Shinzo Abe's Gamble
The investment banking world has largely gone ecstatic over the moves by the ultra-nationalist Japanese premier Shinzo Abe to reflate the long-stalled economy by taming the formidable Bank of Japan and demanding a 2 percent annual inflation target and allowing the yen to drift back down to somewhere in the neighborhood of US$1/¥100 from its current level of ¥88.6 today.
Abe Tuesday achieved a major part of his goals when the Bank of Japan announced that the bank's quantitative easing program would be expanded, and that the bank would push up its inflation target to 2 percent, a plank that Abe campaigned on to return the Liberal Democratic Party to power. While stocks fell, most analysts attributed the three-day drop to profit-taking after the longest run-up in the Nikkei average since 1986. The Nikkei recovered by 133 points today, a 1.28 percent rise. As an indication of how excited the hot money is, foreign investors bought ¥196 trillion in equities in the week ending Jan. 18 as well as ¥485.7 bn worth of bonds last week.
Still, Abe is in a major gamble with his reflation plans. Japan has been managing a mountain of debt left over from its two decades of attempts to reflate its economy through massive public spending that has left the country with roads, bridges, airports and stadiums to nowhere. It is going to have to manage more.
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Japan's national debt is roughly 230 percent of gross domestic product, compared with about 105 percent for the United States, a figure that has driven the deficit hawks in the US Congress nearly to hysteria. Fortunately for Japan, the big difference is that Japan's debt is almost entirely funded domestically, unlike the US's debt, and domestic interest rates remain almost flat, meaning the debt is manageable.
For now, Clyde Prestowitz, in an article in Foreign Policy, quotes Kenneth Courtis, former chief economist for Goldman Sachs Japan and founding partner of Themes Investment Management in Hong Kong, that in effect private debt is being transferred to the public balance sheet as private debt falls and public debt increases.
"Corporations and households have continued to restrict investment and consumption. To compensate for this, the government has been spending and borrowing," Prestowitz said in an email. "So in effect, the borrowing and debt that would normally occur in the household and corporate sectors is not occurring there, but is taking place in or being transferred to the state sector."
"Over the past 13 years, private debt equivalent to about 100 percent of GDP has effectively been transferred to the public balance sheet," Prestowitz writes. "Remaining private debt is about 270 percent of GDP which implies that Japanese government debt could be 500 percent of GDP in the not too distant future."
Abe's new stimulus plan, as did the public pump priming did following the 1990 collapse of the economy, will depend on massive construction spending, with ¥1.4 trillion going into reconstruction projects to rebuild the area devastated by the Fukushima earthquake and tsunami of March 2011.
Japan's construction spending, however, has been notoriously corrupt and characterized as inefficient, with politicians and political parties heavily dependent on construction company contributions. Japanese construction firms have been heavily dependent on public infrastructure projects, especially after the 1990 collapse spurred vast amounts of infrastructure spending. Rather than pouring money into education and social services, Japan spent around US$6.5 trillion on construction-related public investment between 1991 and 2009. The Naoto Kan government sought to re-prime the pump, pledging to spend ¥19 trillion yen on reconstruction over five years from fiscal 2011. It had already spent ¥17 trillion by the time of the initial budget in fiscal 2012. Now Abe has taken over.
According to a 2009 New York Times report, every ¥1 trillion spent on social services like care for the elderly and monthly pension payments added ¥1.64 trillion in growth. Financing for schools and education delivered an even bigger boost of 1.74 trillion yen, the report found. But every ¥1 trillion spent on infrastructure projects in the 1990s increased GDP by only ¥1.37 trillion, mainly by creating jobs and creating travel efficiencies.
Prestowitz estimates the new spending could explode the government budget deficit to 10-12 percent of GDP over the next 12 months. If the Bank of Japan achieves Abe's 2 percent CPI growth through quantitative easing, that is likely to lead to a sharp rise in interest rates.
"Consider that 10-year interest rates in Japan are about 0.75 percent," Prestowitz writes. "Deflation in Japan has not been the crushing force often portrayed in western media, but it has been running at about 1.5 percent annually, meaning that investors in Japanese bonds are earning a comfortable, safe 2.25 percent. With the economy growing only very slowly, the banks have not been lending much. Rather they have been stuffed with Japanese government bonds (JGBs). They now hold a third of all Japanese government debt and equivalent to about 83 percent of GDP.
A rise in inflation to 2 percent could well spur a corresponding rise in interest rates to perhaps 2.5 percent, which would case debt service to explode, Prestowitz writes. "Right now debt service equals 25 percent of the annual budget. If interest rates triple, debt service would suddenly be three quarters of the budget. Today, the budget is one half health, pensions, social security, and education; one-fourth debt service, and one fourth everything else. If debt service suddenly became three quarters of the budget, the budget would simply disintegrate." A substantial rise in interest rates could have potentially dire effects, not only for Japan, but for the rest of the world as well.
Abe's stated goal is to devalue the yen to US$1/¥100 - and some Japanese leaders are calling for the yen at ¥120 - to drive exports and the current account back to levels seen in the 1990s, in turn driving up exports and revitalization of production which in turn would drive up GDP, employment, wages, and tax revenue which could cover the increased cost of debt service.
In the meantime, however, the flip side of a weaken yen is increasing import costs. Japan - especially in the wake of the Fukushima disaster, which closed its nuclear plants - imports 81 percent of its energy needs according to Japan's Director General for Policy Planning and Statistics. With the entire Middle East becoming more unstable, fuel costs could become crushing. It imports roughly 60 percent of its food annually, according to the US Department of Agriculture's Economic Research Service. Food inflation, according to the Food and Agriculture Office of the United Nations, shows little sign of abating, a frightening concern on the part of the vast Japanese elderly population on fixed incomes. In July 2012, the shocking phenomenon of starvation deaths among the elderly appeared, perhaps for the first time since World War II.
However, as Jim Walker, head of the Asianomics financial analysis firm in Hong Kong, points out, Japan is in effect at full employment now. Increasing the job market with a finite labor force dares more inflation - or a bigger imported labor force.
There are also questions over the competitiveness of Japanese firms, many of which, like Sony, have simply lost their edge to nimbler South Korean and even Chinese companies, not to mention companies like Apple in the United States.
"What if the products and services Japan can produce and provide are simply no longer competitive with those from Korea and China?" Prestowitz asks. "What if Japanese corporations fail to invest aggressively enough? What if Japanese can't operate in the global economy as readily as Germans, Chinese, and Koreans? These are the key questions for which Japan and the world hope Abe has answers."