Japan has been plagued with deflation and slow economic growth for the past two decades. In the last twelve months, however, the Japanese Yen has weakened by more than 20%, providing a major boost to Japanese export competitiveness and helping to drive the Nikkei 225 stock index upward more than 65% over the same period. Does this signify the beginning of a turnaround in economic conditions, and if so, what is driving this change? The major driver that we will discuss here is government policy.
In late 2012, Japan’s new Prime Minister, Shinzo Abe, outlined a plan to re-invigorate the Japanese economy. These policies, dubbed “Abenomics,” include a $100 billion fiscal stimulus plan through increased government spending, monetary easing through unlimited purchases of Japanese Government Bonds (JGBs) by the Bank of Japan (BOJ), and various structural reforms designed to increase competitiveness and productivity. The hope is that these policies will be enough to produce a healthy level of inflation into the economy, thereby pulling Japan out of its downward economic spiral of deflation and economic stagnation.
In late May, the Japanese stock market sharply reversed course and plunged 20% over the next several weeks. The market has since rebounded about 17% from that level, but the sharp selloff highlighted concerns over the effectiveness of current policies. Will Abenomics really be enough to sustain an environment of rising prices, rising wages, and increased economic activity? These policies are not without major risks. Below are several key takeaways that should help to de-mystify the uncertainty surrounding Japan’s economic stimulus measures.
Monetary policy has limited impact when rates are near zero. The BOJ’s purchases of JGBs have expanded its balance sheet to just under 40% of Japan’s GDP (as compared to the Fed balance sheet, which is around 20% of US GDP). Such an aggressive rate of government bond purchases by a country’s central bank increases the country’s monetary base significantly, which, in normal circumstances, would drive down interest rates, thereby increasing demand, domestic investment and inflation. However, interest rates in Japan, both long and short term, have been at or near zero for years, meaning the impact of monetary policy will be limited.
There is such a thing as too much debt. The amount of Japanese government debt outstanding is massive, and the implications are serious. Japan’s public debt outstanding today amounts to more than twice the size of Japan’s annual GDP. The burden of servicing all of this debt is onerous – equal to about 25% of annual tax revenue. Total government expenditures are already outpacing revenues, so further increasing expenditures will only exacerbate the debt service burden. Furthermore, because the central bank and other Japanese banks hold so much of this debt on their balance sheets, any decrease in JGB prices will result in major mark-to-market losses and strain the entire banking system. Bottom line: Japan’s already high level of indebtedness makes prolonged increases in government spending look like a potentially economically de-stabilizing policy if not executed with extreme caution.
Currency depreciation has implications for imports as well as for exports. The depreciation of the Yen over the past year has meaningfully helped Japan’s exporters rebound from a period of record currency strength and was a major driver behind the Nikkei’s rally. However, currency weakness in the face of rising import prices could dampen the positive impact that the weaker Yen has had on exports. Rising energy prices is of particular concern, as Japan is an energy importer.
Japan’s policies exemplify a very aggressive set of economic stimulus measures, and the country’s unique situation suggests that drastic measures may indeed be warranted. While uncertainty remains over whether Abenomics will put Japan back on a long-term path to healthy economic growth, there are a number of positive signs so far. Regardless of the ultimate outcome, there are valuable lessons to be learned by observing the multi-dimensional impacts these policies have along the way.