Authored by Joyce Poon, Gavekal Asia Research Director,
In the 16 months since Japanese Prime Minister Shinzo Abe launched his bold plan to reflate Japan’s shrinking economy the yen has depreciated by 22% against the dollar, 28% against the euro and 24% against the renminbi. The hope was to stimulate trade and push the current account decisively into the black. Yet the reverse has occurred. Japan’s external position has worsened due to anemic export growth and a spiraling energy import bill: in January it recorded a record monthly trade deficit of ¥2.8trn ($27.4bn). Having eked out a 0.7% current account surplus in 2013, Japan may this year swing into deficit for the first time since 1980. So why is the medicine not working?
The standard response revolves around timing issues: the so called J-curve effect usually means that the boost to exports after a currency devaluation lags the rise in the value of imports by about 12-18 months. In addition, consumers may be busily buying goods ahead of April’s scheduled sales tax increase, temporarily jacking up imports. On a more structural note, there is also the suspicion that exports are not benefitting from the cheaper yen partly because so much production has been pushed offshore.
This may all be true, but there is more to the story than the trade data. After all, a big devaluation has a ricochet effect across the broad economy that changes the outlook for producers, consumers, the government and providers of capital. The transmission mechanism can be thought as working in the following way. Consumers are immediately hit with an implicit “tax” as imported goods cost more, while export-oriented firms get an effective subsidy. In the capital markets, the effect is to lower the value of domestic bonds in foreign currency terms, with the result that yields rise. This means that the cost to the government of financing its deficit rises, forcing a reduction in government spending. As a result of these effects, resources are shifted from the household and government sectors and into the corporate sector. The effect of this resource reallocation should be to boost productivity, which in turn initiates a virtuous circle of rising incomes and ultimately higher consumption.
Unfortunately, Japan defies this textbook paradigm because in addition to devaluing, it is also engaging in massive quantitative easing. This keeps bond yields low, enabling the government to keep financing its deficit at low cost. There is thus no incentive for the government to cut spending— and in fact the consumption tax hike will be offset by even more spending. Furthermore, low bond yields suppress the financial income of household savers.
The end result of all this is that the government bears none of the burden of the adjustment and the household sector bears all of it, through higher import costs and lower financial income. With the household sector’s spending power thus crimped, companies have no incentive to invest in domestically-focused production. Instead, all their investment will be geared toward exports—mercantilism on steroids.
A mercantilist policy can feel like it is working during periods when strong global growth allows excess exports to be absorbed without ruinous price falls. Between 2001 and 2006 the yen devalued by almost 40% on a real effective exchange rate basis and Japan’s current account improved sharply. Japan may not have won back its global competitiveness (its share of the global export pie fell by 1.5 percentage points in the period), but strong external conditions did allow exports to grow 9% a year in dollar terms.
Today, Japanese exporters do not face such benign conditions and any successful mercantilist boost can only come from eating the lunch of rivals.
Since all the leading economies favor policies that support production over consumption, the world is getting more goods than it can absorb. The result is ongoing price declines, which have the effect of deferring the ultimate global recovery.
What this means is that Japan’s ultra-mercantilism is self defeating. In a global environment of weak demand and disinflation any volume increase in its exports will have to be paid for through price reductions. To be sure, in the short term the trade balance is likely to improve somewhat as a result of the J-curve effect taking hold. But in the longer term Japan looks to be entering a cycle where it must run harder just to stand still.
There are a few ways this could all end happily. Japan might embrace a structural reform agenda that boosts productivity, raises wages and pushes up domestic demand. Alternatively, world growth could surprise on the upside, creating a rerun of 2001-06. Energy prices could collapse, closing Japan’s trade deficit and reducing the incentives for mercantilist policy. But we are not holding our breath on any of these possibilities.
Instead, Japan’s most likely path is that the yen keeps falling, the BoJ keeps printing money, and the dollar value of exports stagnates as devaluation and price cuts offset any volume increases. And so, paradoxically, the current account will continue to deteriorate into permanent deficit, despite ultra-mercantilism. At this point the game will have changed in Japan and Abenomics will have manifestly failed to deliver on its stated objectives.