Japan: 2008: An Option on Miracles

Japan is entering the Crisis phase of the CRIC cycle, the cycle of crisis, response, improvement, and complacency that has repeated over the last 20 years (see “Cobwebs and CRICs,” April 4, 2001.). The Crisis phase could last several months until the next general election. The subsequent Response phase will be the most important. In the Response phase, policy must return to a reformist path if Japan is to have any chance of vibrant growth and vibrant asset markets. At the moment, signs of such a return are scarce, so a defensive stance on Japanese assets seems prudent. After the election, things could turn radically better or radically worse.

Global Shocks

The current growth crisis was brought on by two influences, global changes and domestic policy mistakes. Globally, the energy shock is the most important. At the start of 2007, the yen price of oil was about Y7000/bbl. Most recently, the price is about Y10,000/bbl. Even if other energy prices were wholly unresponsive to oil, a sustained level of Y10,000/bbl amounts to a tax of Y4.7 trl, or about 0.9 ppt of GDP. Since other energy prices are responsive to oil and since a further rise of the oil price seems possible, the overall hit to the economy in 2008 could be much higher.

The global subprime problem will also weigh on Japan. The direct hit to Japan has been relatively small, but due diligence required on foreign investments has risen. Credit availability will shrink, and the cost of hedging will rise. Moreover, further rate cuts in the United States will shrink interest rate differentials and strengthen the yen further. The negative impacts of yen strength will likely emerge before the positive ones. This mismatch will constrain the economy in 2008.

Another shock has come from global food prices. Food import costs have risen by almost 20% over the last 4 years, while food import quantity is down by about 3%. The net cost to Japan has been about Y7 1/2 trl, or about 1 ½ ppt of GDP.

Domestic Errors

Policy mistakes, despite good intentions, will worsen the 2008 slowdown. First, the consumer finance law changes of 2006 have triggered a credit crunch among small business, which comprises 60% of total employment. Second, changes in the construction standards law have multiplied red tape around new construction starts, pushing housing starts down by 41% in the three months ended October. Third, the investor protection provisions under the Financial Instruments and Exchange Law (FIEL) were vague, leaving intermediaries no choice but to be ultra-conservative in implementing suitability rules. The result is a halt to the encouraging trend away from no-risk savings and toward risk-taking investment.

Unfortunately, more policy errors seem likely. Delay itself is an error and is already occurring. Both major political parties are paralyzed by a Defense Ministry scandal, leaving economic policy on the back burner.

Moreover, fiscal reform is dead. The opposition Democratic Party of Japan (DPJ) has proposed increased subsidies for inefficient agriculture, along with more support for small business on the basis of size, not efficiency. While calling for cuts of Y15 trl of wasteful spending, the DPJ wants an equal amount of increased spending elsewhere, pushing deficit reduction off the agenda. It is also pressing for expiration of the special gasoline levy (in effect for 30 years), without mention of how to replace the Y1.7 trl of tax revenue.

The ruling Liberal Democratic Party is little better. It has countered with more spending proposals for regions and small business, postponement of legislated user charges in the medical care system, and oil subsidies (instead of efficiency measures) in response to high oil prices. Not to mention its refusal to honor the promise by PMs Koizumi and Abe to end earmarking of gasoline tax revenues for road building. (For PM Koizumi’s view on the issue, see “Our Common Tasks,” November 13, 2007.)

Fiscal accounting gimmicks are clouding the picture as well. In the draft supplementary budget for FY2007, there is Y1.8 trl of extra spending and a Y1.0 trl revenue shortfall. However, the resulting hole of Y2.8 trl (about 0.6% of GDP) will apparently not require any more bond issuance. When such a large gap does not change issuance plans, investors naturally question the accuracy of government accounting.

Implications for Markets

The stability of JGB yields for the last 6 years has been based on the assumption that fiscal reform is on track. This assumption is no longer true. Hence, risks of higher real JGB yields are growing, in my view, even with an economic slowdown.

For equity markets, any rise of bond yields would be a higher valuation hurdle. Moreover, the adverse implications of a slowdown for corporate earnings could by significant. A simple regression over the last ten years suggests that nominal corporate earnings growth has been 7x geared to nominal GDP growth. Thus, our downward revision of about 1 ½ ppt of nominal GDP growth in 2008 implies recurring earnings deceleration of about 10 ppt. In these circumstances, as my colleague Takehiro Sato contends, it seems unlikely that the Bank of Japan would continue its campaign to raise interest rates.

Is There a Way Out?

Is there a way out of this gloomy picture? If so, that way out rests in the Response phase of the CRIC cycle. A return to reform in the Response phase would rescue Japan from its current problems. In contrast, a return to tax-and-spend, big-government policies would prolong the pain. Either outcome is possible, depending on the next general election.

The fundamental problem in policymaking is that the major political parties are agglomerations of three ideologies. One ideology is “old left,” espousing passive foreign policy and big government. Another is the “old right,” espousing active foreign policy and big government. The third is the “new right,” espousing activist foreign policy and small government.

The voters seem split roughly equally among the three ideologies, and so no single ideology is likely to be dominant. There will have to be some sort of coalition government. One coalition would be new-right + old-right. This coalition implies a pro-reform Response phase in the CRIC cycle and vibrant markets. Another possibility would be a grand coalition among all ideologies. The policy implication would be stagnation. The Response phase in this case would be a muddle, with disappointed markets. The third would be an old-left + old-right coalition. The policy implication would be a return to tax and spend, big-government policies, with band-aid solutions on foreign policy. The Response phase in this case would be destructive for productivity growth and for asset markets. At this point, the timing of the election and the direction of policy shift remain opaque.

With so much uncertainty, it seems prudent to hold weightings in Japanese assets at low levels. It is important to remember, however, that a positive scenario could emerge suddenly. And for this reason, derivative strategies – such as strangles for pessimists or costless collars for optimists – may become attractive as events unfold.

By Robert Feldman Tokyo
Morgan Stanley
December 16, 2007