OpinionJul 3 2014

Growth II

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Not everyone loves a remake, as they know what to expect. This year’s Godzilla movie was more of the same if you have seen the 1954 original, a charge that could be levelled at Japanese prime minister Shinzo Abe’s latest reboot.

When Mr Abe announced his new ‘revved up’ growth strategy, there was little reaction from markets as it was very much a follow-up to the original published about a year ago. But while the announcement may not be considered a bullseye for the latest arrow, at least it is on the board. What we have is a credible plan focused on increasing flagging productivity within the Japanese economy, while setting Japan towards sustainable economic growth.

Last year’s original ‘third arrow’ was light on detail and timeframes, and failed to excite those foreign investors who had been pouring money into Japanese equities on the back of massive monetary stimulus. But back then Abe was on the cusp of an election, so was perhaps more cautious about revealing his grand plans for the country. The new strategy has more detail than the original (in most areas) and seeks to tackle Japan’s weak productivity through a variety of measures, but chiefly by addressing corporate governance, tax rates and labour market reforms.

Japan’s economy has suffered from a lack of productivity, as its population ages and its workforce diminishes. To get the most out of the existing labour market, companies need to invest in capital to drive productivity rather than sitting on piles of cash. This is where corporate governance comes in. By asking companies to justify their investment decisions through a new corporate governance code, it is hoped the result will ensure that companies put cash to better use while reducing the pressure to pay shareholders higher dividends. This should lead to increased productivity and profitability of companies, but only if they follow the code. Profitability, as measured by return on equity, or what level of profits companies are generating with shareholder cash, has lagged behind US companies for more than a decade, much to the annoyance of Japanese equity investors.

The corporate tax rate will likely be gradually reduced to entice companies to set up in Japan and increase Japan’s attractiveness on the world stage. It worked for Ireland. At 35.6 per cent, Japan has one of the highest corporate tax rates in the developed world (the UK’s is 21 per cent), but this rate will fall below 30 per cent over the next few years. However, when your country is running a debt-to-GDP ratio of more than 200 per cent, cutting the tax rate without having a replacement source of revenue may seem like a leap of faith.

Labour market reform is the key component of the country’s economic revival. Unemployment has fallen to 3.6 per cent, the lowest since 2007, but is still above the heady days of the 1990s when the rate was a paltry 2 per cent. The decline in unemployment has been faster than anticipated, thanks to the first two arrows, but it highlights the challenge Shinzo Abe faces. The labour supply has been in steady decline because of demographic shifts, and the problem is not demand but an increase in supply. Looser immigration would help to solve the labour shortage, but in this area reform is still rather light. That said, Mr Abe’s latest growth strategy also announced plans to expand the use of robots to boost productivity, a very Japanese solution to the problem.

Presently, the labour market is extremely rigid and employers find it difficult to let workers go in austere times, because of the strength of employment contracts. The more transparent and flexible labour market envisaged under Abe’s new growth strategy should mean greater flexibility and increased productivity.

Presently, the labour market is extremely rigid and employers find it difficult to let workers go in austere times

Earlier this year, much was made over plans to reform the huge Government Pension Investment Fund and for it to have greater exposure to equities. It looks likely that this will now happen, and an announcement on a new asset allocation is imminent. The new allocation may see the GPIF raise its stake in domestic equities to closer to 20 per cent from the current 12 per cent.

Remakes rarely improve on the original, but while the enhanced growth strategy did not wow the markets, prime minister Abe’s significant political will — and clout — to push the reform agenda still holds a lot of promise. But it will take time to see the specific measures of the strategy lead to an increase in productivity. The focus of markets, and market watchers, will really be on whether Japan can ascend to the lofty goals that Abenomics has set.

Kerry Craig is global market strategist for JP Morgan Asset Management