Please find below former Reserve Bank of New Zealand advisor and multiple CEO, Terry “Macca” McFadgen’s, latest ‘Maccanomics’ article, which tackles amongst other things the stiff headwinds facaing the Japanese economy, Abenomics and its likelihood of success, and what it all means for Australia, New Zealand, and the global economy. Enjoy!
We need to talk about Japan because it is world’s third largest economy and it is going broke. Something major has to change to avoid that outcome. Abenomics may or may not be the game changer- we will come to that shortly-but in a world firing on only one cylinder Japan’s precarious finances are a serious worry.
Amongst the big economies only the USA is in reasonable health. Its banks have been recapitalized and commercial lending is now growing at about 10% pa. In most areas house prices are growing in the high single digits. May retail sales were 11.4% above the pre-recession peak (in nominal terms) and household debt is steadily being cranked down. Critically, the Federal deficit is falling like a stone. In the short term-until the boomers need their transplants-the Federal deficit of about 4% of GDP is quite sustainable and the pressure for further spending cuts has been relieved. The longer term problem remains but is solvable by a combination of better cost control in the health sector, some inflation and better GDP growth.
The consensus is for the USA to grow at about 2% this year and maybe 3% next year. Not great, but not a disaster either. The risks around those growth forecasts are probably to the upside although rising long bond yields could pose problems for the housing sector.
The USA aside, everywhere else looks pretty ugly. The Euro-zone will suffer negative growth this year according to the ECB’s latest forecasts and unemployment remains at mind numbing levels .Bank balance sheets are awful and lending to SMEs is very tight throughout the EU. Next year growth may hit 1% according to the ECB, which will have no discernable impact on unemployment. No-one can predict with confidence that the whole enterprise will be able to sustain the pain for the further period of years required to get the southern periphery back to level pegging in terms of cost competitiveness.
Euro-zone politics are depressing. In France, Hollande appears to be in a coma, removed from reality. In Germany the President of the Bundesbank has initiated a Court case in Germany to try and kill the ECB’s “life saver” OMT initiative, and the Brits on the street want out of the EU whenever they are asked. Crucially, Germany does not seem to be prepared to support with any vigor the economic enterprise which has delivered massive gains for the German people for more than a decade. If they precipitate a walk-out by the South they will have only their obduracy to blame.
China is commencing a long term slow down in growth and a major transition away from infrastructure spending as a source of demand. But the mechanics of the transition are opaque and warnings are now flooding in that China faces a serious credit bubble-most recently from Fitch. Commodity prices have responded to the China slow-down and suddenly the BRICS and emerging markets are out of favour. Copper is down 30% from its 2011 highs and the AUD and Brazilian real are both being hit hard. The commodity producers who squandered the golden years (most notably Australia) are now up the creek without a paddle. The risk of a recession next year in Australia was recently assessed at 20% by Goldman Sachs, and other forecasters are rushing to join the bear brigade. Incredibly, Goldman’s were attacked politically for their professional risk assessment. Here in Australia the gap between reality and public awareness of what lies ahead is large indeed.
So good news has been hard to come by. Financial markets have been playing in a fantasy world of their own fueled by free money and dark glasses. But in June reality intruded. An unexpected but uncontroversial comment from Bernanke-that at some stage the free money would stop- gave all and sundry a shiver and markets went south. Who can tell where they might go from here.
The Japanese Problem
But it is Japan that is our focus today and there the news is scary .The problem can be summarized in a few paragraphs.
For historical reasons which I will touch on soon, Japan has accumulated a mountain of public debt. It can be serviced (just) if interest rates remain very low (circa 1% for 10 year money), but not if rates rise materially, unless the economy is growing fast in parallel with those rising rates. Japan’s growth rate over the last decade has averaged 0.9% pa so a quantum leap in growth is required to avoid a collapse.
Historically, the Japanese Government has been able to borrow at next to nothing because Japanese households and corporates have been “over-saving”. As a result a large domestic savings pool has been able to be tapped very cheaply with almost no reliance on foreign lenders. But even at this price level for money, interest costs account for 20% of Japan’s total Government budget. (Japanese net Government debt equates to around 215% of GDP. Contrast this with the USA at about 75% and Britain at around 85%.
The catch is that the Japanese Government’s ability to access 1% financing is running out as boomers retire and need to draw down on their savings. So Armageddon threatens if foreigners have to be asked to fund the Government coffers. They are certainly not going to be doing so at around 1% pa when they can invest in US Treasuries at over 2 % pa (and likely rising).
The solution is obvious. Japan has to start growing its economy quickly and, through growth and tax hikes, boost its Government revenues. But therein lies Japan’s’ dilemma. To get Japan’s households to spend more it must get some inflation into its economy. After 20 years of skidding along the boundaries of outright deflation Mrs. Watanabe’s household has no incentive to spend today rather than tomorrow, and Japanese corporates have no incentive to invest domestically when demand is flat.
Unfortunately the inflation that is critical to stimulating demand is the same inflation that will push rational lenders to insist on bond yields a lot higher than 1%-even if those lenders are loyal Japanese citizens. And even with 10 year yields as low as 2%, Japan’s debt servicing burden becomes overwhelming. To be more specific, it would rise to consume nearly 40-50% of the Government’s entire income at the same time as demands on the budget from an aging boomer population were growing sharply. At which point collapse is pretty much guaranteed.
If you further assume that non-Japanese funders will have to be called upon, and that US yields normalize in the 4-5% range, then collapse is certainly guaranteed.
This would not happen overnight because Japan will only incur those higher interest costs as existing debt matures. But over a 5-10 year horizon Japan is toast unless it can achieve some meaningful growth in Government revenues. Hence the urgent need for a program to lift nominal output through productivity improvements and inflation.
The Spender of Last Resort
The story behind Japan’s debt mountain is well understood-and comparatively recent.
Following the asset value collapse of the early 1990s Japanese corporations spent over a decade rebuilding their balance sheets-and spent not a dime despite drastic monetary easing by the BOJ. Households-in shock from the collapse in asset values- did the same.
The above chart-from Richard Koo at Nomura-makes the important point that monetary easing alone had only a marginal impact on the Japanese economy. Money has been “free” and the monetary base went through the roof-but money in circulation (M2) hardly responded and bank lending actually fell.
So into the breach came the spender of last resort. For 20 years the Government has built anything that can’t move. Bridges to nowhere it is said-but it kept the Japanese economy alive. To fund its 20 year stimulus program the Government borrowed from its own citizens, and did so cheaply thanks to surplus savings especially in the corporate sector. The story is told in detail by Richard Koo in his recent book ’The Holy Grail of Macro-Economics” and you can delve into that for more. The end result is that Japan’s Government debt has risen from 75% of GDP in 1993 to around 215% today.
Deflation
As is well known, even with the support of massive Government spending, Japan has struggled with deflation for 20 years. This chart tells that story:
As long as deflation dogs prices, wages and hence tax revenues Japan’s real debt burden actually increases over time, even if it can be kept stable in nominal terms. CPI deflation for the 12 months ended April 2013 was a depressing 0.5% pa.
Demographics
Magnifying Japan’s debt and growth problems is a people problem-in fact not one problem but several. For starters it has the same pig in the python that all developed economies are facing. It has a post war cohort of hard working, hard saving citizens that is now reaching retirement and needs to spend its savings. So a vital source of cheap funding for the Government is drying up and will continue to shrink for the next 20 years.
Problem number two is fertility. Japanese couples don’t want babies-or more than one and a bit- which is obviously way below the level needed to keep the population stable in a society which will not tolerate immigration (Japan’s actual rate is 1.3 babies per woman which can be compared to 2.1 for the USA and 1.9 for Australia). The two forces driving the population down-boomers passing on and low fertility- cannot be reversed in the short or medium terms.
In result, Japan’s population is shrinking and its dependency ratio (dependants to taxpayers) is rising. To be precise, Japan’s population has fallen by about 1 million over the last decade and the rate of decline is forecast to accelerate. Japan now sells more diapers for the elderly than for babies-or so the story goes.
Japan has a serious dependency problem. Its workforce is expected to fall to just 51% of the population by 2050, down from 70% in 1990. i.e. every worker will have to support not just themselves but a dependent elderly or young person who is not is the workforce. Elsewhere (USA, Australia) dependency ratios of 2:1 or slightly better are the rule.
The outlook is therefore for a growing debt burden that must be serviced by fewer and fewer taxpayers, even before we bring to account the near certainty of rising interest rates and rising benefit payments. So panic is in order.
Whilst you panic, bear in mind that the obvious solution (immigration) is politically impossible. Uniquely amongst developed economies Japan simply “doesn’t do” immigration. Japan is for the Japanese.
Gender Problems
Then we have a gender problem.
Japanese women are well educated and as capable as any. They represent close to 50% of the annual college graduating class. But thereafter it all goes pear shaped.
They are largely unable to penetrate Japan’s corporate hierarchies which are dominated by males and where promotion tends strongly to reflect time in the job. A frightening percentage of female Japanese graduates simply toss in the towel and leave the work force. Only 67% of female college graduates remain in the workforce long term and many languish in low level jobs.
A large fraction (49%) of the leavers assert they left the workforce because they felt stymied and stalled. They also tend to leave the workforce once they have a child because child care is expensive and difficult to access. Japan’s zero immigration policy means that the sort of home help that is commonplace in the USA and Europe is simply not available. Men do not routinely help with child care or housework.
All up, the result is that the ratio of women to men in the workforce is only about half the level in the USA and Europe Put another way, Japan squanders a huge proportion of its productive potential and does a grave disservice to its female population in the process.
Innovation and Entrepreneurship
Nor, perhaps contrary to your expectations, is Japan particularly innovative-at least outside its established corporate structures. Of course companies like Toyota and Sanyo, Canon and Sony didn’t get to be world market leaders without plenty of innovation.
But Japan’s innovation takes place within closed systems. Outside the big corporate structures entrepreneurship is not actively facilitated. Japan has no Silicon Valley and a very small start- up culture. In fact Japan’s rate of start-ups is (proportionately) less than half the levels achieved in the USA or the UK.
Its venture capital industry is tiny. Total loans and investments in the sector amount to only a nineteenth of the US level. Bank debt for start ups is very limited and clogged by demands for guarantees.
Jobs for Life
Just as Japan doesn’t”do” immigration, it doesn’t “do” unemployment either. Despite 20 years of near recession (and sometimes clear recession) Japan has not suffered from significant unemployment. Jobs once secured are pretty much held for life particularly for older males.
The social consequences have undoubtedly been beneficial at one level –especially in terms of social cohesion and lack of crime. But the costs of “jobs for life” are also high. Promotion of the talented-particularly women-has been frustrated, and shareholders have had to bear the cost of maintaining a fully employed but under-utilized workforce.
The Untouchables
The Japanese economy is riddled with inefficient sectors which have garnered enough political protection to be regarded as untouchable.
Chief amongst these is the farming sector which is fully protected from import completion by tariff and non tariff barriers, and also protected from aggregation by barriers that are designed to keep farms small. Credible analysts estimate that Japan’s farm/food costs are about twice what they should be if the sector were opened to competition.
Farming however is just the start. A lot of the domestic services sector is also protected with health, pharma, life insurance, and the mail system being amongst the most egregious.
Productivity
What Japan badly needs is a massive advance in productivity to compensate for a shrinking workforce and a growing cohort of dependent elderly. What it has got in the past decade is a so-so performance roughly on a par with Europe when measured in terms GDP growth per capita (about half a percent annual growth) but way off the mark relative to the USA ( over 1% pa).
Abenomics
So into this unholy mess of excessive debt, shrinking debt servicing capacity, lousy demographics, weak growth and antediluvian attitudes to race and gender rides Shinzo Abe for a second go at the Prime Minister’s job. Rightly, he argues for fundamental reform-because the alternative is financial oblivion. He promotes a three pronged attack:
- Government spending-funded by further borrowing-will continue for the foreseeable future to maintain growth whilst the economy is reinvigorated.
- The BOJ will commit to creating inflation of 2% pa come what may. This will be achieved by printing whatever quantity of money is required to inflate asset prices and get consumption and investment rising. The initial target is to double Japan’s monetary base by the purchase of Government Bonds (i.e. a conventional Quantitative easing program). Implicit in this-but for obvious reasons unstated-is that the yen will be devalued as the market adjusts to the new inflation parameters. Also unstated is the fact that improved corporate earnings from exports will be funded by the nation’s savers who will see their real wealth (in global currency terms) nationalized.
- Abe’s government will enact a change program designed to lift productivity throughout the economy the details of which were and still remain vague. Changes to childcare arrangements have been mentioned to keep more women in the workforce-but otherwise Abe has been keeping his powder dry until the outcome of the Upper House elections on 21 July are known.
To ensure a compliant BOJ, Abe fired the Governor and put in his own man.
Will It Work?
Until Abe spells out his structural reform program, and secures the political support needed to enact it, it is too early to say. In principle it could work. Japan has a well educated, highly diligent work force and great physical infrastructure. There is vast potential in freeing the economy from its many shackles. A well managed devaluation could add a further boost. But the obstacles appear formidable:
- Japan’s competitors (Taiwan, Korea and China in particular) have to accept that it is better to allow Japan to steal some of their export market share via a yen devaluation, rather than commence a tit for tat devaluation war. The jury is out on this. The risks round a regional currency war are magnified by historical enmities and by Abe’s generally aggressive stance on regional issues.
- Holding interest rates in check in the face of a sworn commitment to raise inflation is a huge and dangerous task, because it flies in the face of economic logic. Sure the BOJ can always print more money in extremis-but then the risks of runaway inflation increase and the currency would devalue further, raising the risks of retaliation;
- Japanese households have to be convinced to spend some of their savings either because they feel richer via asset inflation or because they fear goods and services will be much more expensive tomorrow. For the last 20 years they have refused to do so and, absent some Churchillian leadership from Abe, look unlikely to change. Abe’s track record in the Churchill department is not great. His last Prime Ministership-in 2006-lasted only 11 months before it collapsed.
- At the heart of Japan’s economic problem is a set of cultural mores that are deeply embedded. These include a strong preference for established institutions, resistance to innovation, gender bias, age bias and, dare I say it, racism. Of course all these can change-but that is a generational exercise. The problem is that Japan doesn’t have the luxury of a generation-it might have five to ten years.
So let’s call it a 50/50 probability of success until we find out more about Abe’s structural reform program. This is probably about where the consensus sits today but the skeptics are in the ascendancy. Some leading economists (e.g. Noah Smith) are now openly debating the merits of a managed sovereign default by Japan.
And that is also the line being pursued by some of the world’s best hedge funds including Kyle Bass’s Hayman Capital. They smell blood and the BOJ is going to have to fight not only all the challenges implicit in its new remit but also a posse of hedge funds which is actively shorting Japan.
So What?
For well over a decade the major economies of the developed world have been propped up by illusions. The Greenspan initiated credit explosion which started around 2000 was built on the illusion that asset bubbles didn’t really matter because they could be remedied after the fact. That illusion ultimately laid the American economy flat on its back for four years. It also allowed the Euro-zone periphery to enjoy a fool’s paradise of declining cost competitiveness and “no questions asked” credit.
Japan’s illusion has been somewhat different. There, thanks to a vast pool of domestic savings its Government has been able to access very cheap funding for over 20 years. And instead of making the needed hard decisions on reform, successive monetary easings and deficit funded stimulus programs have kept the ship afloat.
It is now “time up” for Japan.
We must live in hope that Japan’s political class can do better –and that Abe can pull off a minor miracle.
Keep a close watch because if Japan falls over we are all in deep trouble, especially those of us in Australia and New Zealand looking over our shoulder at one of our largest trading partners. This is not what we need at a time when Australia needs to adjust to a huge downturn in mining investment and find some other sources of growth.
