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The three arrows of Abenomics: A report card

The three arrows of Abenomics: A report card
Published 1 Apr 2014 

Today the Japanese value-added tax (VAT: what Australians call the GST) rises from 5% to 8%. This seemingly mundane event is a key part of the 'Abenomics' program, the effort to shake Japan out of its decades-long economic lethargy. So how does Abenomics look after 15 months?

Exhibit 1 is the sharp rise in GDP growth. Comparing the fourth quarter of 2013 with a year before, GDP is 2.6% higher, a break-neck pace by recent Japanese standards. But was this a temporary boost reflecting a belated recovery from the 9% fall in GDP in the 2008 crisis and the 2011 earthquake and tsunami, or is it a trend-breaking reflection of a new growth-enhancing policy regime? 

Shinzo Abe's strategy has three arrows

1. Fiscal policy: Stimulus followed by deficit reduction

The fiscal arrow is intended to provide a strong stimulus in the first year or so, followed by measures to wind back the budget deficit, which is running at an unsustainable 8% of GDP. The initial stimulus was the 'heart starter' hopefully providing enough economic momentum so that even with the subsequent tax increases (the VAT will rise further to 10% in 2015), the economy would be healthy enough to absorb the contraction.

It's hard to be optimistic about this element. The stimulus (theoretically a boost of 2% of GDP, but in practice probably around half of that) should get much of the credit for the pick up in growth in 2013. But Japanese consumers have a tradition of anticipating VAT increases, bringing forward expenditure and then cutting back sharply (particularly on larger items such as electrical goods and cars) after the tax is increased. The economy now has to absorb the downside phase of fiscal policy.

One option would be to soften the restructure by delaying the 2015 increase, but there is not much room for manoeuvre. [fold]

Implementing the two VAT increases would get the deficit down to around 5% of GDP, still not enough to reduce the official debt level. Japan's official debt is far higher than any other OECD country, well above the basket cases of the European periphery. This debt is sustainable only because the interest rate is so low: 0.6% on government borrowing. Also, the debt is predominantly held domestically. The Japanese owe this debt largely to themselves, protecting them from the usual external vulnerability of fickle foreign creditors.

That said, demographics present a formidable challenge for Japanese fiscal sustainability. The population has been declining since 2010 and, more relevant to the task of eroding the debt, the working age population peaked in 1995 and is now 7% lower.

2. Monetary policy:  Inflation up, interest rates down

The monetary policy arrow is being judged by some to be more successful. The Bank of Japan governor (hand picked by Abe) promised to get inflation up to 2%. His bond buying operations (similar to US quantitative easing) have been running at around the same rate as the US, an economy four times as large.

The immediate results are impressive, the more so because Japan's pioneering attempt at similar unconventional monetary policy a decade ago was so ineffectual. Inflation in 2013 was 1.6%, about the same as most advanced countries. True, much of this reflected the inflationary impact of the exchange rate fall, and the underlying rate is half this. But by any measure, inflation is up and as a result, real interest rates (nominal rates adjusted for inflation) have fallen.

Even if the inflation rate fell short of target, the psychological effect on market prices was spectacularly successful. The stock market rose 70% and the exchange rate fell 20%. This (and the fall in real interest rates) should help growth, but the connection to 2013's GDP increase is not clear cut, and thus can't be confidently extrapolated. The exchange rate should have boosted net exports, but there was no impact. The stock market and lower real interest rates should have given business a lift, but investment has been weak. 

The concern is that we are seeing Abenomics at its peak in its fiscal and monetary aspects. The positive phase of fiscal policy is ending. Higher inflation is trimming real interest rates, but this is neither sustainable nor desirable in the longer term. Negative real interest rates distort economic decisions and deprive retirees of their income. If higher inflation pushes up nominal bond rates, the task of fixing the budget will be harder. Higher bond rates would also impose capital losses on banks. If the lower exchange rate succeeds in substantially raising exports, there would be loud complaints of unfair exchange-rate manipulation from Japan's competitors, notably South Korea.

Thus Abenomics' success rests on elements not yet undertaken: the third arrow of structural change.

3. Structural change

The third arrow is targeted at Japan's long standing economic sclerosis. Agriculture is small-scale and inefficient; the construction sector relies on easy profits from government contracts; the service sector is weighed down by labour-intensive methods and uncompetitive practices; and female workforce participation is 10% lower than the OECD average. Reform comes up against tradition, vested interests and political horse-trading. Some hope that joining the Trans-Pacific Partnership will be the catalyst that breaks the political deadlock. But the TPP seems, at best, to be on a slow track.

The 'three arrows' imagery draws on Akira Kurosawa's epic tale (Ran), with the combined strength of three arrows creating resilience where individually the arrows could be easily broken. But the fiscal arrow has been fired off and is now falling to earth. The monetary arrow still has potential to boost exports and business confidence, but its strength will fade. Substantial structural change would demonstrate that a new regime has arrived, but time is running out. The three arrows are starting to look like a fable.

 Photo by Flickr user CSIS.

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