News in Charts: Japan at a Crossroads

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The Japanese economy is at a crossroads. Following exceptional strength during the first half of 2013, fuelled by a wave of optimism on Mr Abe’s ambitious agenda, GDP growth has stalled somewhat. Unless and until Abenomics’ “third arrow” – a sine qua non for any hope of a sustained recovery – strikes its target, it will be up to the BoJ to provide a backstop for fragile sentiment. Although not monetary easing per se, this week’s announcement of an extension in the Bank’s special loan facilities for financial institutions is part of that strategy. Unfortunately, this constitutes neither a necessary nor a sufficient condition for turning the country’s fortunes around.

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Japanese GDP grew at an annualised rate of 1.0% in the fourth quarter. That represents only a slight deterioration relative to Q3 (1.1%), but it is a long way from the rates in excess of 4.0% seen through the first half of last year. Gains in investment (up 8.0%) and consumption (up 2.0%) were largely offset by weak net trade (which contributed -2.2 percentage points).

The unbalanced nature of Japanese economic growth in the final quarter of last year may in part be a consequence of the VAT increase, which takes effect this April. Households are likely to have brought forward some of their expenditures, simultaneously boosting consumption – durables consumption was up 17% on an annualised basis in Q4 – and imports. In this respect, the anticipation of the hike in VAT may have compounded the impact of yen depreciation on the trade balance, making the ‘J-curve’ effect even worse. The Japanese current account balance, which reached a record low in December, has now been in deficit for four consecutive months. There are some bright spots in the data. The increase in capital expenditure, alongside increases in non-core elements of pay, is encouraging and points to a general pickup in corporate outlays. The source of growth also appears to be gradually moving from the public to the private sector, although there is still a long way to go on that front.

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Against this backdrop, the Bank of Japan is trying to strike a fine balance. Overall economic conditions remain fragile, but Governor Kuroda has already made clear his reluctance to proceed with additional, pre-emptive monetary easing at this stage. After all, the economy is so far progressing in line with the Bank’s forecasts – although the BoJ Governor has recently become increasingly vocal about the risk of negative spillovers from troubles in the Emerging Markets.

In any case, even if one were to have doubts – as we do – about the Bank’s rather optimistic outlook, its current stance is understandable. First, the prospective VAT hike is generating a certain amount of statistical ‘fog’. The extent to which the pre-announced fiscal tightening has boosted demand through the final quarter of last year and into the first of this one will not be clear for some months yet. Second, inflation has already gone quite some quite way – headline CPI reached 1.6% in December from 0.7% only eight months earlier – so the Bank may wish to gauge the near-term evolution of price pressures before stepping up its QQE programme. This is also consistent with the message from both BoJ policy statements this year, according to which “the year-on-year rate of increase in the CPI, excluding the direct effects of the consumption tax hike, is likely to be around 1.25% percent for some time” – an implicit acknowledgement that the first round of “easy” gains in CPI, imparted by a sharp depreciation of the yen, is likely behind us. Third, we suspect that Bank officials might not want to add yet more fuel to “bad” inflation right now, by pushing the yen even lower – not least as the spring wage negotiations are currently underway.

At the same time, the BoJ is well aware that, absent any concrete progress on Mr Abe’s “third arrow” of structural reforms, its policies are the only game in town in terms of maintaining positive sentiment on Japan’s economic trajectory. Lack of explicit additional monetary loosening does not preclude communicating an easing bias, and this is the light in which we view the Bank’s decision this week to extend both the scale and the duration of its Stimulating Bank Lending Facility (SBLF). Under the SBLF, financial institutions are now able to borrow up to twice the increase in their net lending, at preferential rates. The BoJ also doubled the maximum amount of fund-provisioning under the Growth-Supporting Funding Facility, to 7 trillion yen. Under both these schemes, funds will be accessible at an annual fixed rate of 0.1% for four years, instead of one-to-three years at present. These moves are intended to enhance the transmission of QQE by incentivizing banks to spur lending. Mr Kuroda talked about bolstering the use of the “large increase in horsepower that [QQE] has given to our engine”.

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But in our view the issue at hand is not one of credit supply. The money multiplier will not increase simply by making more money available; after all, these facilities have so far fallen around 30% short of the Bank’s original 13 trillion yen target. Japanese financial institutions are awash with cash; the excess of deposits over loans stood near a record in January, as our chart illustrates. Although banks are lending again, with the turnaround over the past two years driven by a pick-up in lending to households, the rate of growth of bank credit, at 2.8% in the twelve-months to December, is still weak.

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The primary reason behind slow credit expansion in Japan is a lack of demand for credit, particularly from the corporate sector. The fact that lending rates on new bank loans continue to fall speaks volumes. According to the BoJ’s latest Senior Loan Officer Survey, the long-term prime rate – the benchmark for large firms – was a mere 1.25% in January. This also explains why the country’s banks have been looking to expand overseas, in search of better margins.

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In our view, it all goes back to the time-consistency problem that lies at the heart of Abenomics. Japanese corporates continue to have limited confidence in the ultimate success of Mr Abe’s experiment. They will not meaningfully ramp up their borrowing or capital expenditures – which would allow base wages to rise and lend support to domestic growth – until this perception is fundamentally shaken. To this end, what is called for reaches far beyond monetary expansion; brave structural reforms – including a tax system overhaul – are essential in order to infuse the missing confidence. Only then will the Japanese economy have a chance to achieve “escape velocity”.

It is not surprising, then, that the Nikkei’s initial positive reaction to the Bank’s “Funding for Lending” extension was short-lived. Investors remain inclined to cheer any sign of monetary loosening; but they were also quick to realize that the Bank’s latest initiative amounts to nothing more than a mild psychological palliative; a “message of support”, as Governor Kuroda himself subsequently acknowledged. Meanwhile, the 10-year JGB yield has been drifting lower through this year, reflecting the slowdown in growth and discounting the inevitability of another round of easing by the Bank. After all, there is ample room to do so; the 10-year breakeven inflation rate is still below 1.2%. At the same time, the GDP deflator continues to fall. The contrast between changes in the GDP deflator and changes in the CPI illustrates the nature of Japan’s ‘bad inflation’ problem. It is imported goods that have increased most dramatically in prices, and while these are captured by the CPI, they are excluded from the GDP deflator.

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We see Governor Kuroda maintaining a reactive rather than a pre-emptive stance regarding further QQE. Nevertheless, our sense is that, in view of the absence of any concrete progress on structural reforms, additional monetary accommodation remains a matter of ‘when’, not ‘if’.

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