Two years have passed since the start of Abenomics. The first arrow of Abenomics is the massive monetary easing. There are already a number of debates on how Abenomics should be judged on its target of "2% inflation in two years." Although prices indeed did rise temporarily, the drop in crude oil prices in the middle of 2014 coupled with the slowdown in the inflation rate have made it unlikely that Japan will meet its original inflation target.
However, inflation is not the only expected effect from the monetary easing policy. There certainly was an expectation that an increase in the expected inflation rate would lift the real economy. A look at the real economy over the past two years shows that there have been some positive impacts. Both the unemployment rate and corporate profits have improved. At the same time, some results have differed from the initial expectations. Exports, for example, have been slow to grow in spite of the rapid depreciation of the yen.
Let's take the October-December 2012 quarter as a low point in the economy and consider the real gross domestic product (GDP) for the subsequent two years. The annual growth rates for major categories of GDP were as follows: private consumption -0.01%, private capital investment 1.8%, and public capital formation 8.1%. Compared to the other two periods of recovery since the start of the 21st century, this recovery has had the greatest dependence on public investment.
Perhaps it was inevitable that the increase in the consumption tax rate in April 2014 impacted consumption. But why has private capital investment been so weak? This article discusses the transmission effect of monetary policy on capital investment, based on an analysis of recent investment activities in Japan.
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The route initially emphasized by which bold monetary easing is supposed to stimulate private capital investment is that as the expected inflation rate rises, the real interest rate, namely, the nominal interest rate minus the expected inflation rate, should fall. If the expected inflation rate rises when the nominal interest rate is hovering close to 0%, the low real interest rate should spur companies to invest.
This idea is based on the classical investment theory advocated by Harvard University Professor Dale Jorgenson in the 1960s. However, one more element of expectation plays a critical role--the outlook for future demand--according to his theory. Let us suppose that companies foresee a protracted period of sluggish demand due to the aging population. This would offset the increase in capital investment that results from a lower real interest rate.
The second route by which bold monetary easing is supposed to lead to increased capital investment is that the depreciation of the yen creates a positive environment for developing overseas markets, to the effect that there is an increase in domestic investment to meet foreign demand. However, when a Japanese business moves into an overseas market, capital investment at home is not its only cost. It also must absorb the cost of setting up sales bases and hiring personnel to sell overseas.
Moreover, if the business already has a presence overseas, it is often the case that its production bases had already been transferred overseas because of the appreciation of the yen. Thus, if the business is planning to bring production back to Japan, it has to bear this cost. For a business operating in the Japanese fashion, which considers not only capital but also labor as a fixed production factor, this cost is expected to be greater than it would be for Western businesses.
In light of the above, to set up a production base in Japan to feed overseas demand, the exchange rate prior to the collapse of Lehman Brothers is insufficient. The yen would have to be even lower than that. However, the real effective exchange rate in 2014 was just barely lower than that before the Lehman Brothers bankruptcy.
Furthermore, Japanese firms have tried to sell products overseas with more value added (productivity) in order to fend off competition from China, Korea, and elsewhere. Some studies using firm level data found that the greater the value added of a product, the less responsive it is to the exchange rate. It was found that businesses leave prices unchanged and increase their rate of profit rather than engage in price competition to expand their market.
The recent increase in the profitability of Japanese companies as a result of the depreciation of the yen is consistent with the empirical research. Analysis conducted by Kenji Tanaka of the Development Bank of Japan Inc. and myself also showed that since the financial crisis of the 1990s, major capital investment by Japanese firms has not been highly sensitive to movements in the real exchange rate.
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The third basis for arguing that bold monetary policy increases capital investment is based on Tobin's q theory (market value of a firm's existing shares divided by its replacement cost of the share capital). According to it, as corporate profits rise, the rise in corporate value (i.e., rising stock prices) and in cash flow lead to an increase in capital investment. Certainly, many empirical studies have explained investment behavior in Japan based on this theory. So why is it that capital investment now has not increased very much in spite of the rise in corporate value and corporate profits?
Any detailed verification will have to wait for future research, but for the time being, two factors may be considered. One is the impact that changes in corporate governance structures have had on capital investment. As Hitotsubashi University Professor Kyoji Fukao pointed out, the profit rate on capital in Japan has continued to fall since the collapse of the economic bubble. Gakushuin University Professor Hideaki Murase and Chuo University Professor Koichi Ando state that as the profit rate on capital has fallen, the corporate governance structure in Japan has changed, causing capital accumulation to decline at businesses.
In other words, since the financial crisis of the 1990s, financial institutions have had less impact on company management, and capital markets have had only a weak disciplinary effect. As a result, managers and loyal shareholders have more discretion; instead of taking risks and investing their rising profits in growth, they invest those funds in safe assets, such as currencies or government bonds.
If a rise in corporate value encourages investment in real assets and is referred to as the Tobin effect, then the phenomenon at work in Japan today could be called the inverse Tobin effect. As Waseda University Professor Shinichi Hirota's empirical analysis of corporate behavior suggests, if businesses aim not to maximize their corporate value but to maximize their probability of surviving into the future, we can assume that this would encourage businesses to favor safe assets.
The second reason why capital investment has not been very strong is that it is constrained by weak investment in intangible assets such as human resources and organizational reform. Since the start of the 21st century, there has been a steady increase in information technology (IT) investment despite the fact that overall investment has been sluggish. For that reason, industries with abundant IT assets have taken on the role of growth engines during the "lost two decades."
IT investment can bring about increased productivity and profitability only when businesses have the right human resources and make an effort to improve their organization to accommodate new technologies. Unfortunately, 21st century Japan, even though it is investing more in IT, is hardly increasing its investment in human resources and organizational improvement.
In today's tight labor market, proactive IT investment is expected on both the marketing side and the business streamlining side. However, the reason that this trend is not more pronounced may be related to the bottlenecks in human resources and other resources. In a survey of about 600 businesses taken in November 2014 by the International Foundation for Information Technology, more than half of the companies said that a "lack of human resources specializing in IT" is one reason why they do not utilize IT more.
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Encouraging capital investment does more than just lift the economy from the demand side. It is just as important in that it elevates growth potential through capital accumulation. However, considering analyses of Japanese corporate behavior and capital investment as described above, the originally anticipated process of stimulating capital investment with massive monetary easing was somewhat optimistic.
There can be many breakdowns on the road from monetary easing policy to expanded capital investment. To ensure that the effects of government policy are passed on smoothly, it is essential to provide support for corporate governance reform and human resources development so that proactive real investment can lead to corporate growth.
Our two years of experience since Abenomics began has taught us that the first arrow and the third arrow (growth strategy) will be more effective when they are implemented together, not alone.
* Translated by RIETI.
March 11, 2015 Nihon Keizai Shimbun
