Japanese lessons

Japan faces huge economic and geopolitical issues. Demographics pose the biggest single challenge to efforts to maintain living standards, as an increasing share of resources is devoted to pension provision. Although the central bank has provided a huge amount of liquidity it is likely that the pool of domestic savers willing to hold government debt will require Japan to turn to foreign investors, which is likely to put upward pressure on interest rates and raise the debt servicing problem. All this is taking place against a backdrop of a relative decline in Japan’s economic position as China becomes economically stronger. This suggests that the years ahead will remain challenging for Japanese policymakers.

The background

Japan has become a byword for economic stagnation following the sharp growth slowdown following the bursting of the bubble economy in the late 1980s. Whilst it is true that it is no longer able to recapture the stellar growth rates of the 1970s and 1980s, and it remains mired in a disinflationary environment, Japanese society has remained far more cohesive than many western economies which have suffered much less over a shorter period of time. On indicators such as safety and healthcare provision, Japan routinely scores in the world’s top 10 economies. Moreover, on a per capita basis, Japanese GDP growth since the onset of the financial crisis in 2008 is only slightly below the industrialised country average, whilst the unemployment rate is at its lowest since the mid-1990s.

But Japan faces numerous challenges. One of the biggest is the ageing population which has resulted in one of the oldest demographic profiles of any nation. In addition, the economy has been propped up by a huge financial injection by the Bank of Japan (BoJ), whose balance sheet is larger than that of any other major central bank bar Switzerland, and which vastly complicates the policy mix. In the longer term, Japan will also have to deal with the rise of China.

The economic challenges of the demographic slowdown

The ageing demographic profile is increasingly making its presence felt. Between 1950 and 2015, the share aged 65+ rose from just below 5% to over 25% – the highest in the world. Current projections suggest that by 2050, those aged over 65 will represent 35% of the total population (Chart 1). This matters for a whole range of economic reasons: it impacts on growth; it has implications for productivity, and raises the burden on the public purse.

Chart 1: Age is more than just a number

Share of those aged 65+ as percentage of total population

Chart 1: Age is more than just a number
Source: United Nations

Turning first to GDP, markets are conditioned to view it as a key metric of economic progress. What they fail to take into account is what drives GDP growth. Broadly speaking, we can split it into three components: capital, labour, and technical change. In an economy such as Japan, where the population is ageing rapidly, capital and technical change assume increasing importance. We can strip out the population effect by measuring the increase in GDP had it grown in line with per capita output and attribute the rest to labour productivity and technological change. Using 2000 as the base year, the analysis suggests that Japan has had to rely solely on non-labour sources to drive growth since the turn of the century, in contrast to the US and UK where labour input has played a more important role (Chart 2).

Chart 2: Contribution to GDP growth from labour input

Cumulated percentage contribution since 2000

Chart 2: Contribution to GDP growth from labour input
Source: Commerzbank Research

With regard to labour productivity, the empirical evidence is mixed. Many studies find that productivity tends to rise until workers are in their 40s before tailing off until they reach retirement age, although this view is by no means universally held. One recent study1 suggested that the ageing population could have reduced Japanese total factor productivity – that which is not attributable to inputs such as labour and capital – by around 0.7 to 0.9 percentage points between 1990 and 2005. Moreover, the fact that the ageing problem is likely to get worse in future suggests that in the absence of a significant technological boost, long-term growth prospects are unlikely to be particularly favourable.

A combination of slower growth and mounting pension claims will compound Japan’s already considerable fiscal difficulties. As it is, the gross debt-to-GDP ratio at the end of 2016 was above 230% which is by far the highest of all industrialised countries (Chart 3). Although it has been flattered by low bond yields which have been negative, or only marginally positive, since early 2016, debt is clearly well above levels which are sustainable in the longer term without a combination of faster real growth, higher inflation, sizeable primary public surpluses, and low interest rates. Japanese savers have so far proved willing to fund the debt expansion with the Japanese Government Pension Investment Fund highly exposed to the Japanese government bond (JGB) market, even though low bond yields put downward pressure on retirees’ income.

Chart 3: Japan’s debt burden leaves the rest behind

Gross government liabilities

Chart 3: Japan’s debt burden leaves the rest behind
Source: OECD

But the shrinking workforce implies that the pool of willing debt buyers is limited. The average term to maturity of Japanese debt is only 7.4 years, which implies that by the end of 2024 Japan will have to either repay or rollover around half of outstanding debt. With the working age population (i.e. savers) likely to fall by around 10% between 2016 and 2024 it is increasingly unlikely that Japan will be able to rely on domestic purchases to fund the debt burden. This gives rise to the possibility of a number of adverse outcomes. In the first instance, Japan will be forced to increasingly rely on foreign buyers, who are unlikely to be satisfied with the zero interest rates currently on offer, which in turn raises the prospect of higher bond yields. A second option is that Japan attempts to inflate away the debt burden, though efforts to generate higher inflation have proved unsuccessful so far. Another option might be for the central bank to simply monetise the debt burden, which is likely to produce unfortunate side effects. To varying degrees, all these options are on the BoJ’s agenda.

The BoJ and monetary easing

In 2013, the new government under Prime Minister Shinzo Abe unveiled a three-pronged strategy known as Abenomics which comprised ‘three arrows’ in the form of fiscal easing, monetary easing, and structural reform. The fiscal easing has contributed to a 10 percentage point rise in the debt ratio since 2013, but the ability to use fiscal policy to provide a further significant economic boost is limited. Structural reform efforts have been limited in scope. The OECD has called for measures to raise productivity by enhancing corporate governance; improving the entrepreneurial climate by reducing the stigma associated with business failure; reducing support for zombie firms, and improving labour market flexibility. Even if these measures were to be introduced quickly – and we suspect they will not be – they will in any case take time to have any effect. This has put the onus for implementing Abenomics squarely on the shoulders of the BoJ.

The BoJ is nothing if not innovative. After all, it was the first central bank to attempt a policy of quantitative easing (QE) in 2001. Central bankers in the west treated Japanese QE as an interesting intellectual exercise but never really believed that they would ever have to implement it. But some eight years later the Federal Reserve (Fed) and the Bank of England (BoE) were doing exactly that. However, 16 years later the BoJ is still trying to resurrect inflation, with the Abenomics programme setting a target of getting inflation back to 2% – a level which has only been attained for three months this century once we strip out the distortionary effects of consumption taxes (Chart 4). The BoJ has bought huge quantities of securities, and in the process has raised the central bank balance sheet to around 90% of GDP, which is more than three times that of the Fed, the European Central Bank (ECB) or BoE (Chart 5).

Chart 4: The BoJ is struggling to get inflation above 2%

CPI ex. fresh food, adjusted for consumption taxes

Chart 4: The BoJ is struggling to get inflation above 2%
Source: Bloomberg
Chart 5: The BoJ balance sheet is in unchartered territory
Chart 5: The BoJ balance sheet is in unchartered territory
Source: Bloomberg, Commerzbank Research

In contrast to all other major central banks, the BoJ is buying equities, though it currently makes purchases only in the form of ETFs which have gone from nothing in 2011 to comprising 2.5% of the balance sheet today. The objective of the policy is to boost the equity market, thereby stimulating growth and encouraging individuals to invest in the Japanese market. The BoJ’s purchasing limit of JPY 6 trillion per annum means it is the biggest single purchaser, with the result that its actions can significantly distort Tokyo market movements. For example, in the past a rising yen might have been expected to adversely impact on the equity market, but today the pattern is less likely to be repeated given the BoJ will buy irrespective of market conditions. Ironically, one of the structural elements of the Abenomics is a programme to improve corporate governance which involves efforts to force companies to reduce corporate cross-holdings. Companies which thus attempt to reduce their cross-holdings can do so in the knowledge that any potential losses they incur will be cushioned by the BoJ’s actions.

Although the equity purchases have attracted a lot of attention, the bulk of the BoJ’s balance sheet is still comprised of government securities, which currently account for around 86% of the total – up from around 60% in 2010 (Chart 6). Over the last year, the BoJ has bought an amount equivalent to 90% of all new issuance by the Ministry of Finance and now owns 40% of the entire debt stock. These are huge numbers and reflect the fact that the BoJ began implementing the ambitious Abenomics programme after more than a decade of asset purchases. But they also reflect the extent to which central bank actions are designed to avert a funding crisis, as big pension funds and life insurers retreat from a market where they are simply unable to generate a decent yield on their assets.

Chart 6: The BoJ balance sheet is mainly comprised of government debt
Chart 6: The BoJ balance sheet is mainly comprised of government debt
Source: Bank of Japan, Commerzbank Research
The BoJ and yield curve manipulation

In addition to buying bonds across the whole curve, the BoJ is also attempting to hold ten-year yields at zero. This concept is different from standard monetary policy which holds that whilst the central bank can control the short end of the curve it has no control over the longer end. By fixing the long end and using standard levers to control the short end, this allows the BoJ to control the shape of the yield curve, and thus provide some relief for the banking system in a low-rate environment whose profits are positively correlated with the steepness of the curve.

The policy relies on the BoJ’s policy credibility to persuade the market that long rates will indeed be held at zero, thus prompting investors to fall into line without the need for a huge rise in central bank purchases. In theory, this is a cheaper way for the BoJ to hold interest rates down – if it works. The problem will arise if markets decide to test the BoJ’s resolve, in which case it will ultimately have to buy far more paper than under a conventional QE policy. Moreover, in the event of a global bond market sell-off which prompts a global rise in yields, the BoJ will be required to continue expanding its (already large) balance sheet – perhaps indefinitely. By setting a target for nominal rates, the BoJ is also in effect relinquishing control of real interest rates which are a more important determinant of real growth. Given the serious flaws associated with the strategy, and the BoJ’s failure to achieve its policy objectives over the past 20 years, scepticism remains high that this policy will be no more successful than the others.

Moreover, we are also now very much on the brink of debt monetisation. Balance sheet expansion of the form implied by QE is meant to involve only a temporary expansion of the central bank balance sheet which is run down over time. But the BoJ’s strategy implies that the balance sheet could expand or contract, depending on market forces, which in effect means it has ceded control of the balance sheet in favour of interest rates. The inflationary implications of this strategy are unknown. Admittedly, the BoJ would be very satisfied with some sort of inflation pickup, having spent years trying to get to this point. But as with all untried monetary policies, it should be careful what it wishes for as there may well be unintended consequences which are not yet evident.

Dealing with a rising China

For all the economic problems which Japan faces, one of the most pressing long-term issues is how it will deal with a more assertive China. Over the past couple of decades, Japanese strength in manufacturing has been undercut by low-cost Chinese production, which is increasingly emerging as a rival to Japan. Both countries increasingly compete for business in third markets, and nowhere is this more evident than in their rivalry for Asian infrastructural investment business, where China scores on cost competitiveness but Japan sells itself as a supplier of superior technology. Both countries are also heavily energy-intensive, with Japan relying on imports for 99% of its oil supply and Chinese coastal regions also resource poor. Chinese oil drilling in areas claimed by both countries is thus very much a cause for concern.

None of this would necessarily be a problem were it not for the fact that policy wonks concern themselves with fraught historical relations between the two countries. At a time when nationalism is on the rise in both countries, which tends to boil over into inflamed domestic rhetoric, the world often looks on anxiously. Kerry Brown, professor of Chinese studies at King’s College London, noted in an article in ‘The Diplomat Magazine’ last year that the two have failed to live alongside each other harmoniously for the last millennium as he pointed out, ‘If a strong China and a strong Japan manage to exist alongside each other without conflict in the 21st century … they will be going against the pattern of their whole history with each other.’

1 Y. Liu and N. Westelius (2016), ‘The Impact of Demographics on Productivity and Inflation in Japan’, IMF Working Paper WP/16/237.

Japan is in no position to repeat its stunning economic success of the pre-1990 period due to the increasing burden posed by the demographic background. The fact that policymakers failed to spot the nature of the problem early enough meant that they used monetary and fiscal policy to tackle a problem which they could never hope to resolve. This has limited the scope of the Abenomics programme, which relies on further monetary and fiscal easing, and has forced the BoJ to the brink of monetising the sovereign debt burden. All this is happening at the same time as China threatens to inflict further damage on Japan’s manufacturing base. The years ahead are likely to be difficult.