2015 and a record ¥12.82 TLN deficit in 2014:
The trade picture has shown recent signs of improvement. Japan’s exports rose for a fifth consecutive month in April, up 7.5% YOY but slower than the 12% figure of March. The trade surplus, at $4.33 BLN, was slightly below expectations.
Part of the effect was due to Yen weakness, generated by the American government’s increasingly hostile stance on foreign trade. Demand for Japanese goods from the USA and European modestly rose, with a gain of 2.6% in exports to the former. On the other hand, export demand from Asian partners picked up some of the slack. Exports to China rose 14.8% April, while the figure for Asia was 12.2%. Asian and Australia account for more than 50% of Japan’s total exports, and recent figures are showing a a notable pick up in demand:
Japan’s may find itself in a continued positive export market in 2017, as internal demand remains weak but export markets remain buoyant, sustaining a positive trade balance.
The Japanese Inflation Issue:
Despite a tightening labour market and expanding GDP, the one element still noticeably missing from the picture is a pick up in inflation. The election of Haruhiko Kuroda as governor of the Bank of Japan in March 2013 inaugurated a period of unprecedented expansionary monetary policies. The BOJ upped its monthly purchases of government bonds to $60 BLN, later also implementing programs to purchase Japanese equities to lift up general asset prices. At the end of May 2017 the BOJ held assets worth 500.8 trillion Yen, triple the amount of 4 years ago and close to the amount owned by the US Federal Reserve:
The policies strongly affected value of the Yen, which fell from 95 to the USD in March 2013 to a 13-year high of 125 in 2015:
At the same time, the Nikkei equity index experience a powerful bull run which took it from around the 9,000 level to a 15-year high of more than 20,000 in 2015:
Inflation was affected too, accelerating from -0.5% YOY in February 2013 to almost 3.74% YOY by May 2014, a 23-year high:
The overall success was short-lived, however, as Japan tumbled again into deflationary territory in Q1 2015:
There are some mild signs of Japan exiting deflation in 2017. The April reading of 0.4% YOY is the 7th positive monthly reading since the last deflationary figure of -0.5% YOY in September 2016. It’s also a slight acceleration over the 0.2% YOY registered in March:
Nevertheless, this is mostly the consequence of the exogenous effect of a rebound in oil prices in Q1, rather than domestic wage growth. The latter has in fact remained extremely subdued. Inflation-adjusted real wages fell 0.8% in March YOY, the fastest rate of decline since June 2015:
Unsurprisingly, retail sales and household spending have also stagnated. Household spending in March fell 1.3% YOY, the 13th consecutive monthly decline. Household consumption fell more than expected in April due to less expenditure on cars and education.
While the private sector remains stagnant, industry and business are experiencing more positive conditions. Industrial production in Japan rose 5.7% YOY in April, above March’s 3.5% YOY increase and reaching an over 3-year high:
With household consumption representing 60% of Japanese GDP, it is however clear that only with sustained increases in real wages would can economic growth be sustained.
The Japanese Labour Market
Despite going through 4 recessions only in the last 7 years, the Japanese unemployment rate has remained extremely low throughout. Data for April 2017 shows that Japan’s jobless rate remained at the lowest in more than two decades, at 2.8%. This figure is only about half of what it was at the end of 2009:
The labour market remains very tight, with the ratio of open jobs to applicants hitting 1.48 in April 2017, or the highest figure since February 1974. The number of new job openings rose 3.2% YOY during the same month, and in fiscal 2016 hit 2.57 million, the highest on record.
Although part of this tightness is due to improving business conditions, part of it is due to Japan’s secular demographic trends. Part of the situation is due to the weakness of Japan’s demographics. Fertility rates are among the lowest in the world at 1.41 children per woman, about half the 2.75 rate at the beginning of the 1950s. Approximately 27% of the population is above 65 years of age, compared to only 15% in the USA. The working age population is estimated to be shrinking by 700,000 people annually, and has fallen by almost 5 million people only in the last 5 years:
Despite the tightness in the labour market, upwards pressure on wages is noticeably lacking. Average monthly wages remain stuck at the same levels of early 2011:
Employee earnings unexpectedly fell 0.4% YOY in March, the first drop in 10 months and the first negative figure since the 0.4% of February. The Bank of Japan estimates that wages would have to rise by at least 2.5% annually to generate the 2% target inflation rate. With current numbers less than a quarter of that, this prospect is far from materialising.
Conclusion:
The macroeconomic performance of Japan continues to provide mix signals. Expectations that the extremely expansionary monetary policy of the Bank of Japan would turnaround price growth have yet to be fulfilled. The tightness in the labour market is expected to eventually transmit into wage growth and into inflation. This has however yet to happen on a significant and continuative basis.
Japanese companies continue to respond to labour shortages with increases in efficiency, investments in technology and reduction of working hours for employees, rather than wage increases. Considering that in Japan the output per hour worked is below the OECD average and only 60% of US levels, the space for increasing productivity without hiring new resources remains large. Furthermore, about 60% of the record job opening figure of 2.68 million in April was for temporary or part-time positions i.e. those that pay less and offer less job security to employees.
The implications of Japanese GDP not growing remain to be seen in 2017 and into the future. With a total debt to GDP ratio of 250.6% at the end of 2016, the largest in the developed world, and budget deficit of 4.5% in 2016, Japan is in a precarious balance. The government expects a shortfall in tax revenues that will bring the budget deficit up to ¥8.3 TLN in 2020. The estimate is based on projections of 3% nominal GDP growth and 2% real growth, considerably above the 1% real growth number of 2016. If economic growth fails to manifest itself, the debt burden will continue to rise as tax receipts remain weak. Japanese rates would however likely remain very low in such a scenario, as inflation fails to materialise, making the debt repayment burden relatively sustainable.
With the trade balance moving to a thin surplus after years of deficit, the solution to GDP growth is unlikely to be found in exports, especially given the rising anti-trade positions of governments across the world. Japan will remain vulnerable to other exogenous factors that could worsen the situation, for example a significant slowdown in foreign exports, as happened in 2009, triggering a major recession. In such a scenario, weak internal demand would not be able to drive growth forward. The conclusion is that Japan must implement policies that boost wages significantly in order to face all its macroeconomic challenges - drive GDP growth hire, avoid deflation and defuse investor fears over the serviceability of its debt burden in the long run.