Japan: Nothing Fails Like Success
(co-authored with my Tokyo-based colleague Masashi Murata)
Abenomics appears to be off to a fairly successful start, despite the volatility in the JGB market. The yen is sharply lower. Equities are dramatically higher. The Japanese economy itself is likely boast the best performance in the G7 in Q1, when the GDP estimate is released early on Thursday in Tokyo. Abe and his government are running strong in the opinion polls, putting it in a solid position to win 2/3 of the upper house in this summer's election.
The critics of Abenomics have generally focused on the risks involve. On the fiscal front, the high debt burden limits the government's ability to maneuver. This leaves the onus on monetary policy. Here the BOJ has been exceptionally aggressive. Consider the US economy is nearly three times bigger than Japan and the BOJ is buying roughly $75 bln a month in securities, while the Federal Reserve is buying $85 bln a month. Structural reform to boost the country's growth potential also seem limited, thus far.
However, what could be even worse for Japan than the failure of Abenomics is its success. The ultimate goal of Abenomics is revitalize the Japanese economy by freeing up the vast savings Japan has amassed (in the corporate sector). Savings in the household sector have generally fallen, as one would expect given the unfavorable demographic trends characterized by shrinking and aging population.
Far from a revolution that many observers have hyped, the Abe's diagnosis and medicine is not new, even if the dosage is. The problem, as we have argued before, is not too little investment in Japan but really the opposite; too much investment.
Consider that over the past decade, gross fixed investment in the US averaged about 10.5% of GDP. A comparable figure for Japan is almost 14%. Yet, US growth surpassed Japan's. As we have seen in China, so too with Japan, each new unit of investment generates less economic growth.
Data from Lombard Street Research shows that combined depreciation and retained earnings amount to 29.5% of Japan's 2011 GDP. In the US, where corporations also enjoy a financial surplus, it is closer to 16%. Boosting the wherewithal to invest would seem to compound the problem.
As Martin Wolf of the Financial Times argued in a recent column, corporate savings in Japan are too high relative to the plausible investment opportunities. This problem of surplus savings is incomprehensible to Japanese policy makers. They continue to insist on understanding the problem in traditional terms of boosting investment to increase employment and consumption.
In the early 1900s, a US journalist and presidential advisor, Charles Conant, was the first American to conceive of problem of surplus savings and he gave it a deep think. He argued there finite number of ways to address the issue the surplus. Wars destroy capital, but Conant argued against such a course. Redistribution was another strategy, but Conant was no socialism. Conant also realized that internal improvements (public works) or public investment could absorb some the surplus savings but not enough.
Conant concluded that exporting the saving to other countries, building infra-structure, laying the railroads and telegraph lines, the information highway of the day, was the way to alleviate the US savings congestion, which threatened profit-margins at home.
Japan can export some of its surplus savings, but typically, Japanese investors have been reluctant to do so on a sufficient scale. Japanese companies do invest in plant and production outside of Japan and since the late 1990s, the Ministry of Finance reports that the local sales of Japanese affiliates surpassed exports as the primary way Japanese businesses service foreign demand. For example, roughly 70% of the Japanese-brand cars in the US were produced in the US.
Portfolio capital flows are even bigger. Until very recently, Japanese investors have been net sellers of foreign financial assets this year. Moreover, Japan's past investments in foreign bonds (and equities) generate a large monthly capital stream that is the main driver of the country's current account surplus. The stock of that investment is so great that on a given month, the income it generates may be larger than the new portfolio outflows and that is with record low bond yields in the US, Germany, UK and France.
In the past when the private sector was unable to recycle Japan's current account surplus, the government would through intervention. Japan has accumulated more than $1 trillion of reserves. This route seems to have been effectively blocked by the G7/G20), given the sharp depreciation of the yen seen in past six months.
Japan does need to revolutionize its thinking, but Abenomics is not it. Japanese officials think their world is characterized by a shortage of investment. Instead it is plagued by a surplus of savings. It can boost consumption (what Conant saw as redistribution), but instead the Abe government is still poised to raise the retail sales tax next year and in 2015, as the DPJ legislated, with what appears to be its dying political breath. Abe said he wants wages to rise, but wanting and doing are not the same thing.
Lower real interest rates, even negative nominal rates, may not absorb the surplus savings as change their location by prompting a reallocation of portfolios to equities and real estate, for example. Instead, Japanese officials may be better served by addressing the corporate savings surplus directly.
There are many forms this could take, such as dramatically reducing the depreciation allowance applied to business investment. The tax on dividends could be cut, but this might not trickle down to households as their equity holdings tend to be a small part of their financial assets, and could end up simply redistributing the corporate surplus among businesses. Of their financial assets, the equity holdings of Japanese households as of March 2012, was about 6.5%, nearly half of what it was in March 2007. The comparable figures for the US households are 31.9% and 36.3% respectively.
Businesses are opposed to the suggestion that retained earnings should be taxed. Corporate governance reform could also force a reduction in corporate savings if shareholders had more power. A more politically palatable route seems to be tax based on the size of the business (pro forma basis).
In order to conceive of the solution, Japanese policy makers and investors need to perceive the problem. Yet, ideological blinders are preventing this and keeps Japan pushing on the same string, albeit somewhat harder, as it has for the better part of two decades.