by Claus Vistesen: Copenhagen
What happened in Japan this week obviously came as something of a surprise for many a financial commentator and analyst; over at Morgan Stanley's GEF Takehiro Sato even felt the need to apologize to GEF's readers for erroneously making the call that the BOJ would raise interest rates this month. He has not been alone in this, however, and last Monday Bloomberg reported that 76% of investors were expecting the BOJ to raise come Thursday. This feeling had been reinforced by strong incoming data earlier in the week on machinery orders but alas, even as we reached Wednesday and the BOJ began its two day policy meeting local Japanese media were releasing insider information that the BOJ might actually have to hold rates steady one more time, and then yesterday, as yields on ten-year government bonds plunged accordingly, the leak was confirmed by the official BOJ decision to hold steady for yet another round effectively invoking the continuing weakness of Japanese consumer spending and the extremely low inflation reading. So what on earth is happening here?
One of the underlying discourses has of course become that of the BOJ's independence from the politicians and consequently many see the recent decision by the BOJ as evidence of a clash between the central bank and domestic political interests , a clash where the BOJ has been almost bullied into holding off raising rates despite general market expectations which have persistently and almost stubbornly pointed to the desireability of the opposite course, most notably given the perceived need to unwind the yen carry-trade. Now it is not that I don't think the political situation is unimportant, and clearly given the BOJ's relatively short stint as an officially independent institution old habits, it seems, still linger. However, I also think this is a question of the proverbial chicken and the egg since the real question here is whether in fact, given the economic situation in Japan, a raise would have been prudent? It should also not be forgotten that decision making in Japan is now extremely constrained, and what is often interpreted as undue political influence may well in part be a debate about where to move first, on interest rates or on the fiscal deficit, since as is well known (and as Edward cogently argues here) Japan - as the country with the largest debt to GDP reading on the planet - also need to do something to address the government debt issue, and there is a real difficulty presented , given the underlying weaknesses in Japan, by trying to move forward on both fronts simultaneously. In the following I will argue that given the past and future trend of consumer spending and inflation in Japan I do not see the foundation materializing for a rate hike let alone a process of interest rate normalization in Japan.
In order to frame my argument it is usefull to look at the recent history of Japanese monetary policy and economic growth. If we begin by the former Japan's monetary policy has since 1998 been characterized by a policy of zero interest rates (ZIRP) and quantitative easing (QE) set in place to combat deflation. The chart below shows the evolution of headline and core inflation in Japan between 2002 and 2006.
The policy of ZIRP was temporarily (and briefly) terminated between August 2000 and March 2001 (so there is some precedent for the present situation) and now one more time the BOJ is trying to break out of the vice and is currently running an interest rate of 0.25% on the back of the ending of ZIRP which was officially initiated in June 2006. Already here, history should teach us something since we might very all ask ourselves whether or not the current stint above 0% interest rates will be temporary as well? So far the signs have been pretty clear in my opinion and it is actually very telling to look back to June 2006 when the BOJ's decision to take Japan out of ZIRP was hailed by many prominent economic commentators as the signal that Japan finally had escaped the claws of deflation and was on its track to join the leaders of the global economy. Yet, 9 months later the party just keeps on getting postponed it seems and in my opinion the continuing surprise amongst economic commentators on Japan's economy relates to the inability or reluctance to factor in one of the biggest structural drivers of the Japanese economy.
It's the Demographics Stupid
I will not go into a detailed description of Japan's demography in this entry but merely highlight the important factors. In short, Japan is the oldest society on earth with a median age of 42.9 years. This process ageing is driven by two factors; firstly increasing life expectancy where the average Japenese can expect to live a respectable 81.3 years and and secondly by a decline in fertility where Japan is hovering at around a TFR of 1.3. The crucial point here is then what in fact happens to an economy which experiences a process of sustained ageing like has been having in Japan in the latter part of the 20th century? I am moving the perspective up here but I do not think it is wholly unreasonable to link Japan's gradual transition in the 1990s into a growth path characterized by very low inflation rates and, as the chart below shows, a steady decline in consumer spending relative to GDP, to the sustained change in the population structure. The point is that as a population ages consumer spending declines relative to GDP based on the economic theory life-cycle behavior. There are of course bound to be notable differences between countries in terms of the effect of this but since the process of ageing at this point across OECD only seems to be accelerating we should expect the life cycle component to gain more weight.
What Drives Economic Growth in Japan?
At this point, you would perhaps be tempted to claim that I, against my own assertion, am falling victim to the application of a monocausal explanation for an, after all, pretty complex problem situation. Obviously demographics are not destiny, but by applying demographics as an anchor for the economic analysis of Japan I sincerely believe we can take one step closer to the proper understanding of what is going on. The most important point here is the notion of the growth path and what in fact drives economic growth in Japan. Looking at the above chart which plots consumer spending in Japan as a share of GDP from 1995 to 2005 we can see that the overall trend is one of secular decline. However, if we look at economic growth in terms of real GDP in Japan in the recent years the numbers actually do not look that bad. As such, the period from 2001 to 2006 reveals an impressive transition from a meager 0.1% growth in real GDP in 2001 to an estimated rate of 2.7% in 2006 with growth running above 2% in both 2004 and 2005. In fact, this impressive growth stint coupled with two very strong first quarters in 2006 were a big part of what prompted the BOJ to end ZIRP in June last year. Yet, although 2006 in terms of GDP growth indeed shows a strong performance Japanese inflation is still creeping along very near the bottom and close to the 0% mark while household spending on a y-o-y basis is in negative territory as shown by the graph below.
So where is the growth in Japan coming from? A notable indication here comes from the Q3 growth figures where GDP expanded 0.8% primarily on the back of export growth and corporate spending (investment) in factories and equipment, an analysis which is supported by the fact that consumer spending actually declined during the same period. This state of affairs is also mirrored in the continuing widening of the trade surplus and exports, for example, grew at the notable clip of 12.1% y-o-y in November 2006. I believe this detail to be very important especially in the light of how economic data and news sometimes tend to be interpreted. A notable case in point was the data for machinery orders released on Monday of this week, and which was immediately linked to the perceived need for the BOJ to raise. Moreover, we have also on several occasions heard how momentum in the buoyant corporate sector, as epitomized by investments in equipments and factories, has been narrated as a strong foundation on which the BOJ should soon raise. Yet, why is this evident? Clearly, the figures on consumer spending suggests that all these investments and machinery orders are not driven by domestic capacity components. This also allows me to debunk one of the most common Japan fallacies of the moment which concerns how the momentum in the corporate sector will automatically spill over into the domestic economy. Given the trajectory of Japan's demographic evolution we should perhaps not expect any notable transmission mechanism to be at work here. Another area where we might also wish to correct our views is in terms of the labour market which has been very tight throughout 2006, with an unemployment rate of about 4% going into 2007. Once again most commentators have connected the dots throughout 2006 in order to argue that the tightening of the labour market was a clear sign the that the recovery was on track and that notable momentum was present in the domestic economy. However, with a rapidly ageing population and thus declining labour force we might want to ask what in fact the structural component is in this 4% figure which indeed appears on the one hand to be a sign of such a tight labour market but on the other has not done much in terms of, for example, promoting wage-push inflation? Global labour arbitrage is an argument which is often advanced here, but may there not, actually, be other and deeper structural factors at work?
A Future Growth Path For Japan?
Given my analysis it is clear that one of the most important deductions to be made here is that an economy such as the Japanese with a rapidly ageing population will structurally tend to be driven by a growth path where domestic supply continuously exceeds domestic demand and thus the economy relies on exports to grow. Another way of putting this would be to invoke high capex (investments) as the main driver of growth but since this high capex is not met by domestic demand (capacity) the economy, as a function, of its demographics will run a surplus on the external balances. In fact, I am not the only Japan observer to be arguing this and in fact Morgan Stanley's own Robert Alan Feldman came damn close to a more adequate conceptualization of the whole situation a while ago back when he asked the tantalising question: What's 'funny' about Consumption in Japan? In essence, Feldman argues, as I do, that Japan in order to grow and as a function of its ageing population will need to continuously raise capex and productivity in order to compensate for lower consumption which again means that growth to greater and greater extent will be driven by its need and ability to export.
Now, dear reader, the plot indeed thickens even more does it not, since what Feldman (perhaps) does not realize is that by arguing that Japan with an ageing population will revert to a growth path driven by the need to leverage excess supply outside its borders is walking right smack into the discourse about demographics and global macroeconomic imbalances. The point is as simple as it is intriguing. It is consequently all well and good to argue that Japan needs to export as its population ages but what about Germany and Italy; will they not need to continually run trade surpluses as well. This is not to mention the behemoth China whose population is at some point also transisting into a rapid process of ageing as a function of its one-child policy. In fact, it does seem as if poor America (and perhaps places like the UK, Australia etc) is almost the only economy out there which is really able to run a respectable deficit and suddenly dear reader we are right back where I started a couple of days ago with the structural drivers of global macroeconomic imbalances and as such Japan will provide an important test case for our hypothesis on this.
What About the Rates Then?
Signing off with a brief tour back to my starting point I do not see the data supporting a BOJ raise in 2007. There are of course the Q4 2006 GDP figures still to come, and these are widely expected to show a considerable rebound in consumer spending, a rebound which might perhaps allow for an interest rate raise when we get to February. However, as oil prices are declining going into 2007 (and at the time of writing sharply so) this will have the subsequent consequence of bringing down headline inflation even further (and remember part of the issue in Japan is still that of finding a path to escape from the grips of deflation), so I am not very bullish on the future of Japanese inflation rates. Neither, by the way, is Takehiro Sato, who in the GEF post I linked-to at the very beginning of this note suggests that a return to some sort of negative price increase process is rapidly becoming more of a reality than simply a mere possibility. Thus I believe he makes a very valid argument in terms of whether the BOJ should raise in February on the back of 2006 Q4 GDP figures, whatever they may be. As such, I would be very wary indeed of pushing for a BOJ raise in February as I fear it could very well pull Japan back into the deflationary territory which we all so much wish to see it breaking out of.
1. IMF - Global Inflation 2006, taken from the World Economic Outlook September 2006 (Figure 1.4).
2. Julien Seetharamdoo (2006) RBS - The Royal Bank of Scotland Group, What if the US consumer stops spending?3. The Economist (2007) - Taking a Hint.
In my post above I linked to the recent contribution by Takehiro Sato at Morgan Stanley's GEF on Japan but also chief economist at Morgan Stanley Stephen Roach has something to say on the recent flurry about the BOJ's decision. The gist of Roach's piece is indeed that the BOJ has seen a considerable blow to its confidence towards markets as function of the fact that its independence vis-à-vis political pressure has been seriously compromised with Thursday's decision. And as Roach puts it ...
(...) in my view, the damage has been done. Financial market participants have long memories. Expressions of BOJ policy intent will long suffer from the credibility fiasco of January 18. Trust in
As Roach also excellently points this perhaps first and foremost has implications for the Yen's international position and the continuation of the much allured yen-carry trade. However, and this is where I especially take note, Roach also generally recognizes the frailty of the Japanese economy at the current juncture which thus in any case did not warrant a raise. This of course makes this a double whammy for the BOJ because although the right decision at the end of the day was perhaps made it was made in an environment where market expectations were counting on something else and in the global world of central banking's communication with markets this bodes rather ill for the future.