Japan Focus: A Snapshot of the Japanese Economy
About a month ago, on January 29th 2016, the Bank of Japan decided to cut its benchmark interest rate below zero to -0.1%. This doesn’t seem to be anything new as we have seen the likes of Sweden, Switzerland, and the European Central Bank implementing the same. But Japan’s case entails an entirely different story and this article will focus on establishing Japan’s path to the negative interest rate area.
Before we begin to see what led to the Bank of Japan taking such a step, it is important that we understand what it means. This interest rate applies to Bank of Japan’s deposit facilities, taking care of excessive reserves parked by institutions at the central bank. The aim of this measure is lowering interbank interest rate, so that banks would be more willing to lend out the excessive amount of money they hold to consumers and expand the economy by inducing an increase in spending.
This step does not come out of the blue by the Bank of Japan. Since Shinzo Abe came into power for the second time in 2012, he has tried to revive the economy. In his January 2013 policy speech, Abe declared that economic revival and escaping deflation were “the greatest and urgent issues” faced by Japan. His economic strategy, referred to as Abenomics, consists of the so-called “three arrows”. First, a stimulating monetary policy in the form of low rates along with “quantitative easing” or asset buying, similarly to what the U.S. Federal Reserve successfully did in the wake of the 2008 economic crisis. Secondly, a fiscal reform and thirdly, and perhaps most vital, structural and corporate reforms.
Together these three policies were aimed at ending the country’s two decade long stagnation and boost growth. However, something didn’t work as it was supposed to. Let’s look into the arrows in depth in order to ascertain what might have gone wrong.
As per the first arrow, the Bank of Japan conducted money market operations to increase the monetary base by about ¥60tn to ¥70tn (£420bn to £490bn). In essence, an increase in the supply of money encourages private consumption. At the same time Bank of Japan planned to increase purchases of Japanese government bonds to total ¥50tn a year, therefore injecting more money into the economy. In theory, increasing the money supply decreases the interest rate, which facilitates lending. Consequentially, this increases consumption and investment, leading to a higher aggregate demand.
As we can see in Table 1, which shows the money supply in Japan, there was a huge increase in total currency outstanding during the past couple of years.
Table 1: Japan’s Monetary Base from 2006-2016
This increase in the money supply lowered the domestic interest rates and also led to the depreciation of the Yen. As basics of macroeconomics suggest, this should lead to increased exports as Japanese goods became cheaper for the rest of the world.
Such expansionary monetary policies are intended so that manufacturers end up selling more, hoping that the increased profits translating into increased consumption by the people and increased investment by both consumers and businesses. It is important to know that many scholars suggest that this first arrow was merely an extension of the Quantitative Easing carried out by the Bank of Japan from 2001 up until the 2008 Financial Crisis and hence was at the crux of Abenomics.
The second arrow saw Abe promising to impose flexible fiscal policies, depending on the requirements of the economy. It has been clear for two decades that Japan faces demographic difficulties. Its low birthrate and cultural aversion to immigration means that its working age population is shrinking at an alarming rate, while the population of non-working retirees (who demand expensive healthcare) is on the rise. An expansionary fiscal policy involved the government spending being increased in order to deal with the aforementioned difficulties. This increase in spending has been focused on two things:
– Welfare of Japan’s aging population
– Infrastructure (concentrated on 2020 Tokyo Olympics)
The initial expansionary fiscal policy was necessary and worked up to a point: about a third of growth before April 2014 came from fiscal policy, according to the System of National Accounts released by the Cabinet Office. Japan’s gross domestic product has increased by about 25 trillion Yen from January 2013 to March 2014. The government expenditure has increased by about 8 trillion Yen for the same period, as we can see in Graph 2.
Graph 2: Japan’s Government Spending from 2012-2016
Despite being implemented, this policy hasn’t completely materialized yet for Japan. Female participation in the labour force was at 63% according to 2014 figures, far lower than in other rich countries. When women have their first child, 70% of them stop working for a decade or more, compared with just 30% in USA.
The third arrow, consisting of structural reforms, is where Abenomics diverges into more than just a short-term solution. While fiscal and monetary policies tend to impact the economy in a relatively shorter run, structural reforms tend to increase growth by focusing on increasing the quality and quantity of the factors of production. Structural reforms are not meant to take place overnight, but are gradual. A few core reforms that Abe intended to bring included:
Despite high levels of education and worker skills, Japan still has a highly regulated and insular corporate sector, which makes it tougher to raise productivity and wages, both of which are crucial to increasing growth.
– Lowering barriers to trade
For instance Japan is a part of the Trans Pacific Partnership which will open up the economy in order to facilitate free trade
Abenomics also plans to increase women participation in the labour force by increasing childcare as a way to plug the labor shortage and increase the quantity of Human Capital.
It also aimed at easing its policy with regard to residency. The government plans to provide fast-tracked permanent residency for “highly-skilled” foreigners,
If these three arrows were supposed to revive the Japanese economy, why did we see the Bank of Japan reduce its interest rate to sub-zero territory? There are various reasons behind that.
Firstly, many argue that Abenomics was lacking a crucial fourth arrow – involvement of the private sector. If Japan’s private sector was incorporated into Abenomics, it could have moved the economy onto a path of faster growth. Innovations in one company would cascade across its entire industry by forcing competitors to raise their game. In the 1950s and 1960s, for example, Toyota introduced more efficient production processes that were eventually adopted by the entire automobile industry.
Secondly, Japan’s experiment with quantitative easing earlier this decade created a large increase in bank reserves, but had a debatable effect on inflation, since only a small part was passed through to the economy via increased bank lending. This could be explained by the fact that credit didn’t expand the way it was supposed to because businesses did not see the investment perspective to borrow. Businesses in Japan don’t need money but need investment opportunities, which can only be achieved through structural reforms, which brings us to the third and final reason why Abenomics is deemed as a failure. Another possible explanation is that the Bank of Japan’s quantitative easing program was perceived by citizens only as a short-term measure. Expectations play a key role in monetary policy, and the failure of the Bank of Japan in keeping them under control completely offset the initially obtained positive results.
As the first two arrows were implemented, Japan fell back in its implementation of the much-needed structural reforms. As in many other parts of the world, the sugar high of easy money actually made governments and companies less likely to do the hard work of fiscal and structural reform. They didn’t have to, because for some time now they have been able to rely on cheap money rather than real, underlying innovation and growth to keep the economy afloat.
But wait, isn’t it three years only a short span of time to be expecting structural reforms to reap results? A recent paper published by the Bank of Japan suggests that all these efforts have not led to long-term inflation forecasts coinciding with the 2% inflation target. Hence, we saw the negative interest rate.
WRITTEN BY CHETAN SHARMA FOR BESA
PLEASE DIRECT ANY INQUIRY TO AS.BESA@UNIBOCCONI.IT