TOKYO -- The biggest cause of the financial and capital market turbulence that has swept the world this year is China's economic slowdown. One of its biggest victims could be Abenomics, the vaunted economic policy agenda being promoted by Japanese Prime Minister Shinzo Abe.
If China remains in a funk, Abe may have to abandon his vision of a "painless economic revival" -- which relies on the Bank of Japan's monetary policy for stoking growth and using the resultant boost in tax revenue to fix the government's fiscal woes.
This may hurt
China has enormous excess capacity in manufacturing mainly because of the massive public spending by the government to keep the economy growing amid the global recession that began in 2008.
The Chinese steel industry, for instance, can churn out 1.2 billion tons annually but is currently using only two-thirds of its capacity. The auto industry, which can manufacture 38 million cars a year, has excess capacity of nearly 40%.
With those kind of numbers, a long and painful capacity adjustment is inevitable.
Finance Minister Lou Jiwei has said China's economy is in for five painful years of structural changes. Companies curb investment when trimming capacity. When it happens on a big scale, the entire economy is dragged lower. All the while, companies tend to cut the prices of their products to keep their factories running. The weakening of the Chinese currency, the yuan, only accelerates the trend.
As the world's second-largest exporter to China and third-largest importer from the country, Japan is bound to take a direct hit from its neighbor's economic shift.
China's downturn and the U.S. Federal Reserve's move to raise interest rates will keep prices of oil and other commodities depressed for the foreseeable future, hurting the economies of resources-dependent countries. With less money to spend, commodity exporters will also curb imports, denting global trade.
Lower resource prices are a boon for Japan, which imports huge amounts of oil and other materials to keep its economy running. But the global fallout from China's slowdown could offset all those price benefits. Indeed, it threatens to render the BOJ's 2% inflation target -- and, by extension, Abe's economic vision -- unattainable.
For starters, the targets of average real economic growth of 2% and nominal growth of 3% the administration has set for the period until 2020 are too ambitious. Japan's potential economic growth rate, as estimated by the Cabinet Office, is a much lower 0.5% due to, among other factors, a shrinking working population.
The BOJ decided last week to introduce negative interest rates, which means charging fees on deposits held by commercial banks in current accounts at the central bank. The move is partly aimed at encouraging companies to raise wages. But with the global economic outlook growing murkier, companies are hardly in a mood to hike their pay. And if wages stagnate, so too will the domestic economy.
The BOJ's aggressive monetary expansion over the past 34 months has helped weaken the yen and drive up stock prices. But the extremely easy monetary policy has done little to pump up economic growth. Since Abe took office about three years ago, Japan's average economic growth has been slightly less than 0.8%.
Furthermore, the central bank's large-scale monetary expansion risks triggering a fiscal crisis by sending interest rates soaring when the policy is ended.
Faced with these dangers, the government needs to overhaul its economic policy. That includes lowering the real growth target to around 1% -- in line with many private forecasts -- and focusing its growth-oriented policy efforts on more practical measures, such as supporting technological innovation.
Yoko Takeda, chief economist at Mitsubishi Research Institute, said Japan should "not take lightly" the implications of China's economic policy shift toward innovation-driven economic development.
Last year, Beijing decided on two plans to unleash a new wave of technological innovation: "Made in China 2025" and "Internet Plus." Both are designed to help create sophisticated and competitive products and services by integrating the Internet and manufacturing.
While working to reduce excess capacity in the steel and other traditional sectors, Chinese policymakers are also trying to help high-tech industries, such as robotics, sophisticated machine tools and aerospace, catch up with their rivals in advanced economies. The technological prowess of a country that has a successful manned space mission under its belt should not be underestimated.
The main drivers of Japan's economic growth in the coming years will also be cutting-edge technologies, such as artificial intelligence, robots, the Internet of Things and regenerative medicine. If Japan can use these technologies to boost its competitiveness and productivity and create new demand, economic growth will come faster. If, on the other hand, Japan lags behind China and others in these areas, its economy will struggle to achieve even 1% growth.
Social security revamp
If policy decisions are made based on the assumption of 1% average real annual growth, the government needs to radically reform its social security spending, which is huge and growing rapidly. Social security benefits that can no longer be financed by the economy have to be reduced, all while giving consideration to the needs of low-income earners.
Under the public health care insurance program, for instance, patients ages 70-74 are required to pay only 10-20% of their medical expenses out of pocket, lower than the 30% workers must pay. Also, pensioners are eligible for generous tax breaks, creating serious inequality in the tax burden between generations.
These are just a few of the many social security problems that need to be addressed.
Japan has a capable and patient population, and possesses the technology and money necessary for healthy economic growth. Even if China's slide triggers prolonged global stagnation, Japan still has a chance to rejuvenate its economy.
Accomplishing that requires the right economic policy and the political will to implement it.