News In Charts: Abenomics Is Floundering – Time To Fire The Third Arrow!

The magic of Abenomics is fading fast – Japan is back in recession and core inflation remains stuck in low gear. In response Prime Minister Abe has postponed planned tax hikes, but what can the Bank of Japan do to help? Is more QQE the answer? Not in our view – at least not on its own. In this week’s News in Charts we highlight in particular the notable failure of monetary policy to drive credit creation – Mr Kuroda seems to be pushing on a string. What is needed is the long-lost Third Arrow – meaningful structural reform – to support the Bank of Japan’s efforts.

According to its protagonists, Abenomics – the set of economic reforms announced by Japan’s Prime Minister Shinzo Abe following his election in December 2012 – has three key elements, or ‘arrows’. The first is monetary stimulus. The second is fiscal stimulus. The third and final arrow is that elusive cure-all known as ‘structural reform’. The first two arrows were fired quickly. Whether they hit their targets is open to debate.

Within weeks of the election, Prime Minister Abe had appointed Haruhiko Kuroda as Governor of the Bank of Japan with the objective of restarting the QE programme to deliver inflation of 2% within two years. In April 2013, the Bank of Japan duly announced its intention to double the monetary base. It would achieve this by purchasing assets – largely JGBs – at an annual pace of between ¥60 trillion and ¥70 trillion for a period of two years. The policy was welcomed by financial markets and consumers alike. Japanese equities rallied, and consumer confidence reached levels not seen for more than five years.

Fiscal stimulus came in the form of a further package of government spending, worth in excess of ¥10 trillion. Japan has tried many times to revive its economy through increased government spending. Between 1992 and 2008, lawmakers passed no fewer than 15 stimulus packages, worth on average some 2.3% of GDP. Many of these were focused on infrastructure – the infamous ‘bridges to nowhere’. Largely as a result of this fiscal largesse, Japan’s net government debt has ballooned from little more than 10% of GDP in the early 1990s to reach almost 140% this year – substantially higher than the average among the major economies, and higher even than Italy. In gross terms, the picture is bleaker still. At 250% of GDP, Japan’s gross government debt is higher even than that of Greece.

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It was the dire state of the public finances that pushed Prime Minister Abe into his first structural reform. In April of this year, the national sales tax was raised from 5% to 8%. And it was almost certainly this move that pushed the economy back in to technical recession. GDP contracted by more than 7% on an annualised basis in Q2, with private consumption falling almost 20%. This collapse in household spending was seemingly even larger than retailers had feared, as stockbuilding made the largest contribution to growth in more than five years, raising the prospect of further fall in output in Q3. Sure enough, GDP fell almost 2% in Q3 as inventories were run down. Earlier this week, Moody’s became the latest ratings agency to downgrade Japanese government debt.

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With core inflation now falling – stripping out the effects of the tax rise, it stands at just 0.9%, lower than it was at the time of Shinzo Abe’s election – ‘Abenomics’ appears to be floundering. In response, a further increase in the sales tax scheduled for next year has been abandoned, and the Bank of Japan has ramped up its QQE programme. In late October, it was announced that the annual pace of asset purchases was to be increased from an annual pace of ¥60 trillion to ¥70 trillion, to as much as ¥80 trillion. But is more QQE the answer to Japan’s woes? We think not.

More QQE is not the answer

In an accounting sense, the impact of QE, or indeed QQE, on nominal GDP depends on the response of both the money multiplier – the ratio of broad money to the monetary base – and the velocity of circulation of broad money. As our chart shows, Japan’s money multiplier fell sharply following the launch of QE in March 2001. The rapid expansion of Japan’s monetary base did not produce any material response from broader monetary aggregates. This pattern was repeated following the launch of QQE. One year into this new experiment, the monetary base had risen by 55.0%. M2 had risen by just 3.6%, little changed from the 3.0% rate witnessed in the twelve months before its launch.

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The substantial increase in the deposits of commercial banks held at the Bank of Japan has not feed through to broader measures of money, and to the wider economy, because the Japanese banking system is still broken. It has not yet recovered from the bursting of Japan’s asset-price bubble more than twenty years ago. The stock of bank lending, which fell through the early 2000s, has been broadly flat for the past ten years. Lending to small corporations, which account for around two thirds of total employment in Japan, has been particularly weak.

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Earlier this year, we compared the experience of Europe’s single currency bloc since mid-2007 with that of Japan since the end of the 1980s. There were, as we set out, some disturbing parallels. In particular, some euro area economies, notably those in the periphery, already had a non-performing loan (NPL) problem that was worse than that of Japan at its peak.

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Officially, NPLs held by Japanese banks have fallen from a peak of 9% of assets in 2002 to around 3% today. But have the banks really cleared out all the rubbish? Have they really written down all of the debts that will never be repaid? We doubt it. In our view, Japan’s NPL problem has not been cured. It is merely lying dormant. The effective rate of interest on the outstanding stock of prime loans to non-financial corporates has approximately halved since 2002, and now stands at little more than 1%. That is what twenty years of near-zero interest rates does for you. It is relatively easy for a loan to perform at an interest of 1%. Were interest rates ever to rise in Japan, those bad debts would make their presence felt once more. In our view, it is the knowledge that Japan’s banks are laden with assets that will perform only at near-zero rates of interest that prevents them from extending more credit.

It is an empirical regularity that, over long periods of time, an economy tends to grow in line with its average rate of interest. Since the policy rate of interest fell almost to zero in late 1995, Japan’s nominal GDP has on average contracted by 0.2% per annum. The policy rate of interest has averaged 0.2% over the same period. Efficient capital markets will equate the interest rate with the marginal product of capital, which in turn is closely related to an economy’s rate of growth. But perhaps causality runs in the other direction too, particularly in the case of Japan. Persistently low rates of interest allow companies that would otherwise go bankrupt to survive. It leads to the formation of zombie companies. At the same time, recognising that their balance sheets have become impaired, this kind of environment discourages banks from lending to small firms that might come to the market with new ideas. It prevents the creative gales of destruction, the clearing out of the dead wood if you will, that typically promotes a strong rebound in growth as an economy emerges from recession.

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Shinzo Abe’s first arrow has been fired. It generated a burst of inflation that is already coming to an end as the economy enters recession. Now is not the time for more of the same. Investors recognise this. The first wave of QQE was associated with a surge in Japanese equity prices, and a sharp depreciation of the yen. But even adjusting for changes in the exchange rate, the Nikkei gained around 30% in US dollar terms through the first half of 2013. The same cannot be said of phase two. When the rate of purchases was stepped up in October, equity prices rose further still, in local currency terms. But that was matched step-by-step by a decline in the yen. In US dollar terms, the Nikkei has drifted sideways since the middle of last year. Nor is it appropriate to engage in yet more government spending. Japan has already issued more government debt, relative to its tax base, than any other developed economy including Greece. Now is the time for the third arrow – that of structural form. And what needs reforming more than anything else in Japan are the banks. It is the broken banking system – the failure of Japan’s banks to lend in meaningful quantities, and particularly to small firms, despite abundant liquidity – that is holding back recovery.

This research note is provided by Fathom Consulting. All of the charts below and many many more, covering a range of topics and countries on both the macroeconomy and financial markets are available in the Chartbook to Datastream users at www.datastream.com. Alternatively you can access Fathom’s Chartbook at www.fathom-consulting.com/TR.

 
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