[Andrew Sheng] Wealth effect may make Abenomics work

When the Liberal Democratic Party returned to power in December 2012, Prime Minister Shinzo Abe vowed to restore growth and inflation through what is now known as Abenomics. This comprised three arrows ― monetary policy, fiscal policy and structural reforms.

The monetary policy arrow caught the most attention, with the change in the stance of the Bank of Japan that aimed to push inflation to 2 percent a year through massive quantitative easing. Given the current misgivings in the West about more quantitative easing, it is not surprising that there are also skeptics about the Japanese monetary stimulus. 

How big is the stimulus?

The balance sheet of the Bank of Japan is already the largest amongst the G4 (reserve currency) central banks, at 35 percent of GDP, compared with Fed (20 percent), Bank of England (26 percent) and European Central Bank (28 percent). The Bank of Japan aimed to increase base money by 60-70 trillion yen a year, or roughly $60 billion monthly, compared with $85 billion monthly by the Fed.

At these levels, the Bank of Japan balance sheet will rise by about 12 percent of GDP, bringing it to 60 percent of GDP by end 2014. This is unprecedented monetary escalation.

So far, the stock market rose by nearly 40 percent to break 14,000 Nikkei index, and the yen depreciated to 98 to $1. Some market analysts think the yen will depreciate to 105-110, which will put pressure on Japan’s export competitors, especially Korea.

The second arrow of fiscal adjustment is also pretty aggressive, with the intent to increase public spending by 13.1 trillion yen, financed half by debt issuance. This would bring the Japanese gross public debt to over 230 percent of GDP, already the highest amongst the OECD countries.

The third arrow of structural reforms will be the hardest, because it has been tried for over 20 years. Japan has a highly efficient export sector, but a non-tradable service and agriculture sector that is protected and rigid. Abe has created two councils ― the Industrial Competitiveness Council, chaired by himself, and the Regulatory Reform Council, chaired by a business leader, to map out and engineer the shift in productivity and competitiveness. Japan has also announced that it will join the Trans-Pacific Partnership in free trade with the U.S. which will give foreign pressure to force through domestic reforms.

There is general agreement that the three arrows have to work together, with the last being the toughest politically. If previous administrations had been able to push through structural reforms, Japan would not have been in a low-growth, low inflation trap.

The Japanese balance sheet recession is exactly what the other advanced countries are facing today. Prolonged central bank easing does not necessary get inflation or growth up, when the private sector is busy deleveraging through saving. The risk is that if the central bank gets active, the politicians may not move on the tough structural reforms in the labor market and removing rigidities and inefficiencies in the system.

So quantitative easing buys time for structural adjustment to take place, but if there is delay in the third arrow, we are back to square one.

Abenomics seeks to change the mindset of the consumer to start spending and the business to start investing again, so that the economy gathers enough steam to get out of the liquidity trap. Initially, I was also skeptical, but I think this time Abenomics will work, not through the flow channels of more exports, but through the balance sheet wealth effect.

The devaluation of the yen may not necessarily flow through into a larger current account surplus, because import costs such as energy would increase. The inflation effect may not work if there is huge surplus capacity still. However, it is true that the cheaper yen would enable Japanese companies to switch production back to Japan, create more employment and also stimulate tourism spending.

The real benefit to Japan comes from the wealth effect of the devaluation, since Japan is the largest net lender to the world, not China. Japan has gross foreign exchange assets of 5.6 trillion yen and net 2.5 trillion yen at the end of 2010. The 20+ percent devaluation would give Japanese holders of foreign exchange a yen gain of more than 1.2 trillion yen (gross) and 500 billion yen (net), equivalent to a “feel good” effect of between 12 percent (net) to 25 percent (gross) of GDP. Add to the 40 percent increase in the stock market, that would mean a wealth gain effect in Yen of roughly one-third to two-fifths of GDP. No wonder the business community is supporting Abenomics and wealthy people are spending again.

The bottom line is that Abenomics may be able to push the Japanese economy out of the liquidity trap, if the authorities executes the tough third arrow. All this is good news for Japan after suffering more than two decades of slow growth.

So far, the rest of Asia has not felt the pressure yet, because historically, a strong yen has been good for the region-ex Japan, because production is shifted out of Japan to Asia and FDI increases. The stronger the yen, the more the outflows of both direct and portfolio investments. The weaker the yen, the greater the reversals of flows.

The Asian emerging markets will have to adjust to the possibility of more volatile capital flows. Managing this will not be easy, because if you raise interest rates, you will attract more inflows. More flows will also come in when you raise exchange rates, which can then send the economy, property and equity prices down.

Japan paid for the higher exchange rates and asset bubbles in the 1990s through low growth. It will be quite a challenge for the rest of Asia, if they have to go through the same effect when the reserve currencies begin to depreciate around their strong Asian currencies.

So far, the Nikkei and Dow are heading higher, but risks are building up in the asset markets. Enjoy the recovery while it lasts. 

By Andrew Sheng

Andrew Sheng is president of the Fung Global Institute. ― Ed.

(Asia News Network)