Having emerged from parliamentary elections on July 10 with a solid majority in the upper house, Japan’s ruling party can turn its attention back to the country’s ailing economy. Liberal Democratic Party officials left monetary policy off their campaign agenda and delayed an unpopular tax hike to secure voters’ support. Now that they have it, Japan’s leaders will forge ahead with a similarly disliked stimulus program intended to increase inflation and weaken the yen.
But the stimulus program, like the rest of the Japanese prime minister’s much-maligned “Abenomics” strategy for stimulating growth, will likely be undermined by tremors in the global economy. Perhaps the most destabilizing of them all will be the United Kingdom’s recent decision to leave the European Union, which stands to undo what little progress Japan has made in getting its economy back on track.
Japanese Prime Minister Shinzo Abe rose to power on the promise of Abenomics, an economic reform package designed to pull the Japanese economy out of a two-decade slump characterized by low inflation and sluggish growth. The plan sketched out three “arrows” of action: aggressive monetary easing, flexible fiscal policy and structural reform. The first two arrows, which were to be implemented by the Bank of Japan and the Finance Ministry, respectively, were crafted with the intent to increase inflation to a reasonable level, around 2 percent. This, in turn, would boost consumption, corporate earnings, investment and economic growth in the short term. The third arrow, structural change, was devised to re-engineer the Japanese economy in a way that would improve its long-term potential. Labor, land, energy, tax, immigration and corporate reforms, in theory, would counteract the many factors diminishing Japan’s prospects, including its aging and shrinking population.
To some extent, Abe has been able to work with the Bank of Japan and the Finance Ministry to craft fiscal and monetary policies that may improve the Japanese economy’s prognosis. But structural reform has proved much more difficult to implement, even with the backing of a Liberal Democratic Party majority in the National Diet. Though the ruling party is united behind Abe, its factional divisions could become more pronounced over the next two years if Abenomics — now supported by only 38 percent of Japanese citizens — continues to falter as the prime minister’s tenure draws to a close.
The first two arrows miss their target
So far, Abe’s primary instrument for putting his strategy into practice has been the Bank of Japan. In April 2013, the central bank announced its new quantitative and qualitative monetary easing policy, which outlined the bank’s goal of reaching 2 percent inflation within two years by doubling its monetary base over that period. Initially, the bank planned to do this by accruing 60 trillion to 70 trillion yen (about $600 billion to $700 billion) in money market operations each year and by purchasing 50 trillion yen in Japanese government bonds, 1 trillion yen in exchange-traded funds and 30 billion yen in Japanese real estate investment trusts annually. But in October 2014, Bank of Japan Gov. Haruhiko Kuroda doubled down on his aggressive approach, increasing those figures to 80 trillion yen, 80 trillion yen, 3 trillion yen and 90 billion yen, respectively.
In many ways, the bank’s tactics worked. Japan’s consumer price index rose from the negative range in March 2013 to 1.3 percent in December 2015. The value of the yen, meanwhile, dropped steeply, plunging from 85 yen to the dollar when Abe took office to 125 yen in August 2015. The real effective exchange rate fell just as dramatically over the same period, decreasing from 117 to 90.
But since the beginning of 2016, several factors have reversed Japan’s fortunes. Damaging developments in the global economy, particularly in China and in post-Brexit Europe, have called into question the sustainability and efficacy of the Bank of Japan’s measures to boost inflation. Japanese consumption lagged amid the higher inflation rates of 2015, but over most of the past year retail sales have declined compared even with the year before, falling by as much as 1.9 percent in May. Household spending has not fared much better as real wages have shrunk, showing that the bank’s aggressive monetary policies have not had a substantial impact on the psyche or spending habits of the Japanese consumer.
At the same time, the Bank of Japan has had to continuously push back its deadline for reaching an inflation rate of 2 percent. After implementing negative interest rates for the first time in February, the bank now aims to meet its goal by the 2017 fiscal year. Yet the yen has appreciated by 16 percent since the start of the year, while the real effective exchange rate has risen by 18 percent, returning the yen’s value against the dollar to where it started before the Abenomics reforms began. Now that the elections are over, Abe will renew efforts to enact the first two arrows of his strategy, likely feeding an additional 5 trillion to 10 trillion yen into the national budget and expanding the central bank’s monetary easing program. But the Bank of Japan is quickly approaching the limits of its main quantitative easing tool, and it will be forced to find an exit strategy from it soon, perhaps as early as next year.
The third arrow falters
Meanwhile, the third arrow of Abenomics has yet to reach its target, though the prime minister has had some success in meeting his structural adjustment objectives. The biggest achievements have come in the form of changes to Japan’s corporate standards and governance. Historically, the Japanese business structure, also known as keiretsu, has come under fire for being inefficient, uncompetitive and, at times, corrupt. A 2014 study by Singapore’s Association of Chartered Certified Accountants and the United States’ KPMG ranked Japan’s corporate regulations between those of Vietnam and Cambodia in terms of effectiveness, highlighting how far the country still has to go to meet global standards. The report’s findings were echoed a year later, when the CEO of Toshiba was forced to resign after the company was found to have misrepresented its profits by more than $1 billion.
Unsurprisingly, one of Abe’s first acts in office was to push through a new corporate governance code to address these issues. The code, which took effect on June 1, 2015, introduced requirements for company boards to include multiple independent directors while increasing transparency, disclosure, and the rights of whistleblowers and minority shareholders. Though breaking down the culture and dominance of the keiretsu system is no easy task, doing so has been one of the clearest, most tangible benefits of Abenomics so far.
The emergence of the Trans-Pacific Partnership (TPP) has been another important success for the prime minister, who advocates free trade agreements as pathways to economic growth. The implementation and ratification of the TPP is far from certain, of course, especially since its success partially hinges on the outcome of the U.S. election. But reaching the deal in the first place required Abe to overcome considerable opposition from the Japanese agricultural sector — quite a feat given its massive lobbying power, even if its clout is slowly declining.
Japan’s trade negotiations elsewhere continue to move at a snail’s pace, as have some aspects of liberalizing and deregulating the country’s industrial sector. Still, Japanese industry has been moving in the right direction. Its biggest success has been in reforms to the electricity sector, though even there Japan will not be on par with Western countries until at least 2020. The establishment of special economic zones — another feature of Abenomics — has been even more gradual.
Furthermore, the prime minister’s success in key areas such as labor and immigration reform has been fairly limited. Abe still hopes to introduce legislation that would undo some of the country’s long-standing labor issues, including lifetime employment offers, seniority-based wages and strict layoff laws, each of which has contributed to Japan’s underemployment epidemic. But his efforts, as well as his plans to support Japanese women in the workforce and import foreign labor to offset the country’s demographic decline, have proceeded in fits and starts.
And so, as he enters the last two years of his time at the head of the ruling party, Abe finds himself back where he began in 2012. With his political legacy riding on the health of the Japanese economy, Abe will have little choice but to redouble his efforts to make Abenomics a success. But there are few reasons to expect the next round of quantitative easing and fiscal stimulus to be any more effective than the last, boding ill for the country’s economic future.
© 2016 STRATFOR GLOBAL INTELLIGENCE