While Japan no longer attracts much attention these days, it is still the worlds third-largest economy, with a gross domestic product equal to France, Italy, Spain, and Portugal combined. Its industries still pose the main competitive challenge to U.S., European and Korean manufacturers, and its regional weight is still sufficient to trigger financial crises across the whole of Asiaas it did in 1997.
To make matters worse, the Japanese government bond market is in an enormous financial bubble that could burst catastrophically if Prime Minister Shinzo Abes audacious economic program is seen to have failed.
I was an early enthusiast for Abenomics, but I became alarmed about Japans prospects last October, when Abe decided to impose a massive tax hike on consumers beginning in April this year. With this crunch point now approaching, I travelled to Japan to get a first-hand feel for economic conditions. What I saw and heard from financiers, businesses and officials has heightened my concerns.
Abenomics was initially a promising program because it seemed to pierce the complacency of previous governments with its three arrows of radical economic policymonetary expansion, fiscal stimulus, and structural reform.
By last October, however, two of these three arrows were veering off course. Structural reforms in labour regulation, corporate governance, competition policy and pension management had already been abandoned or delayed sine die in the summer. When Abe bowed to the longstanding demand from Japans powerful Ministry of Finance for a doubling of Japans consumption tax, his fiscal arrow was transformed into a boomerang, threatening the hopes of economic acceleration in 2014 and 2015.
This boomerang will hit Japan on April 1, when the consumption tax jumps from 5% to 8%, and again in October 2015, when it will rise again, to 10%. The result will be a fiscal tightening worth roughly 2.5% of GDP this year, plus another worth 1% in 2015, according to IMF estimates confirmed by unpublished projections from the Ministry of Finance. This fiscal squeezealmost exactly equal to those in Britain in 2011 (2.4%) and Italy in 2012 (2.2%)will cut Japans economic growth from 2.5% in 2013 to 1.4%, according to official forecasts.
The reality, however, could be much worse. Private sector forecasts collated by the ministry point to just 0.8% growth this year. Even that is probably over-optimistic, since many private forecasts still reflect hopes of various growth-promoting measures that could, in theory, be implemented to offset Aprils tax hikes.
Such hopes can be divided into six broad categories, all of which now seem quite forlorn:
* Structural reforms to stimulate investment, productivity, and hiring. Although there are more than 30 reform bills on structural issues now going through the Diet, ranging from mild encouragements for women in the workforce to rationalizing rice farming, most of these have disappointed expectations and none will likely have any significant impact on growth in the next year or two.
* Pay increases of 3% or more could, in principle, have compensated workers for higher taxes. This week, however, the annual pay deals at Toyota and Hitachi showed basic wages rising less than 1%, even in the most profitable companies. While many Japanese workers can expect substantial bonuses and seniority payments, experience suggests that basic wages are the main determinant of consumer spending and these will be declining in real terms once the higher consumption tax bites.
* Corporate tax cuts were widely mooted last year to encourage investment and to offset fiscal drag. But they have been rejected for two reasons. First, because reducing corporate taxes would defeat the purpose of the consumption tax hike, which is to expand the governments long-term revenues. Second, and less creditably, because the Ministry of Finance and the ruling Liberal Democratic Party (LDP) both have a natural institutional bias to maximising taxes, and then offsetting the deflationary economic effects by spending money on public works, which increases the ministrys bureaucratic influence and the LDPs political patronage powers.
* Additional public works spending has been announced to the tune of 5 trillion yen. But this only maintains the increased levels of investment already implemented in 2013. Although further supplementary budgets are likely if growth suffers after the tax hike, the governments ability to spend more money on public works is already constrained by lack of suitable projects, shortages of construction workers, and bottlenecks in materials such as cement.
* Regulatory measures could be attempted to pump up the Tokyo stock market in the hope of boosting consumer confidence, but the scope is limited by the disappointing review last November of the $1 trillion Government Pension and Investment Fund. This was expected to recommend a big shift from bonds into equities, producing a surge of demand for Japanese shares. But bureaucratic resistance within the GPIF resulted in only a marginal shift in asset allocationand no further reviews are now planned until 2015.
* More aggressive monetary expansion will be the final recourse, if the Japanese economy suffers a serious slowdown. But the Bank of Japan is already committed to doubling its balance sheet by the end of 2014, and it is far from clear that simply expanding bond purchases would have much effect on growth. An alternative might be for the Bank of Japan to try to boost the stock market by buying shares instead of bonds. But would pumping up share prices really do much for growth
In short, Japan seems to have no convincing options if next months tax hike precipitates an economic slump. Of course, everyone hopes that this will not happen.
But hope is not a strategy.