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Japan likely to return to slow growth in 2015

At the heart of the Japanese economy, there seems to be a conflict between the hope of policy and the reality of demographics. Japan's population is aging, not growing and the labor force is stagnant. Countries without any labor force growth lose a key contributor to economic growth, a factor that helped fuel their halcyon times of elevated growth. One can argue arithmetically (i.e., not causal) that long-term average real GDP expansion is the sum of the growth in the labor force and labor productivity. Take away labor force growth and one is left with the prospect of 1% to 2% real gross domestic product growth on average, unless there are major surprises in labor productivity. That is not to say it cannot happen, but a sharp and sustained upsurge in labor productivity is not easy for an already modernized and capital-intensive economy. Moreover, a depreciating exchange rate, quantitative easing, or an expansive fiscal policy are not likely to have a long-term, sustained impact on average growth in labor productivity.

Fears of deflation and growth prospects

Much of the logic behind Abenomics has been the concept that if the psychology of deflation could be beaten, consumer spending would increase at a more rapid rate and potentially drive real GDP growth back toward the higher levels of the 1970s and 1980s. Certainly, there is a case to be made that rising inflation expectations can bring consumption demand forward in time to beat the anticipated price increases. This pattern of economic behavior was on full display before and after the April 1, 2014, rise in the national sales tax. Consumption and real GDP surged in the January-March 2014 quarter, only to be totally offset by a corresponding decline in real GDP in the post-tax April-June quarter. Indeed, the lagged impact of the sales tax extended into the modestly negative performance of the July-September 2014 quarter. The sales tax increase was a one-off event, and the tax-induced rise in inflation is quickly abating.

     There is a similar one-off nature with rising inflation expectations. If inflation expectation ratchets up from, say, 0% to 2%, then there would be some incentive to advance spending plans, which might help real GDP grow a little faster for one year, after which spending levels would probably have adjusted to the new, and assumed, relatively steady rate of inflation. Only if inflation keeps rising will the incentive to increase current spending to avoid unexpected price increases remain in place. This approach to encouraging economic growth does not represent a sustainable plan.

Currency depreciation as the main weapon against deflation

Over the longer-term, sustained weakness in the Japanese yen (against the U.S. dollar) is likely to be the main driver of inflation. The yen-dollar rate was in a trading range from 78-80 in mid-2012, prior to the election of Prime Minister Shinzo Abe in December 2012. His promise of more aggressive policies sent the yen-dollar rate to the 98-102 trading range by April 2013, where it remained for many months. As the promise of Abenomics faded in 2014, another round of yen weakness ensued, taking the yen-dollar to the 118-122 trading range. Compared to mid-2012, the yen has declined some 50% against the U.S. dollar from the yen-dollar perspective. This steep currency depreciation can work through the system with some important lags and eventually lead to an increase in measured inflation. This time around, the likely inflation increase from the currency depreciation may be partly offset by falling oil prices. Japan is a big energy importer so the sharp drop in crude oil can provide a partial counterweight to the falling yen.

Japanese stocks and the yen

A more dependable relationship with the currency trend has been the performance of Japanese stocks. Japanese companies have massive operations outside of Japan and huge holdings of non-yen assets in the form of property, capital and even securities. When the yen weakens against the U.S. dollar, in yen terms there is revaluation upward on the large non-yen assets on the books of Japanese multinational companies. In short, one does not need to project future export increases from Japan due to a weaker currency to see why Japanese stocks have performed so well during the period of yen weakness.

     Indeed, we would argue that only small increases in exports are likely due to yen weakness. Japanese companies have a time-honored tradition of placing a very high value on market share. The yen weakness will give some companies a chance to either raise yen prices or keep yen prices more or less the same and try to gain market share. It is probable that many will opt for the latter.

Japan's debt burden

Japan has among the world's highest debt burdens. Public debt is close to 250% of GDP, to which household and non-financial corporate debt add an additional 66% and 102%, respectively. This brings total debt to GDP at 411%, the highest level in the world. The good news is two-fold: 1) these debts are financed almost entirely from domestic savings, and 2) interest rates are close to zero, even as far up as the 10-year point on the yield curve. The bad news is that the scope for generating growth by taking on higher levels of leverage may be somewhat limited. Moreover, the high levels of debt underscore the necessity of easy monetary policy. On the one hand, were policy to tighten, the burden of servicing the debt would quickly become unbearable. On the other hand, the only way to safely reduce debt levels (without the risk of widespread defaults) is to create positive nominal GDP growth.

     Interestingly, the purchases of Japanese Government Bonds by the Bank of Japan effectively removes a significant portion of outstanding government debt from private markets. If one used a consolidated accounting approach in which the national balance sheet merged the Ministry of Finance debt issuance with the Bank of Japan's debt ownership, then one would observe a substantial decline in government debt outstanding as a percent of GDP. Whether the credit rating agencies will take this consolidated approach into consideration is not clear; however, from our perspective, quantitative easing in Japan is reducing the country's credit risk while it increases the country's exchange rate risk and probably reduces the depth and liquidity of the government debt (JGB) markets.

     Our last observation relative to the Bank of Japan's quantitative easing program is that as long as the BOJ is buying huge quantities of JGBs every month, it probably would not pay to expect rising bond yields. Central banks are not profit maximizing market players, and can create money to pay their bills regardless of whether their investments have gains or losses.

     The bottom line is that we are not optimistic about Japanese growth. A stagnant labor force means that productivity growth will be the only long-term driver of real GDP. Moreover, already high levels of debt limit the scope for increasing public or private sector leverage as a means of stimulating economic growth. The weakness of the yen, however, will improve the terms of trade, making Japan more competitive and also increasing the likelihood that Japan will keep its inflation rate above zero, even in the absence of further hikes to the national sales tax. Keeping inflation and real GDP growth positive will be essential in managing Japan's debt burden.

Erik Norland is a senior economist at CME Group.

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