Japan awaits Abe’s third arrow

Japan has been the focus of global economy over the past year. It is generally believed that the first two arrows of Abenomics were well received, at least during the first 3 quarters of 2013. However the statistics released on Feb. 17 indicated that Japan’s economy expanded at a slower-than-expected 0.3 percent in the final quarter of 2013, which showed disappointing private consumption, business investment. This result raises doubts for Abenomics: does it really going to work?

1. The first two arrows are unlikely to make lasting impact

Abenomics refers to the economic policies advocated by Shinzō Abe since the December 2012. The first two arrows of Abenomics generally constitute massive monetary easing and expansionary fiscal policy which lead to a weaker Yen, therefore rendered Japan with stronger competitiveness of exports.

The first arrows did receive some positive outcomes in the first 3 quarters of 2013, as a result Nikkei 225 stock index has gained by more than 47% during its peak time in Dec. 2013. But the fresh economic statistics put an end to the glad news from early 2013, which indicates shooting only two arrows is not enough to boost Japanese economy in long term.

Here is the logic chain why first two arrows are unlikely to make lasting impact on the economy:

One of the major theme of Abe’s plan is boosting country’s export by devaluation of yen, and the yen depreciated about 25% against the U.S. dollar in the year of 2013. Theoretically, a devaluation of domestic currency will yield Japan with a lower trader deficit, whereas Japanese trade deficit widened to 2.79 trillion yen in January of 2014 from 1.6 trillion yen reported in the same month of 2013. Imports surged 25 percent while exports grew only 9.5 percent. A recent article from the Economist indicated that a shutdown of the country’s nuclear power plants since Fukushima Nuclear Power incident and the higher cost of imported energy due to a weaker yen partly explained the widening trade deficit, which dragged GDP about 1.8 percent.

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Yet with exports weak, Japan will rely more on domestic consumption to drive up its economy. However, according to terms of a bill passed last year, the consumption tax is set to increase from 5 percent to 8 percent at the start of April. It is believed that the raising consumption tax will exert a “push up” effect on domestic consumption, namely consumers will eager to get purchases in head of the tax increase; and then a suppressing effect will come into being. The assumption has been approved by the last tax increase in April of 1997 when Japanese private consumption increased by 9% before introduction of higher consumption tax. But the reality is that consumer spending only increased by 2% in the fourth quarter, which might already reflected forward spending. Therefore it is highly likely to expect a disappointing result on consumption in the following quarters.

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2. Shooting third arrow: an arduous task

As the first two arrows are unlikely to yield a long lasting impact on Japanese economy, a growing consensus view is that Abe needs to embrace more impactful structural reform, which is the third arrow of Abenomics. But there are several long-term economic obstacles need to be tackled by this third arrow.

Arrow

1)    Embrace free trade and ease political tension with China

As mentioned previously in the first section, net exports had been a drag on Japanese economic growth. The Trans-Pacific Partnership (TPP) is a free trade agreement that has been in negotiation since 2010, which might be a feasible solution to boost Japanese net exports. Japan officially joined in on the 18th round of talks. However, Japan maintains tariffs on various kinds of key farm products, including wheat, beef, and rice; and that will become one of the major obstruction for Japan to enter into this agreement. According to data from Economic Cooperation and Development compiles Japan’s farmers depend on government subsidy for about 56 percent of their income. Therefore if Japan wants to be included in the TPP, it must forego its high trade tariffs on agricultural products. Although it is believed that Japanese farmers would surely face competition from other countries, the law of comparative advantages indicates free trade will ultimately permit Japan a better industry structure.

Obviously, Japan’s domestic initiatives are not the only effort that can boost the country’s economy. It is well recognized that Japan’s future will depend heavily on the future of its top rival in the Asia-Pacific region: China. In 2013, Sino-Japanese political relations has deteriorated due to conflicts on Uotsuri Jima Island. As a result, protests in China against Japanese products led to falling sales of majority export oriented companies in Japan. Some economists believe that Japan cannot afford to jeopardize its economic relationship with the world’s second-largest economy especially under current economic circumstance, as China has become far too important a cog for Japan’s leading companies — and its economic turnaround.

2)    Shrinking workforce

According to Statistics Bureau of Japan, because of nearly no net immigration and falling birth rate, Japan is at a population inflection point. While the overall population is gradually decreasing, the workforce has been shrinking at a higher pace: it is estimated by IMF that by 2050 the working-age population of Japan will fall to about 55 million from its peak of 87 million in 1995. An aging population means a growing number of people on the receiving end and shrinking number of people on the contribution end, which will become a heavy burden for future economy growth.

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3)    Fiscal deficit and swelling debt

Japanese government has been running in fiscal deficit in the last decade, meaning that revenues comprised a shrinking share of GDP while expense constituted a larger share. As a result, gross public debt amounted to over 200% of GDP at present.

The major issue when we look at structural budget of Japanese government is social security expense, which almost doubled in last 20 years (from 7.1% in 1992 to 13.9% in 2010). According to Hiroshi Yoshikawa, the chairman of the council and an economics professor at the University of Tokyo: “because of social security imbalances it will be impossible to balance the budget by 2020, even with the April tax increase and the next planned tax hike in 2015”. To solve the issue, one recommendation from OECD states that Japan should accelerate the eligibility age of pension, also the government should reform health and long term care programs which are major parts of social security system in Japan.

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To sum up, this short article provides a brief analysis on three arrows of Abenomics adopted by Japan right now. The first section demonstrates the argument that a weaken Yen cannot boost net exports since Japan is a country with inadequate natural resources; higher expense in energy import becomes too big a burden for most export oriented companies in Japan. Also, a weak performance in net exports does not means the economy should count on domestic consumption as fresh statistics indicate a disappointing result on consumption even before we consider the push up effects engendered by consumption tax increase on April.

In order to exert a more impactful and long-term stimulus impact on Japanese economy, the third arrow of Abenomics is imperative. However, it is a an arduous task for Abe to revitalize the Japanese economy in sustainable fashion as there are several structural economic issues need to be addressed which require some difficult economic and political choices.

 

 

 

 

 

References:

  1. http://en.wikipedia.org/wiki/Abenomics
  2. http://www.reuters.com/article/2014/02/17/us-japan-economy-gdp-idUSBREA1F0XF20140217
  3. http://www.tradingeconomics.com/japan/balance-of-trade
  4. http://www.economist.com/blogs/banyan/2014/02/japans-economy
  5. https://www08.wellsfargomedia.com/downloads/pdf/com/insights/economics/international-reports/Japan_GDP_02172014.pdf
  6. https://www08.wellsfargomedia.com/downloads/pdf/com/insights/economics/special-reports/Japan_Structural_Reform_11252013.pdf
  7. http://www.fool.com/investing/general/2014/01/25/the-3-biggest-threats-to-japans-economy-in-2014.aspx
  8. Video: http://video.cnbc.com/gallery/?video=3000245704
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