While Japan’s economy has improved since Abe assumed office, not everything has come up roses. For starters, Japan’s economy has slowed since early 2015 and the BoJ’s experiment with negative short-term interest rates does not appear to have been a success.
If anything, the negative rates introduced in February 2016 serve as a tax on the banking system and might be slowing, rather than accelerating, economic growth. Moreover, instituting negative rates halted the depreciation of the yen in 2016 (Figure 3), which may have slowed economic progress by dampening export growth and delaying a return to positive rates of inflation. The currency weakened slightly after the election results became known on Sunday but it will take a sustained down trend to continue to boost Japan’s exports.
Negative rates not only stopped the decline in the yen, it halted Japan’s already faltering return to positive rates of inflation (Figure 4). Positive rates of inflation, along with solid real (inflation adjusted) economic growth, are critical for managing Japan’s massive public and private sector debt burdens.
Approximately half of the temporary 2013-2014 spike in inflation can be attributed to Abe’s increase in the value added tax (VAT) from 5% to 8%. This was policy was meant to offset the fiscal impact of supply-side reductions in income tax rates and to help close the size of Japan’s massive budget deficits. It proved to be politically unpopular and a second increase from 8% to 10% has been delayed, leaving the public sector still running deficits of 5.7% of GDP, albeit an improvement of the 8.7% deficit to GDP ratio that Abe inherited five years ago when he assumed office.
Although it was not a major theme of the campaign, one key thing to watch for will be another attempt to hike the VAT from 8% to 10%. If the government was to go ahead with such an increase it would probably have the same impact as in the past:
- A boost to economic activity before the hike as consumers move purchases forward.
- A drop in consumer spending after the hike that lasts six months or so but then fades.
- A reduction in budget deficits of about 0.5% for over 1% rise in the VAT.
The good news for Japan, at the moment, is that it benefits from a favorable international context with the first synchronized global growth since 2007. That said, China poses a major risk. 25% of Japan’s exports head to China or to Hong Kong and both places have run up massive debts. China also has a flat-to-inverted yield curve, which may signal a slowdown in 2018.
With little downward potential in rates and a flat yield curve, JGB holders are faced with little upside compared to bond holders in the U.S. where the risks are evenly balanced. As such, with little cost to being short JGBs, some hedge funds may be tempted to be short JGBs and long bonds elsewhere in the world. Additionally, some remaining domestic holders of JGBs might be tempted to search for higher yields abroad.
The campaign also largely sidestepped another burning issue: nuclear power. Following the Fukushima disaster in 2011, the Democratic Party government closed nearly all of the country’s nuclear power plants, which had been responsible for over 20% of electrical generation. This resulted in soaring imports of crude oil and natural gas at a time when prices of both were much higher than they are currently. Abe’s government has reversed course and has allowed for a progressive and partial return to nuclear energy. As such, his win should marginally reduce Japan’s demand for fossil fuels in the years to come which will be good for the country’s terms of trade but less positive for global oil and natural gas demand. Even so, the country remains a potential consumer of U.S. LNG exports.
And, in an adjustment to previous policy, we expect the BoJ to pull back from negative rates on short-term deposits. Removal of negative rates, as discussed earlier, may work to weaken the yen, as will anchoring JGB’s near a zero yield, and policy comparisons with the Fed and ECB.
