The common perception as to why the Japanese economy is challenged is centred on the low or no growth the country has achieved since its heyday during the 1980s.
Growth rates did struggle initially after this period, but Japan has grown in real (inflation-adjusted) terms at a similar level to many key European countries – including the UK – over the past decade.
The real issue is debt. As with any debt, interest needs to be paid and buyers of debt issued have to be found. In spite of being the first country to have the ultra-low bond yields that are now so prevalent across the global financial markets, more than 15 per cent of Japanese tax revenue goes on paying the interest on the accumulated government debt every year.
Interestingly, this statistic is not dissimilar to the equivalent one for the US in spite of Japanese 10-year bond yields being materially lower. The reason for this is the sheer magnitude of Japanese government debt which, as a proportion of GDP, is clearly the highest among the larger and more economically developed countries of the world.
So why is Japan the biggest economic experiment in the world?
Simply because without very careful economic management it could be the first major and significant economy to face a debt default threat of this generation. This is no Greece – a country whose GDP is a per cent or so of the eurozone’s GDP; no, this is the only Asian country that even has the remotest chance today of looking the Chinese economy square in the face. So this matters.
So Japan is faced with a careful economic management challenge or ‘experiment’. It has to stop its debt levels rising and the only way it can do this is by running a national budget that is much closer to balance, using inflation to reduce debts in today’s money terms or by defaulting.
As far as I can see the Japanese authorities are undertaking the first two in order to avoid the third.
In early November, the country’s central bank ramped up its quantitative easing (QE) programme. So why is this so different from a whole range of other countries that have used the QE policy to underpin and boost local economies?
The difference is the sheer size now of the Bank of Japan’s balance sheet compared to other major global central banks. Try 50 per cent plus of the country’s GDP versus nearer 20 per cent for the Federal Reserve, Bank of England or the European Central Bank. That’s an economy much closer to the edge and a big reason why the yen is sliding on the global foreign exchange markets.
And the reason for this? First, it is the extreme efforts being put in to generate a local, underlying rate of inflation of roughly 2 per cent to help inflate away some of the debt. Second, it is a policy that is trying to offset the impact of the now delayed hike in taxation levels.
It is hard to cut spending and Japan with its ageing population will find it harder than most. So the only solution will be to raise taxes. One sales tax increase has already been passed and another was in the offing. Higher taxes are never good for spending levels, with the first tax increase inducing a gut-wrenching pause in the Japanese economy.
There is no reason to think the second would not have had a similar effect. And with fewer people spending and companies investing, it will get harder and harder for the Japanese government to hit the tax receipt targets it is hoping for. That is one difficult balancing act and arguably one that over time will fail to provide a stable and sustainable backdrop. That is why a few years down the track the default option still lingers.
So should investors ignore Japan? On the contrary, investors should redouble their interest in the country. All of the above issues could be applicable to many other countries – especially in Europe – in a few years’ time. And what about investments in the country? The one flipside of a lower yen and a volatile domestic economy is that Japanese companies with global sales and profits are going to have an easier time. Keep the focus on these names as the experiment unfolds.
Chris Bailey is European strategist at Raymond James Euro Equities
Expert view
James Dowey, chief economist at Neptune Investment Management, comments on the snap election called by prime minister Shinzo Abe:
“We believe that this will prove to be a very positive development for Japanese equities. This is because delaying the sales tax hike is good economics and calling a snap election for next month is good politics.
What we now know about the first part of the sales tax hike in April is that it had a substantial negative effect on the economy, both in terms of growth – as third-quarter GDP data underlines – but also, more importantly, in terms of working against one of the main goals of Abenomics: to raise the inflation rate to a sustained 2 per cent a year. It makes sense to get the inflation job done first and then hike VAT later, given that the effect of delaying the hike on fiscal sustainability is very small (adding probably less than 1 per cent to Japan’s government debt-to-GDP ratio).
Politically, this is a good moment for [Mr] Abe to consolidate power. His opponents are at present extremely weak – support for the opposition Democratic Party of Japan is currently around 6 per cent of the electorate, and minority parties are highly fragmented – and this election is likely to play domestically as a show of strength.”
