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Satyajit Das: Failure of Japan's 'Kamikaze' Economics Could Affect Entire World


Abenomics does not deal with key Japanese problems of debt and demography. But its policy failures will affect not only Japan, but the global economy as well.

Abenomics' ultimate problem is that does not address Japan's two problem 'Ds' – debt and demography.

Japan is one of the most heavily indebted developed countries. Its total debt to GDP is over 500%, compared to the US's 370%. Japanese gross sovereign debt is around 240% of GDP, while its net debt is around 135%, substantially higher than most developed countries. The government borrows to finance over 50% of its spending. Prime Minister Abe's program is likely to lead to further deterioration in public finances.

To stabilize debt levels, Japan would need to move to a structural surplus (budget deficit before interest payments on government debt) of 3-4%, compared to a current deficit of around 8%. Given the lack of growth and deteriorating demographic profile, the required tax increases or spending cuts may not be feasible.

In October 2013, Mr. Abe announced the implementation of an increase in the consumption tax from 5% to 8%, initiated by the previous government. A further rise to 10% is planned in 2015 but is contingent on economic conditions.

Even this modest rise was resisted by Mr. Abe's own party and advisors. The rise is well short of the 20% rate of consumption tax needed to stabilize public finances, as calculated by economic modelers.

The government has sought to allay concerns on the effects of the tax increase with new public works spending, cash grants, and other stimulus measures totaling Yen 5 trillion (US$ 50 billion), absorbing around 60-70% of the revenue generated. The stimulus, which is additional to the earlier large spending package, is inconsistent with the increase in consumption tax, which was designed to bolster Japan's "credibility" in financial markets as to its efforts to bring its debt under control.

The government argues that the revenues from the higher tax are permanent whereas the increased spending is temporary. But the government is also looking at corporate tax cuts, which would reduce the long-term revenue impact.

The effect on overall government finances and debt levels depends ultimately on its impact on economic activity. When Japan last increased tax rates in 1997, it triggered a recession. Although some factors (the Asian crisis, weaknesses in the Japanese banking system, and simultaneous reductions in government spending) are not relevant, the effect on the Japanese economy remains uncertain. Given that recent improvements have been driven by higher consumer spending, the effects of higher consumption taxes on this trend will be closely watched.

A falling saving rate driven by an aging population and stagnant incomes will increasingly make it more difficult for the government to finance spending domestically, at least at current low rates. Forecast current account deficits will complicate the government's financing task. Japan's large merchandise trade surplus has shrunk and will remain under pressure, reflecting weak export demand and high imported energy costs.

Japan may also face increasing stress on its government finances from higher rates. Increased borrowing costs may be driven by several factors.

If Japan has to resort to financing from foreign investors rather than Japanese investors, then its interest rates may increase, perhaps significantly. If current policy initiatives result in inflation reaching its 2% target level, then interest rates on Japan government bonds (JGBs) will need to rise. If Japan's risk profile continues to deteriorate, then investors may require more compensation to purchase JGBs.

Higher interest rates will increase the stress on government finances. Despite low interest rates, approximately 25% of tax revenue is used to service outstanding government debt, compared to 6% in the US. At higher rates, Japan's interest payments will be an unsustainable proportion of tax receipts.

Higher JGB rates will also trigger problems for Japanese banks, pension funds, and insurance companies. For example, JGBs total around 24% of all bank assets, which is expected to rise to 30% by 2017. According to the Bank for International Settlements, the JGB holdings of Japan's banks equate to 900% of their Tier 1 capital, compared to about 25% for UK banks' exposure to gilts and 100% for US banks' exposure to US Treasuries. Higher rates increase the risk of a Japanese banking crisis.

An aging population, a shrinking workforce, and an increasing dependency ratio of the number of aged supported by a reduced number of workers are integral to Japan's problems.

Current initiatives will have limited impact on low fertility rates, immigration levels, or an increase in labor force participation rates. Prime Minister Abe's programs may exacerbate economic risks without addressing the demographic problems.

The policy deficiencies point to several discontinuities.

Like other developed countries, Japan's deep-seated fundamental problems are within its real economy. It needs to deal with it debt levels, demographics problems as well as declining competitiveness and the industrial leadership that underpinned its recovery from World War II. These structural problems cannot be dealt with by adjustments in fiscal and monetary policy, despite attempts by governments and central bankers to convince audiences to the contrary.

Until 2013 and Abenomics, years of disappointing economic data and moribund policy meant that it was fashionable to dismiss Japan. But it remains the world's third-largest economy after the US and China.

Japan is also financially significant. Its large foreign asset holdings, totaling around US$4 trillion, make it the world's biggest net international creditor. The Bank of Japan is the largest investor in US Treasury bonds, with holdings of around US$1 trillion. Japanese banks, insurers, and corporations are major supplier of global investors, wielding significant influence in financial markets.

Abenomics has implications outside Japan. A Japanese recovery would assist the global economy recovery and generate demand for imports to Japan. Japan would also continue to be a source of capital to the rest of the world.

Failure would be equally significant. If economic growth does not pick up, then a combination of budget and trade deficits that require financing would affect the global economy. Japan's overall current account may move into deficit as soon as 2015.

Japan would gradually run down its overseas investments, selling foreign assets and repatriating the capital. The selling pressure would affect prices and rates for a wide range of assets, transmitting financial market volatility.

At the same time, the BoJ's aggressive monetary policy and devaluation of the yen may lead to large outflows of private capital from Japan. Seeking yield and preservation of purchasing power, Japanese investors may move money into foreign markets, with destabilizing side effects.

In the 1990s, aggressive easing by the BoJ in the aftermath of the end of Japan's bubble economy led to a large and rapid outflow of capital, fueling rapid increase in debt levels, especially in Asia, which was one of the factors underlying the Asian monetary crisis of 1997-1998. There is now a heightened risk of a repeat of that episode.

The devaluation of the yen against other Asian currencies, such as the Chinese renminbi and South Korean won, increases Japanese export competitiveness at the expense of competitors. It forces affected nations to become "shock absorbers" to Japan's attempted revitalization through reduced exports and lower growth.

But this risks retaliation from affected nations. Facing a reduction in competitiveness, China, South Korean, and Taiwan, may intervene in foreign exchange markets to reduce the appreciation of their currencies. Trade restrictions may be introduced to reduce Japanese exports.

In seeking to offset the effect of aggressive Japanese monetary policy, affected countries may be forced to reduce rates, risking over expanding credit supply and increasing the risk of subsequent debt crises.

But ultimately, Japan's significance lies in the fact that it is a laboratory for the global economic and financial crisis. Japan's predicament has marked similarities as well as some differences with that in many developed countries. In both its policy successes and failures, it may provide a useful guide to the fate of other troubled economies and policy prescriptions.

Prime Minister Shinzo Abe's program is also evocative of a different episode of Japanese history – the kamikaze (literally, "divine wind"). By the end of World War II, Japan had suffered several crucial military reversals and lost the air war due to losses of aircraft and flight crew. Its declining economy made it increasingly unable to support the war effort. Desperate, Japan used kamikaze attacks against allied shipping where pilots literally crashed their planes into the target. Four thousand kamikaze pilots died. But the poor success rate (only a small number of attacks hit their target) was not able to change the course of the war.

The attacks were based on tradition and culture, embodied in the Samurai and Bushido code of conduct, where death is preferable to the shame of defeat. The current policy initiatives have a desperate kamikaze element. Like the war efforts, it is unlikely to succeed in changing Japan's economic trajectory.
No positions in stocks mentioned.

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