Japan: Welcome Back the LDP?

The LDP is back, this time armed with a mandate for aggressive fiscal and monetary expansion. It has long been my view that the LDP's decades-long efforts to bankrupt Japan would eventually be crowned with success. But as it moves re-occupies Nagatacho this time the world has changed. Most fundamentally, almost without exception its trading and investment partners are operating far below what used to be thought of as levels of potential output eagerly seeking any source of extra demand. Secondly, the major developed nations of the world have all despaired of traditional monetary policy instruments and/or effective supply-side reforms, and - not coincidentally - have central banks which are committed to financing more or less directly fiscal policies which are plainly unsustainable in the long-run.  

After decades of finger-wagging at the LDP's fiscal incontinence, Western governments find themselves facing problems which Nagatacho's politicians have known all their active political lives. As I put it, we're all in Howl's Moving Castle now.  So whilst Japan's actual financial is be worse than ever, it is no longer the sad and isolated exception it had become. Rather, it is merely further down the road much of the developed world is travelling: its government more indebted, its deflation more entrenched, its financial confidence more fully evaporated, and its demographic decline more advanced. 

So  if the Shinzo Abe is really prepared to double-down on 'irresponsible' fiscal and monetary policies once again, the success or failure of the gamble matters for politicians all over the world. 

This piece extends the analysis contained in this week's Espresso, to look briefly at some of the cyclical and structural features of Japan's economy Abe inherits.  It reaches conclusions which are slightly less negative than I expected. 


1. The Starting Point: Momentum  What condition will Shinzo Abe’s LDP find the economy in, and what are the constraints on, and opportunities presented by, the promised newly aggressive monetary and fiscal policies? I hope these four charts help. The first summarizes a mass of industrial, monetary and domestic demand data, showing 6m deviations from monthly seasonalised trends. 

The industrial indicator finds the current downturn in momentum is actually worse than after the March 11 earthquake/tsunami disasters (this measure includes output, exports, inventory/shipments and capacity utilization).  Japan's manufacturers are enduring a grim 2H12, with output falling 5.8% yoy in the 3m to October, and its exports falling 7.6% on the basis,  whilst inventory/shipment ratios rose a full standard deviation above the post-2007 average, and capacity utilization rates sank to half an SD below the same trend.

Despite the industrial weakness, domestic demand is just about holding steady to the underlying very weak trend. This measure include employment, wages, retail sales, auto sales, construction orders and service industries’ activity. What's propping up the indicator are surprisingly-strong labour markets: by October, employment was up 0.9% yoy (and more than a full standard deviation above post-2007 trends) and the monthly rise in cash earnings was also about half a standard deviation higher than trend. But there's little sign this relative strength is carrying through to final demand: auto sales were down 10.8% yoy in October, retail sales were down 1.2% yoy, construction orders were down 2% yoy.  Worse, the 4Q Tankan found companies are becoming increasingly worried about overstaffing. 

Finally, monetary conditions are only mildly positive, accurately representing that current quantitative easing policies are no major departure from Japan’s historic norms. They offer no salvation for the fragility of demand or industrial sector momentum. By November, M3 growth had sunk to 1.9% yoy, which is the lowest since 2009.  

What can Mr Abe conclude as he enters office: that the industrial sector is under considerable stress, and that its continued weakness may undermine the fragile stability of domestic demand. Finally, that current monetary policies are unlikely to help much.

2. Debt & GDP  On all traditional assumptions and measures, Mr Abe has extremely limited rooms for policy-manoeuvre. Here’s the chart which is the default worry for Japan: nominal GDP peaked in 1997 and 15 years later is 8.1% smaller, with no positive growth trend. Meanwhile, after stabilizing during 2005-2009, public sector debt is once again soaring, rising to about 225% of GDP (nb, this is my best attempt at counting public sector debt – it’s not easy: this includes taking into account FLP loans, whilst discounting net BOJ holdings of government debt).

We are already in unchartered territory, and there seems no likely exit from it rapid nominal GDP growth. And we know that Japan’s traditional combination of monetary accommodation, fiscal expansion and supply-side immobility does not deliver that. Historically, however, Japan has sustained structural private sector savings surpluses, encouraged by decades of financial repression, which have provided the cashflows needed to buy the debt issued by the government to finance its deficits. As a result, at end-Sept 2012, only 10% (exactly) of the stock of JGBs was owned by overseas investors, Bank of Japan flow of fund tables show. Whilst foreign investors might doubt Japan’s fiscal credibility, the audience that matters is overwhelmingly domestic.   

3. Private Sector Savings Surplus  But might that be changing? The days of big and reliable savings surpluses are over, exhausted mainly by the aging of the population (pensioners may scrimp, but they rarely save), and partly owing to the declining competitiveness and terms of trade of the corporate sector. To put some numbers on it: in the 12m to September Japan’s private sector savings surplus came to just Y7.746tr, whilst total outstanding JGBs rose by Y28.70 tr. In other words, the private sector savings surplus could finance only 27% of the debt, leaving the rest to come from a combination buying from Bank of Japan and overseas investors, and a financial system willing to sell other assets in order to finance JGB buying.

This sounds dreadful, but there are reasons why disaster has been slow to overtake Japan. First, obviously, holding only 10% of the JGB stock, foreign investors are not in a position to lead the market. Second,  Japan’s post-bubble financial history has bred a deep financial scepticism and risk aversion amongst Japanese savers, and Japanese financial institutions. This risk aversion naturally sustains a ready market for government bonds (rather than, say, equities or real estate). Third, the average debt-maturity bequeathed by decades of savings surpluses is high, at an average seven  years and one month.  Fourth, the government and bureaucracy retain a large degree of influence over the financial system, both directly and indirectly.  In other words, the cashflows have deteriorated, but the balance sheet defences are strong.     

To all this we can now add a fifth factor: right now, government debt markets the world over are sustained by ‘quantitative easing’. The days when bond yields were set by markets in order to discover the balance between supply of savings and the demand for them are, at the end of 2012, a receding memory.  Worrying about the erosion or evaporation of private savings flows is so. . . . . pre-Crisis. The world’s governments and central banks have set out to greet Japan. We’re all in Howl’s Magic Castle now.

4. Source of Profits  All this is known, and seems ultimately likely to prove disastrous. But in the meantime, the automatic assumption that these desperate monetary policies will immediately destroy currencies is no longer so easy to make. The key is in what we can expect to happen to Japanese corporate profitability (and thus cashflows, and the private sector savings surplus) under greatly expanded monetary accommodation and fiscal expansion.  

This is where it gets interesting, because it is not difficult to construct scenarios in which such expansion produces a benign spiral. Consider, for example, the source of Japanese corporate profits. By juggling economic definitions of GDP, one can isolate the major components of profits. These are: i) consumption minus wages; ii) exports minus imports; iii) government spending minus taxes; and iv) investment. 

As the chart shows, at the margin, what is driving profits is the excess of consumption over wages (ie, wage restraint), and the fiscal deficit, whilst the deteriorating trade position is sapping profits. If Abe does indeed put in place far more fiscal and monetary policies, one will see profits attributable to the fiscal deficit rise sharply (by definition), and one would expect also to see investment rising as well. If economic confidence is engendered, the contribution of consumer (vs wages) might be expected to be maintained, whilst the trade balance would deteriorate. With three profit factors rising vs one falling, it is reasonable to expect the market to anticipate and price a rise in profits.

And in those circumstances, rather than financial Armageddon, we may see the opposite – a bull market sustained by inward foreign investment.  

Bullish? Not really – merely a reminder that where Japan is concerned foreign investors are well informed about fear, but may yet discover the imagination needed for greed.