Japan's Economy: Chasing Illusions?

by Claus Vistesen

What happened in Japan this week obviously came as something of a surprise for many a financial commentator and analyst; over at Morgan Stanley's GEF Takehiro Sato even felt the need to apologize to GEF's readers for erroneously making the call that the BOJ would raise interest rates this month. He has not been alone in this, however, and last Monday Bloomberg reported that 76% of investors were expecting the BOJ to raise come Thursday. This feeling had been reinforced by strong incoming data earlier in the week on machinery orders but alas, even as we reached Wednesday and the BOJ began its two day policy meeting local Japanese media were releasing insider information that the BOJ might actually have to hold rates steady one more time, and then yesterday, as yields on ten-year government bonds plunged accordingly, the leak was confirmed by the official BOJ decision to hold steady for yet another round effectively invoking the continuing weakness of Japanese consumer spending and the extremely low inflation reading. So what on earth is happening here?

One of the underlying discourses has of course become that of the BOJ's independence from the politicians and consequently many see the recent decision by the BOJ as evidence of a clash between the central bank and domestic political interests , a clash where the BOJ has been almost bullied into holding off raising rates despite general market expectations which have persistently and almost stubbornly pointed to the desireability of the opposite course, most notably given the perceived need to unwind the yen carry-trade. Now it is not that I don't think the political situation is unimportant, and clearly given the BOJ's relatively short stint as an officially independent institution old habits, it seems, still linger. However, I also think this is a question of the proverbial chicken and the egg since the real question here is whether in fact, given the economic situation in Japan, a raise would have been prudent? It should also not be forgotten that decision making in Japan is now extremely constrained, and what is often interpreted as undue political influence may well in part be a debate about where to move first, on interest rates or on the fiscal deficit, since as is well known (and as Edward cogently argues here) Japan - as the country with the largest debt to GDP reading on the planet - also need to do something to address the government debt issue, and there is a real difficulty presented , given the underlying weaknesses in Japan, by trying to move forward on both fronts simultaneously. In the following I will argue that given the past and future trend of consumer spending and inflation in Japan I do not see the foundation materializing for a rate hike let alone a process of interest rate normalization in Japan.

In order to frame my argument it is usefull to look at the recent history of Japanese monetary policy and economic growth. If we begin by the former Japan's monetary policy has since 1998 been characterized by a policy of zero interest rates (ZIRP) and quantitative easing (QE) set in place to combat deflation. The chart below shows the evolution of headline and core inflation in Japan between 2002 and 2006.

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The policy of ZIRP was temporarily (and briefly) terminated between August 2000 and March 2001 (so there is some precedent for the present situation) and now one more time the BOJ is trying to break out of the vice and is currently running an interest rate of 0.25% on the back of the ending of ZIRP which was officially initiated in June 2006. Already here, history should teach us something since we might very all ask ourselves whether or not the current stint above 0% interest rates will be temporary as well? So far the signs have been pretty clear in my opinion and it is actually very telling to look back to June 2006 when the BOJ's decision to take Japan out of ZIRP was hailed by many prominent economic commentators as the signal that Japan finally had escaped the claws of deflation and was on its track to join the leaders of the global economy. Yet, 9 months later the party just keeps on getting postponed it seems and in my opinion the continuing surprise amongst economic commentators on Japan's economy relates to the inability or reluctance to factor in one of the biggest structural drivers of the Japanese economy.

It's the Demographics Stupid

I will not go into a detailed description of Japan's demography in this entry but merely highlight the important factors. In short, Japan is the oldest society on earth with a median age of 42.9 years. This process ageing is driven by two factors; firstly increasing life expectancy where the average Japenese can expect to live a respectable 81.3 years and and secondly by a decline in fertility where Japan is hovering at around a TFR of 1.3. The crucial point here is then what in fact happens to an economy which experiences a process of sustained ageing like has been having in Japan in the latter part of the 20th century? I am moving the perspective up here but I do not think it is wholly unreasonable to link Japan's gradual transition in the 1990s into a growth path characterized by very low inflation rates and, as the chart below shows, a steady decline in consumer spending relative to GDP, to the sustained change in the population structure. The point is that as a population ages consumer spending declines relative to GDP based on the economic theory life-cycle behavior. There are of course bound to be notable differences between countries in terms of the effect of this but since the process of ageing at this point across OECD only seems to be accelerating we should expect the life cycle component to gain more weight.

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What Drives Economic Growth in Japan?

At this point, you would perhaps be tempted to claim that I, against my own assertion, am falling victim to the application of a monocausal explanation for an, after all, pretty complex problem situation. Obviously demographics are not destiny, but by applying demographics as an anchor for the economic analysis of Japan I sincerely believe we can take one step closer to the proper understanding of what is going on. The most important point here is the notion of the growth path and what in fact drives economic growth in Japan. Looking at the above chart which plots consumer spending in Japan as a share of GDP from 1995 to 2005 we can see that the overall trend is one of secular decline. However, if we look at economic growth in terms of real GDP in Japan in the recent years the numbers actually do not look that bad. As such, the period from 2001 to 2006 reveals an impressive transition from a meager 0.1% growth in real GDP in 2001 to an estimated rate of 2.7% in 2006 with growth running above 2% in both 2004 and 2005. In fact, this impressive growth stint coupled with two very strong first quarters in 2006 were a big part of what prompted the BOJ to end ZIRP in June last year. Yet, although 2006 in terms of GDP growth indeed shows a strong performance Japanese inflation is still creeping along very near the bottom and close to the 0% mark while household spending on a y-o-y basis is in negative territory as shown by the graph below.

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So where is the growth in Japan coming from? A notable indication here comes from the Q3 growth figures where GDP expanded 0.8% primarily on the back of export growth and corporate spending (investment) in factories and equipment, an analysis which is supported by the fact that consumer spending actually declined during the same period. This state of affairs is also mirrored in the continuing widening of the trade surplus and exports, for example, grew at the notable clip of 12.1% y-o-y in November 2006. I believe this detail to be very important especially in the light of how economic data and news sometimes tend to be interpreted. A notable case in point was the data for machinery orders released on Monday of this week, and which was immediately linked to the perceived need for the BOJ to raise. Moreover, we have also on several occasions heard how momentum in the buoyant corporate sector, as epitomized by investments in equipments and factories, has been narrated as a strong foundation on which the BOJ should soon raise. Yet, why is this evident? Clearly, the figures on consumer spending suggests that all these investments and machinery orders are not driven by domestic capacity components. This also allows me to debunk one of the most common Japan fallacies of the moment which concerns how the momentum in the corporate sector will automatically spill over into the domestic economy. Given the trajectory of Japan's demographic evolution we should perhaps not expect any notable transmission mechanism to be at work here. Another area where we might also wish to correct our views is in terms of the labour market which has been very tight throughout 2006, with an unemployment rate of about 4% going into 2007. Once again most commentators have connected the dots throughout 2006 in order to argue that the tightening of the labour market was a clear sign the that the recovery was on track and that notable momentum was present in the domestic economy. However, with a rapidly ageing population and thus declining labour force we might want to ask what in fact the structural component is in this 4% figure which indeed appears on the one hand to be a sign of such a tight labour market but on the other has not done much in terms of, for example, promoting wage-push inflation? Global labour arbitrage is an argument which is often advanced here, but may there not, actually, be other and deeper structural factors at work?

A Future Growth Path For Japan?

Given my analysis it is clear that one of the most important deductions to be made here is that an economy such as the Japanese with a rapidly ageing population will structurally tend to be driven by a growth path where domestic supply continuously exceeds domestic demand and thus the economy relies on exports to grow. Another way of putting this would be to invoke high capex (investments) as the main driver of growth but since this high capex is not met by domestic demand (capacity) the economy, as a function, of its demographics will run a surplus on the external balances. In fact, I am not the only Japan observer to be arguing this and in fact Morgan Stanley's own Robert Alan Feldman came damn close to a more adequate conceptualization of the whole situation a while ago back when he asked the tantalising question: What's 'funny' about Consumption in Japan? In essence, Feldman argues, as I do, that Japan in order to grow and as a function of its ageing population will need to continuously raise capex and productivity in order to compensate for lower consumption which again means that growth to greater and greater extent will be driven by its need and ability to export.

Now, dear reader, the plot indeed thickens even more does it not, since what Feldman (perhaps) does not realize is that by arguing that Japan with an ageing population will revert to a growth path driven by the need to leverage excess supply outside its borders is walking right smack into the discourse about demographics and global macroeconomic imbalances. The point is as simple as it is intriguing. It is consequently all well and good to argue that Japan needs to export as its population ages but what about Germany and Italy; will they not need to continually run trade surpluses as well. This is not to mention the behemoth China whose population is at some point also transisting into a rapid process of ageing as a function of its one-child policy. In fact, it does seem as if poor America (and perhaps places like the UK, Australia etc) is almost the only economy out there which is really able to run a respectable deficit and suddenly dear reader we are right back where I started a couple of days ago with the structural drivers of global macroeconomic imbalances and as such Japan will provide an important test case for our hypothesis on this.

What About the Rates Then?

Signing off with a brief tour back to my starting point I do not see the data supporting a BOJ raise in 2007. There are of course the Q4 2006 GDP figures still to come, and these are widely expected to show a considerable rebound in consumer spending, a rebound which might perhaps allow for an interest rate raise when we get to February. However, as oil prices are declining going into 2007 (and at the time of writing sharply so) this will have the subsequent consequence of bringing down headline inflation even further (and remember part of the issue in Japan is still that of finding a path to escape from the grips of deflation), so I am not very bullish on the future of Japanese inflation rates. Neither, by the way, is Takehiro Sato, who in the GEF post I linked-to at the very beginning of this note suggests that a return to some sort of negative price increase process is rapidly becoming more of a reality than simply a mere possibility. Thus I believe he makes a very valid argument in terms of whether the BOJ should raise in February on the back of 2006 Q4 GDP figures, whatever they may be. As such, I would be very wary indeed of pushing for a BOJ raise in February as I fear it could very well pull Japan back into the deflationary territory which we all so much wish to see it breaking out of.

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1. IMF - Global Inflation 2006, taken from the World Economic Outlook September 2006 (Figure 1.4).

2. Julien Seetharamdoo (2006) RBS - The Royal Bank of Scotland Group, What if the US consumer stops spending?

3. The Economist (2007) - Taking a Hint.

Update 20.01.2007

In my post above I linked to the recent contribution by Takehiro Sato at Morgan Stanley's GEF on Japan but also chief economist at Morgan Stanley Stephen Roach has something to say on the recent flurry about the BOJ's decision. The gist of Roach's piece is indeed that the BOJ has seen a considerable blow to its confidence towards markets as function of the fact that its independence vis-à-vis political pressure has been seriously compromised with Thursday's decision. And as Roach puts it ...

(...) in my view, the damage has been done. Financial market participants have long memories. Expressions of BOJ policy intent will long suffer from the credibility fiasco of January 18. Trust in Japan’s central bank has been all but shattered.

As Roach also excellently points this perhaps first and foremost has implications for the Yen's international position and the continuation of the much allured yen-carry trade. However, and this is where I especially take note, Roach also generally recognizes the frailty of the Japanese economy at the current juncture which thus in any case did not warrant a raise. This of course makes this a double whammy for the BOJ because although the right decision at the end of the day was perhaps made it was made in an environment where market expectations were counting on something else and in the global world of central banking's communication with markets this bodes rather ill for the future.

Steady as She Goes?

(Cross-post from Alpha.Sources)

Thursday has arrived and so has the BOJ's decision to hold as well. In terms of the general market expectations this is quite surprising since most major analysts predicted at the end of 2006 that the BOJ would raise rates in 2007 starting off with a raise in January. This has not been the case and now of course questions are mounting on the real state of the Japanese economy not to mention market observers who are beginning to question the BOJ's independance vis-á-vis policy pressures from the ministry of finance which has been against a rate raise this time around due to the inability of consumer spending and inflation figures to provide support for such a decision.

(from Bloomberg - bold parts are my emphasis)

The Bank of Japan held its benchmark interest rate at 0.25 percent, averting a clash with government officials who say household spending and inflation are too weak to withstand higher borrowing costs.

The decision was split six-to-three, the bank said today in Tokyo, prompting traders to bet on a February increase. Board members were divided over the outlook for consumer spending, Governor Toshihiko Fukui said.

(...)

``The impression that they caved to political pressure is unavoidable,'' said Noriko Hama, professor of economics at Doshisha Business School in Kyoto. ``It's not a bad decision, given the statistics, but it certainly does not look good for the BOJ.''

Moreover, the article also reports how Q4 GDP numbers and general economic data should show a considerable rebound in consumer spending which could allow the BOJ to push rates up in the end of February. I have argued why I don't see this happening but as always we will see. In terms of more coverage of this the FT also has the story.

Over at Morgan Stanley's Global Economic Forum Takehiro Sato actually apologizes to the readers of GEF that he mistakenly predicted a BOJ hike this time around. Sato initially focuses on the political conflict between the BOJ and Abe's administration and also argues that the BOJ perhaps generally lacks the political clout to persuade policy makers that the normalization process is the right way to go.

In our view, the additional rate hike in question was never a ‘must’, but our misreading of the forcefulness of political pressure played a part in our error. It is also probably true that the BoJ, though it shifted to a forward-looking monetary policy following the end of quantitative easing, struggled to persuade politicians with its contentions in the current environment where consumption and prices remain sluggish; the BoJ lacked the track record to push this through.

I won't deny this analysis but this is really a question of the proverbial chicken and egg since we might as well also ask whether in fact the economic data has been supporting the idea of a rate hike at all? However, by reading through Sato's analysis we are also told which kind of fundamentals our expectations should be aligned towards. In short; what is in fact the risk of Japan slipping back into deflation and thus the BOJ slippling back in ZIRP at some point in 2007?

The problem is that even if the bank ploughs ahead with a February rate hike for instance, the outlook thereafter is quite uncertain as prices are expected to remain sluggish. Our official core CPI outlook calls for the baseline to improve by +0.6ppt YoY through January-March 2008, but such high-paced gains are hard to imagine in light of recent weakness. If the baseline fails to improve, the core CPI could revert to negative territory this spring, spurred by falling crude oil prices, and rather than anchor in positive range in F3/08, could even sink below the water level throughout the year. If so, we would be forced to retreat from our present scenario of 0.25% rate hikes every six months. The current hike delay by the BoJ also makes the above less a risk, and more a reality. We plan to issue another report next week to amend our official outlook on the policy rate, based on the bank’s current policy decision.

As I argued with some force recently we really need to look at the general market expectations on Japan here and ask whether these are viable? In the end, investors and analysists just cannot fight the fundamentals by sticking their head in the sand as an austriche.

Faceoff in Japan

(Cross-post from Alpha.Sources)

If you thought in the beginning of this week that a raise by the BOJ come tomorrow was a sure bet you should perhaps think about revising your views. The situation in Japan is a difficult one; ever since the BOJ ended its ZIRP policy back in June 2006 markets have more or less been expecting the transition towards a normalization process where the BOJ would be able to raise the interest gradually to take it off its current very low level of 0.25%. However, the economic data to support such a process has simply not been going the BOJ's way. It is not that Japan has not experienced economic growth but most of it has been driven by exports and this is the main issue here ... even though the BOJ ended ZIRP key economic data such as consumer spending and inflation figures simply have not supported the BOJ to go north.

However, the pressure is mounting on the BOJ to set off this normalization process and until the beginning of this week it was widely expected that the BOJ would raise at least one time in the beginning in 2007. Yet, as domestic political interests now are being mobilized as well as a function of the Japanese ministry of finance the BOJ is really caught between the proverbial rock and hard place.

(from Bloomberg - bold parts are my emphasis)

The Bank of Japan faces a test of its credibility tomorrow after local media said policy makers will delay raising interest rates, spurring concern they are bowing to government pressure.

Bonds rose the most in almost four months and the yen fell to a 13-month low after Kyodo News, the Nikkei newspaper and NHK Television said the central bank will likely keep its benchmark rate at 0.25 percent. Ruling Liberal Democratic Party Secretary General Hidenao Nakagawa said on Jan. 14 that the government should request a policy decision delay.

Governor Toshihiko Fukui risks appearing to yield to political opposition, hampering his plan for gradual rate increases to head off a repeat of the 1980s asset bubble that triggered a decade of stagnation. The government is concerned that a rise in borrowing costs would exacerbate a slump in consumer spending.

``This is a shame and disgraceful,'' said Tomoko Fujii, senior economist at Bank of America N.A. in Tokyo. ``Can't they trust their own central bank? This kind of thing never happens in the U.S. and Europe.''

(...)

Japan's households became the most pessimistic they've been in a more than year in December after wages fell, the Cabinet Office said today. The report signaled consumer spending may be slow to rebound after declining at the fastest pace since 1997 in the third quarter.

The FT also has the story and highlights the strenuous relationship between the BOJ and the domestic political scene.

The Bank of Japan began a two-day policy board meeting Wednesday amid intense political pressure not to raise interest rates.

In recent days, bank officials have, through speeches and background comments, prepared markets for a possible rise in the overnight call rate from 0.25 per cent to 0.5 per cent. That has elicited a strong counter-offensive from the administration of Shinzo Abe, prime minister, which says it is premature to raise rates before Japan has definitively escaped from deflation.

(...)

Local media quoted unnamed sources Wednesday suggesting the BoJ might be willing to hold off raising rates. The bank is in a blackout period and strictly forbidden from making any comment.

Overnight swap futures immediately reacted, suggesting there was a 40 per cent chance of a rate rise Thursday against the 80 per cent likelihood they were factoring in a few days ago. The benchmark 10-year Japanese government bond rose, pushing the yield down 6bp to 1.675 per cent. The yen weakened to a 13-month low of Y120.80 against the dollar.

Jesper Koll, economist at Merrill Lynch, said: “This is a blackout period. The BoJ should launch an investigation into how this got out.” He added: “If the BoJ doesn’t raise rates [Thursday], they’ve clearly caved in to political pressure and have given control [of monetary policy] to the politicians. They have lost control of the debate.”

Of course this is a lot about communications and essentially how the BOJ is in fact and most definitely caught between a rock and a hard place. We all want and need to see a raise but what if expectations are just off here? I mean, would it be so hard just to state the obvious here and look at the fundamentals which simply don't merit a raise at this point. Moreover, we need to ask ourselves what really is the key to the Japanese economy at this point and then I believe we could begin to let expectations correct to the much allured fundamentals. Lastly, I want to point you to the aggregate blog of me and Edward Hugh's posts on Japan which pretty much has been predicting this a year now; so expectations have not been off all over the board it would seem.

Japan in a Quandry

To raise or not to raise, that is the question, for the BoJ at least. This seems to be just one more between a rock and a hard place situation. According to Bloomberg:

The Bank of Japan may raise its benchmark lending rate from 0.25 percent, stepping up efforts to head off an investment bubble.

The reason for the fear is not a sudden and excessive rise in consumer related activity (like construction) but a rapid build up in investment (which means more capacity, capacity for which the demand may be lacking in sufficient quantity):

Large companies plan to increase investment in the year ending March 31 by the fastest pace since 1991, the central bank's quarterly business survey showed in December.

``Short-term interest rates are exceptionally low in Japan, in particular against the backdrop of the much improved structural situation of the economy,'' said Jan Lambregts, head of Asian research at Rabobank International in Hong Kong.

Now it is important to keep in mind here that Japan's recent growth spurt is largely driven by export demand, and the investment activity needed to sustain this dynamic. Domestic consumption still remains extraordinarily weak (and the reason for this may well be the age structure of Japan's population, as I attempt to argue here):

Some economists said the bank may postpone a rate increase until February so that it can confirm a revival in consumer spending when the government releases its gross domestic product statistics in mid-February. The 0.9 percent drop in consumer spending was the main drag on growth in the third quarter.

Now obviously containing animal spirits on the investment side is important, but what of the impact of any coming rate hike on domestic consumption, the deflation issue, and of course the costs of servicing Japan's enormous public debt?

A one-percentage-point gain in the yield on Japan's benchmark 10-year bond would increase the country's debt-servicing costs by about 1.6 trillion yen next fiscal year, the finance ministry estimated in December.

The deflation isssue should not be treated lightly, in particular since, as MS's Takehiro Sato pointed out last Friday:

Fundamentals are favorable, but there are a number of headaches for policy makers. Since oil prices are dropping faster than expected, the possibility of a drop into negative territory for the CPI is moving beyond just a risk and becoming the main scenario.

All in all, confrontation may well be looming, between the Japanese government and the BoJ, and if it is not very careful the bank may gain short term advantage by damping down excess investment only at the price of provoking a return to deflation and a loss of its credibility and independence in the longer term.