Yes it’s too soon to give up on Abenomics


Japan’s effort to get its economy moving entered difficult terrain last week. Bond yields rose and stock prices fell. Some promptly declared “Abenomics” – the reforms launched by prime minister Shinzo Abe – a failure.

This is ludicrous. Abenomics may fail. But it will not be because bond yields rise or stock markets wobble.

On the contrary, bond yields must rise if Japan recovers and the stock market will always wobble.

The much-needed Japanese recovery programme will run risks. But last week told us little about them.

Government bonds
True, the yield on 10-year Japanese government bonds was 347 basis points (0.347 percentage points) higher than on May 6th. But it was still only 0.91 per cent. This is where it was just over a year earlier.

The Nikkei stock market index fell 9.5 per cent between May 22nd and 27th. But this followed a jump of 80 per cent between November 13th, 2012, and May 22th, 2013.

Yes, the yen rose a little against the dollar last week, but it is still 23 per cent below its level in early October 2012.

How is one to interpret such movements, other than as possibly meaningless short-term fluctuations?

Paul Krugman of The New York Times argues that if a fall in the stock market is to be more than sound and fury, it would reflect either fears about weaker than hoped for economic growth, fears about Japanese debt or fears about the resolve of the Bank of Japan.

Bond yields
The first would explain the fall in the stock market, but not the jump in bond yields. The second would explain the rise in yields, but not that in the yen. But the third would explain higher bond yields, a weaker stock market and a stronger exchange rate – all in response to a tighter monetary policy than the one now promised. He concluded that the last was the plausible explanation. Yet this is an analysis of the very short run.

In the longer run, bond yields remain well above their trough, which was close to 0.4 per cent and the stock market is up 63 per cent from November’s bottom, while the yen has fallen a long way from recent peaks.

This bigger picture suggests that investors still believe that both the Bank of Japan and the government are serious about the new policies they have adopted. The 3.5 per cent annualised economic growth in the first quarter of 2013 may have little to do with new policies. Yet it, too, is cheering.

It is also inevitable that Japan’s policy changes will be destabilising. Some board members of the BoJ believe that the policy stance is confusing, because the aim is both to raise inflation and lower interest rates. The volatility of the bond market has also led to criticism of Haruhiko Kuroda, the new governor. Some argue that the losses suffered by banks on their portfolios of JGBs will undermine their ability and willingness to lend into a recovery.

Meanwhile, criticism over the decline in the yen is coming from abroad. Many, particularly in east Asia, agree with the warning from David Li of Tsinghua University that, far from a rise in Japanese inflation, “the world has merely seen a sharp devaluation of the yen. This devaluation is both unfair on other countries and unsustainable”.

In a letter to the FT, Takashi Ito from Tokyo responded: “I just find it unbearable that countries that have debased or manipulated their currency can accuse Japan of depreciating the yen.” This does begin to look like a currency war.

How do we assess such debates? First, a determination to end deflation and restore growth ought to raise yields on JGBs. A stable economy with annual inflation of 2 per cent will not have long-term interest rates as low as 0.5 a per cent. Last week’s small jump in rates, then, is no mark of policy failure; it is, rather, a tentative indicator of the new policy’s success.

Interest rates
Yet it is crucial that interest rates do not rise by more than expected inflation if real interest rates are to fall, as needed. The BoJ must give guidance to the path of long-term rates.

It should be willing to buy without limit when interest rates exceed a (presumably, moving) ceiling. It can support the policy by indicating a period over which it will maintain zero short-term rates, subject to some override.

Interest rates might stay at zero, for example, until the price level (not the rate of inflation) reached a specified level. In such ways, the BoJ might succeed in bringing a degree of predictability.

Managing debt
Second, the government and the BoJ need to find some good way of managing the mountain of Japanese government debt.

The radical step of monetisation has to be a part of any solution. This would probably require a permanent rise in the reserve requirements imposed on banks. That would be a tax on their depositors.

But making banks provide ultra-cheap permanent finance to government makes sense in Japan, since prospects for growth are poor, a vigorous revival of private borrowing is unlikely and the stock of public debt is so huge.

Low (probably, negative) real returns on bank deposits may also produce a falling yen, rising asset prices and higher private spending. All of these effects would be highly desirable.

Third, the concern about the effect of the weak yen is understandable. Increasing the current account surplus is a way to offset the excess savings of Japan’s corporate sector, as discussed in my column of April 9th on “Japan’s unfinished policy revolution”.

But Charles Dumas of Lombard Street Research argues that Prof Li’s concern is well-founded: China is the most exposed of the world’s large economies to Japan’s big devaluation. Yet China has also been a big currency manipulator in the recent past.

What is needed is a discussion, under the auspices of the International Monetary Fund, on the principles governing the policies affecting exchange rates. This will not happen. Instead, Mr Abe’s economic nationalism may clash with that of China. When elephants fight, the grass suffers.

Destabilisation risks
The risks of domestic and external destabilisation are indeed large. This is painfully clear. But Japan had to break out of its malaise. It could well still do so. But it will only achieve ultimate success with a structural transformation: it must shift income from corporations to shareholders, the government and wage earners.

Higher real wages, lower depreciation allowances, higher taxation of retained earnings and much bigger dividends are needed, in the longer run.

Ultimately, Mr Abe cannot rely on monetary manipulation and a weaker exchange rate alone. He must tackle Japan’s entrenched corporate establishment. That would be a real revolution.

Will he try? Alas, I still greatly doubt it.

– (Copyright The Financial Times Limited 2013)