This will be a crunch year for the Japanese economy

January 15, 2014 5:45 pm

This will be a crunch year for the Japanese economy

By David Pilling

Experimenting with a bold and radical monetary policy will have profound consequences for the rest of Asia

For many years, the only economic story that has really mattered in Asia has been China. The motor of regional growth for a decade or more, it has year after year been the single most critical factor in determining the temperature of the Asian – even the global – economy. But this year, China is in for a run for its money. For the first time in as long as almost anyone can remember, there is perhaps even more interest in how Japan’s economy will fare.Japan is in the throes of a radical experiment in monetary policy, so bold it has been given a fancy new name: quantitative and qualitative easing, or QQE. This is the year when we will find out whether it works. One of three possibilities exists. The first is that QQE, which calls for doubling the monetary base in two years, could fizzle out. Inflation would then sag back towards zero. Possibility two is graver still; the danger that Abenomics – named after Shinzo Abe, prime minister – will slip into “Abegeddon”. Inflation would run out of control, interest rates surge and capital flee. Possibility three is – wait for it – that QQE actually works. If that were to happen, Japan would move towards sustainable inflation of 2 per cent and growth might be 1.5 per cent.

In a recent note, HSBC’s Frederic Neumann says the two recent engines of Asian growth – cheap money supplied by the US Federal Reserve and fast Chinese expansion – are both sputtering. “But there is a third force … that will exert greater influence over the region in 2014 than it has for many years: Japan.”

Japan is a huge investor in Asia, but also a competitor with a corporate depth that is often underestimated. It is a huge market with an economy more than twice the size of Britain’s. It is also an enormous source of liquidity. As what Mr Neumann calls the “biggest monetary stimulus in history” gathers force, liquidity flowing from Japan could help fill the gap that may be left as a result of the tapering of monetary stimulus in the US. He estimates that Japanese banks, which have been snapping up regional lenders, could pump an extra $60bn-$140bn into southeast Asian economies alone. Thailand receives 60 per cent of its foreign direct investment from Japan. Further afield, Japanese companies are rediscovering their animal spirits. Suntory Beverage and Food has splashed the cash – too much of it, according to some – by acquiring whiskey maker Beam Inc in a deal valued at $16bn.

China, of course, has a bigger economy than Japan’s – roughly $9tn against $6tn. Beijing, too, has a challenging year ahead as it seeks to introduce market reforms. There is also potential for a negative shock if, say, theshadow banking system unravels or local governments start defaulting on debt. However – famous last words – China has a record of defying the doomsayers. The best bet is that it will grow at above 7 per cent in 2014 and that the economy lives to fight another year.

In Japan, consumer prices are key. Mr Abe has staked his reputation on hitting a 2 per cent inflation target within two years. So far, the news is encouraging. This year will show whether it is sustainable. November figures put core inflation, which excludes fresh fruit but includes energy, at 1.2 per cent. The concern is that recent price rises merely reflect higher imported energy costs resulting from a weaker yen. If that is the case, inflation could simply stall. Yet prices may be genuinely flickering to life: even excluding energy, inflation picked up to 0.6 per cent, the highest in 15 years.

If wages do not rise, even that could be snuffed out. Mr Abe is leaning on big companies to do their bit for the inflationary cause by raising salaries. Even if they oblige, cash-strapped smaller businesses, which employ far more people, will also need to dig deep. At least the job market is tightening. Unemployment has fallen to 4 per cent and the jobs-to-job seekers ratio has risen to 1.0.

On the negative side, Japanese consumers are about to be coshed with a consumption tax rise of 3 percentage points to 8 per cent. Even Etsuro Honda, a close adviser of Mr Abe, thinks this is crazy. The danger is that the April tax rise will be followed by a sharp drop in demand.

In the medium term, it is crucial that growth continues at above trend so as to close the output gap. Haruhiko Kuroda, the Bank of Japan governor, told the Financial Times last month that he thought the output gap was a negative 1-1.5 per cent and that it had already “shrunk considerably”. At this rate, he said, it could become “slightly positive” in a year or two.

Even steady inflation of 2 per cent is no panacea. As Martin Wolf says, it will do nothing for Japan’s demographic crunch, since you “can’t print babies”. Nor can cranking the printing presses make offices more female-friendly or rice paddies better farmed. Still, if Japan were to reach 2 per cent inflation and achieve 1.5 per cent growth, its economy would look in better shape than it has done in years. Abegeddon or Abesuccess: 2014, you decide.