Tuesday, April 1, 2014

Critical period ahead for Japan

There's an ongoing debate in Japan about the success or otherwise of “Abenomics”.  Regular readers will know I'm less than convinced that Japan is on a path to sustainable growth and out of deflation.  That still requires a good dose of the third arrow of Abenomics: structural reform.

We now also throw the scheduled increase in the consumption tax into the mix.  The tax increases from 5% to 8% today.  How the economy comes through the next few months will be a key determinant of what work is still left to do to for the Bank of Japan to meet its 2% inflation target.

Recent data out of Japan has been relatively good, at least by recent Japanese standards.  GDP growth came in at an annual rate of 2.6% in December although the quarterly rate disappointed on the back of soft net exports.  Since then activity data has strengthened as household spending picked up into the tax increase.  Retail sales came in at 3.6% for the year to February – still a solid increase even if it was lower than the 4.4% recorded for the year to January.

It's not rocket science to expect retail sales will be sharply lower in the period immediately after the tax increase. Indeed industrial production is already heading lower as the “rush demand” abates from retailers.  Production was down -2.8% in the month of February for an annual growth rate of 6.9%, down from 10.3% in the year to January.
The critical question is what happens after that?  While Japan is better placed now than it was at the time of the last hike in 1997 which pushed the economy into recession, we are still cautious about the outlook.  Firstly, beyond the initial slump in consumption spending, it seems to me retail sales will continue to be constrained by the decline in real incomes post the tax increase.
Secondly, recent export performance has been disappointing and can’t be expected to fill the gap, at least not in the short term.  Exports have not fired on the back of the depreciation in the exchange rate due to insufficient demand, particularly from Asia.  Stronger global growth, particularly out of Europe and America should help that later in the year.
The ¥5.5 trillion supplementary budget will also assist, although it remains to be seen how quickly projects can be implemented.  I also question how successful incentives for capital spending will be; I think business is looking for progress on structural reform before committing to new investment.
On balance I think we are in for a soft period of growth in Japan, with stronger growth reliant on a recovery in exports later in the year.  That appears likely to put a dent in the other success story of Abenomics: reflation.  Headline inflation appears to have stabilised at around 1.5% per annum recently while core inflation (excluding both food and energy) is running at 0.8%.
Much of the recent rise in inflation has been due to energy prices and the exchange rate depreciation.  In the near term we don't expect growth will be strong enough to sustain inflation at its current level let alone move it further towards the BoJ target of 2% (excluding the tax increase).  Of course the other tool Japan has now is quantitative easing.  If we do see a prolonged soft patch in growth and a drift lower in inflation, I expect we will see more action from the BoJ.