|Date||September 30, 2015|
|Speaker||FUKAO Mitsuhiro (Program Director & Faculty Fellow, RIETI / Professor, Faculty of Business and Commerce, Keio University)|
|Moderator||INOUE Seiichiro (Consulting Fellow, RIETI / Director, Macro Economic Affairs Division, Economic and Industrial Policy Bureau, METI)|
Taking stock of Abenomics
Prime Minister Shinzo Abe put forward bold monetary easing, flexible fiscal spending, and a pro-growth strategy as the "three arrows" of his economic policy. Against this backdrop is the dire fiscal situation, i.e., huge fiscal deficit and a persistent increase in government debt. In order to restore fiscal health, the government needs to cut spending and raise taxes, but such measures have a dampening effect on the economy. The idea behind Abenomics is to offset that effect by easing monetary policy to prop up the economy. The Bank of Japan (BOJ) put this into practice by setting an annual inflation target of 2% and implementing massive quantitative and qualitative easing (QQE). The QQE program was meant to boost the economy, particularly by stimulating domestic demand. As it turned out, however, this goal was achieved through the significant depreciation of the yen.
Haruhiko Kuroda, who had been showing willingness to take more aggressive easing steps, was appointed as the governor of the BOJ. Under his leadership, the central bank embarked on massive buying operations with the outright purchases of Japanese government bonds (JGBs) as its key ingredient. In doing so, the BOJ sought to maximize the announcement effect by using a series of "two's." Specifically, in announcing the new regime of monetary easing policy, the BOJ said it will achieve an annual inflation target of 2% within about two years by increasing the amount of its JGB holdings and the monetary base (banknotes and coins + commercial banks' deposits held in current accounts with the central bank) by twofold in two years, and more than doubling the average remaining maturity of its JGBs by the end of 2014.
Some critics call the BOJ's current monetary policy "helicopter money policy," but such is not the case. The QQE is being implemented by means of an exchange of equivalents at market prices, with the BOJ purchasing securities such as JGBs and real estate investment trusts (REITs) from financial institutions in exchange for banknotes and current deposits at the BOJ. Indeed, the BOJ managed to push already low long-term interest rates further down by making outright purchases of JGBs on a massive scale.
The BOJ bought about 100 trillion yen of long-term JGBs in the two years from the end of 2012 to the end of 2014. Since the amount of JGB purchase by the BOJ exceeded the budget deficit in the two years, the BOJ absorbed JGBs held by financial institutions. This drove the market yields on JGBs down to extremely low levels. Meanwhile, the balance of current deposits held by commercial banks at the BOJ rose sharply to reach a level now well exceeding 200 trillion yen.
What increased as a result of quantitative easing is not the amount of banknotes in circulation but that of current deposits of commercial banks held at the BOJ. The BOJ pays no interest on required reserves of about seven trillion yen. However, the BOJ does pay 0.1% interest on excess reserves. Being able to be withdrawn on demand, such excess deposits are the safest means of investment with short-term money market yields.
In terms of the real effective exchange rate--an index constructed as a weighted average of exchange rates between the Japanese yen and the currencies of Japan's key trade partners adjusted for price changes--the competitiveness of Japanese goods and services is at its highest level recorded since 1973. Go out for lunch and you can see just how low prices are in Japan relative to those in other developed countries. You can have a decent lunch for 700 yen to 800 yen in Tokyo, but good luck getting one for 2,000 yen in Western Europe. As such, Japan's price competitiveness has been boosted greatly thanks to a weak yen and low prices.
Under the current currency situation, Japanese manufacturers find themselves at a significant advantage over their foreign competitors in export markets. Some non-manufacturers have been benefiting from a weak yen and low prices as well. In particular, the Japanese tourism industry has been enjoying a sharp increase in the number of inbound travelers and their shopping sprees, as a weaker yen makes Japan an attractive tourist destination where they can stay, shop, and enjoy leisurely activities cheaply.
An increase in Japan's outbound foreign direct investment (FDI) by Japanese firms also contributed to the weakening of the yen. The BOJ's aggressive easing coincided with a contraction in Japan's current account surplus due to a significant rise in energy imports. Those factors together led the yen to depreciate. So, the timing was perfect for Abenomics, and the trends in international capital flows at the time provided a significant tail wind for the monetary easing. Furthermore, less aggressive easing by the U.S. and European monetary authorities, which came just as the BOJ was strengthening its easing stance, also helped weaken the yen.
With prices continuing on a downward trend, Japan's real gross domestic product (GDP) has been edging up steadily. Indeed, Japan's growth performance over the past 20 years has not been as bad as many people might believe, with the growth rate of real GDP per capita fairly comparable to that of the United States. People have been unable to sense improvement in the economy as nominal GDP has been mostly flat all those years. In real terms, however, their livelihood has improved to the extent that prices have gone down.
Now, let's take a look at changes in the GDP deflator. Falling import prices since mid-2014 have been pushing up nominal GDP, giving a temporary hike to the GDP deflator. Meanwhile, excluding imports, the GDP deflator is now beginning to bottom out. Although overall consumer prices have been growing only marginally because of falling import prices, the prices of domestic products have been showing a slow but steady growth, and I believe that the so-called "core-core" consumer price index (CPI), which excludes energy and food, will be able to sustain an inflation rate of about 1%. In other words, as far as the domestic economy is concerned, Japan is now moving out of deflation into modest inflation.
Although the Nikkei 225 Stock Average remains far below levels observed during Japan's bubble period, the market capitalization of the first section of the Tokyo Stock Exchange (TSE) is now reaching a level comparable to the peak set in the bubble period. So, I think that Japanese stock prices are currently at a relatively high level. However, the number of listed companies is on the rise, and, as a result of massive direct investment overseas, Japanese companies today have much greater earning power than they used to. The aggregate value of listed stocks reflects those facts. In this sense, the rise in the market capitalization, even to a level on par with the peak in the bubble period does not pose a sign of strong overheating. Rather, it can be said that the Nikkei 225 Stock Average has been somewhat underestimating the value of Japanese stocks.
Turning to corporate earnings, which underpin stock valuations, we can see that Japanese companies' earnings have been showing strong growth as a share of GDP, achieving a level beyond that observed in the bubble period. However, capital spending by the corporate sector has been kept very low relative to that of retained earnings and growing only marginally. In other words, despite increased profits and strong cash flows, Japanese companies have been making little net capital investment (i.e., capital investment in excess of depreciation), resulting in a marked improvement in their financial positions. They have been active in investing overseas but not in Japan, and this is posing a big problem for the Japanese economy.
Risk factors for the Japanese economy are long-term in nature
Risk factors for the Japanese economy can be defined as long-term challenges. First, the postponement of the planned consumption tax rate hike by 18 months (from October 2015 to April 2017), though having a somewhat positive impact on the economy in the short term, poses the risk of aggravating the already serious problem of fiscal deficit over the long term.
Second, a contraction in Japan's working-age population portends a worsening labor shortage in the future. In the coming years, we will see a severe shortage in the number of medical and healthcare workers. We need to pay attention to the risk of loss of productivity which may result from an increased caregiving burden on the working generation.
Third, the current economic policy depends too much on monetary easing. Under the QQE regime, the BOJ is effectively underwriting government debt and its current goal is to increase the outstanding balance of JGB holdings at an annual pace of 80 trillion yen (BOJ release dated October 31, 2014). Meanwhile, Japan's overall fiscal deficit (central and local governments' deficits plus deficits in public social security funds) is expected to amount to 31 trillion yen per year (forecast by the International Monetary Fund as of April 2015).
I think that the government's decision to postpone the consumption tax rate hike was a mistake. It is quite regrettable that Prime Minster Abe failed to use the precious legacy left by his predecessor, Yoshihiko Noda of the Democratic Party of Japan (DPJ) who had paved the way for raising the consumption tax rate from 5% to 10% at the cost of splitting his party and losing the subsequent general elections. Without raising the consumption tax rate, Japan's fiscal situation would be unsustainable.
It is also imperative to reinforce the growth strategy. The current growth strategy, which constitutes the third of the original three arrows of Abenomics, lacks power and it would be difficult to achieve a GDP target of 600 trillion yen, a new goal set by Prime Minister Abe in his recent announcement of new three arrows. As determinants of Japan's potential growth rate, we can cite two major factors: working-age population growth and productivity growth. Over the next 20 years, Japan's working-age population (between 15 and 64 years old) is expected to decrease at an annual rate of slightly below 1% or by 17% in total (based on the medium-variant projection by the National Institute of Population and Social Security Research as of January 2012). This presents a dire future.
We often hear that Japan's productivity is particularly low in the non-manufacturing sector and that improving it to a level comparable to that of the United States would bring Japan's overall productivity to a level nearly comparable to that of the United States. But I am skeptical. Two sectors excluded in an international comparison of productivity are healthcare services and education. Those who have lived in the United States would know that both healthcare services and education are extremely expensive there. Tuition for Harvard University is approximately seven times higher than that for private universities in Japan, and the cost of attending graduate schools is nearly tenfold more expensive in the United States than in Japan. Things are very much the same for the cost of healthcare services. I dare say that not a single Japanese who has done little research on the reality of healthcare services in the United States would want to replace the Japanese healthcare system with that of the U.S. system. So, if we include those two sectors, where the United States has low productivity, the livelihood of the Japanese people is not that much different from that of the American people. I believe that Japan's productivity has reached a level close to that of the United States.
In advanced countries that are roughly on par with the United States in the level of national income per capita, the growth rate of productivity as measured in terms of GDP per capita generally stands at about 1.5%. Meanwhile, in the United States, the population has been growing at a pace of about 1%, which is attributable to higher fertility as well as significant inflows of immigrants. The potential growth rate of the United States is estimated to be 2% to 2.5%, of which one percentage point is contributed by population growth. In contrast, the potential real growth rate of Japan, where the working-age population is on the decline by 1% annually, is estimated to be around 0.5%, and perhaps raising it to about 1% is as much as can be achieved with government measures to promote workforce participation of women and elderly people.
In order to achieve a sizable increase in Japan's potential growth rate, the government needs to implement powerful measures to address the population decline. Increasing fertility should be the backbone of those measures. However, even if we manage to raise the fertility rate immediately, it would take roughly 20 years before today's newborns join the workforce. Therefore, Japan should pursue a pro-immigration policy, defining it as a pillar of the growth strategy.
Positive and negative effects of accepting immigrants
What I have in mind is a policy that promotes immigration with a special focus on Japanese language proficiency. By actively accepting immigrants with high Japanese language proficiency, Japan can increase its potential growth rate while keeping out the negative effects that immigrant inflows might have on its economy and society. Specifically, the government should issue a five-year working visa to foreign nationals who have passed the Level N1 Japanese Language Proficiency Test (JLPT), and those who have worked peacefully and paid taxes properly should be granted permanent resident status or allowed to naturalize.
Currently, the JLPT is held in 64 countries. Each year, approximately 600,000 foreign nationals take the test with roughly 60,000 of them certified for Level N1. Thus, by implementing appropriate measures, Japan could attract some 50,000 "quality" immigrants per year. This is far from sufficient to make up for a decrease in Japan's working-age population, which is contracting at a pace of 600,000 per year. However, we can perhaps expect twice as much impact as what the number of prospective immigrants may indicate as they would bring their spouses to Japan and fertility would increase.
The Ministry of Health, Labour and Welfare estimates that a total of two million workers will be necessary in the field of health and caregiving services in the next 10 years. Securing two million workers at a time when the overall working-age population is expected to decrease by six million would be impossible unless working conditions for those workers are improved significantly. We should start actively accepting immigrants now. Otherwise, we would not be able to secure the necessary workforce.
By attracting a number of Japanese-proficient quality workers from other Asian countries, Japan would be able to become Asia's business and financial center and seek to become a hub for healthcare services as well. Brighter prospects for the supply of human resources would have a positive impact on domestic capital investment and entice more foreign companies to Japan.
Quality immigrants would also help restore Japan's fiscal health as they become financially independent and start paying taxes. Furthermore, since the fertility rate of the first generation of immigrants tends to be higher than that of the native born, a pro-immigration policy could also help address the low fertility problem. If we could slow the pace of population decline, we would also be able to keep property prices from falling at least to some extent. Moreover, the presence of such immigrants from other Asian countries would help deepen mutual understanding between Japan and their countries, thereby contributing to the prevention of regional conflicts.
The negative effects of accepting immigrants include a possible increase in the burden on the healthcare, educational, and social welfare system. Also, we all know that cultural friction with Muslim immigrants is intensifying in Europe. In order to minimize such negative aspects, we should focus on Japanese language proficiency as criteria for accepting immigrants.
Adverse effects of enhanced quantitative easing
By holding a huge amount of long-term JGBs, the BOJ is taking too much risk. Reducing risk for the private sector may not be a bad thing, but the BOJ is taking on all of the risk by itself. Some people might think that the BOJ has the capacity to absorb a degree of risk as an issuer of banknotes. However, the amount of the risk is now reaching a level beyond that capacity.
The amount of the BOJ's long-term JGB holdings is expected to reach approximately 360 trillion yen at the end of 2016. Assuming that the average remaining term to maturity is seven to eight years, a two percentage point rise in interest rates would translate into a valuation loss of 58 trillion yen. The BOJ's maximum loss-bearing capacity is about 80 trillion yen based on the current outstanding balance of banknotes issued, which is equal to the amount up to which the BOJ is capable of making available cost-free funds. However, demand for banknotes falls when interest rates go up. A demand function for banknotes based on data from January 1991 through July 2015 shows that the outstanding balance of banknotes issued, which currently stands at nearly 90 trillion yen under the current levels of interest rates, would have been 35 trillion yen if the interest rate were 2%.
How should the BOJ deal with massive valuation losses? The simplest way is to bring about inflation by keeping the zero-interest rate even when prices start rising. When prices go up several-fold, demand for banknotes will grow. And as the government refinances its bonds, interest rates on the BOJ's JGB holdings will rise and income will recover. Another way is to transfer losses to commercial banks by raising the required reserve amount, for instance, to 200 trillion yen compared to the current level of about seven trillion yen. This would force commercial banks to hold massive amounts of money in their current accounts at the BOJ at a zero or extremely low interest rate, enabling the BOJ to achieve a positive cash flow by investing their deposited funds in JGBs and other interest-bearing instruments.
In order to improve its financial position, the BOJ needs to execute either one of the two drastic measures. In other words, the BOJ has gone with its quantitative easing to the point where its credibility as a central bank might be jeopardized. It is not too late now to turn back, but I think the BOJ crossed the line when it stepped up its easing in autumn 2014.
Up to the point where Governor Kuroda made clear his commitment to quantitative easing by lining up a series of "two's," things were manageable and within the BOJ's risk-bearing capacity
However, with the additional easing in 2014, the BOJ took in the risk that goes beyond its income buffer. At that stage, Governor Kuroda should have declared victory instead of enhancing quantitative easing. With the inflation rate rising to slightly below 1%, he could have said that Japan had almost overcome deflation and that the BOJ would continue--but not strengthen--its easing efforts toward achieving the 2% goal. That would have been enough, but this did not happen. The BOJ ended up carrying forward enormous potential damage into the future. I am afraid that the next governor of the BOJ will have a very hard time.
*This summary was compiled by RIETI Editorial staff.