Tuesday, May 21, 2013

Japan: A new dawn?

Japanese GDP growth for the first quarter of 2013 surprised on the upside, posting an annualised increase of 3.5% (0.9% q/q).  The result was ahead of market expectations of an annualised increase of +2.7%.  It was all the more impressive for the fact that the higher than expected growth came off a higher base following an upward revision to growth in the fourth quarter of 2012 to an annualised +1.0%. 

The growth was reasonably broad-based over the quarter.  Consumption was the star performer, but exports contributed with their first quarterly increase in a year.  Housing investment also remained strong.  The only laggard was business investment which is to be expected given the lags between a boost to confidence and the implementation of investment plans.

The question is where to from here?  There are a number of reasons to believe the recent strength will be maintained, at least in the near term.  Consumer confidence is strong on the back of recent equity market gains which will support consumption growth and underpin further gains in the housing market.  A significant public works program following the supplementary budget announced in February will also support activity in the period ahead.  And of course the recent depreciation in the Yen combined with higher global growth in the latter part of the year (particularly in America) will provide further support for exports.  Business investment is likely to show some strength as profitability improves on the back of stronger demand and the depreciation in the Yen.

Remember there are three components of Abenomics: an increase in fiscal stimulus focussing on public works, an aggressive monetary easing by the Bank of Japan and structural reforms to boost productivity.  So far we have seen action on the first two which is delivering gains.  However, from my perspective, it’s progress on the third leg of the trifecta that’s necessary to make higher growth sustainable.

I think it’s a bit like Europe where the ECB has created a window of opportunity for politicians to get on with the job of fiscal consolidation and structural economic reform; in Japan fiscal and monetary stimulus is creating a window of opportunity for the Government to get on with the hardest part of the reform agenda.  We need to see policy reform in goods markets, the regulatory environment (particularly the regulation of network industries) and the labour market also needs some work to address rigidities.

An important part of the necessary structural reform is dealing with the related issues of tax reform and unsustainable fiscal settings.  Japan needs a long-term fiscal plan (where have we heard that before?).  Here’s where a better economic environment is creating room to move.   An increase in consumption tax is scheduled to take effect in two steps from April 2014.  At that point the tax increases from 5% to 8% and then again to 10% in April 2015.

When the tax increase was announced it was qualified with the implementation being conditional on the state of the economy at the time.  This recent economic strength and its likely continuation this year means the consumption tax increases are more likely.  They will take an economic toll and inevitably add volatility to the growth profile over the next couple of years as people pre-spend prior to the tax increases, followed by a soft patch.  But they are a step in the right tax-reform direction.

We see annual average growth of 1.6% (2.9% q4/q4) in calendar 2013 followed by 1.4% (0.5% q4/q4) in 2014.  After that we see growth slipping back to trend growth of around 1.0-1.5% per annum.  I need to see a more ambitious reform agenda getting too excited about the medium term outlook.