How Japan is managing economic uncertainty

However, our view is that a rise in investor appetite will be driven by the steady recovery of the economy, for which we are seeing positive signs, and policymakers’ willingness to maintain an accommodative monetary policy.

Of course, we need to continue to pay close attention to risks, such as soaring energy costs and commodity prices, but we believe Japan is well positioned to absorb these and Japanese business is set to see positive results based on increased investment activity – creating an attractive investment proposition for foreign investors over the coming months. 

Outlook on the Japanese economy

Despite the uncertain times we are living in, we are optimistic about Japan’s economic recovery and growth. When it comes to the global economy, we expect momentum to pick up after a temporary slowdown due to the Covid-19 Omicron wave in the first quarter of 2022.

However, the big question now is how the Ukraine crisis could affect global growth. We estimate the negative impact on global growth will be -0.7 per cent over a two-year period (2022-23), assuming oil prices peak at around $120 (£93) per barrel. The negative impact will differ greatly by country and region, depending on their economic and financial exposure to Russia.

 With inflation (excluding food and energy prices) still close to zero, changes in monetary policy, if any, should be very limited. 

We project that Japan could grow by more than 2 per cent in 2022. Japan has a relatively low exposure to Russia and limited reliance on Russian trade. Russia accounted for only 1 per cent of Japan’s exports and 1.8 per cent of its imports last year.

As for Japanese banks, their exposure to Russia at the end of September 2021 was around $9.6bn, lower than the US and some European economies such as Italy whose exposures are $14.7bn and $25.3bn respectively. The negative impact of the Ukraine crisis on Japan will largely be through higher commodity prices, particularly the price of crude oil. 

According to Japan’s Cabinet Office’s models, a 20 per cent rise in the price of crude oil would depress Japan’s real GDP by 0.08 per cent, so a 20 per cent to 30 per cent rise in energy prices would only mean around a 0.2 per cent reduction in Japan’s real GDP growth. Therefore, while the impact of steeper energy prices is not negligible, it is manageable, and still means Japan’s economic growth could exceed 2 per cent in the current financial year.

Bank of Japan to maintain monetary policy

Due to changes in board membership, we expect the Bank of Japan (BoJ) board to become slightly less dovish. However, with inflation (excluding food and energy prices) still close to zero, changes in monetary policy, if any, should be very limited.

Next year, the BoJ may consider some changes but they are likely to be minimal, such as widening the range allowed by the BoJ for long-term interest rates.

Japan’s CPI inflation could accelerate to 1.9 per cent year-on-year in April according to our calculations, with energy accounting for 1.5 per cent and food prices contributing the remaining 0.4 per cent. After peaking mid-year, we expect CPI inflation in Japan to fluctuate between 1 per cent and 1.5 per cent. In other words, energy and food prices should have very little spillover effect on other sectors.

Despite some labour market tightness in Japan, an acceleration of wage growth as seen in the US is highly unlikely. In Japan, roughly half of the labour force are regular workers with long-term contracts whose compensation is revised only gradually. In addition, Japan experienced deflation for 15 years so people’s inflation expectation is very low.

Short-term and long-term interest rates are expected to stay low in Japan over the next two years. This would make Japan’s financial market unique among developed economies as low interest rates continue to make some risk assets interesting such as real estate and J-REITs.

Downside risks as rising commodity prices weigh on consumption

If commodity prices rise much more than our current assumptions, it could lead to a significant deterioration of Japan’s trade balance. In that case, the yen could decline much more sharply than we are expecting. In such an event, a 10 per cent depreciation in the yen could push up Japan’s inflation by 0.3 per cent to 0.4 per cent.

As things stand, we are expecting only a 5 per cent to 10 per cent decline in the yen, but if it depreciates by more than 30 per cent that would push Japan’s inflation higher.

 Short-term and long-term interest rates are expected to stay low in Japan over the next two years. 

If that were to occur, CPI inflation could stay somewhere between 1.5 per cent to 2 per cent, and that could be a reason for BoJ policymakers to consider more material changes to monetary policy, potentially changing the landscape of Japanese financial markets significantly.

In addition, as a country that imports most of its commodity supplies, the depreciation in the yen at a time when commodity prices are rising is effectively a consumption tax on Japanese consumers, which decreases their purchasing power. A further rise in commodity prices could result in weaker consumption.

However, this focuses only on the short term, and little attention has been paid to the significant capital gains on Japan's external assets (mostly denominated in foreign currencies) as a result of a weaker yen. Japan is the world's largest net foreign asset holder, which provides a macro hedge against the yen's depreciation.

Upside potential: increase in business investment

We must pay close attention to the increase in business investment by private companies for three reasons.

Firstly, despite the rise in import prices, the (non-financial) corporate sector is still looking highly profitable. This indicates that Japanese companies are either dealing well with higher commodity prices or are able to control costs.

Secondly, the sector is likely to replace old facilities in the coming years. Business investment activities have been lower in Japan than other countries in recent years, meaning that old facilities remain that will require replacement investment in the near future.

Finally, Japanese corporations are aware of the necessity to embrace digital transformation and reduce carbon emissions, and many have announced plans to increase investment in these key areas. 

Masayuki Kichikawa is chief macro strategist at Sumitomo Mitsui DS Asset Management