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The Three Arrows: Abenomics 2.0
An Update on Japan’s Bold Pro-Growth Plan
December 2014
Martin C. Schulz, J.D.
Managing Director
International Equity
To no one’s great surprise, Japan’s Prime Minister Shinzo Abe and his Liberal
Democratic Party (LDP) were returned to power in the nation’s snap election
held this month. Abe has secured the requisite time, stability, and political
cover to implement his reformist agenda. With a new electoral mandate and
a continued supermajority, Abe is redoubling his efforts and refocusing his
ambitious economic agenda all the while securing the government for quite
possibly another four years – all the way until 2018. On the one hand, it was as
the markets had expected. And yet, global investors remain skeptical of Japan’s
longer term prospects. We remain near-term believers and are cautiously
optimistic that Japan is on the cusp of potentially, fundamental changes.
The timing for the elections was well planned. Abe had dissolved the lower house of
parliament (the Diet) and called for snap elections in order to take advantage of the disarray
of his political opponents and to consolidate power within the LDP – and importantly vis-à-vis
the powerful special interests and Japanese bureaucracy. The initial reason was to get buy-in
for his postponement of another planned hike in the consumption tax originally instituted by
the DJP but also to strengthen national support for Abenomics, his plan to revitalize Japan’s
sagging economy. Not surprisingly, his announcement for new elections came one day after
quarterly GDP reports indicated that Japan had entered a another recession and less than
three weeks after the Bank of Japan (BOJ) surprised the global financial markets and revealed
that it was further increasing its monetary stimulus program.
The LDP and Komeito, its junior coalition party, won 326 seats to maintain its two-thirds
supermajority in the Diet, a position that allows Abe to smooth the path for implementing
his initiatives. The coalition’s victory enables him to consolidate his power over a weak and
disorganized opposition party, and he enters 2015 with a majority in both the lower and
upper houses of the Diet. While Abe has trumpeted the election as a mandate, it’s important
to note that voters turned out in record low numbers – hardly suggestive of a tidal wave of
popular support.
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We first flagged in 2012 that Japan was possibly at an inflection point after a generation of deflation and
potentially headed on a more productive economic path. After the failed reform efforts by Prime Minister
Koizumi in 2005 and the political backlash that ensued and led to the ouster of the LDP, Japan has been
at the cusp of attempting radically new pro-growth policies the past two years. At the time, PNC Capital
Advisors went overweight Japan for the first time since 1998, focused on export companies and reflation
beneficiaries, and simultaneously hedged a portion of our domestically exposed Japanese yen exposure.
It has now been two full years since Abe’s initial victory in 2012 and the launching of Abenomics. At
first, the markets, especially foreigner investors (domestic ones were more battle scared, cynical, and
circumspect) cheered as the Nikkei outperformed and the yen decreased in value. From December 2013
until August 2014, however, skepticism and cynicism reigned. It was not until Japan’s economy showed
signs of weakness in the face of the ill-timed increase in the consumption tax in April that yen weakness
and Nikkei strength reasserted themselves.
Now is an opportune time to reevaluate
Japan and to take stock of where we are
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and measure the government’s progress
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and future prospects. Japan is clearly a
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beneficiary of lower global energy prices.
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But the real key to Japan’s success in
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their ability to escape deflation will hinge
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on whether they can increase wages. And
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that is the crux of the matter. To gain first-6.00
hand insights, we recently visited Japan
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for the third time this year where we had
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the opportunity to meet with numerous
corporate leaders, academicians, investors,
government officials, politicians, and ordinary citizens. Based on our visits and assessment of the
impact of the government’s policies, Japan is taking the right steps to boost the economy and achieve
competitiveness. But it will take time. There is no doubt great challenges lie ahead – and many of the
most difficult policies have yet to be implemented – and success over the long term is by no means
guaranteed. But progress is being made at least in the short and intermediate terms.
% Change in Real Wages
ABENOMICS – THE THREE ARROWS
Based on promises to revive Japan’s economy and crush the threat of deflation, Abe and the LDP swept
into office in December 2012. Prime Minister Abe wasted no time in launching Abenomics, a three-pronged
plan composed of monetary easing, fiscal stimulus, and structural reforms to strengthen the nation’s
competitiveness. Quite simply, the plan is one of the boldest experiments to revitalize a major developed
economy in recent history.
THE FIRST TWO ARROWS: MONETARY EASING AND FISCAL STIMULUS
The first two arrows represented the easy part. The first of Abe’s arrows, an activist monetary policy
geared towards generating 2% inflation, was intended to do most of the hard work in the early going.
As we mentioned in our earlier papers, the BOJ had been summarily criticized in the past for not doing
enough to combat deflation and help the economy grow. Since the BOJ’s traditionally hawkish stance
resulted in a strong and overvalued yen, Japan’s exporters faced strong competitive headwinds. This was
especially problematic given the country’s heavy reliance on international trade, and many corporations
began offshoring production. Once in office, Abe quickly named Haruhiko Kuroda as the BOJ governor
2 The Three Arrows: Abenomics 2.0 – An Update on Japan’s Bold Pro-Growth Plan
Central Bank Balance Sheets
— Federal Reserve — Bank of Japan — European Central Bank
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80
in early 2013. Kuroda pledged to raise the
inflation target from 1% to 2% by doubling
both the BOJ’s purchase of bonds and the
monetary base.
% OF GDP
Excluding the effects of the ill-fated
consumption tax hike in April, core inflation
Here
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is currently estimated at 0.9%, less than
20
half of the BOJ’s 2% goal. In the surprise
announcement on October 31, 2014, the BOJ
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2016
said it plans to provide further monetary
stimulus to ward off deflation and spur
©BCA Research 2014
the economy. The BOJ intends to make
purchases of longer-term debt at an annual pace of 80 trillion yen (approximately $670 billion), up from
the original target of 60-70 trillion yen. It’s a bold move, and one that was contested. With the BOJ board
voting 5-4, the decision to ramp up purchases was narrowly won. Not surprisingly, the Japanese yen has
weakened considerably.
60
On the fiscal front – Abe’s second arrow – the government announced in January 2013 that it would spend
10.3 trillion yen over the short term to drive Japan’s recovery. The boost in government spending was
targeted for public works investment, disaster prevention and reconstruction following the earthquake
and nuclear disasters in 2011. The government expected that the extra spending would increase gross
domestic product by about two percentage points and create about 600,000 jobs. To shore up its budget
which stands at approximately 230% of GDP, Abe’s internal opponents pushed through a plan to increase
Japan’s consumption tax from 5% to 8% in April 2014 with another subsequent increase scheduled for
October 2015.
THE STRUCTURAL REFORM ARROW: THE THIRD AND MOST DIFFICULT SHOT
That brings us to structural reform, Abe’s third arrow. This is where the rubber meets the road and as
many of us know, it is difficult and painful and will take much longer than many expect. Monetary easing
and fiscal stimulus were actions that Abe and his party could implement quickly and fairly effectively,
and it’s natural that these took center stage early in the administration. But lasting revitalization requires
major changes to Japan’s economy, which include improving labor market flexibility, drawing more women
into the workforce, removing competitive constraints, raising productivity, and enhancing free trade.
Turning a tanker around mid-stream is no easy feat. These structural prescriptions will likely take years.
Abe began to take actions to reform Japan’s economy immediately following his election in December 2012
which included the following:
• I mproved Industrial Competitiveness – Enacted tax breaks for companies restructuring
unprofitable operations and for businesses investing in venture capital. The objective is to
encourage companies to speed the consolidation of overcrowded manufacturing industries.
• D
eregulated Power Producers – Passed a bill to break up regional monopolies of utilities. The
retail electricity market will be liberalized in 2016, while the grids will be opened 2018-20. The
government is also focused on restarting nuclear power to assist with Japan’s massive need for
importing energy sources.
• S
pecial Economic Zones – Enacted a bill to set up special economic zones to allow construction
of more condos in business areas, allow foreign doctors to practice, and let businesses run
public schools. Considered to be a trial for more extensive reforms later, the special economic
zones could be rolled out nationally.
3 The Three Arrows: Abenomics 2.0 – An Update on Japan’s Bold Pro-Growth Plan
• R
eforming Agriculture – Approved a plan to end subsidies for rice growers that protect them
from price declines, making the industry more market-oriented. In addition, land banks will be
created to help transfer land ownership to large operators.
On the corporate tax front, Abe also made good progress. His view is that a healthy and globally
competitive corporate sector will invest for growth and increase wages. Japanese corporations are
sitting on hordes of cash – a result of twenty years of deflation. In December 2013, the LDP repealed the
special reconstruction surtax effective for taxable years beginning on or after April 1, 2014, resulting
in a reduction of the effective corporate tax rate from 38.01% to 35.64%. With his recent re-election,
corporate tax rates will certainly come down lower - much lower. While the decline in the corporate tax
rate was welcome news for businesses, Japan’s tax rate is still well above rates of around 25% or lower in
neighboring countries.
Some argue that he may push them down into the lower 20% range. In return, Abe is also forcing Japan’s
business establishment to accept significant changes in corporate governance and transparency. His
goal is to help raise corporate profitability by producing the country’s first governance code of best
practices, one that meets Organization for Economic Cooperation and Development (OECD) standards.
The most recent draft proposal in November included a “comply-or-explain” rule for corporations to have
multiple independent directors and incorporated detailed sections on the role of the board, the function of
independent directors, director training, and board self-evaluation.
STILL THERE IS MORE REFORM NEEDED
There is much more for Abe to do, however. Most importantly, labor market rules and practices need
to be revamped and modernized. When Japan was growing rapidly, firms offered job guarantees and
protections to minimize turnover. Unfortunately, this legacy continues long after the high-growth era
ended. Dismissals remain rare as labor unions resist any loosening of rules. As a result, Japanese
employers created a second tier of irregular or part-time workers who aren’t covered by job protection
rules and are paid less than regular workers.
In addition, Abe is aggressively seeking to bring more women into a rapidly aging workforce. One of his
public goals is to have women represent 30% of the nation’s leaders by 2020. Abe has his work cut out for
him. According to a recent article (“Abe Wants to Get Japan’s Women Working”, The Wall Street Journal,
September 11, 2014), only one in 10 managers in Japan are women, compared with 31% in Singapore,
38% in Germany, and 43% in the United States. Resistance to changes in firmly established gender and
institutional traditions will be strong.
Agriculture is another major area needing extensive reforms. Begun as a support system for farmers,
Japan Agriculture (JA) has become a massive monopoly of local farm cooperatives and employs 240,000
people in a bloated bureaucracy. JA is one of the nation’s most powerful lobbyists, and it is an aggressive
advocate for high tariffs on food products. Japan has rice tariffs exceeding 700%. While Abe has taken
some early steps to hasten consolidation in agriculture, he has much more to do to change an industry
composed of many tiny and unproductive farms and ruled by entrenched and powerful special interests.
His recent election success will provide him greater leverage.
Markets also need to open up much further to free-trade and allow greater foreign competition and
investment. One of the most important areas of structural reform is Japan’s participation in the talks on
the free-trade Trans-Pacific Partnership (TPP). Discussions focus on opening up protected industries and
services and reducing high tariffs, especially on farm products. TPP subject areas include government
procurement, competition policy, labor standards, intellectual property, financial services, investment,
telecommunications, and environmental standards. The expectation is that a broad-ranging regional trade
deal will be reached and Japan’s economy could get a significant boost.
4 The Three Arrows: Abenomics 2.0 – An Update on Japan’s Bold Pro-Growth Plan
THE RESULTS SO FAR
After getting off to a good start taking the reins of government in 2012, Abe has watched this year as
Japan entered a recession for the first time since 2012. The economy fell by an annualized 1.9% in July to
September after dropping 7.3% in the second quarter of 2014, prompting the call for snap election and
the BOJ’s stimulus announcement. No doubt, Japan is facing real challenges. However, there are some
positive developments:
• A
Weaker Yen – The yen had weakened to a low of approximately 120 to the U.S. dollar in
December, compared with 87 yen to the dollar when Abe took office. As a result, exports have
strengthened and the Nikkei has surged: Japanese exports grew at a 9.6% annual rate in
October, the fastest pace in eight months and better than September’s 6.9%. With foreigners
buying Japanese equities, the BOJ executing even greater quantitative easing, and domestic
pension funds allocating more to overseas investments (we estimate that these funds are one
third of the way there), we suspect the yen may weaken to 130 – possibly more – in the next
one to two years. Japanese exporters will take major market share from their competitors –
especially the from Koreans and also the Europeans.
USD/JPY – Price
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• C
yclical Tailwinds – The Markit/JMMA
Japan Manufacturing Purchasing
Managers Index (PMI) posted a seasonally
adjusted score of 52.0 in November,
remaining above the 50 threshold that
separates expansion from contraction for
the sixth consecutive month. However,
confidence in Japanese manufacturers
slid in December and is expected to
deteriorate while the mood at service
firms rebounded, according to the closely
watched BOJ Tankan Survey.
• W
ages and Unemployment – Wages remain depressed but there are signs of fundamental
change. Recent union demands are for 2% and part-time workers are already seeing increases
of over 5%. Unemployment is only 3.5% – impressively low compared with other advanced
economies. We believe there is scope for unemployment to decrease to 2.5% in the next
two years.
• R
eturn on Equity – Japanese corporations are notorious for having low ROE’s relative to their
global peers. Recently, RIOs in Japan have increased by 3%. While some of the improvement is
the result of share buybacks and accounting changes rather than improved profitability, ROEs
of Japanese corporations have picked up from traditionally low levels compared with other
countries. Corporations are beginning to use leverage again and to invest for future growth.
• T
he Stronger Nikkei – The Nikkei is up almost 40% since Abe took office. In addition to increasing
ROEs and corporate earnings growth, stocks in Japan will get a further boost from the nation’s
$1.1 trillion Government Pension Investment Fund (GPIF). In a coordinated effort with the BOJ,
other Japanese pension funds are likely to do the same, and the result will be a major shot in
the arm for Japanese equities. GPIF said it is setting allocation targets of 25 percent each for
Japanese and overseas equities, up from 12 percent each, and reduce domestic bonds from
60% to 35% of assets. The massive purchase of global assets will further weaken the yen.
5 The Three Arrows: Abenomics 2.0 – An Update on Japan’s Bold Pro-Growth Plan
Finally, there’s one other bit of news, and this happens to be especially good for Japan. And that is the cost
of energy prices. While lower energy costs will make it more difficult for the BOJ to attain its 2% inflation
target, the Japanese economy will get a boost from falling energy prices, which is especially critical for a
country with no fossil fuel resources.
GEOPOLITICAL BACKDROP: A MORE ASSERTIVE JAPAN
The over-emphasis on geopolitical and national security issues is a risk that Abenomics gets sidetracked.
An ardent nationalist, Abe and the LDP came into power in 2012 emphasizing economic reform but also
national security. North Korea’s nuclear ambitions are well known, and Japan has territorial disputes
with Russia, South Korea, and China. Confrontations with China in the East China Sea over the contested
Senkaku Islands have been especially heated: China continues to send vessels into waters around the
islands claimed by the Japanese. Both sides have rattled their sabers.
Abe’s security agenda includes the creation of a National Defense Force, a full military capability which
Japan’s post WWII pacifist constitution explicitly prohibits. Japan currently pursues a defense-only policy,
and Abe wants the flexibility to conduct pre-emptive strikes and engage in aggressive military actions with
its allies. The LDP also talks about strengthening the nation’s air force, establishing a new marine corps,
and perhaps building their first aircraft carrier since World War II. Abe uses the curious term of “proactive
pacifism” to describe Japan’s more muscular stance.
Militaristic posturing aside, Japan is also signaling that it will work through normal diplomatic channels.
For example, Japan, South Korea, and China announced in December that they had agreed to form a
network to quickly exchange information in a nuclear emergency such as the Fukushima disaster in 2011.
Japan continues to have free-trade trilateral talks involving China and South Korea. In the past two years,
the discussions have covered a number of areas, including goods, services, investment, competition,
intellectual property rights, e-commerce, and the environment, all under the objective of achieving a
comprehensive and high-level trade agreement.
JAPAN AND THE ROAD AHEAD
There is no doubt that Japan faces significant challenges as it moves forward. Demographic challenges
will likely remain. Structural reform must involve bolder steps to confront rigid labor rules, deregulate
business activity, extend free-trade initiatives, and remove industry barriers that stifle competition.
Entrenched and powerful special interests in the agricultural, medical, and government bureaucracy will
continue to fight these efforts every step of the way. In addition, Japan’s debt burden is more than twice
the size of its economy – an astonishingly high figure – and strains on government finances will continue.
The country will be coping with rising social welfare costs associated with an aging population at the
same time that it is increasing spending on
stimulus and defense. And while the recent
% Change in CPI
election keeps Abe in power, his public
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support may be driven more by a sense
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of despair over alternatives rather than
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enthusiasm for his program.
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6 The Three Arrows: Abenomics 2.0 – An Update on Japan’s Bold Pro-Growth Plan
Nonetheless, Abe and his LDP party have
made progress in these past two years. We
remain guardedly optimistic that Abenomics
will be successful in moving the economy
forward over the near- and intermediateterms. We are overweight Japan within the
The Three Arrows: Abenomics 2.0
An Update on Japan’s Bold Pro-Growth Plan
developed market universe. Some might argue that it’s only a short term fix, but we will look for continued
signs of progress. Only time will tell if Abe will fully transform the nation’s economy over the long term.
Is Japan out of the woods? Will it rise quickly like a phoenix out of the ashes? No, but it is in a unique position
in spite of all its challenges. Japan is now at the forefront of taking the proverbial bull by the horns. It is
the only major developed country where you have foreseeable political stability and unity, supportive and
predictable pro-growth fiscal and monetary policy, cyclical tailwinds, and a leader on a mission. Europe looks
interesting as it rebounds next year and trades at 20-year lows relative to global equity valuations. But unlike
Europe which remains stuck in its “two steps forward, one step backward” policy rut and has seemingly
wasted an opportunity to enact real, structural reform after the sovereign debt crisis, Japan is on the move.
We currently remain slightly overweight Japan as part of top down country allocation process. Although
its valuations are not as compelling as Europe’s, Japan has best in class growth prospects, a good risk
profile as the yen weakens, and strong momentum. We also expect Japanese corporations, especially large
cap exporters, to increase ROEs and profitability, to become even more competitive globally, and for their
earnings to rise in excess of 15% in 2015.
2015 could be a really big year for Abenomics. What is important is that Abe has tightened his grip on power
in order to more quickly institute the necessary structural reforms. He has not only cemented the LDP’s
supermajority for several more years, but more important, he has strengthened his hand within the LDP,
amongst the disparate interest groups, and with Japan’s powerful bureaucracy. If he can get corporate
profitability to lead to greater investment – and here’s the crux – and to jump start wages increases, we may
be close to the beginning of the end of the scourge of deflation once and for all in Japan. Only time will tell.
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