Miyuki Kashima, managing director and head of the Japanese equity investment division at BNY Mellon Asset Management Japan, reflects on the remarkable approach taken by Prime Minister Shinzo Abe and his government, and the potential once-in-a-generation transformation this could prompt for the long-suffering Japanese economy.
Amid questions about the sustainability of Abenomics, she argues it is the combined power of Abe's "three arrow" policy components that makes the success of his plan a genuine possibility. She says that it is important for investors to step back and see the bigger picture.
With a very high approval rating, the prime minister seems to have the luxury of time to push through his deflation-busting plans. Furthermore, with domestic ownership accounting for over 90% of the Japanese government bond market, he won't need to rely on the support of international bond market participants.
At the heart of Abe's plans lie a weaker Japanese yen, incentives to shift Japanese savers towards spending, and a greater deployment of women in the workforce to mitigate the challenges of an ageing population. Kashima emphasizes that the scale of Abe's plans is unlike anything Japan has seen before and therefore the boldness of his reforms could make the difference in moving beyond Japan's two decades of stagnation.
Since returning to power as Japan's prime minister in December 2012, almost six years since his previous term in office, Shinzo Abe has wasted no time in shaking the timbers upon which Japan's economy is built, with his distinctive reforms quickly dubbed "Abenomics." His three-pronged strategy for monetary, fiscal and growth reforms is referred to as his "three arrows." This refers to a legend from the prime minister's native region of Yamaguchi in Southern Japan: a lord asks each of his three sons to break an arrow in two; with some ease, this is achieved. He then challenges his sons to break three arrows at the same time and they all fail. The lesson is that one arrow can easily be broken, but three arrows together are unbreakable. Like the three arrows in the legend, Abe hopes that his unprecedented three-pronged policy will be too strong to fail in leading Japan to a new and improved economic reality.
The last time something transformational occurred within the Japanese economy was in the late 1980s when the government tackled Japan's overheated property market. At the time there was talk of introducing a high additional property tax of as much as 1% for large-scale real estate owners. That possibility, coupled with sharply increasing rates, caused asset markets — notably the highly correlated property and equity markets — to decline precipitously. In fact, by the time the property tax was introduced, asset prices were already in decline because of rising rates and the fear of higher taxes. In the event the tax was introduced at only 0.3%, promptly reduced to 0.1% and then suspended.
From a policy perspective, it was striking that the government was prepared to use both fiscal and monetary tools to deal with the bubble. After years of poor performance following the collapse of Japan's property bubble, we believe we are now in another transformational period for both the Japanese economy and equity market. Abe's government is deploying both monetary and fiscal tools to boost the economy, with the added stimulus of a new growth policy. More importantly, the scale of Abe's policies dwarfs those of the late 1980s.
The Three Arrows in Abe's Policy Quiver Consist of:
- Bold monetary policy
A target of 2% inflation and the doubling of the monetary base in two years
- Flexible fiscal policy
To date, a ¥10.3 trillion supplementary budget has been announced
- New growth policy
A focus on encouraging spending through tax breaks, deregulation and higher deployment of women in the workforce.
A strong Japanese yen impeding exports, deflation, and the resulting weakness in corporate earnings and the economy — these are the ills of the last 20 years that Abe is determined to reverse. Unprecedented in terms of speed and size, his policies are leaving few stones unturned in an effort to put Japan back on a growth path. Abe might also have the tide of history on his side: a usually conservative nation that has disliked rapid change appears ready to break away from two decades of stalemate. The landslide victory of Abe's Liberal Democratic Party (LDP) in December 2012 provided him with a strong political mandate to push through change.
Reflating the Economy
Following the collapse of Japan's property bubble, Japanese companies found themselves unable to borrow. A prolonged period of corporate and consumer deleveraging resulted. While deleveraging is often followed by recovery, in the case of Japan, a deflationary cycle took hold and the yen strengthened steadily versus all major currencies, impeding recovery. In this unique economic climate, the propensity of both individuals and companies to postpone purchasing decisions led to a self-reinforcing spiral. The more consumers and businesses delayed spending because of a slowdown in the economy, the longer the economic stagnation continued.
Long-term economic change will come about in Japan only if companies decide that return prospects are high enough for them to borrow money to invest, let alone invest the large cash piles upon which many companies currently sit (see Exhibits 1 and 2).
In other words, businesses decide it is wise to spend the money they make, and borrow once again, thereby replacing the government as the sole borrower of funds in Japan. Clearly, the most important measure of success will be if the Abe government achieves its inflation target of 2% to help end its long deflationary slumber.
Chart 1 // Japanese Companies Can Afford To Spend:
Corporate Savings as a % of Nominal GDP
Source: Bank of Japan, Bloomberg, June 2013
Meanwhile, the long-term strengthening of the yen versus most currencies and, in particular, the Korean won, has had a severe negative impact on the competitiveness of Japanese exporters. Abenomics entails commitments that the authorities will do whatever it takes to address the persistent problem of yen strength.
Chart 2 // Corporate Cash Pile:
Cash and Deposits Held By Non-Financial Corporations
Source: Bank of Japan, June 2013
As Abe Attempts To Reset Japan's Economy on a Sturdier Path To Growth, We Will Be Monitoring Three Areas of Reform for Progress:
1) Normalizing Investment and Lending
We believe the first visible sign of the long-term success of Abe's policies will be a normalization of company behavior as return prospects are improved, enhanced by healthier lending and borrowing conditions. Abe's hope is that stimulating corporate investment will eventually lead to an increase in borrowing. He has introduced tax incentives for companies hiring full-time workers and is working on plans for tax breaks as a means of boosting capital expenditure (CAPEX). More details are expected to be announced later in the summer of 2013.
A distinctive feature of Japan's situation is that despite the country's economic difficulties, its banking sector is now in excellent health and well capitalized. As such, banks have for many years been well placed to lend, but in practice neither households nor companies have wanted to borrow. The latest figures indicate that lending has been increasing as well as deposits, meaning that the absolute size of Japan's deposit base continues to grow.
Despite fears in some quarters, we do not believe Japan will enter a hyperinflationary environment because of an increase in the monetary supply from current monetary stimulus. Japan has a comparatively high net debt-to-GDP ratio of around 150%1 but, for now, it can afford to continue to issue more debt to kick-start the economy because banks' loan-to-deposit ratio is only 60%,2 and deposits are still growing faster than loans (see Exhibit 3); so banks are expected to continue to support the bond market.
Ultimately, it is Japan's huge surplus of bank deposits that has funded the massive expansion of the Japanese government bond market, which remains one of the world's largest in market capitalization. However, an important point of context is that the market is, by a very large majority, domestically owned. Indeed, foreigners own less than 10% of outstanding Japanese sovereign debt.3 This matters, because it means that Japan is far less reliant than many other developed economies on the sentiment of international investors to support its funding requirements.
Against this backdrop, what would be the implication of a sudden (and in our view highly unlikely) explosion in bank lending? We think the answer lies in the announcement by the Bank of Japan (BoJ) about its long-term commitment to supporting the bond market by further expanding the monetary base to continue buying Japanese government bonds. In other words, the central bank is committed to absorbing the effects of sovereign bond selling activity by commercial banks, if and when it happens. This, we believe, should be more than sufficient to maintain low market interest rates, and is why these developments are likely to play out over many years.
2) Social Reform
Japan's ageing population and related economic problems are well known. The working population aged 15-64 peaked in 1995 at 87 million4 and the government forecast says that number will decline to 44 million in 2060.5 To boost the size of the working population, Japan could opt to increase immigration. Abe is focusing on encouraging more Japanese women to enter the workforce to help boost the number of workers to help support an ageing population and to put more disposable income in the hands of households for spending.
Although legislative changes in 1986 were aimed at putting women on an equal employment footing to men, Japanese women are under-represented in the full-time employment market. This situation is gradually starting to change. For example, this year, for the first time ever, the proportion of female graduates offered jobs is exceeding that of males.6 However, as in other countries, a significant constraint on more women in the workplace is the lack of sufficient day-care facilities.
Indications are that 79% of women aged 35-39 want to go back to work after having children, but only 34% of them are actually able to do so.7 It is likely that insufficient day care is a contributing factor. According to the Japanese Ministry of Health, Labor and Welfare statistics, there were over 46,000 babies on the wait list to get into day care as of October 2012. The actual demand is estimated by the same ministry to be 850,000, more than 20 times that number, because many mothers give up looking.
According to the prime minister's official website, Abe aims to increase day-care availability by 200,000 places by March 2015, and a further 200,000 by March 2018. The Ministry of Health, Labor and Welfare's plan focuses on building smaller-scale daycare centers (which are easier to build and run) and provide subsidies to smaller private sector facilities.
Enabling women to play a larger role in the workforce might help offset the problem of a declining working-age population. At present, over 50% of women who work are part-timers (compared to 20% for men).8 In the Global Gender Gap Index, Japan, the world's third largest economy, ranks 101 out of 134 countries in terms of female economic participation and opportunity.
To move closer to the government's target of raising the participation of women in leadership positions to 30% by 2020, Abe has requested three core business federations/associations: KEIDANREN (Japan Business Federation), the Japan Chamber of Commerce and Industry, and the Japan Association of Corporate Executives, to encourage listed companies to proactively appoint women to management and director positions. As a first step, he has asked that they appoint at least one woman to their boards. This request made headlines since, according to the Japanese Cabinet Office, of the 3,608 listed Japanese companies, there were only 505 female directors as of May 2011.
As more women go to work, the hope is that higher household incomes will encourage larger families, another way to help mitigate Japan's demographic challenges. Boosting female employment was one of the earliest causes Abe championed as part of his plan to raise the potential growth rate from its current level below 1%. While most governments in the past have paid lip service to more women in the workforce, Abe is the first prime minister to make it a central part of his platform.
3) Business Reform
The third manifestation of the long-term success of Abe's policies will be tangible changes within Japanese corporate culture. A common complaint from the international business community is the difficulties of doing business in Japan. This sentiment is in fact shared by many Japanese companies. However, we believe that these problems have resulted primarily from the negative effects of overregulation; as such, we believe that internal and external investment should be boosted by pragmatic but careful deregulation.
An interesting example of Abe's determination to make Japan more "open for business" was his rapid decision to join the Trans-Pacific Partnership (a free-trade agreement between a number of countries, including the US). A shift toward free trade is clearly good for Japan, and Abe, unlike his predecessors, was able to achieve membership despite strong opposition from the established agricultural lobbying groups. We expect this development to raise the return prospects on investment, which should also support a return to more normalized behavior and investment by corporate Japan.
More broadly, while we believe that a small number of failures of corporate governance (such as the highly publicized Olympus accounting scandal of 2011) are isolated examples, there is a strong case to argue that Japanese corporate culture has long been in need of change. Fortunately, there are already signs that this is happening.
One of the many long-term consequences for Japan of the global financial crisis has been that some Japanese companies — struggling to break even — have been forced to do the previously unthinkable, and shed large numbers of workers. This, coupled with reform-driven increases in labor market flexibility, means that by and large Japanese workers can no longer expect to spend the majority of their career working for a single employer. The silver lining is that culturally, these developments have helped to foster an attitude among workers that says there is "something to work for," replacing the attitude that had previously dominated in which it was widely felt in workplaces across the country that, from an employee's perspective, there was only ever "something to lose."
In general, corporate governance in Japan is becoming "normalized" from an international perspective. Although many foreign institutional investors are underweight the Japanese market (see Exhibit 4) — notwithstanding that they own around 28% of the market,9 a record high — we believe that improving economic fundamentals should prompt greater international investment and, in turn, more "shareholder-friendly" polices. While mistrust of the notion that "it's all different this time" will be understandable among many foreign institutional investors, one irony is that Japanese investors are even more skeptical about the domestic market than foreign investors; indeed, some of the biggest sellers during the May 2013 sell-off were large Japanese trust banks.
Cultural change alone will be insufficient to help corporate Japan back onto its feet, though, and we believe that significant improvements in corporate governance are likely to remain something of a "slow burner." Once again, we return to the promise of Abe's multi-pronged approach, a key component of which is designed to support business reform by dampening the strength of the currency. Yen strength has been a serious constraint on Japan's competitiveness. When the US dollar has fallen to lows of 75 yen, it has been virtually impossible for many Japanese exporters to compete internationally, particularly with South Korea, which benefits from a weak currency and is a direct industrial and manufacturing rival. Furthermore, as the yen strengthened, investors had to keep assuming the trend would continue, thus lowering the potential return on capital and in turn overall CAPEX.
All of this said, we believe there is sometimes a tendency to overstate the importance to Japan of the export economy. As it stands, the contribution of exports to Japan's GDP is only around 15%.10 Against that backdrop, the improving economic health of the US — accompanied by any strengthening in the US dollar — should be beneficial for the rest of the world and, therefore, for Japan. Meanwhile, although we recognize the concerns of some investors, we do not believe the government's actions amount to engaging in currency wars. Rather, we believe efforts to suppress yen strength are a recognition of Japan's need for a break from the pernicious effects on exports of having a perpetually strong currency.
Abe's Unique Position
Prime Minister Abe's economic policies are beginning to show early signs of success, although it could be argued that, over the very short term, financial markets are focusing on the individual announcements of policy changes. There is also a palpable sense among the investment community that Abe is very much more market-aware than his predecessors. His appointment of the dynamic and pro-business new Bank of Japan governor, Haruhiko Kuroda, would appear to back up this thesis.
Furthermore, Abe's mandate and rate of support (running at around 67% approval in July 2013, according to some polls) position him ideally to make the necessary changes in Japan; for example, in relation to the level of Japanese fiscal spending that has been a source of much comment over recent decades. In part, high levels of public spending have been a by-product of the famously short tenures of many of the country's postwar political leaders. In this context, the timing of Abe's return to power was fortuitous, coming after a period in which the ruling Democratic Party of Japan had over-promised and failed to deliver.
Hitting the Target
Abe's task is enormous, but we believe it is the comprehensive combination of monetary, fiscal and regulatory levers, and the flexibility Abe has accorded himself in using them, that could make Abenomics succeed where others have failed. Monetary policy is boosting the stock market and reversing yen strength (see Exhibits 5 and 6). Abe's fiscal policy will help him push through the required tax changes and thereby lend support to areas such as construction, which should be a key beneficiary of rising capital expenditure in the long run. Finally, a concerted growth policy will help boost businesses in all segments of the economy.
Chart 5 // TOPIX: The Start of a New Phase?
Source: Bloomberg, June 2013
There are already early indications that his arrows are well aimed. For example, efforts to encourage large firms to award pay increases are showing signs of having had the desired effect; summer bonuses in 2013 increased by around 5% for manufacturers.11 Meanwhile, the government encouraged manufacturers to raise full-time pay for the new financial year (which started in April) and a meaningful proportion of large manufacturers did so, as their optimism was buoyed by a declining yen. The hope is that these pay increases will find their way back into the real economy.
Chart 6 // A Reversal in the Strength of the Japanese Yen? Yen Versus US Dollar
Source: Bloomberg, June 2013
We believe it is a mistake to focus on individual components of Abenomics. In our view, the sum of the parts is greater than the whole. So far, the market has probably only discounted the effects of Abe's monetary policy. Indeed, the equity market still has some way to go in terms of catching up with earnings per share (EPS) growth (see Exhibits 7 and 8). Consensus forecasts expect EPS to increase by over 40% this year,12 yet the market has hardly even caught up with last year's growth; we expect this to change. Furthermore, the flexibility of the economic and fiscal policies implemented should enable officials to offset a significant proportion of the negative effects of any single policy decision. As such, so long as the necessary reforms are implemented over the coming 5 to 10 years (while Japan still boasts ample domestics savings), we have confidence that the Japanese economy will begin to normalize.
Chart 7 // TOPIX: Versus Trailing Weighted EPS
Source: Bloomberg, June 2013
Chart 8 // MSCI World Index Versus Trailing Weighted EPS
Source: Bloomberg, June 2013
In our view, Japan is on the cusp of a remarkable transformation. Change will undoubtedly take time and require a fundamental shift in the deflationary psyche of the Japanese nation. It will not be smooth sailing, but for the first time in nearly 25 years, there is a collective will and determination to turn things around. Given the unprecedented scale of the reforms, we believe Abe's three arrows might prove not only unbreakable but might also actually hit their targets.
1 International Monetary Fund, June 2013.
2 Bank of Japan, June 2013.
3 International Monetary Fund, June 2013.
4 Japanese Ministry of Internal Affairs and Communication, June 2013.
5 Japanese Cabinet Office, June 2013.
6 Japanese Ministry of Health, Labor and Welfare and Japanese Ministry of Education, Sports, Science and Technology, February 1, 2013.
7 Japanese Ministry of Internal Affairs and Communication, June 2013.
8 Statistics Japan.
9 Tokyo Stock Exchange, Nikkei, June 2013.
10 The World Bank, 2011.
11 Nikkei Survey, June 2013.
12 Bloomberg, June 2013.
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