Japan: Tip of the Spear
On Sunday, December 16, 2012, Shinzo Abe, the leader of the Liberal Democratic Party (LDP), led his coalition to a decisive electoral victory in Japan. The LDP won 294 out of 480 seats and, with the additional 29 seats captured by its coalition partner, the New Komeito Party, will control the lower house in the Japanese Diet. Abe was named the new prime minister ten days later.
Japan’s economy has been struggling since the early 1990s, when both an equity and property bubble collapsed. For the past two decades, the country has been unable to overcome its balance sheet problems that led to the early 1990s downturn, despite very low interest rates, massive fiscal deficits and quantitative easing.
Abe’s election, on its face, doesn’t appear to be a game changer. Abe, in fact, held the office for just under 12 months in 2006-07, abruptly resigning due to health issues. It should be noted that Abe’s approval ratings had dipped below 30% at the time he left office. Abe is the seventh Japanese prime minister in 6 ½ years. Clearly, the Japanese politicians, much like their counterparts in the U.S. and Europe, are struggling to cope with significant policy challenges.
However, despite his checkered history and the lack of political consensus, Abe’s election is being treated as a major change. In the financial markets, the Nikkei is up 9.3% since Abe won. Since elections were called, in mid-November, the Japanese stock index is up 23.7%. Over this same period, the yen has depreciated by 9.3%. It would appear that the financial markets are taking Abe’s election as an important event.
In this report, we will offer a short biography of the new prime minister, discuss his policy proposals and examine why these proposals have brought such dramatic changes in Japanese financial assets. Part of the analysis will focus on Abe’s foreign policy views and the remarkable lack of response from the Obama administration. We will conclude with potential market effects from this new government.
Who is Shinzo Abe?
Shinzo Abe is a 57-year-old LDP political figure. He entered public service in 1982, holding a series of bureaucratic and elected positions. Abe has a deep political lineage. His paternal grandfather and father were both LDP politicians. His maternal grandfather was Nobusuke Kishi, the cofounder of the LDP. Kishi had a rather checkered history. He was held by the Allies as a Class A war criminal. During his period as military governor of Manchuria, he supervised the policy of forced labor of Chinese workers during the Japanese occupation. However, he was never indicted or tried by the military tribunal. After 1952, when the U.S. lifted bans on former imperial officials from public office, Kishi became a leading figure in the Liberal Party which eventually merged with the Democratic Party, becoming the LDP. He became prime minister in 1957 and held power until 1960.
Abe’s political lineage is conservative. On several occasions he has publicly stated that the atrocities that Japan was accused of during WWII were overblown. This includes pushing for changes to Japanese history textbooks that downplay Japan’s role in WWII and suggesting that enslaved “comfort women,” Koreans and others who were captured and forced to provide sex to Japanese soldiers, were really prostitutes who willingly engaged in this behavior. He has also made visits to the Yasukuni Shrine which includes convicted Class A war criminals among its honored dead. These acts, as one would expect, have raised concerns with Japan’s neighbors. Abe’s general response has been that these visits are a matter of Japan’s national honor and foreign criticism is an unwarranted intrusion on Japan’s domestic affairs.
Of greater importance is Abe’s long-standing call for changing Article 9 of Japan’s constitution, which requires Japanese pacifism, allowing its military to only engage in defensive actions. Abe wants the constitution changed to allow Japan to engage in more military activities.
His first stint as prime minister was marred with scandal, with one agricultural minister committing suicide and his replacement being forced from the position by a financial scandal. Abe resigned in less than a year due to unpopularity and health reasons. His return to power is something of a surprise and reflects the disarray of Japan’s political situation.
At heart, Abe is a nationalist. He views the war crimes tribunal and the Japanese Constitution as the justice of the victors. Although there has been a nationalist element within Japan since WWII, it has mostly been subsumed within the U.S. security arrangement. Thus, its impact has tended to be relatively minor.
The New Abe Government
As noted above, both the Japanese equity markets and the yen reacted strongly as polls indicated that Abe was likely to return to power. This is due to the policy proposals he made. His first recommendation was fairly standard issue LDP fiscal spending—the LDP is famous for building “bridges to nowhere” and new spending is planned. In addition, a return to nuclear power has been discussed, reversing the anti-nuclear trend since Fukushima. The second, and more interesting proposal, is for the Bank of Japan (BOJ) to place an inflation target of 2% and, to achieve that target, the BOJ should engage in unlimited quantitative easing (QE) until inflation rises. The BOJ has generally conducted an easy monetary policy for years but with little success. Numerous commentators have argued that the reason for the BOJ’s failure to boost growth is that it has been overly cautious. What Abe is recommending is a radical policy, although one that has become more acceptable among the G-7 nations in the wake of the 2008 financial crisis.
One of the problems with Abe’s proposal is that the BOJ is legally independent of the government; legislation in 1997 gave the BOJ independence on par with other western central banks. However, all central banks face some degree of political interference because their independence is created by legislation. Political bodies can change their minds; thus, central bankers are forced to navigate an environment where independence is conditional on maintaining workable relations with governments. In the U.S., the Chairman of the Federal Reserve makes an official visit to Congress twice a year to discuss monetary policy. These hearings are mostly political theater but it does show that central banks, to varying degrees, face political pressure.
Among the major western nations’ central banks, the BOJ probably has the weakest degree of independence. This is mostly due to the lack of diversity in the political process. The LDP dominated Japan’s political life for most of the past six decades and so, to gain power and influence in any part of Japan’s government, good relations with the party are necessary. This situation is changing slowly, but is still critical.
Thus, it is highly likely that Abe’s policy recommendation for the BOJ will, at some point this year, be adopted by the central bank. What makes this policy important is that a 2% inflation target will most certainly lead to a weaker yen.
This chart shows Japan’s GDP from 1969 to the present. We have regressed trend lines for GDP, from 1969 to 1991 and 1992 to the present. The first trend line shows that growth averaged 4.6% per year; the second tend line declined to +0.9% average growth. Essentially, Japan grew strongly until the early 1990s; since then, growth has fallen sharply.
At the top of the chart, we plot the yen/dollar exchange rate. For most of Japan’s strong growth period, the yen was weak (the exchange rate scale is inverted to highlight that a lower yen/dollar number implies a stronger yen).
Japan’s economic development was predicated on export promotion. The development program stifles consumption to create saving which reduces the cost of investment. In a developed economy, investment usually grows with consumption; by keeping the two roughly in line, economies can avoid the problems of over-investment (or worse, malinvestment) that have adverse consequences, like unemployment and deflation. In a developing economy, using a program of forced saving provides funds for investment. Export promotion has had a better track record than its alternative, import substitution, which tends to be more consumption oriented. If an economy is not blessed with abundant natural resources, export promotion is a superior development option.
As part of the process of restraining consumption, nations adopting export promotion also employ an undervalued exchange rate. Not only does this reduce the price of its exports, making them more attractive to foreign buyers, it also raises the price of imports, further discouraging consumption.
Japan’s export promotion policies worked very well, allowing the country to recover from the devastation of WWII. However, there were two problems with the policy that led to the collapse in growth over the past two decades.
First, export promotion depends on import buyers. Other nations must be willing to absorb your imports to allow development to take place. The U.S. has played this role since WWII as part of the dollar’s reserve currency function. In fact, being the reserve currency encourages foreign nations to sell to the U.S. in order to acquire dollars. As part of America’s superpower responsibility, the U.S. wanted to create dependency on the part of other nations so they would support America’s containment of the Soviet Union. Having allies become dependent on U.S. consumption became part of that policy.
In terms of America’s Cold War foreign policy, Japan and Germany were special cases. The U.S. wanted to ensure that neither nation rebuilt their militaries in such a way as to repeat WWII. At the same time, America did not want either nation to fall into the clutches of the communists. Their economic recovery was critical to preventing that from occurring. The U.S. decided to provide for the security of both nations to convince them not to rearm. So, both Japan and Germany were able to recover through exports and were allowed to refrain from defense spending which allowed these funds to be deployed elsewhere. Essentially, the U.S. tolerated Japan’s mercantilist economic policies for geopolitical reasons.
As the Cold War was coming to a close, the U.S. began to be less accommodating to its allies. At the Plaza Accord in 1985, the U.S. demanded that the dollar weaken to reduce a widening trade deficit and falling manufacturing jobs. For Japan, initially, the stronger yen allowed the BOJ to ease policy because the appreciating currency reduced inflation. The additional liquidity found its way into the equity and real estate markets, creating a massive price bubble. As the BOJ tightened policy to contain the asset bubbles, it caused a balance sheet recession that continues to affect the economy to this day.
After the Soviet Union fell, the U.S. became increasingly intolerant of Japan’s weak yen policy. During the Cold War, the U.S. had a interest in supporting Japan’s growth for geopolitical reasons. After the war ended, this interest ended as well.
This leads us to the second problem of export promotion. In any government, either authoritarian or democratic, constituencies develop around policies. One of the great strengths of democracy is that policies are more prone to change because new people are elected and can overcome entrenched interests. In authoritarian states, this often becomes impossible; most authoritarian rulers project the image of absolute power, while in reality they are usually required to balance different interests and powers within the state.
Japan, though nominally democratic, was essentially a single-party state. The LDP dominated the government for most of the postwar period. Major interests within the party had a stake in continuing export promotion. This meant that in the early 1990s, when Japan needed to change to policies more appropriate for a developed nation such as balanced consumption and investment, the political system was unable to adopt these changes. Japan was trying to run the same export promotion policies it used during development with an exchange rate too high to support the policy. As the earlier chart noted, once the yen’s exchange rate fell below 150 yen/dollar (implying a stronger rate), the Japanese economy began to stall. It had too much investment in export industries that were no longer competitive at this higher exchange rate, and had a saving policy that would not allow for consumption to replace exports as a driver of growth.
Because of Japan’s inability to adjust to a stronger yen, the Japanese economy has languished for the past two decades. Although the LDP’s grip on power has diminished to some extent, Abe’s return to power, especially with the landslide victory in mid-December, indicates that the party remains a powerful force.
The Dog That Didn’t Bark
Since President Clinton, American administrations have generally tended to become less tolerant of developed nations using export promotion to maintain growth. The U.S. has been more open to developing nations using such policies (it expands U.S. global influence) but, as the currency debate with China shows, such tolerance isn’t without limit. China’s reluctance to allow its exchange rate to rise likely reflects the country’s fear of repeating Japan’s experience.
So, the lack of comment from the Obama administration on Abe’s inflation target for the BOJ is worth noting. Implicit in raising the inflation target is that the yen will weaken. Comments from members of the Abe government are hinting at a 90 yen/dollar target. Why, when U.S. growth is sluggish, would the administration tolerate the potential for rising Japanese imports?
It appears a weaker yen may simply be Japan’s price tag for supporting America’s pivot to Asia. This pivot, though officially denied by the Obama administration, is likely a plan to contain China’s growing geopolitical ambitions. The U.S. would be hard pressed to afford higher military spending to provide blanket security to Asia. Encouraging regional powers to fund a major portion of their own defense is likely required. However, if nations are going to be providing most of their own security (with U.S. backup), then they will have quid pro quos as well. It would appear that Japan is offering a trade; support for containing China requires a weaker yen.
The New York Times reported on January 7th that the Abe government is reviewing national military strategies with the idea that it will lift military spending for the first time in a decade to counter the rising threat from China. Increased military spending could boost Japan’s economy; at the same time, if it can extract a weaker yen in the process, then Japan’s economy could show some strength.
If our assumptions are correct, the investment ramifications from Abe’s policy changes are rather straightforward. The yen should weaken and Japanese equities should rally. We have, as noted earlier, already seen markets move in this direction. At present, the yen is technically oversold and Japanese equities overbought, but once these markets consolidate there should be further gains in both.
The trickier question relates to Japanese long-term sovereign rates. Japanese longer term rates have been depressed since the late 1990s; in fact, the investment landscape is littered with strategists that are betting on rising bond yields.
This chart shows 10-year Japanese bond yields. Despite massive bond issuance (Japan’s government debt/GDP ratio exceeds 200%), yields remain low.
If Abe’s policies are successful in raising inflation, the risk is that these yields could rise, making financing of future borrowing more expensive for both government and the private sector. Perhaps this is a risk worth taking but it should be noted that Japan has become accustomed to long-term government borrowing rates below 2%. An increase above that level will be a serious shock to the economy.
Essentially, Abe is embarking on a major policy change. Not only is he looking to change inflation and currency policy, he is attempting to change Japan’s pacifist military policy that will not be popular in the region. To some extent, Japan has been struggling for so long that a policy risk is preferable to continued withering. The fact that this policy change is being considered at all reflects how much conditions have changed not only in Japan but in the U.S. as well.
January 14, 2013
This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
© Confluence Investment Management
© Confluence Investment Management