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Abenomics and the Japanese economy

FINSER Asset Management | December 2013
Backdrop and current environment The last eighteen months have seen an impressive rally in the equity markets of developed economies. The major indices of the US, the UK, Hong Kong and Japan have all experienced double-digit gains over this period of time. Whats interesting, however, is that by looking at the underlying economic situation of these countries, there is little evidence to suggest that such a spectacular rally should be taking place right now. Although the particular circumstances and headwinds that each of them face are different, a disconnect between economic and stock market performance is evident. In general, there has been no dramatic reduction in unemployemnt, GDP growth has not been remarkable by any standards and governments have failed to implement meaningful structural reforms to revitalize their domestic economies.
Indexed price of major market-cap weighted indices (December '12 to December '13) 160 +49% 140 120 100 80 Dec-12 Tokyo SE Source: Bloomberg. +24% +9% +3%

Politicians and economists from Washington to Brussels and Tokyo have argued bitterly about the appropriate measures to take with regards to deficits, taxation, employment laws, healthcare and the growing burden of aging populations. The result has been an increase in tensions and a lack of constructive legislation and proactive structural reforms. In light of the political gridlock and fiscal inertia, Central Banks have been left to carry the load of keeping economies afloat and stimulating growth. The Federal Reserve, the Bank of England, the European Central Bank and the Bank of Japan have all implemented, with different levels of aggressiveness and to various degrees of success, a loose monetary policy with the purpose of boosting liquidity and keeping interest rates low. Without going too deeep into the mechanics and repercusions of loose monetary policy, two of its consequences are that borrowing money becomes easier (low interest rates) and inflation increases. This is supposed to be stimulating for the economy because companies can use the cheap money they borrow to invest and increase production. The expectation by consumers that inflation will rise makes them more suceptible to buying goods today vs. tomorrow (when these will become more expensive). So far, the effectivenes of these policies in reaching their objectives is debatable. Whether or not they will lead to higher growth and positive secular trends in the future is a topic of controversy among economists. What is undenible is that they have boosted the profits of large corporations and led to historic gains in stock markets. Nowhere have these gains been so spectacular and at the same time so closely linked to monetary policy than in Japan. What is Abenomics? On December 16th, 2012 Japans Liberal Democratic Party won the majority of the seats in the lower house of Parliament and elected Shinzo Abe, the partys leader, as Prime Minister. This seemed to put an end to a prolongued period of political instability in the

Mar-13 S&P 500

Jul-13 Hang Seng

Oct-13 FTSE 100

At the heart of this inaction by governments is the harsh political climate of recent years in some ways a consequence of scars left by the global economic meltdown of 2008. Most officials agree in terms of the lessons that should be carried from the crisis, including the perils of excessive leverage, easy credit and free market capitalism without proper regulatory standards. Where they fail to reach consensus, however, is in deciding the necessary fiscal steps that must be taken in order to emerge from the ensuing economic stagnation and avoid another disaster in the future.

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worlds third largest economy, which had seen seven of its leaders come and go over the previous six years. Following his victory, Abe outlined a bold economic plan aimed at growing the economy, boosting private investment and combating Japans chronic deflationary problem the continued decrease in the price of goods, services and real estate that had been plaguing the country since the 1990s. The plan announced by Abe, popularly refered to as Abenomics, is best understood by examining its three inidividual components (or three arrows, as the prime minister labeled them): Aggressive monetary easing by the Bank of Japan (BoJ): this involves keeping interest rates at or near 0% in order to stimulate corporate and consumer borrowing and in turn promote spending and investment. The BoJ also started a program of quantitative easing, or QE. Under this program the bank has commited to purchase $1.4 trillion in financial assets (bonds and other credit linked securities) from commercial banks and other private institutions over the next two years. By purchasing these assets, the BoJ is effectively increasing the monetary base 1 and lowering the yield on those credit linked securities. Furthermore, by promoting spending and increasing the monetary base it is trying to create inflation (the target has been set at an annualized 2% rate). Massive fiscal stimulus: the second arrow implies significant short-term fiscal expenditures, especially investment in public works and renovation of infrastructure. The government also plans to give tax incentives to companies that invest in research & development, hire more employees, pay higher salaries and purchase new equipment. Structural reforms: These measures include the enactment of de-regulatory laws and the inclusion of Japan into international trade agreements such as the Trans-Pacific Partnership (TPP). They aim to liberalize Japans traditionally protective corporate sector and force it to compete with international corporations in the domestic market. Some of the reforms will be directed at flexibilizing Japans strict employment
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laws and promoting the integration of more women into the workforce. Because of the intrinsic ambiguity of this section of Abes plan, along with the difficult political negotiations that will be required to carry it out, many believe it will be the hardest to implement.
BoJ Asset Purchase Program (outstanding current total) 80 70 JPY (in trillions) 60 50 40 30 20 Aug-10 Source: Bloomberg. Feb-11 Sep-11 Apr-12 Oct-12 May-13 Nov-13

Abenomics was received with great interest within Japan and throughout the international business community. The stock market began an impressive upward trend that continues until today and there was a sense that the plan might finally end the economic stagnation and deflation of the past 20 years. In order to better understand the aggresiveness of the policies and the enthusiasm they generated domestically and internationally, it is useful to quickly review Japans recent economic past. The Rise of a Superpower Japans spectacular rise as an economic power started in the second half of the 19th century with the policies enacted during the Meiji Restoration the period that restored imperial rule after the last shogunate was overthrown in the 1860s. During this time the country began an era of westernization, applying a number of political, social and economic reforms that ended the feudal system and catapulted an industrial revolution. The end of the feudal system transformed the structure of Japanese society, fomenting social mobility and education across all classes. A young, dynamic and educated workforce emerged. Coupled with the governments fiscal policies of investing in

The monetary base is defined as the portion of the commercial banks reserves that are maintained in accounts with their central bank plus the total currency circulating in the public (cash). When the Bank of Japan engages in QE it is effectively crediting money into the commercial banks accounts held in the BoJ.

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infrastructure, transportation and agricultural development, it propelled Japan into the 20th century. During the 1910s and 1920s, Japans rise as an economic power continued as it expanded its political and military influence to other parts of Asia including Taiwan, Korea and areas of Northern China. It benefited from the absence of European competitors that resulted from the destruction caused by World War I and was able to generate consistent trade surpluses. Starting in the 1930s through the beginning of World War II, the countrys GDP grew at an average annual GDP rate of ~5%. The nation seized significant portions of land in China and sought to develop resources in other Asian countries (because it is an island-nation, economic self-sufficiency has always been a major concern within Japanese domestic and foreign policy). These included oil and other natural resources in the Dutch East Indies, Burma and Malaysia as well as agricultural products in Thailand and the Philippines. The war, however, put a sudden stop to Japans economic rise with over 40% of the countrys plants and infrastructure being destroyed over the course of the conflict. Following its surrender in September of 1945, the United States occupied Japan until 1952 and played an important role in the countrys rebuilding and transformation into a modern democracy. Over $2 billion in foreign aid flowed into the country. The Allied Powers contributed in driving a series of liberalizing measures, including land reform, which many economists believe to have helped Japans recovery as they boosted competition and opened its economy. During the early postwar years major investments were made to rebuild the nations industrial capacity. By the mid-1950s production was back at prewar levels and GDP expanded by over 9% per year from 1953 until 1965. In the late 1960s it expanded its industrial capabilities and major importance was given to heavy manufacturers including automobiles, shipping and machinery. The oil crisis of the 1970s had significant repercussions for the structure of international trade. Higher oil prices meant that many industrialized nations, including Japans most important trade

partners, suffered from periods of high inflation. This fact, coupled with the increase in the manufacturing capacity of Korea and Taiwan, hurt its competitiveness in the international markets. What followed in the late 1980s was a structural change in Japans export-driven economy. Domestic demand began playing a fundamental role in its growth as industries like retailing, telecommunications, insurance and finance started to expand. The rise in living standards caused by the previous 30 years of economic prosperity propelled this increase in internal demand, with companies investing heavily in plants and manufacturing. Domestic investment, and consequently asset prices (including real estate and stocks), were at an all-time high. It was during this period that Tokyo became a major financial center of critical importance to the global markets.
320 280 240 200 160 120 80 Sep-85 +93% +85% Indexed price of major market-cap weighted indices (September '85 to December '89) +185%

Feb-87 Tokyo SE

Jun-88 S&P 500

Nov-89 FTSE 100

Source: Bloomberg.

The spectacular rise in asset prices that had unfolded by the late 1980s eventually created a bubble that burst in 1989 when the BoJ decided to raise interest rates. This caused a sharp drop in real estate and stock market prices and marked the beginning of years of deflation and slow economic growth that came to be known as Japans lost decade. The Lost Decade(s) The term lost decade is controversially used by some economists to refer to the period from 1991 until 2000 when slow growth and deflation affected the Japanese economy (some claim that 2001 2010 should also be counted). The reason it is controversial is that depending on what variables are used to analyze the situation, it could be argued that Japans economy actually performed better than that of the

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US and other industrialized nations during this time period. What occurred was a sharp decline in stock market and real estate prices from the historic levels they had reached in the late 1980s. The reason they had reached such levels in the first place was an excess of liquidity in the system that resulted from a combination of years of economic prosperity, protectionist policies promoted by the government and an ever increasing aging population that was looking to save money for retirement and therefore causing high deposit rates in banks.
140 120 100 80 60 -57% 40 Dec-89 Jul-90 Tokyo SE Feb-91 Aug-91 S&P 500 Mar-92 FTSE 100 Indexed price of major market-cap weighted indices (December '89 to June '92) +15%

domestic debt crisis. Unable to meet interest payments, many firms declared bankruptcy, a wave of consolidation took place and the government was forced to make significant capital infusions to a large percentage of the financial institutions. Although GDP and unemployment never reached depression levels and many corporations quickly returned to profitability, the bursting of the bubble unraveled a series of issues that Japan is still dealing with today. One of the most critical is that the major capital infusions and the stimulus put into place to prevent an economic collapse made the government incur massive amounts of debt and run a budget deficit starting in 1996. For a country with a decreasing population and long-term deflation, dealing with a prospective debt crisis in the future might prove catastrophic 2. This is why so much hope and enthusiasm has been put into Shinzo Abes program to overhaul the economy. Abenomics so far Since its announcement on December of last year, only the first two arrows of the plan have been implemented. Haruhiko Kuroda, the governor of the BoJ, has led the execution of a very aggressive form of QE and committed the bank to buying some 50 trillion (~$485 billion) of Japanese Government Bonds per year. If this rate is maintained, the countrys monetary base will double by the end of 2014. A 10 trillion (~$100 billion) fiscal stimulus package has also been put into place, with investments being made in large scale infrastructure, construction and transportation projects. The result has been economic growth at an annualized rate of roughly 4% (nominal GDP) during the first three quarters of 2013 the highest within the G7 nations. There has been a modest decrease in unemployment from 4.3% to 4.0%. The massive easing by the BoJ has caused the yen to depreciate by over 20% vs. the dollar, boosting the profits of Japanese industrial giants like Toyota and Sony (cheap debt has also helped their margins). The Tokyo Stock Exchange has been the big winner, with the index up almost 50% since December of last year.

+4%

Source: Bloomberg.

High deposit rates enticed banks to lend more money so credit became easier to obtain. As a result, many corporations started borrowing directly from banks (they are a cheaper source of capital than issuing bonds or equity in the markets). This low cost of capital, coupled with a weak yen, increased Japanese corporations competitiveness in the international markets and amplified the countrys trade surplus. The ease of obtaining capital fueled speculation, especially in real estate assets and the stock market. The Nikkei index traded at all-time highs in 1989 and real estate prices skyrocketed to the point where retail properties in Ginza, one of Tokyos most exclusive neighborhoods, reached $200,000 per square meter. The ensuing wealth effect prompted many people to take mortgages on their homes and encouraged excessive borrowing by corporations. The BoJs decision to raise interest rates to combat the asset bubble that had formed, combined with the excessive leverage that existed in the system, led to a
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Most of Japans debt is denominated in yen. Because deflation increases the value of a currency, it has actually increased the value of Japanese debt and made it more difficult for the country to pay its interest obligations.

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Structural reforms, however, have still not been implemented. Abes push for Japan to join the TransPacific Partnership 3 has been met by strong resistance from sectors within the national business community. Skeptics argue that important reductions in tariffs on Japanese exports should be made, a concession that the US, the TPPs most powerful member, has so far been unwilling to make.
Value of Japanese Industrial Production vs. Stock Market Performance 330000 20000 16000 12000 190000 8000 120000 4000 0 Dec-13 Nikkei 225 Index

locally in factories, machinery and real estate (big fixed costs) that might decrease in value if the BoJs policies are not effective. Furthermore, a key element that has been hurting the banks ability to spur inflation, and that has its roots in a much deeper structural problem of Japanese society, has been a lack in the velocity of money. Velocity of money is the number of times one unit of currency is spent to buy goods and services per unit of time. An increase in the velocity of money points to an increase in the number of transactions that are taking place between individuals in an economy. The BoJ hoped that by expanding the monetary base (by way of QE) and keeping interest rates low, banks would be enticed to lend and consumers to borrow. Ideally this would drive domestic consumption and create inflation. The issue is that by lowering interest rates in a country where one third of the population is over 60 years old, the BoJ created another problem. As people get closer to the age of retirement they tend to increasingly rely on the interest income that is generated by their savings. Therefore, reduced interest income further reduced the likelihood of increased spending and borrowing in this segment of the population. With interest rates being so low and the expectation of inflation, investors started re-allocating capital to the equity markets in search of yield and protection. This fueled the sharp rise in the Japanese stock market to the point that its valuation has become divorced from the economic reality. Having placed so much hope in Abenomics, and with the feasibility of structural reform still unclear, the expectation is that the BoJ and the government will continue to engage in quantitative easing and fiscal stimulus (they basically have no alternative until the economy and inflation show continued signs of recovery). Consequently, stock market outperformance and a decline in the value of the yen will probably continue in the short to medium term.

Industrial Production (Value) (JPY, Millions)

260000

50000 Dec-08

Dec-09

Dec-10

Dec-11

Dec-12 Nikkei 225 Index

Industrial Production (Value) Source: Bloomberg.

Changes to the countrys strict employment laws have not been carried out either. It is still very difficult for companies to lay off workers (the concept of atwill employment 4 does not exist in Japan) which makes them hesitant about hiring people in the first place. Many companies say they are waiting for more permanent signs of an economic recovery before taking on additional employees. The process of integrating more women into the workforce has also been hard, and faced with a declining population and a dire need to increase birth rates, it will probably be an increasingly difficult issue for the country to tackle. Although inflation has started to pick up, much of the rise in prices has come from an increase in import cost due to the yens decline (since the yen is worth less, Japan now has to spend more yen to import the same amount of goods) and a hike in electricity rates due to the Fukushima nuclear accident. Sustainable inflation requires that wages start to rise too not just prices. Another headwind to sustained inflation has been the fact that domestic investment by large corporations has not been as significant as expected. After years of deflation, companies are skeptical about investing
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A proposed trade agreement between 12 nations including Japan, Vietnam, Malaysia, Singapore, Brunei, Australia, New Zealand, Canada, USA, Mexico, Peru and Chile. 4 A contractual relationship in which an employee can be dismissed by an employer for any reason without having to establish just cause for termination.

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While supporters of Abenomics point to market performance and GDP growth as evidence of the programs success, the truth is that without important structural reforms it is unlikely that the efforts will lead to secular changes in the economy. On the contrary, continued quantitative easing and fiscal stimulus that adds to Japans massive fiscal deficit and debt burden might create problems that will be extremely hard for a country with a rapidly decreasing population to tackle. The debt problem Regardless of whether or not Abenomics has been positive for Japans economy so far, the unescapable reality is that it faces a major structural challenge in the form of population decline. It peaked at almost 128 million people in 2010 and is currently hovering around 125 million. One third of the population is over the age of 60 and one fourth over the age of 65. The country has arguably the most homogenized society among developed nations (less than 3 million of its citizens are non-Japanese). This makes it unlikely for it to adopt progressive immigration laws like the ones implemented in Europe to combat its population problem. At approximately 250% of GDP, Japan currently has the biggest public debt balance in the developed world. Over 90% of this debt (Japanese Government Bonds or JGBs) is held by Japanese financial institutions on behalf of Japanese citizens. Some economists like Eamonn Fingleton point to Japanese social cohesion and the fact that such a big proportion of Japanese debt is held by its own citizens as a sign of strength and stability in the countrys sovereign debt market. The problem is that once inflation starts to kick in, the value of the JGBs will be affected. Inflation decreases the value of a currency and therefore the value of debt that is denominated in that currency. While this makes it easier for countrys to pay their debts (assuming the debt is denominated in their national currency), it also erodes the capital of individuals and institutions that have invested in that debt. The fixed income they receive is gradually worth less (this is
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why fixed income instruments are generally not considered good hedges against inflation). As fund manager Kyle Bass of Hayman Capital points out, even in a population with a very high degree of social cohesion it is unlikely that socio-cultural norms will precede human nature. An individual close to or at retirement age who sees the value of his savings in JGBs erode will most likely be enticed to sell them, in turn creating a sharp rise in yields. A sharp rise in yields would pose a major threat for a country so heavily indebted and running a massive fiscal deficit, making it difficult for it to keep up with interest payments. Until recently, economists from Japans Ministry of Finance argued that the deficit was not a major problem as long as Japans current account 5 was positive. The problem is that the recent pickup in inflation has dramatically increased Japans import costs, especially in the case of energy imports, and as of last month the country was running a negative current account.
Current Account (JPY, Billions) 3500 3000 2500 2000 1500 1000 500 0 -500 -1000

Source: Bloomberg.

Being an island-nation, it is unlikely that Japan can implement any effective solutions to reduce its reliance on imported energy and food products. It can try to boost productivity to increase exports, but even some of these efforts have come under threat lately. Almost 20% of Japans exports are to China. These have been in decline recently and increased political tensions have not contributed to the situation. In September of last year, as the Senkaku Islands conflict was unfolding, Japanese auto sales to China fell by as much as 63%. Fiscal stimulus has added to the countrys debt but industrial production has continued to be on decline. The TPP seems like a good alternative to enhance trade, but at the moment it is

The sum of the balance of trade (i.e., net revenue on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors) and cash transfers.

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unclear whether parliament and Japans powerful agricultural lobbies will provide support. Adding to the debt problem is the massive fiscal deficit, currently at ~10% of GDP. Parliament recently approved a measure to increase the sales tax from 5% to 8% starting in April of 2014. However, the tax increase comes with a 5 trillion stimulus package of its own (to help the economy from slowing down) which will add to the deficit in the short term. A negative current account is not making the situation any easier. Industrial production needs to grow, and so far, the increase in corporate profits is probably more correlated to the monetary landscape than to secular long-term trends. Another worrying sign is the fact that many companies are using excess funds to carry out share buybacks which, although boosting share prices in the short-term, have little effect on long-term productivity improvement. To make matters worse, a declining population means a declining tax base. Faced with these facts, it is hard to be optimistic about the future.
Evolution of Japan's population Japanese population (millions) 130 120 100 90 80 Actual Projected 110

In his book Antifragile, scholar Nassim Taleb points to the fact that when you suppress volatility long enough, the volatility event that ends up happening is much greater than the sum of all the volatility that you tried to suppress. Whether in the form of neurotically overprotective parents or the former Fed chairman Alan Greenspan trying to smooth out economic fluctuations by injecting cheap money into the system, you usually end up making things more fragile, not less. Assuming Talebs argument is correct, the longer aggressive quantitative easing is implemented in Japan, the graver the potential debt crisis that could unravel. This is not to say that a crisis is inevitable. Japan still has an impressive industrial infrastructure and counts with world-leading corporations and a highly-skilled workforce. Even though its population is declining, its cutting edge technology and standards of education are assets that boost its competitiveness in the world economy. Over the course of history its population has proved to be resilient. It successfully rebuilt itself from the ashes after WWII and went on to become the worlds second largest economy until it was overtaken by China in 2010.
Value of Japanese Industrial Production vs. Government Debt Industrial Production (Value) (JPY, Millions) 330000 260000 190000 120000 50000 1000 900 800 700 600

Source: United Nations Department of Economics and Social Affairs.

The future On April 4th of this year the BoJ announced its shockand-awe campaign to double the monetary base in the next two years by purchasing government debt. Economic theory suggests that such an announcement should have led to rising bond prices and falling yields. Instead, the 10-year JGB yield sky rocketed and prices dropped. The bonds futures opened limit down 6 and trading had to be halted twice throughout the day to stabilize prices. It took several months, reiterated promises to keep interest rates at or near 0% and trillions of yen in QE for the BoJ to reduce yields and trading volatility.

Industrial Production (Value) Source: Bloomberg.

Government Debt

However, if it is to succeed, monetary policy and fiscal stimulus will not be enough. Measures must be taken in order to combat the basic problem of population decline. Prime Minister Abe must fire his third arrow without significant structural reform Japan could very well have a major debt crisis in its hands. If this were to happen, the damage that took place during the lost decades would pale in comparison. Juan Andres Jacobus-Avila Registered Investment Adviser jja@finsergroup.com

The maximum amount by which the price of a futures contract or stock may decline in one trading day. If the maximum decline is surpassed, trading on the security is usually halted. These limits were introduced to counter unusual market volatility and prevent panic-driven selling.

Government Debt (JPY, Trillions)