Can the Rising Sun Shine Brighter Under Suga’s Leadership?

Yoshihide Suga has been elected as the new Japanese prime minister with a comfortable majority and with this a new era has dawned for Japan. Although Shinzo Abe leaves behind a strong legacy of political stability, global statesmanship and Abenomics, Japan’s current weak conditions pose challenges to the new premier. Our earlier article had assessed the legacy of Mr. Abe, the probable candidates for the premier’s post and the challenges that a new prime minister may have to contend with.

In this article, we outline Japan’s macro policy issues and investment returns over the past three decades to provide a perspective on the challenges confronting the new administration.

On 16 September, Mr. Suga highlighted his priorities as tackling the “social and economic impact of the Coronavirus” along with digitization, administrative reforms and repatriation of Japanese prisoners from North Korea. He has retained the core of the experienced ministers in the cabinet but is expected to call for a snap election as early as the year-end to consolidate his position.

Shinzo Abe and Political Stability
When he came to power in 2005 at the age of 52, Mr. Abe became the youngest post-war Japanese premier. His second stint starting December 2012 ushered in an era of political stability, positive expectations, radical vision and a pride in Japanese excellence. Mr. Suga, on the other hand, became the premier at the age of 71. The background of the outgoing and the incoming prime ministers also provides a contrast. Mr. Abe comes from political royalty as the grandson of a former prime minister and the son of a foreign minister, whilst Mr. Suga is the son of a strawberry farmer and rose through the ranks to become the longest serving chief cabinet secretary of Japan.

Although Mr. Abe’s vision was at the core of Abenomics, Mr. Suga has been instrumental in implementing many of the structural reforms, including promoting the “hometown tax” program and tourism, encouraging immigration, lowering mobile network charges and raising the minimum wage. The new premier also has a reputation of getting things done by cutting through bureaucratic red tape given his core decision making experience in the cabinet.

Japanification and Success of Abenomics

Japan is unique in many respects on account of its ageing population, traditional and somewhat rigid labor market and deflationary experience. The Japanese experience of the “lost two decades” (1992-2012) along with deflation (1998-2012) shows that even advanced economies could fall into prolonged stagnation and deflation. The term “Japanification” refers to prolonged periods when: 1) GDP growth rate is lower than the potential growth rate, 2) the natural negative real interest rate is lower than the actual real interest rate, 3) the policy interest rate is zero and 4) there is deflation.

The asset bubble burst of 1990-92, inability to deal with non-performing loans, a banking crisis, lack of inflation target and inadequate fiscal stimulus contributed to the gradual process of Japanification since the 1990s. While some developed countries experienced many of the characteristics of Japanification outlined above after the Global Finance Crisis (GFC), only Japan had to face prolonged deflation.

Although Mr. Abe’s economic policies spurred corporate profits and market sentiments, inflation and wage growth remained well below targets. Fear of a resurgence in COVID cases, especially once “Go To Travel”¹  comes into full swing, and economic recovery should dominate Japan’s macroeconomic policy in the short run, but a revival in domestic demand remains the key to medium-term growth.

The average annual GDP growth rate during the Abe regime (0.9%) was better than during the previous decade, when the GFC, tsunami and the subsequent Fukushima Daiichi nuclear disaster occurred (2003-2012: 0.7%, Figure 1). The second planned consumption tax increase in October 2019 (to 10% from 8%) negatively affected private consumption, pushing Japan into a recession, despite some offsetting fiscal measures. There were signs in early 2020 that consumption might recover, but that was before the COVID-19 crisis hit Asia. A rollback of the tax hike also remains unlikely due to a push back from the Ministry of Finance.

Labor Market Reforms Key Within Structural Reforms
A strong labor market will play a key role in reviving spending and boosting consumer sentiment. The rise in Japan’s unemployment rate, which peaked at 3.0% in May, has been relatively low due to the large fiscal transfer program and a lack of dynamism in the labor market. Though the number of active jobs per applicant is low, there are signs that the labor market stress is easing (Figure 2). The uptake on the government’s Employment Subsidy Program has also grown lately and the program has been extended until the year-end.

In this context, Mr. Suga could focus on structural reforms to further increase youth employment while balancing the employment needs of urban and rural Japan. He also needs to put in plans to revitalize IT innovations. In addition, policies concerning the labor market must tackle the immediate demographic challenges of an ageing workforce. Mr. Abe tried to address this by encouraging more female participation and by being more open to immigration. These initiatives need to continue alongside reskilling, career-long training programs and productivity-enhancing plans.

Fiscal Policy and Debt
With the economy being under severe pressure from the COVID-19 shock, we do not anticipate any changes to fiscal policy in the near future. Mr. Suga also has been keen to promote digitization and tackle thorny issues such as regulatory reforms, consolidation of regional banks and administrative inefficiency.

The record $2 trillion (>40% of GDP) in COVID fiscal stimulus will add to Japan’s already high debt – the debt-to-GDP ratio in Japan is among the highest in the world, exceeding 200% of its GDP. A large portion of this debt is linked to ageing-related expenditures on pensions, health care and long-term care, with Japan’s median age being nine years higher than that of the United States (US). The outgoing prime minister was able to stabilize the debt-to-GDP ratio due to nominal GDP growth and low debt servicing costs (Figure 3).

There is a global need to take on debt and run fiscal deficits in this COVID period. But we believe that worries about Japan’s government debt are a bit overblown, especially considering the fact that Japanese investors hold around 90% of the debt with over 40% owned by the Bank of Japan (BoJ). Domestic pension funds as well as insurance companies are large holders, too. In addition, the country is the world's largest creditor (more than US$3 trillion net assets in FX reserves and direct investments abroad).

Monetary Policy and the Yen
The appointment of Haruhiko Kuroda at the helm of the BoJ was pivotal to the success of Abenomics. The fact that the new prime minister has expressed his support for the BoJ governor bodes well for the long-term prospects of Abenomics. Although the current monetary policy framework (short-term interest rate target at -0.10% and a pledge to cap 10-year government bond yields around zero) should be maintained, the central bank could be induced to cut the policy rate one more time if the yen were to appreciate rapidly and persistently.

Further cuts than the one mentioned above are unlikely in the context of the BoJ encouraging banks to expand lending as more cuts would mean a reduction in Japanese banks’ lending margin. Credit easing in coordination with fiscal policy alongside accommodative financial conditions continues to remain a good policy combination.

An unchanged economic policy stance and support for the BoJ governor mean that broad fundamentals impacting the yen should remain unchanged in the short term. So far this year, portfolio outflows have likely kept the currency weaker. The yen has been a reserve currency for investors wanting to avoid the US dollar or the yuan due to trade and geopolitical uncertainties. As risk-averse investors will still be drawn toward the yen, it could prove to be a conservative way to gain exposure to the US dollar market while hedging risks of market volatility.

Contrary to the past periods (1980s to 2007), USD-JPY dynamics are not only determined by bilateral factors (demand, supply, microstructure and central bank policies) but also by the emergence of China and the European Union as important global trade players alongside regional trade agreements in the Asia-Pacific, among others.

Stock Market and Asset Returns
In 1990 the Japanese stock market was the largest in the world with a weighting of 45% versus the US’s 29%² . But from 1990 to 2019, it was the worst performer among a sample of the 23 largest mature equity markets due to the Lost Decades and an asset price bubble collapse. Despite losing some of its past allure, Japan is still the second-largest equity market and the third-largest bond market. Japanese real equity returns for 2010-2020 were 8.9% p.a., real bond returns were 4% p.a., equity premium (versus bonds) was 4.1% p.a. and real bill returns were -0.6% p.a. The annual (2019) real equity returns were 17.9%, real bond returns were 3.7% and real bill returns were -1% with inflation at 0.8%.

The financial market was bullish on Abenomics during the initial years, but the BoJ’s limitations regarding policy options and slower-than-expected progress in reforms led to Japanese equity being underweighted by global investors for some years. The credibility of Abenomics was somewhat dented due to a lack of policy coordination across the three arrows of aggressive monetary policy, fiscal consolidation and growth strategy.

Conclusion
The future of Japanese growth will hinge on balanced growth and structural reforms (labor and institutions), which the new prime minister is best placed to pursue. Internal progress and positive sentiments regarding the country are most likely usher in foreign investments as well. The future of Japan’s asset markets will depend on the profitability of Japanese companies and their cash flows, discounted by the (adjusted for growth) yield curve, which are influenced by expectations, sentiments and macro fundamentals that we have outlined above.