Japan seems to have fallen off the financial media radar of late, so perhaps it is a good time to check in with the world's third-largest economy. Even as the political calendar continues to heat up with the recent U.S. election which now shifts to Europe, Japan remains at the forefront of several grandiose economic experiments that probably have just as good a chance at being looked back upon decades from now as transformative as any shuffling of the political deck chairs in Western countries. Only time will tell, but it is certainly useful to cut through the political noise and appreciate what Japan is actually attempting. For the first time in the history of modern capitalism, we are witnessing a government-driven attempt to engineer sustainable economic growth in a country with an aging and shrinking population. This will be no simple task.
It has been said that demographics is the future that has already happened. It has also been said that demographics explains two-thirds of everything. Given the demographic cards that Japan has been dealt, over the long term, the Japanese economy should theoretically either become more productive or shrink. This is because a country's long-run potential GDP growth is roughly equivalent to its change in labor force plus the change in productivity growth. There has been an enormous amount of intellectual capital deployed trying to develop the perfect policy prescription to get Japan's GDP to grow, even as its population and workforce shrink. We believe what is being discussed in Japan is at best increased government meddling and at worst attempted central planning. All told, perhaps Japan would be better suited by deploying its cadres of intellectuals and control engineers not toward trying to figure out how to make the economy grow, but to get it to shrink gracefully along with its population without causing a destabilizing calamity in global financial markets.
To understand why policymakers are so concerned with GDP growth, it is worth considering what the function of growth is in the first place. First and foremost, it is a mechanism to increase incomes and wealth for a country's population. However, one could argue that this is less relevant for Japan, as per capita incomes can still grow in a stagnant economy when the population is shrinking. An overly simplistic analogy would be that 10 people are marooned on a desert island where coconuts represent wealth. If two of them pass away and their coconuts are divvied up among the survivors, then the latter are wealthier in terms of number of coconuts. In short, Japan doesn't need GDP growth to become wealthier. It is already one of the wealthiest countries in the world and also one of the most egalitarian in terms of the distribution of that wealth.
There are two other "purposes" of economic growth that we believe are more relevant for Japan. The first is to be able to fund an ever-growing military. We have believed from the start of "Abenomics" that Prime Minister Abe is a nationalist at heart whose end goal is to strengthen and reinvigorate Japan's military, and stronger economic growth was always a means to this end. The other reason that governments pursue growth is that nearly all governments across the globe have debt to pay. Debt is an easy way for governments to pay for the support of voters, since often the people who are ultimately taxed to pay that debt are those who were not eligible to vote (or even alive, for that matter) when the debt was incurred. Hence, nearly all governments carry a debt load. The problem is that when the sustainability of this debt is called into question, the cost of funding it can increase dramatically. At this point, a higher proportion of tax revenue must be set aside for debt service, leaving less for governments to dole out, either through handouts or projects, in an effort to buy support of the ruled class. A rudimentary way to measure the sustainability of a country's debt is simply to look at the spread between trend nominal GDP growth and the cost of funding, using a 10-year bond yield as a proxy. This spread, sometimes referred to as the interest gap, has turned sharply negative after almost two decades in positive territory. We must concede that if the purpose of "Abenomics" was to improve the sustainability of Japanese debt, it has been a success in this regard, at least for now.
For nominal growth to continue to be higher than debt service, the country will, of course, need to engineer some combination of positive real growth and inflation. Both of these have been, and will continue to be, uphill battles because of demographics. To improve its potential growth, Japan needs reforms that will improve productivity, increase labor market flexibility, enhance internal competition, and open the country up to foreign workers. Specifically, areas in need of bold reform include healthcare, education, and agriculture, among others. Most of this falls under what is usually referred to as the "third arrow" of Abenomics, and unfortunately, we have seen little progress on this front in recent years. The first two arrows, namely fiscal and monetary accommodation, were - in our view - not much more than a confidence game which seeks to end Japan's famous "deflationary mindset" by printing money and massively devaluing the currency. This would theoretically lead to inflation and hopefully sustainably higher wages, thus incentivizing people to go out and spend money into a virtuous cycle of growth.
We have been skeptical of the government's ability to engineer growth via the above-described channel from the time Abenomics was announced. The logic of the first two arrows was, and is, dubious at best. First of all, the belief that inflation is a problem per se in terms of the consumption habits of an aging population, many of whom are living on a fixed income, should not be taken at face value. In fact, it can just as easily be reasoned that slight deflation should be good for such a consumer base, as their purchases become cheaper every year, which supports purchasing power in real terms. Conversely, if the items one buys increase in price, it becomes more difficult to pay a mortgage or afford other goods.
Secondly, and perhaps more importantly, the notion that slight deflation will imminently turn into a deep "deflationary spiral" is possibly the most widely accepted piece of economic sophistry ever parroted by the intellectual and pundit classes in the history of capitalism. If anything, Japan is a glaring counterexample to this belief system. Consumer price inflation has very rarely gone below negative 1%, and yet, conventional wisdom states that consumers will delay purchases into the future if they think prices will be lower. While we do not dispute the logic of that statement directionally, it is extremely challenging to come up with a list of purchases that consumers would likely delay if they thought the price would be 1% lower in one year's time. Moreover, there are simply fewer purchases that can be delayed in a services-based economy, both in terms of the proportion of consumer wallet share and in terms of the proportion of the CPI basket. People will not delay the purchase of healthcare services, drugs, electricity, haircuts, etc. in hopes of saving 1%.
Just as the idea of eroding the purchasing power of people's income and savings in order to make them wealthy is illogical, equally as unreasonable is the argument that a country can become rich by massively devaluing its currency. This idea is even more senseless for a country which imports most of its energy needs and much of its food. The result of this radical policy experimentation was that rising import prices due to a weaker yen, higher electricity prices due to the shuttering of Japan's nuclear reactors and subsequent importing of fossil fuels, and a deliberately devalued currency caused a massive gap to open up between nominal and real wage growth. As these factors caused real wage growth to plummet in late 2013 and into 2014, it was no surprise to see consumer confidence and personal consumption growth weaken substantially as well.
Breaking the deflationary mindset via a weaker currency and higher import prices was not instilling the confidence necessary to get people to stop delaying purchases. The results were not fitting the narrative. Perhaps to the average consumer, watching the government implement a radical policy - with the appointment of a Central Bank Governor who literally cited Peter Pan by insinuating that believing something strongly enough can make it reality - is not quite as confidence inspiring as authorities had hoped. After all, it can be argued that things were not that bad in Japan. Per capita GDP growth has been more or less on par with the U.S. for over a decade, and the misery index is among the lowest in the world and falling.
So without a crisis, why would Japanese policymakers risk rattling people into thinking that one was impending? It is probably safe to say that the inflation target has served another very useful purpose. The mechanism by which the BoJ hoped to achieve this target was also a convenient excuse to be able to have a government in the modern era afford itself the luxury of being able to buy up almost all new issuance of government debt without sparking a crisis and a destabilizing stampede for the exit. They have undoubtedly been successful on that front, at least for the time being.
When the BoJ cut its benchmark rate below zero in January, markets took this as a sign that they were running out of tools or the willingness to use them to continue to weaken the currency. The yen subsequently rallied from around 120 at the beginning of 2016 to 100, undoing all of the depreciation that had taken place primarily in the second half of 2014. Since a strong currency tends to make inflation harder to come by, the BoJ needed to get creative.
At the September meeting, BoJ policymakers made the unorthodox move of introducing yield curve control. By doing so, the BoJ has essentially committed to pegging the yield of the 10-year government bond to around zero (i.e., they will attempt to fix one of the most important prices in any economy, essentially the price of money) and controlling the world's largest debt market by fiat. Despite the monumental implication of such a bold and potentially risky endeavor, the market more or less took the announcement in its stride. After all, nominal bond yields were negative at the time, so a cap above the prevailing market rate was of little consequence. Following the U.S. election, bond yields globally have been dragged higher, with Japanese yields in tow. Markets soon came to realize that the BoJ had committed itself to virtually unlimited asset purchases, and that under this arrangement, the external adjustment mechanism for the Japanese economy would be solely the yen.
We agree with this prognosis, and expect further yen weakness. Fundamentally, although the USD has become more attractive from an interest rate differential standpoint, we do not expect extreme yen weakness due to our continued belief that inflation will be harder to come by in Japan than in the U.S. Therefore, while nominal rates look to be heading higher in the U.S. while they are supposedly pegged in Japan, an offset to this will be the strong deflationary forces still present in Japan. We have yet to see bond markets willing to pick a fight with the BoJ, and it is likely that the BoJ will be able to simply overpower any meaningful rise in yields. However, if U.S. rates climb higher than we currently expect, this would presumably drag up rates globally, requiring more asset purchases from the BoJ to keep yields down. Either way, we believe the path of least resistance for the yen is to be weaker. We also suspect there has been some realization on behalf of policymakers that while too strong a currency can damage the economy through exports, too weak a currency can really burden the consumer through higher import costs. If the currency remains range-bound within this "sweet spot," then it is possible that the tight relationship between the stock market and the currency may begin to break down. We think this should happen naturally over time anyway as Japanese companies continue to move production overseas and Japanese multinationals actually become less export-focused.
Despite our initial skepticism regarding the coherence of the overall policy thrust and the government's ability to engineer growth through inflation and devaluation, we do believe some of the things that are being talked about now could be positive for Japan's economic growth and operating environment going forward. Furthermore, Japan is a bastion of political stability in a world where political tail risks are increasing. The governing parties now hold two-thirds majorities in both houses of the legislature following the victory of the ruling party in the upper house election in July. The outlook for reform therefore remains constructive, and we are starting to see a shift toward incremental steps to improve demographic and labor market outcomes. The government is currently in the process of proposing and implementing small but potentially meaningful steps with the goal to boost the marriage rate and incentivize people to reproduce, and also to boost the number of foreign workers in the economy. To the extent that these policies increase the supply of labor, we think these small steps should cumulatively be viewed as a positive for Japanese companies, even if they do not meaningfully alter the country's long-term growth trajectory.
Despite the domestic headwinds to growth, there are Japanese companies that have adapted to the difficult environment and achieved success all over the world. Though we have a favorable view of the country from the point of view of having a relatively business-friendly operating environment and being a base for very innovative companies, Japan's macroeconomic challenges lead us to maintain selective exposure to Japanese equities, targeting companies tied to secular growth trends rather than the country's economic growth. Ultimately, while we remain skeptical that attempted central planning can overcome the natural forces of demographics within a large democracy, we think Japan should continue to provide select opportunities to invest in innovative companies that are solving problems globally.