Is Abenomics building a false economy?

There is a real danger that Abenomics will work 'too well' – that the yen will fall too far, inflation rise too much and Japanese corporates rely on cheap exports, not innovation.

Until last week the double act of levitation and leverage at the heart of Abenomics seemed to be working flawlessly.

The price of golf memberships, the archetypal metric of the bubble years, was up. So was the stock market - a 70 per cent rise in six months. And so was the price of electricity for households. In other words, both asset price inflation and real world inflation finally appeared to be taking hold.

Yet it is an odd time in Japan. Some at the country’s central bank fear the 2 per cent inflation target will not be achieved, that it is too ambitious. The markets fear the yen may not fall enough to trigger a real revival of exports - the only real growth engine Japan has ever had.

However, the shudders of the stock market and the Japanese government bond market in the wake of Federal Reserve chairman Ben Bernanke’s recent remarks on quantitative easing “tapering” suggest fears should lie in the exact opposite direction. The real danger of Abenomics is not that inflation and a weak yen fail to go far enough but that they go too far.

While many analysts believe talk about tapering is premature, even the mere thought of a gradual easing of the Fed’s asset purchases was enough to send the markets into a tailspin. That prospect has implications for the financial markets and the real economies of Japan and the emerging markets of Asia.

If the Fed does ease off and the US economy strengthens, the dollar is likely to soar, which means the yen will plummet. That in turn raises the prospect of inflation that will raise the cost of imports beyond the 2 per cent target. And when that happens, interest rates will go up much more, underscoring the contradiction at the heart of Abenomics: that it is impossible to have both higher inflation and super low interest rates.

Japan may quickly discover that there are worse things than deflation and zero interest rates - namely the wrong kind of inflation and high interest rates. The big source of vulnerability is of course Japan’s reliance on imported energy. The costs of all imported inputs are dollar-denominated and will rise a lot, at least partly offsetting the competitive lift of a cheap yen for exporters. But given the structure of the labour market, with its growing share of temporary workers, wages are not likely to increase proportionately, suggesting that the standard of living of many people will fall and any increase in consumption will prove temporary. The wealth effect of higher property prices and stock market prices does not affect most workers, especially ageing workers.

So far, the animal spirits of Japanese management have stirred only to the extent of a few hikes in one time bonuses rather than in annual salaries, while capex fell in the first quarter as it has done in every quarter for five consecutive quarters now. The pressure for structural reform is less, precisely because a cheap yen gives an artificial sense of comfort and competitiveness so depreciation replaces innovation as the solution to lack of growth.

Already economists such as Masaaki Kanno at JPMorgan in Tokyo are scaling back their expectations for the content of that reform. A commitment to responsible energy will yield instead to a slow return to nuclear energy. Talks on the terms of joining the Trans Pacific Partnership will not result in a drastic change in protectionist agricultural policies. Immigration is not on the agenda.

At the same time, Japan’s neighbours in China and South Korea are increasingly disturbed by the slide in the yen and Germany may soon join the chorus of the naysayers. Economics is exacerbating political tensions in Asia (and it does not help that Japan is increasing its military spending for the first time in 11 years).

Meanwhile, the first consequence of Bernanke’s reminder that easy money in the US cannot last forever has been increasing volatility in the Japanese equity market and the Japanese government bond market. That volatility testifies to how fragile market sentiment remains, especially for locals.

Moreover, the volatility is not confined to Japan. If the dollar continues to gain strength and the yen continues to slide, a lot of the money that ended up in emerging Asian markets might flow out again. As the dollar rises against emerging market currencies, these economies too will be looking at higher costs and a squeeze on corporate profits.

The last time the yen plunged, it contributed to the Asian financial crisis of 15 years ago. True, this time around most emerging markets have reduced their debt load, particularly their foreign currency debt load, making such a crisis much less likely.

But the Japanese experiment is still likely to have adverse consequences for Japan and the rest of the world. It will be sad indeed if it turns out that the time the BoJ is buying for Corporate Japan at such a high cost is wasted.

Copyright The Financial Times 2013.

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