Japan Outlook: BNP Paribas

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Japan
The macroeconomic policy stance should remain very accommodative in the coming two years. Corporate and income
taxes will be raised to pay for the reconstruction. However, a proposed consumption tax hike in 2014-15 is likely to be
rejected. Electricity shortages could be expected during the summer, as all nuclear reactors will be halted. Against this
backdrop, the economy should return to a moderate growth supported by reconstruction-related demand and
strengthening global activity. Labour market conditions are expected to improve gradually, but mild deflation is projected
to persist.

In search of a new growth model

Getting out of the soft patch

According to surveys and business indicators, GDP picked up in Q1, following a

modest decline in Q4 (-0.2% q/q). This improvement was due to three factors.

First, reconstruction spending is taking off. Demand for construction workers is

so strong, that some firms have already expressed concern about manpower

shortages. Second, household consumption is strengthening thanks to

compensation payouts to the quake-stricken area. Lastly, industrial production

has been boosted, not only by pent-up demand following the supply chain

disruptions caused by the flooding in Thailand, but also by the strengthening of

global activity. In addition, the weakening of the yen following the expansion of

the Bank of Japan (BoJ)’s Asset Purchase Programme has brought some relief

for exporters.

The improvement of the business climate has been confirmed by the production

data. Despite a decline in February (-1.2% m/m), industrial production was 3.5%

higher in the period December-February from the preceding three-month period.

Moreover, producers expected output to strengthen by 2.6% in March and 0.7%

in April. As a result, labour market conditions have been improving. In February,

the unemployment rate edged down to 4.5%, while the job-to-applicant ratio, a

more reliable indicator for labour market conditions, inched up to 0.75.

Nevertheless, the March Tankan Survey was on the whole lacklustre. The

overall business conditions indicator only gained one point, thanks to improved

sentiment in the non-manufacturing sector. In the manufacturing sector,

business confidence weakened as higher commodity prices and yen strength

had reduced profit margins. Against this backdrop, manufacturers further scaled

down their investment for FY2011 to 5.9%, 2.5 percentage points lower than in

the previous survey.

Quantitative easing to dope activity

Macroeconomic policies have been very loose. The BoJ has been pursuing a

quasi-zero interest rate policy, which will remain in place until price stability is in

sight, under the condition that no significant risks, such as the accumulation of

financial imbalances, are materialising. At the Policy Board meeting on 14

February, the BoJ adopted an official medium-term inflation target of 1%. The

objective of the Bank was to align its policy to those of other major central

banks.

At the same meeting, the Policy Board also decided to expand its Asset

Purchase Programme by JPY 10 trillion for the purchase of government bonds

(JGBs). As a result, the Bank will buy about JPY40 trillion yen in JGBs this year.

This almost covers the central government deficit excluding reconstruction

spending for FY 2012 (JPY44.2 trillion). By end 2011, the BoJ already held JPY

66.1 trillion or 14.2% of GDP in JGBs. This is much more than the government

bond holdings by the US Federal Reserve (10.8 % of GDP) or the ECB (2.2% of

GDP). The decision triggered a sharp depreciation of the yen. Between 14

February and early April, the currency lost about 5% of its value against the US

dollar.

In March, the Board rejected almost unanimously a proposal by Mr. Miyao to

increase the Asset Purchase Programme by about JPY 5 trillion. It does not

imply that further extensions are excluded. The Bank may step up its assets

purchases if the Fed decides on QE3.

Fiscal consolidation at a snail’s pace

Even though gross public debt is well above 200% of GDP, the fiscal stance will

remain very accommodative in the coming two years. That is mainly due to the

implementation of the JPY19 trillion reconstruction programme for the Tohoku

region during the coming 5 years. The larger part of the programme will initially

be financed by the emission of Reconstruction Bonds. These bonds will be

reimbursed through temporary tax hikes on the corporation tax (from April 2012,

JPY 800 billion during three years) and the income tax (from January 2013, JPY

300 billion during 25 years).

Prime-minister Yoshiko Noda has been pushing to increase the consumption tax

from 5% to 8% in 2014 and 10% in 2015. The prime minister has staked his

political career on the project, fearing that its rejection could spark credit-ratings

downgrades and a sell-off of JGBs. The plan is much contested. As the DPJ

government does not have a majority in the Upper House, the legislation is

unlikely to pass. It could already flounder in the Lower House, as the former DPJ

chief Ichiro Ozawa, also nicknamed the “shadow Shogun”, claims to have as

many as 100 hundred MPs opposing the law. The consumption tax hike will not

be sufficient to put government finances back on a sustainable path. Even if the

measure were to pass, the primary deficit is projected to remain at -3% of GDP

in the medium term.

The government and opposition are close on a deal on the privatization of the

Post Office. The privatization law, already adopted in 2005, would be revised,

which will lift the freeze on the government selling shares. Japan Post is valued

at around JPY10 trillion, which could be used to finance disaster reconstruction.

Shake up of the electricity sector

Power shortages are expected this summer as the nuclear power stations has

been progressively halted for maintenance. The only working plant in Hokkaido

is set to be halted in May. Since the disaster at Fukushima Daiichi, electricity

companies have found it difficult to gain approval for restarting their nuclear

operations due to local opposition. Depending on the weather, electricity usage

has to be reduced by 5%-10% in the whole country during the summer to

prevent blackouts.

The nuclear disaster has led to a rethink of the medium-term energy plan. This

has to be drawn up by May, but the commission in charge is hopelessly divided

between pro- and anti-nuclear camps. Proposed ratios for nuclear power by

2030 range from 0 to 35% of electricity capacity. A related issue is the future of

TEPCO. The company has asked the government for a capital injection of JPY1

trillion, but the parties cannot agree on the terms. Given that the market

capitalisation is JPY350 billion, the government’s stake could become as high as

70%. A majority share would allow the government to reshape TEPCO by

separating its power generation from grid operation activities and introducing

competition in the sector. Such reform is fiercely opposed by the regional

electricity monopolies.

Back to moderate growth

Supported by the extremely loose monetary and fiscal policy stances, the

economy is likely to return to a moderate recovery path. Domestic demand

should be robust as reconstruction-related activity takes off. Exports could

nonetheless still be sluggish due to the moderate strengthening of global

demand and the high value of the yen. Exporters are set to lose again market

share due to intensified competition from other Asian countries and the

offshoring of production capacity. Conditions for exporters might improve

eventually, as the yen is set to depreciate by the end of 2013, due to the

widening of the differential on long-term interest rates with the US.

Nevertheless, the trade balance is projected to remain in deficit due to increased

imports of fossil fuels. The deficit could reach 1.7% of GDP in 2013.

Nevertheless, the current account should remain positive thanks to the

substantial surplus on the income balance.

Despite moderate growth, labour market conditions are expected to improve

gradually, mainly due the retirement of the baby boomers. The unemployment

rate is forecast to inch down to close to 4% by the end of 2013. We expect

wages to increase again by a meagre 0.1% in 2013. However, mild deflation is

projected to persist for the forecast period.

The major downside risk is the European sovereign debt crisis. On the domestic

side, the main concern is that the government fails to implement policies

assuring the long-term sustainability of public finances, which could ultimately

result in a loss in confidence in government bonds. On prices, the major risk is

that the current deflation will get anchored in expectations.