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June, 2013

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Insight

Japan shadow boxes with structural reform imperative


Japanese prime minister Shinzo Abe has promised structural reforms, alongside monetary action, to drag the country out of decades of slow growth. The jury is out on whether he is making sufficient progress.


Structural reforms are the third arrow in Abe’s aggressive economic plan Abenomics – and probably the most difficult to deliver. The policies are designed to raise incomes by 3% a year and per capita income by 40% to about $60,000 over 10 years.

The problem is that while fiscal stimulus and quantitative easing merely require a parliamentary majority and a cooperative Bank of Japan (BoJ), economic reforms and deregulation entail taking on powerful vested interests and transforming entrenched cultural values.

Abe has sketched a broad reform package, from promoting trade and investment, switching subsidies away from job protection to job creation in growth sectors and boosting the number of skilled foreign workers, to getting more women into the workforce.

The challenge has defeated many before, most recently former prime minister Yoshihiko Noda, who partnered with the BoJ in an effort to develop key growth sectors. Junichiro Koizumi prioritized structural reform during his 2001 to 2006 administration, most notably privatizing Japan Post, then the country’s largest employer – only for the process to be shelved in 2010.

Their efforts – even within their limited scope – delivered few results. Abe has revealed little detail and done even less... so far.

The market has reacted negatively as doubts over his resolve to push through difficult reforms creep in. The Nikkei was down almost 20% in recent trade after surging more than 70% since Abe’s election victory in December on hopes his policies would boost growth and corporate profits.

Given the inevitable pain involved in implementing his reforms, Abe is sensibly holding out for a mandate he hopes to win in elections for the upper house of the National Diet in July. Victory could buy his Liberal Democratic Party (LDP) up to three more years to get as much of the reform programme through as possible.

Capital Economics’ chief global economist Julian Jessop says while many of the reforms have been on the policy agenda for years, Abe has the best opportunity for success in a generation.

“This time around there is a recognition that they can’t go on as they have been and the appetite for reform is much stronger than it has been in the past,” he says. “So far, the country is behind the LDP with a pretty convincing election win in December. They’ll get a convincing win in the upper house as well, and consumer and business confidence are all pretty strong.

“What’s fundamentally different is a fourth arrow of Abenomics, which is a coordination of the first three [fiscal stimulus, monetary easing and reform]. This time they are more serious and they’re going to try them all at the same time, one helping another.”

Jessop says probably the biggest test of the government’s mettle will be whether it pushes through two planned hikes in the consumption tax – from 5% to 8% in April and then from 8% to 10% in 2015.

“If they’re willing to press ahead with this hard decision, it would make me that much more hopeful about some of the other reforms,” he says.

The consumption tax represents a fiscal tightening that flies in the face of stimulus. However, it is seen as critical to achieving fiscal sustainability, with tax revenues under pressure from the shrinking of the labour force and an ever-growing population of retirees. Japan’s VAT is one of the lowest of any developed economy.

One area where Abe is pressing ahead is trade – joining negotiations for the Trans-Pacific Partnership, a proposed free-trade area of 12 Asian and Americas economies. Membership could reinvigorate Japan’s uncompetitive agricultural sector, according to researchers at the University of Auckland.

Reform efforts are likely to get a boost from figures showing that the economy grew at a quicker pace in the first quarter than originally thought. Revised government numbers show GDP growth of 4.1%, up from 3.5%.

Companies across all sectors plan to boost investment by more than 7% in the fiscal year on a sharp rise in business sentiment in the second quarter at firms capitalized at ¥1 billion ($10.4 million) or more, according to a finance ministry survey.

Even if many of the reforms are implemented, there is one few believe is possible for any government: immigration. Japan’s demographics are a ticking fiscal time bomb, which the UN says it needs to address by increasing annual immigration from about 50,000 to 650,000.

Immigrants comprise just 2% of the population. Japan has successfully absorbed some 600,000 Chinese migrants in recent years, 100,000 of whom have become citizens. But mass immigration is a non-starter given Japan’s homogeneity and strong cultural biases.

“I don’t think we’re going to get anything on immigration, but many of these reforms are going to be difficult because of the strong influence special interest groups exert over the political elite,” says Michael Taylor, director of research at Lombard Street Research.

“There’s going to be lots of squealing from powerful groups such as the agricultural lobby who want to keep their huge food import tariffs. The labour market is also going to be tough because there are all these temporary workers and permanent salarymen who are underemployed and a drag on productivity growth.

“The service sector especially has very poor productivity levels. There are some major obstacles to be overcome.”

He adds: “There’ll be some modest reforms but we have to wait to see how far they’ll go. The effort will be helped by the benefits Abenomics is already producing – on wages, for example, summer bonuses this year will be higher than a year ago. Toyota, Honda and others have agreed significantly bigger bonuses.

“Firms are going to increase investment and others, such as Toyota, that were going to relocate production overseas are now staying put.”

Taylor, counter-intuitively and perhaps optimistically, concludes that the expectations of a revival plan could fall victim to its own success. “There is a significant risk of the impetus for difficult reforms fizzling out if the economy improves dramatically in the next two or three years,” he says.

That is perhaps a more optimistic assessment of Abenomics’ cyclical prospects for success.

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