A progress report on Abenomics

Web Posted on : Sun, 15 Nov 2015

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Japan’s Q3 GDP will be released this week. Analysts expect data to show that the economy shrank by 0.3% on an annualised basis. If their expectations materialise, Japan would have fallen into a technical recession, defined as two consecutive quarters of negative growth. Beyond quarter to quarter numbers, it is important to consider the big picture. When Shinzo Abe assumed the prime minister’s office in December 2012, the Japanese economy was facing a number of challenges. First, it was stuck in a seemingly permanent state of deflation, which was damaging to investment and growth. Second, the fiscal balances were stretched as public debt was almost 240% of GDP. And third, the economy was facing structural challenges from the aging and declining population. Abe came with a comprehensive plan based on three “arrows” to tackle these challenges. How has he fared in the last three years?

The first arrow is centred on active and aggressive monetary policy to solve the problem of deflation. Deflation increases the real rate of interest, making it more burdensome to borrow and invest. It also hurts consumption, which is postponed in anticipation of lower prices in the future. The overall effect is lower aggregate demand and growth.

Shortly after Abe took office, he changed the leadership at the central bank, the Bank of Japan. The Bank of Japan then embarked on a large scale open-ended qualitative and quantitative easing (QQE) programme in April 2013, which was then significantly expanded in October 2014 in order to try and achieve the 2% inflation target. While Japan is still some way from its inflation target, the country has clearly exited the state of deflation. Core consumer price inflation (which excludes volatile items such as food and energy) was 0.9% in September, and has been consistently out of the negative territory since the summer of 2013.

Japan Consumer Price Inflation (Excluding Food and Energy)
(year-on-year percentage change)

Sources: Ministry of Internal Affairs and Communications and QNB Economics

The second arrow aims at addressing the problem of high public debt in the medium term while providing stimulus in the short term, when necessary. Part of the problem is the low taxation rates in Japan, especially consumption tax. Consumption tax (a value-added tax) in Japan was only 5% in early 2014, one of the lowest in the world, much lower than the European average of around 20%. The International Monetary Fund estimates that consumption tax needs to rise to around 15% to contribute to a more sustainable path for public debt. Abe’s strategy to address this was to combine permanent increases in consumption tax (to make public finance sustainable) with temporary fiscal stimulus (to boost demand in the short run).

The first increase in consumption tax (from 5% to 8%) occurred in April 2014, and its impact was dramatic. Real GDP declined by 7.6% on an annualised rate in Q2-2014 and 1.1% in Q3-2014. This prompted Abe to postpone the next tax hike (to 10%), which was originally planned in October 2014, to April 2017. The government now seems determined to implement this round of tax increase to avoid larger hikes in the future. On this arrow, despite the government’s initial steps to improve the fiscal arithmetics, there is still some way to go.

The third arrow of Abenomics is concerned with improving the supply capacity of the economy. The declining and aging population have led to lower potential growth. Official Japanese sources estimate that potential GDP growth has declined from 4.9% in the late 1980s to only 0.5% today. Abe sought to tackle this problem through numerous structural reforms to improve competition and productivity in the labour market, agricultural and health sectors. Structural changes, by nature, take time to implement and it could take years before they start bearing fruit. But one area of reform is already making progress: the higher participation of women in the labour force to counteract the demographic decline. Through a number of financial and non-financial incentives, Abe succeeded in increasing the number of women in the labour force by nearly half a million in around three years. This is significant in a country with a total labour force of around 66 million.

Overall, the three arrows of Abenomics have been travelling at different speeds. Beyond the importance of Japan as one of the world’s largest economies, Abenomics is an important case study on how to tackle problems that many countries are facing or are expected to face in the near future. Many countries, such as those in the Euro Area, are experiencing the risk of deflation, want to implement fiscal consolidation without creating economic depression and face the challenge of declining productivity and a smaller and older population. The Abenomics experiment should be closely monitored by the rest of the world.

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