Abenomics must overcome one crucial flaw

Abenomics is all the rage.

• Japan grew at 3.5% in the first quarter;
• The stock market is up; and
• Sentiments, consumption, and exports are all picking up – even if recent stock-market performance has created some uncertainties.

But negative inflation is still present.

• March 2013 CPI inflation was -0.9% (year on year), down from -0.6% in February.
• Survey-based inflation expectations are flat.

Although the market inflation expectation (break-even inflation rate) had increased from 1.3% in April to 1.9% in mid-May, it recently declined to 1.4% (as of June 6) (Figure 1).

Figure 1. Headline inflation in Japan (% change year-on-year)

Source: Bank of Japan, Statistics Bureau of Japan.

Why is the CPI still falling? The answer crucially hinges upon the implementation of structural reforms, especially in the labour market.

Labour-market reform is the key

According to a survey by Reuters in February, 85% of responding firms said they would maintain current wage levels or make further cuts this year. Japanese companies typically resort to wage cuts for workers with so-called life-long employment contracts rather than lay-offs to adjust for cyclical downturns or due to tougher price competition from abroad. As a result, the unemployment rate has been low, but wages continue to decline. Due to the strong protection of permanent workers, firms typically have redundant permanent workers, thus have no incentive to increase their wages.
Worse yet, only a third of the Japanese labour force (typically older and male labour) has a permanent contract. The majority of the young and female labour force is working under a temporary contract with much lower salary and practically no job security, which creates a kind of caste system in the labour market.

A permanent contract is especially hard to come-by for the younger generation and female workers. The youth unemployment rate in Japan is 8% (the total unemployment rate is 4.8%) as of 2011 according to the OECD, and the wage gap between male and female is the second worst among OECD economies.

Three pillars

Abenomics is comprised of three pillars:

• Aggressive monetary policy easing (Figure 2).
• Fiscal stimulus.
• Structural reforms.

Figure 2. Expanding balance sheet of the Bank of Japan

Source: Bank of Japan, Statistics Bureau of Japan.

The last piece of the three pillars – structural reforms – will not be fully implemented until late summer or fall, because the Upper-House is still dominated by the opposition party, the Social Democratic Party of Japan, making it difficult to pass reform bills.

Presently, Mr Abe’s structural reform plan is still at a conceptual level and lacks a clear strategy to achieve the intended goal. Given the extraordinarily high (by Japan’s standard) approval rating of Prime Minister Abe (exceeding 70%), it is expected that the Liberal Democratic Party of Japan will win a landslide victory in the July election. Only after will most of the details of the structural reforms be clearly spelled out and (possibly) implemented.

A few details are already known, including entering trade talks known as the Trans-Pacific Strategic Economic Partnership and deregulations of certain sectors, such as agriculture and medical care. These supply-side reforms can push up Japan’s potential output in the long run, but some of them can cause deflationary pressures in the short run.

The most urgent reform to reflate the economy and enhance growth needs to occur in the labour market. Despite impressive GDP growth in Q1, the unemployment rate and the job-to-applicant ratio has remained largely unchanged since Mr Abe took office. Breaking the labour-market rigidities, and allowing females and young people to be properly trained and enter the job market with a decent wage and job security will be pivotal to achieve sustainable growth without causing deflation. Also, from this perspective, the proposed tax reform for 2013 – which allows companies to claim a 10% tax credit when they raise wages by 5% or more from the base year – is a welcome development.

True, consumption went up in Q1, but a large part of it has been spent on luxurious goods and/or durable products, supported by capital gains from the stock market surge – thus, it may not be sustainable. With capital gains, many (rich) consumers are spending money on luxury products from abroad, such as European cars and high-end apparel. This partly explains why the trade deficit in April worsened despite the country’s strong export growth.

True, the stock market is bullish amid some recent volatility, but only a handful of Japanese households park their money in stock markets – most of them still prefer a conventional bank deposit which earns little interest. In Japan, cash and deposits represent half of the total household financial assets, whereas the equivalent figure for the US and Europe is 16% and 30%, respectively (Nakawaga and Yasui 2009).

Wages are the most important component of a disposable income by far. Thus, inflation without wage increases will only hurt the poor, or inflation might not happen at all without wage increases as normal households hold back on spending. This further underlines the need for labour-market reforms.

Don’t forget the public debt

Many have been ringing an alarm about Japan’s looming public debt. So far, Japan managed to defy gravity (Figures 3a and 3b). Ito and Hoshi (2012) claimed that this is because investors know that there is still ample room left for revenue increases – the tax burden is still low in Japan compared to the OECD average, and the scope for increasing the tax base is sizeable. However, this does not justify complacency. The administration should come up with a credible medium-term fiscal consolidation plan that walks a tight rope between growth and fiscal consolidation. Especially, the planned consumption tax raise in the coming two years should be implemented without delay. Given the large uncertainty and anxiety over Japan’s fiscal sustainability, a credible fiscal consolidation plan can be growth-enhancing. Fiscal consolidation in Denmark (1982-86), Ireland (1987-1990), Finland (1992-98) and Sweden (1993-98) were associated with economic expansion. While expansions in Ireland and Finland were driven by exchange rate-based stabilisation, in Denmark expansion was driven by internal demand (Perrotti 2011).

The poor fiscal outlook also affects consumer confidence. Japanese citizens have been, and increasingly are, worried about the country’s pension system. With public debt ballooning, the younger generation is sceptical about whether they can actually receive pension benefits when their retirement comes. As a result, instead of contributing to the national pension system, they save money to prepare for their own retirement.  As of January 2013, the payment rate of national pension premiums is just 58%,creating a vicious cycle that affects the sustainability of the national pension system.

Figure 3a. Basic indicators of government debt

Source: Author’s calculation based on data from IMF-IFS and Reuters. The yield is as of June 6, 2013.

Figure 3b. Government debt-to-GDP ratio and ten-year government bond yield of advanced economies

Source: Author’s calculation based on data from IMF-IFS and Reuters. The yield is as of June 6, 2013.

Conclusion

Abenomics appears to be thriving so far, and now could be the time for Japan to emerge of its long-lasting economic stagnation. While the bold policy shift of the Bank of Japan received some credit, monetary policy alone will not bring growth and 2% inflation. Moreover, inflation alone does not bring sustainable growth without proper structural reforms in place.

The success of Abenomics crucially hinges upon the last pillar of ‘three pillars’ – namely, structural reform. It is yet to be revealed how Mr Abe will turn his talk of structural reforms into actual implementation.

Needless to say, political continuity is a crucial factor for structural reform. Japan has had seven prime ministers since 2006, and Mr Abe’s last term lasted for just a little less than a year. In addition, while the previous structural reforms implemented by Mr Koizumi (Prime Minister from 2001 to 2006) produced some benefits, its focus on deregulation also came with high costs due to a larger income disparity and the creation of the working poor, who hold low-wage (less than ¥2 million (approx. $19,000 per year), temporary jobs with few benefits. It is estimated that 20% of Japanese workforce falls under this category.

According to the OECD, Japan’s in-work poverty is fifth worst among the OECD economies. Mr Abe’s structural reforms should specifically focus on the labour market, including removing labour-market rigidities, fostering equal job access for the youth and the female labour force, and providing improved job security for the ‘working poor’.

Note: The opinions expressed here are solely the ones of the author’s and do not necessarily reflect the view of De Nederlandsche Bank. The author thanks Peter van Els and Hiro Ito for their valuable comments.

This article originally appeared in voxeu.org

Author: Ayako Saiki Economist, De Nederlandsche Bank

Image: A japanese flag is seen atop the Bank of Japan building in Tokyo REUTERS/Toru Hanai