14-06-20 LSR View Japan's ninja arrow - Lombard Street Research

LSR View Japan's ninja arrow 20 June 2014

Highlights • Japan’s unusual labour market key to explaining its massive loss of export market share • Japan’s budget was written for the demographic of the 1980s and pensioners’ escape from the tax man is unhelpful • JGBs wealth is artificially inflated by a grand Ponzi scheme • BoJ policy spreads the burden of a JGB correction to the whole economy • New GPIF policy could force Kuroda to reveal his hand • JGB default is a likely solution – this is the Ninja arrow!

LSR View Big picture analysis of global economic issues

Japan's ninja arrow Freya Beamish

20 June 2014

Summary

1

What are the root causes of Japan’s malaise?

3

Scenario 1: is the status quo sustainable?

15

Scenario 2: exit

18

The ninja arrow

19

Further Reading

21

Landmark LSR Reports

21

This Lombard Street Research report is intended to encourage better understanding of economic policy and financial markets. It does not constitute a solicitation for the purpose of sale of any commodities, securities or investments. Although the information compiled herein is considered reliable, its accuracy is not guaranteed. Persons using this report do so solely at their own risk and Lombard Street Research shall be under no liability whatsoever in respect thereof. The contents of this publication, either or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without written permission of the Managing Director.

www.lombardstreetresearch.com

Japan's ninja arrow Summary In this LSR View we will tackle extortion, nationalisation, monetisation and the elephant in the room – government debt and default. Default is the ‘ninja arrow’ or one-shot ‘Piketty tax’ on Japanese pensioners’ huge wealth. Retirees have prematurely escaped the tax man and a likely solution is to ‘tax’ their wealth by a de jure or de facto default. Current BoJ policy spreads the incidence of this tax to the rest of the economy. In essence, the Abe policies implemented so far represent a gamble on the assertion that Japan has nothing to fear but fear itself. In fact, Japan has much else to fear. Labour and capital markets are in serious need of reform and the budget needs to be brought into the 21st century to reflect Japan’s current demographic structure. The Japanese are older than most and are aging faster than most. The population and labour force are shrinking. The capital stock and additions to it are excessive. Yet labour is cheap and receives a depressed share of income relative to capital. The dysfunctional labour market is to blame, left behind in the transition from command to market economy. Lifetime employment inhibits innovation. Risk is anathema to those accustomed to being protected from it. Seniority pay increases with age faster than productivity. Lost market share from lack of innovation motivates employers to cut costs and prices. “Lifetimers” and bonuses are at the discretion of employers. The young earn and produce less but their costs per unit of output are lower. Early retirement cuts costs but exacerbates the impact of ageing. Wage compression lowers consumption and tax revenues. Retirees consume but they do not produce and their transfer incomes are paid by workers or borrowed from the future, resulting in structurally endemic government deficits and growing debts. The third arrow addresses some of these problems but in a half-hearted way. Meanwhile, other third-arrow policies are aiming at the wrong target and could be counterproductive. Even if a perfectly weighted third arrow – politics permitting – were shot by Apollo himself, it may be too late to reverse the damage done by Abenomics. Providing cyclical remedies to structural problems has pushed Japan onto a path from which it is increasingly difficult to exit without calamity. Up until this point, it’s nobody’s business if the Japanese wish to continue holding and passing round securities that promise posthumous taxes. Here we continue in the same vein as the LSR View “Japan’s reign of error” and search for the circumstances under which this delusion gets shattered. My colleague Charles Dumas has shown how pursuing the 2% inflation target through expanded use of the monetary and fiscal arrows could shatter the delusion. Japan has two other options: to maintain and enhance current policies or to abandon them. In this LSR View, we show how blithely continuing and waiting for the third arrow to work is folly. The third arrow is misconstrued. In any case, the BoJ’s hand

LSR View | 20 June 2014

1

may be forced by current JGB holders’ portfolio rebalancing, either because such a move makes sense or due to political pressure. We then show how withdrawing cyclical support could also shatter the Japan delusion. Removing BoJ purchases of JGBs from the equation would expose the intractability of the government deficit. Here we build upon the flow of funds analysis done by Charles Dumas. It is our view that the government deficit appears to be locked in because the budget was written for Japan’s demographic profile in the 80s. It is hard to escape the conclusion that large swaths of the population are now largely beyond the reach of Japan’s primary forms of taxation. The government needs to change the focus of taxation to flows that matter to retirees. But it must also be admitted that pensioners are much more concerned about wealth than income. And in the Japanese case some portion of their wealth is artificial. Japan has exchanged the problem of excessive private leverage for private wealth whose flip side is excessive public leverage. The private debt problem has been solved on paper but in reality has just mutated into a public debt problem, to which the private sector is exposed. Our final conclusion is that a government default may be the very thing that Japan needs to finally rebalance. It is not the destruction of artificial wealth per se that would bring about rebalancing but rather the concomitant leap in yields, which would focus minds on curbing the deficit. Bursting the JGB bubble may be the “ninja arrow” that has eluded policy makers. Persistent budgetary outflows financed by persistently increased debt are a Ponzi scheme writ large. For young and old it must end in tears. Defaulting on government debt would in effect be a one-shot tax on wealth. Or, perhaps, more accurately, it would be a final recognition that current retirees were in effect partly purchasing securities but also partly paying taxes every time they went to the JGB market. Default or some kind of arrangement amounting to default would clearly be politically unsavoury but may just end up being the only exit left open. In fact, current BoJ policy is already preparing for this by spreading the burden away from JGB holders to the rest of the economy.

Export performance 1993=100, Change in country’s exports of goods and services relative to increase in size of those markets

Germany

France

Italy

UK

Japan

USA

120 110 100 90 80 70 60 50 1993


1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2

What are the root causes of Japan’s malaise? In April, I undertook a research trip to Japan in search of the third arrow. This View outlines what the optimal third arrow might be and assesses how far from this ideal Abe’s arrow is, should he ever loose it. We conclude that the labour market reforms on the agenda would help over the long-run but there are gaps in implementation. We also show that a shake-up on the capital and capital market side of things is equally important. These reforms are not on the agenda. Japan’s main structural imbalances (as laid out in our LSR View “Japan’s reign of error”) are that wages do not grow, corporations run large financial surpluses and the government runs large deficits. These problems stem mainly from long-term structural trends, which are compounded by asymmetrical cyclical responses. The third arrow addresses some these “problems” either directly or indirectly and with varying likelihood of success. The policies can be divided into those which address causes and those which address symptoms. The former aim to drive up wages against the incentives of employers. They force a reduction in corporate sector financial balances against the natural inclination of management. The latter aim to change employers’ preferences by tackling the underlying causes of wage slippage, corporate surpluses and government deficits. Wages rise and corporate surpluses and government deficits then disappear of their own accord. The first type of policies may be necessary to break old habits and get things started but without the second they will ultimately fail and/or introduce other distortions. A key conclusion of this report is that policies so far have been almost exclusively of the first type but that Japan has become so unbalanced that it will be unable to cope with the effects of these even if they may have been helpful in other circumstances. Let’s look at the root causes and policies adopted so far in turn.

1. Companies are mean Companies clearly have large surpluses that could be diverted towards labour. The decision not to increase wages (or to cut wages) could be partly cultural, in which case little can be done about it in the short run. But culture is unlikely to be the sole cause. After all, Japan has had sturdy wage growth in the past. It seems more probably that there is some tangible reason why wages don’t grow. Leaning on companies through moral suasion, which is what the government has done so far, can work for a while with the larger firms, particularly where there are ties with government. But this is not a sustainable solution.

2. Companies continue to expect deflation Defusing expectations of deflation is one of the primary aims of Kuroda’s policy. Entrenched expectations of deflation may explain Japan’s inability to rebound after its long rebalancing period but must be only one part of the story. The argument is that deleveraging over more than a decade’s grind of paying down debt has left corporations traumatised and unwilling to borrow, invest or raise wages because of their continued expectation of deflation. But there is more to it than that. While economy-wide deflation is a fear, cutting costs and prices is an internal priority.


3

Corporate deleveraging was completed more than a decade ago. Households were never over-leveraged. It’s possible that Japan was on a healthy trajectory before the financial crisis hit and then got derailed. If expectations of inflation had just begun to revive and were prematurely curtailed, it could be a question of once bitten, twice shy. Defusing expectations of economy-wide deflation certainly seems a good idea. But eradicating the individual desire to cut costs and prices is a necessary condition. In the LSR View “Japan’s reign of error” we have set out how further pursuit of the 2% inflation target through larger QE could be very destabilising. While it would be excellent if Japan’s corporations could get over their debt trauma, forcing them to do so risks igniting financial crisis. This policy seems very much to have been dessert first and a main course of plain spinach second. Tackling the budget deficit and putting the public debt on a credible path to sustainability ought to have been the first order of business.

3. Feudal labour market Japan does not have a labour ‘market’ as such, or if so-called it is dysfunctional. It has peculiarities that differentiate it from most other developed countries’ markets. These notably include life-time employment, pay and promotion by seniority and the fact that employees’ incomes depend more on discretionary bonuses than on wage settlements. These are legacies of the post-WW2 recovery and miracle growth years. Until growth slowed in the 1970s, Japan was a command economy – “communism with beauty spots, not capitalism with warts” as my colleague Brian Reading wrote in his seminal book “Japan – the coming collapse”. The transition to a market economy began with financial liberalisation. But in the labour ‘market’ it remains incomplete. It functioned well in an environment that has long since changed. Companies competed to maximise market share. Growth was the priority with profit a secondary consideration. Labour was drawn from the countryside, hoarded and nurtured. Paternalism was the order of the day with employers providing a surrogate social security system. Rapid expansion produced demographic employment pyramids. There was always room for older workers to become managers as the younger ranks swelled. But feudal paternalism has now collided with demographic ageing. This goes a long way far to explain lost export market share, wage compression and anaemic consumption. Employers crimp wages and hoard profits when an ageing and shrinking labour force should make scarce labour expensive and an overblown capital stock unrewarding. This section deals in detail with these anomalies. It demonstrates how the dysfunctional labour market, coupled with ageing, holds Japan back. But it is unrealistic to expect more than glacial change. a) Lifetime employment Lifetime employment is much to blame for Japan’s failure to innovate. Since the Asian financial crisis, companies have markedly reduced the proportion of new employees awarded permanent jobs. But at the same time the number of new employees has also shrunk. Consequently, permanently employed older workers remain the dominant part of the labour force. This primarily affects the supply side, but indirectly


4

affects demand. Spending one’s entire career in the same company means employees move up the chain of command. This may work as long as the demographic base is expanding: more Indians create a need for more Chiefs. But demographic middleaged spread produces a superfluity of monolithic middle and senior management. Changing employers and jobs diversifies work experience. It broadens both mind and skills. Bringing new people into a company at all levels is invigorating and gets new ideas flowing. The world of technology, products and markets is constantly evolving. When the same people do the same jobs for decades, change and innovation become institutionalised anathema. No wonder Japan appears to have got stuck with yesterday’s technology and products and has been surpassed by the much more agile Korea. Below, we discuss how Japan and Korea are at different phases of their investment supercycles. Lifetime employment also affects demand by inhibiting one way in which people obtain higher salaries – by quitting old jobs for better pay with new employers. Historically, workers lost seniority when they changed jobs, returning to the foot of the ladder with impaired pension rights. Lifetime employment reduces labour bargaining power within the company when there is little likelihood that workers will leave. Japan: quit rate and GDP

US: quits rate and GDP

Voluntary quits % employed population, LSR calculations

Voluntary quits rate, source BLS

JP voluntary quits rate JP GDP QoQ (rhs)

US quits rate NB this is voluntary US GDP QoQ (rhs)

2.0%

3%

1.9%

2%

1.8%

1% 0%

1.7%

2.5%

2.0%

2.0%

1.0%

1.5%

0.0%

1.0%

-1.0%

0.5%

-2.0%

-1%

1.6%

-2%

1.5%

-3%

1.4%

-4%

1.3% 2002Q1

2006Q1

2010Q1

-5% 2014Q1

0.0% 2002Q1

2006Q1

2010Q1

-3.0% 2014Q1

US: quits rate and consumer confidence confidence

Japan: quits rate and consumer confidence Quit rate as above, confidence

US quits rate NB this is voluntary

JP voluntary quits rate JP consumer confidence, excl HH65

Tightening of age group 20-39

0-19

40-64

>65

Tightening of age group 40-64

Tightening of 20-39 bracket

Tightening 40-64 bracket

Annual growth of monthly average cash earnings for 20-39 year olds, weighted average

Annual growth of monthly average cash earnings for 40-64 year olds, weighted average

4%

2.0%

2%

1.0%

0%

0.0%

-2%

-1.0%

-4%

-2.0%

-6% 1992

20-39

1999

2006

Source: CEIC, LSR calculations


2013

-3.0% 1992

1999

2006

2013

Source: CEIC, LSR calculations

7

c)

Bonus structure

Because bonuses make up a large chunk of labour compensation, employers enjoy a great deal of flexibility. Companies can increase bonuses rather than base salaries when times are good and lower them when the economy turns down. But firms have not been symmetric in this. They have tweaked bonuses to bring down overall compensation over the course of the cycle. What appears to be a cyclical issue thus mutates into a structural problem. Special wage % of total compensation, 12mma 18%

Special wage % total earnings

16% 14% 12% Dec-71

Jan-86

Feb-00

Mar-14

Source: Ministry of Health, Labour and Welfare d)

Bonuses are paid primarily in June, July and December. In 1992 they accounted for more than 16% of total compensation versus 12.5% in 2013 (for companies with more than five employees). An international comparison is tricky because definitions differ. But data from the US Bureau of Labour Statistics suggest that Japan is an outlier. Japanese hourly direct benefits - mainly comprised of bonus, sick leave and leave time - made up 25% of total hourly compensation costs in manufacturing in 2012, down from nearly 29% in 1996. But this is still significantly above the next member of the sample. For the US, the figure has stayed flat over the same period at roughly 9%. There is not a perfect relationship between the method of remuneration and the importance of competitiveness for a country’s growth model. But it is interesting that Japan is at one end of the spectrum and the US at the other. It is also notable that bonus pay accounts for a high proportion of total compensation in Germany, the other major economy with a long-standing penchant for competitiveness. Germany comes third in the sample after Austria. To some extent, companies choose the method of remuneration based on how they want to treat their workers. A large bonus component gives the employer much more flexibility. But how did this pay model evolve in the first place? This system pre-dates the decline of wages in Japan and so it is not the cause of salary slippage. Rather, it facilitates it. In this way, Japan’s labour force is afforded less protection against the natural inclinations of enterprises.


8

Direct benefits % of total compensation Hourly direct benefits (mainly bonus and leave) % of total compensation in manufacturing

1996

2012

30% 25% 20% 15% 10% 5% 0% IS US AU CA SE NZ CZ UK AR BR IT IR PH SG FR SW SL GR FI PT SP HU BE DE AT JP Source: BLS

Meritocratic bonus payments could theoretically introduce flexibility into the seniority pay system. In practice they are paid across the board, steepening the progression of income with age. They provide macro-flexibility but not micro-flexibility. The policy response here is far from clear-cut. At some stage, if the process continues, Japanese bonuses will shrink to such a small proportion of total pay that macroflexibility no longer exists. It’s hard to say where this point is but it seems likely that it hasn’t been reached yet. As for the need for government carrot and stick measures to speed up this shift, the same considerations apply as in the case of seniority pay. Supply-side benefits should speak for themselves but appear not to. Demand-side benefits suffer from a positive externalities problem. Increasing wages for your employees is good for demand in general but it is only a very small fraction if anything of employee income that will actually come directly back to the same firm. Employees that benefit from wage gains will spend those gains at many other companies than just one that gave the increase to them. It would be a company with an unusual degree of social awareness to take this positive externality into account when setting wages.

4. Cross-shareholdings This issue has been discussed in “Japan’s reign of error”. Here we add only a brief comment on the effects of ageing. It isn’t a given that capital takes a larger share of income in an ageing population, but it certainly has in Japan. If the holders of equity are primarily companies, this increase in capital’s share simply signifies resources leaving the real economy never to return. That is simply a destruction of resources.

5. Japanese uncompetitiveness From the perspective of productivity-adjusted labour costs, Japan was already competitive against other countries even before Abenomics. And yet, with Japan experiencing a continual loss of market share, there is a feeling that the economy needs to be even more competitive. As pointed out above, labour costs have been cut by reducing wages faster than productivity has declined. This is folly. Raising productivity faster than wages is the route to sustainable competitive gains.


9

Japan’s capital stock is still remarkably large for the size of its population. This affects its need for competitiveness in two ways. Because Japan’s capacity to produce far exceeds the capacity of its domestic population to consume or invest at current prices, the country has to run large current account surpluses if it is to escape deflation. Real capital per head appears to have remained higher than in the US, let alone Korea (in PPP terms). The situation is even worse with respect to the working-age population. Japan therefore needs an inordinate degree of genuine competitiveness to compensate. Because the capital stock is over blown and the population is declining, there is little need for investment. In fact, Japan might even be happier if the net investment rate were negative. But new machines and techniques are needed to keep up with rapid product development, especially in sectors such as technology. Japan has clearly fallen behind on this score. This lack of product innovation pushes companies to compete on price. Japan’s problems in this area would be less pronounced if it wasn’t sandwiched between a neighbour that has historically been very price competitive, China, and one with a very innovative product line, Korea. a) The China effect While they lasted, China’s famously undervalued currency and competitive labour markets exposed northeast Asia and other exporting nations to a major source of deflation. Initially China was producing goods that did not compete directly with Japan. Even so, deflation exerted itself by sucking demand towards Chinese-type goods from Japanese-type goods. As China developed, the overlap between the two countries’ export baskets increased. Japanese steel may be of a higher quality overall, but China has grabbed considerable market share at the lower end of Japan’s product range. This story was current until 2011. China has run into demographic barriers and its supercharged investment binge has caused the labour market to remain perpetually overheated. Chinese companies have been unable to pass on the pressure of the lost competitiveness to the labour market and as a result the real appreciation of the currency has continued unchecked. Capital stock to labour and population ratios

Relative unit labour costs

2011 PPP for capital goods

JP & KR 100: average 1973-2013, CN 100: average 87-92

Productive capital stock per capita, 2011 PPP per head of working age population, 2011 PPP 250 200 150 100 50 0 Japan

Korea

Source: OECD, CEIC, LSR calculations


US

USA Japan

Eurozone China

150 140 130 120 110 100 90 80 70 60 50 1989 1992 1995 1998 2001 2004 2007 2010 2013 Source: OECD, LSR calculations

10

Japan probably feels some marginal effect of the resulting deflationary forces because of its economy’s close links to China. Japanese corporations use China as a base for exports, so their profits are hurt by the RMB’s overvaluation. Moreover, because Chinese enterprises have been unable to alleviate their profit squeeze domestically, pressure has grown to pass the burden on to foreign suppliers. Paradoxically, if China had Japan’s labour market characteristics and vice versa, the problems each faces might be attenuated. Japan would have buoyant wages with crimped profits. As both are confronted by ageing, declining work forces and tighter labour markets, their opposed trends in the rewards to labour versus capital reflect differences in labour market liberalisation. On the other hand, the rate of off-shoring to China should slow under these conditions, meaning Japanese corporations could put their funds to more positive use by increasing capex. Japan’s investment rate is already too high, but there is probably a lot of waste. Workers who are making the most of new machinery that is actually needed are much more likely to enjoy rising wages. The Chinese economy’s medium-term strength actually depends upon depreciating the renminbi, so Japan’s new-found competitiveness is unlikely to last. But it could help in the shorter term. b) The Korea effect Both Japan and Korea have been engaged in a long-term rebalancing of investment rates. Korea had to reduce investment as a share of GDP, while Japan actually should have halted the increase of its capital stock. Unfortunately, this situation is unlikely to improve any time soon. Korea has now finished its rebalancing – investment rates look roughly optimal but in Japan wasteful investment continues and the ratios of capital to labour and population remain elevated. The policy response so far has largely ignored this factor and has instead aimed to boost investment. The rebalancing forces remain in place, though, and resisting them only prolongs the pain.

6. Ageing Japan was one of the first economies to enter the new demographic era of a shrinking working-age population and increasing dependency ratios. At the time, it was often supposed that this would help Japan in the transition to consumption-led growth. The decline in the working-age population would tighten labour markets and keep wage pressure on, while retirement would prompt households to finally start spending their accumulated resources. In the event, things haven’t exactly turned out that way. Instead, the demographic changes appear to have had more of an impact on demand than on supply. This effect was probably amplified by the scale of deleveraging that was necessary. Nevertheless, it also makes logical sense. On the supply side, the number of people who can work is determined by demographic forces that prevailed decades before. On the demand side, consumption is based on the income and wealth that people expect to have in future. Investment is forward-looking, too, based ultimately on expected future consumption.


11

The potential labour supply may be lower in this period, but that also means fewer income earners to new investment. Investment planning incorporates this prospect over multiple periods, so the adverse affect on capex could easily reduce the demand for labour by more than the one-period effect on supply. Despite corporate early retirement drives, the tightening of the labour supply has mainly hit the younger generations. The effect of leaning against seniority wages (see above) has merely softened the trend. This tightening is set to spread to older workers as more baby boomers retire. It is worth remembering that young Japanese suffered more than most in WW2. Japan’s post-war baby boom was later and bigger than in other countries. The miracle growth years coincided with a young and rapidly expanding labour force, augmented by migration from rural farms to urban factories. All this is now reversed. The impact of ageing on savings and consumption could now start to come into play. Unfortunately it is not clear that retirement will boost consumption. The retirement of large swaths of the population certainly has reduced the savings rate, but that doesn’t mean consumption is strong in absolute terms. Income compression offsets falling savings rates – and the household savings rate have been falling throughout Japan’s decades in the doldrums. In theory, assuming individuals aim to smooth consumption over their lifetime, consumption ought not to change when people retire despite a sharp drop in income. In practice, though, retirees may well consume less. Meanwhile there are fewer productive people as a proportion of the population. In Japan that hasn’t been reflected in higher wages. And people are retiring, so there are fewer people earning an income. So consumption in aggregate is understandably increasing as a share of household income. This means a lower household savings rate. But that lower household savings rate has translated into higher consumption as a proportion of GDP because the funds that would have flowed into the household sector have gone instead into corporate savings and driven up the overall savings rate of the economy.

7. The budget is written for the wrong population profile In “Japan’s reign of error” we addressed the intractability of the government deficit from a flow of funds perspective. Here we look at why the deficit has been seemingly impervious to the consolidation attempts of successive Japanese leaders. We suggest that a big reason is that the budget was written for a demographic structure that, since the early nineties, no longer exists. A budget for an older population may need to be radically different. A detailed analysis of the budget is beyond the scope of this report. We will have more to say on this. A number of topics merit deeper examination. On the expenditure side, questions need to be answered about the sustainability of the welfare system as social security contributions are insufficient to pay for the benefits. On the revenue side, it may be time to recognise that the older generations are slipping further and further beyond the reach of the tax man. Income tax misses a large portion of the population that is now retired. Japan’s consumption tax is low by


12

international standards – although increasing the tax without tackling the structural problems outlined above merely makes matters worse. Another solution would be to recognise that the importance of labour income flows is in decline and that of capital income flows is in the ascendancy. It is not clear that labour income has to become lower as a share of total income when the working age population falls. In Japan this has not happened because of the way the country’s labour ‘non-market’ functions. One solution would be to tax capital income or, as my colleague Charles Dumas has suggested, retained earnings. The stock of wealth becomes much more important in an older society. The Piketty solution to increasing inequality is to tax wealth directly. We have a different proposal: default on government debt. (See section on The ninja arrow below for more on this and the impact that BoJ policy is having on the potential efficacy of a default.) Inheritance tax could get funds out of their pit and is a policy option that seems to have gained some traction. A flow of funds analysis also supports the view that an inappropriate response to ageing is a key problem. Japan’s demographics were transformed in the early nineties. The peak-saving cohort started to decline as a proportion of the population and households in aggregate simply had less funds to accommodate corporate sector deficits. The corporate sector had to decrease its deficit and eventually swing into surplus to deleverage. Ideas about balance sheet recessions and the necessity for governments to make room for private-sector deleveraging by running deficits were not unheard of in Japan at the time, but they were rare. It seems much more likely that the emergence of a government deficit was at least in part an automatic response to the same factors that had originally caused the decline in the household sector’s financial balance. Now the corporate sector has deleveraged, so the government has no cause to run an accommodating deficit. But the deficit is locked in. What’s more, the lack of a labour market not only compounds this imbalance but also gives corporations a host of incentives to keep running surpluses even though they no longer need to pay down debt. But it seems that these surpluses are no longer enough to offset the government deficit and the external surplus is waning. As a result, with an entrenched need for funds to plug the government deficit, Japan is now flirting with a current account deficit. This need for borrowing from abroad would probably have emerged sooner had it not been for the BoJ stepping in as another domestic lender in the equation. See below. If it is indeed government deficits that are causing savings, we would, under normal circumstances, see interest rates rising in a normal crowding-out response. The demand for funds is exceeding the supply at current interest rates, which must therefore rise to attract more lenders. That is not what we see because QE policy has effectively destroyed the JGB market. So we have to rely on working out what would happen if the BoJ was not buying bonds in such vast quantities.


13

The structural problems “Problem”

1 2 3 3a 3b

Corporate surplus

Government deficit

Companies are mean

Companies don’t pay higher wages

The government is left to offset it

Companies expect deflation

Companies are debt-traumatised and unwilling to give lasting wage increases

Income tax lower

Great flexibility for employers to set salaries

As above

Inefficient labour system Bonus structure Seniority wage

Productivity and innovation damaged. Overpayment of older workers forces Thwarted positive wage impact of labour early retirement = strain on the market tightening in younger cohorts budget. Higher pension payouts & lower income tax revenue

3c

Lifetime employment

Fewer quitters: disables (a) bargaining mechanisms with current employers and (b) negotiation with new employer. Stagnant staff = lack of innovation = greater burden on price competition

4

Cross-share holdings

Cross share holdings: c. 2/5ths of shares held by companies. Dividend distribution just goes to other firms, swelling retained earnings

5

Japan is uncompetitive

Japan is not uncompetitive from a ULC perspective but yet dramatic market share loss. (a) Product line outdated – need greater price competitiveness. See also lifetime employment and seniority wage (b) capital stock out of line relative to labour, making Japan excessively reliant on external demand.

5a

China effect

China's labour competitiveness used to put Lower income tax, lower corporation downward pressure on Japanese wages tax due to lower corporate earnings

5b

Korea effect

Korea’s superior product line highlighted Lower income tax, lower corporation Japan’s outdated offerings. tax due to lower corporate earnings

Ageing

Negative effects on demand ahead of Lower income tax, lower corporation tax tightening of labour supply. Effects amplified by seniority wage system.

6

Capital stock even more overweight

7

Budget written for economy more than 20 years ago

Corporate savings reflect the rigid budget Income tax misses a large portion of deficit. Depreciation allowances inflate the population that has no labour business savings. income. Depreciation allowances and capex incentives prolong rebalancing. Tax system still favours producers and the wealthy.


14

"Problem"

1

2

Policy response

Companies are mean

Appropriate policy response

T1: Moral suasion. Likely NRR: ability of companies to be mean likely a reflection of ineffective outside the some underlying distortion that needs to be addressed. largest companies and Moral suasion may be warranted if other reforms have been anyway unsustainable made and there is still no reaction from corporations.

Corporations T1: Inflation targeting, yen expect deflation depreciation and liquidity

WAS: make the structural reforms first. Then WAS whether they work. Then undertake Kurodanomics.

pumping

3a

Bonus structure

T1: Moral suasion

NRR: Could sort itself out over time. But some T1 policies probably warranted

3b

Seniority wage

T1 so far: moral suasion; T2: Dismantling the system is on the agenda

ARR: Dismantling seems appropriate. But also policies to construct a labour market not just dismantle the old system. Some T1 probably also required.

3c

Lifetime employment

So far T1: moral suasion. T2: Dismantling is on the agenda

ARR: As above. Need reinforced job agencies.

Crossshareholdings

Little or no response

Tax retained earnings (see The reign of error)

4 5 5a 5b

Japanese uncompetitiveness China effect

T1: Yen depreciation

ARR/NRR: address product stagnation

Korea effect

T1: Yen depreciation and capex incentives

ARR/NRR: Address product stagnation. Stop leaning against capital stock rebalancing. See also lifetime employment.

6

7

Ageing

Elements of T1 and T2: Encouragement of immigration and greater participation of women and older workers

ARR/NRR: Immigration can help but not necessarily on a per capita basis. Encourage female and older participation. See 3b. Accept lower growth and switch focus to per capita figures. Stop expanding capital stock. Give 2nd hand capital goods instead of monetary foreign aid

Budget written for T2: move to consumption demographic tax but without having structure of >20 properly addressed the years ago above, cut corporation tax;

Consumption tax as part of the solution. One shot Piketty tax on the holders of JGBs. Drop capex incentives and depreciation allowances.

T1: increase the deficit and finance it by having the BoJ chip in

If the deficit is the key rigidity then whatever the policy response is, it would appear not to be QE.

Key: Key: T1: type-one policy response, see above; T2: type-two policy response, see above; NRR: No response required; ARR: Active response required; ARR/NRR: Some elements require an active response. Others don’t.; WAS: Wait and see


15

Scenario 1: is the status quo sustainable? In the section above we established that the third arrow is misconstrued and that even an optimal set of policies would take years to start having a beneficial impact. We now look at what could go wrong if the BoJ continues on its current path. If Japan tries to perpetuate the monetary status quo, two outcomes are possible. Either events will force the attempt to be abandoned or the BoJ will end up owning all outstanding JGBs. At the moment, it seems more likely that events will take control if Kuroda remains wedded to the task of holding down nominal yields. Japan’s financial institutions and other JGB holders have already been busy reducing the share of government bonds in their portfolios. This shift may have continued in any case, simply based on the logic of the move. But the Government Pension Investment Fund (GPIF) has come under substantial political pressure and, with a much more understanding board, it was finally disclosed last week that the fund would step up its diversification away from JGBs. Yasuhiro Yonezawa, the hand-picked head of the investment committee has stated publically that GPIF will significantly increase its allocation to domestic equities. It will also buy more foreign equities and bonds. This reallocation by the GPIF will be followed by others, not least life insurers, which have been waiting for the move. Domestic institutional investors have been slow to lighten their JGB holdings and so there may be pent-up selling pressure. The shift towards risk assets could be more inflationary than the current portfolio mix even though no additional money is being pumped into the system. It also forces Kuroda to declare himself. He will have to decide how determined he is to keep a lid on nominal yields. The GPIF will likely reduce its JGB target allocations from 60% to around 40%. The BoJ is probably the only buyer with the means to pick up the slack. What has happened in effect is that the GPIF is now taking on the fiscal policy role that has already proved too big for both the MoF and the BoJ. The central bank’s purchase of equities always had an element of fiscal policy about it and is viewed in that light in the halls of the BoJ. BoJ equity is injected by the MoF and BoJ governors, including Kuroda have considered their purchases of non-traditional central bank

Portfolio allocation to JGBs & % of total outstanding outs

Flows of JGB purchases 4QMA

BoJ

Life insurers

BoJ Life insurers Overseas

Pension funds

Banks Pension Central government

25

% of gov securities

45% 40% 35% 30% 25% 20% 15% 10% 5% 0%

Banks

15 2013Q4 5 2011

2013

-5

% of own total financial assets 0%

20%

40%

60%

Source: BoJ, LSR calculations


80%

100%

-15 1999 Q4

2004 Q3

2009 Q2

2014 Q1

Source: BoJ, LSR calculations

16

assets to be limited by the amount of this equity. The BoJ’s purchase of JGBs has not been sufficient to induce erstwhile government bond holders to boost inflation to the target level. Since BoJ buying was enough to induce Japan’s financial institutions and other JGB holders to purchase equities, the authorities have concluded that they should buy equities themselves. So the GPIF has stepped in. The question is whether this will turn out to be a purely fiscal policy (covert though it is) that bypasses the BoJ or whether it will also induce a monetary response from Kuroda despite any reservations he may harbour. Markets barely moved with the GPIF announcement, so the assumption must be that further BoJ JGB buying is priced in. Below we discuss why any reduction of willing lenders in Japan could expose the government deficit and shatter the current delusion. Japan’s assets aren’t worth enough for the private sector to want them at current prices. They do not provide sufficient returns at near-zero interest rates, so the government has decided to go one step further and replace them with truly zero interest rate assets, namely yen cash. Kuroda’s capacity, should he prove willing, to respond to the GPIF reallocation will depend upon the hedging practices of Japan’s financial institutions as they invest abroad. Most of the relevant institutions habitually give up some of the investment upside in order to reduce risk. But if everyone is following going in the same direction, the likelihood is that they will be slightly less prudent than usual. In this event, the yen would at some stage need stabilising by allowing a rise in nominal yields. So by using the GPIF for fiscal policy, Abe is in effect forcing Kuroda’s hand and we end up back on the path detailed in “The reign of error”. What if the BoJ does manage to walk the line, say if institutions decide to keep larger hedge ratios so that the BoJ just continues to buy up the JGB market? Does it matter if the Boj owns 50% of the market? Or 100%? What would the BoJ buy then? Would it nationalise Japan? Any private capital that got wind of this would surely head for the exits sharpish. And by backward induction, if there is indeed little hope that Kuroda can exit this policy, this should be an immediate concern for the market. In reality, despite the logic of this argument, a catalyst is probably still needed. Certainly, the fact that the BoJ has gobbled up a big chunk of outstanding JGBs wouldn’t save the day in the event that the government could not maintain its debts. If the government defaults on bonds held by the central bank, the JGB liability disappears and this would increase government equity. But the write-off would be against BoJ equity, which is injected by the MoF, i.e. it is an asset of the government. And BoJ equity is anyway minimal. So there would be no improvement in the government’s net position. The yen and bank reserves created when the BoJ bought JGBS from the non-bank and bank public respectively would remain in existence as liabilities of the BoJ, whose position has been compromised. The liabilities of the government have been turned into central bank liabilities and the debt monetised.


17

People are less willing to hold the liabilities of the BoJ. The non-bank public could feel the urge to get rid of their yen for real goods or other currencies, directly causing domestic inflation directly and yen depreciation. The bank sector could feel compelled to get rid of their reserves with the Bank of Japan and take them elsewhere if possible. In this scenario, the difficulty is simply knowing where the tipping point is. But on this path, there is a trip switch somewhere that flips Japan from a state of low inflation or deflation to hyper inflation. We discuss below the extent to which the rapid disappearance of JGBs into the maw of the BoJ is a way, conscious or otherwise, of shifting the burden from Japan’s key electorate (the older population) in the event that a default were to occur.

Scenario 2: QE exit The second scenario to consider is an exit from QE. The likelihood of Japan ever reaching the point at which Kuroda could do that easily is slim. It’s possible that Kuroda’s intended next move is to wind down QE, possibly in H2 of next year. To be fair to him, he has done all he can with the tools at his disposal. But it seems more likely that either his hand will be forced before then (by the threat of rising nominal yields) or it will become obvious that more not less QE is needed to generate 2% inflation. (For more details on how that might pan out, see “The reign of error”.) A climbdown at that stage would be extremely difficult to justify. Going through the logic of a QE exit reveals just how precarious Japan’s situation is. We take a step back to provide a thematic description of the problem facing Japan. It could well be the case that Japan has switched from having a savings problem to a borrowing problem with the natural pressure on interest rates shifting from down to up. This, as observed above, is deleveraging over-leveraged private wealth. At the heart of this is that (a) The budget was written for the wrong demographic profile. Japan’s population has finally grown old enough for this mistake to hurt. See section 7 above. (b) The government seems hell-bent on growth at any cost, which has set Japan on a slow path to nationalisation that can be financed only by printing money. At base Japan has too much financial wealth, debt liabilities, for its ability to pay back so they are replacing low nominal yield assets with zero nominal yield assets (privately held interest-bearing JGBs are bought in exchange for non-interest-bearing yen cash). Again, a flow of funds analysis makes this clearer. The economy has further internalised the process of wasting savings and the current account has declined accordingly. Excess savings have created the conditions in which the government could continue to run deficits without consequences. They may have created a monster addicted to borrowing. Japan’s government deficit is to private sector savings as the evil Mr Hyde (over-leveraged debt) is to the virtuous Dr Jekyll (over-leveraged wealth).


18

Excess savings are perpetuated by somebody borrowing and propping up income. Until last year the rest of the world had been willing to perform some external Mr Hyde functions so that Japan could run current account surpluses to offset its Dr Jekyll savings. Foreigners were willing and able to increase their liabilities to Japan. But now Japan’s own internal Mr Hyde (the government deficit) has become so large that he is more than capable of eating up Japan’s private-sector savings all by himself. Japan is now flirting with a current account deficit and could have gone into deficit earlier if the BoJ had not stepped in as a further domestic lender. If an entrenched government deficit and the demand for borrowing really are now at the root of Japan’s flow of funds, then Kuroda’s asset purchase programme has been the only thing preventing a natural rise in yields. So not only was QE a cyclical response to a structural problem, it has perpetuated the government deficit, which is a major obstacle to Japan’s long-awaited recovery. The internal Mr Hyde is the critical one. Excess savings can persist as long as somebody is willing and able to run offsetting deficits. These hold up income as leverage is increased. When external Hydes die, another can step in. But if there are no more external Hydes or they are not large enough, then Japan has to provide its own Hyde. When this Hyde comes under pressure is the moment the correction happens since he exists only because there is nobody outside that wants to chip in. If no reforms are made, the same imbalances can re-emerge, but the internal Mr Hyde is the last one in any given round of savings wastage.

The ninja arrow In the above we have hinted at the existence of a ninja arrow. During my trip to Japan in search of the third arrow, I found the government’s posited policies to be somewhat in the right direction. But many critical policies are simply not on the agenda. Japan could relapse into malaise and the same imbalances could continue to build until a day of reckoning comes at some point. But most of the scenarios seem to have an uncomfortably close day of reckoning. It seems to me that the best thing that could happen to Japan at the moment is for it to admit that there is one final stage of rebalancing that must be completed. Japan’s ninja arrow is to come to some kind of arrangement with its citizens and write off government debt. There are two ways of looking at this. One is to call it a Piketty tax on wealth. The other is to say that a certain portion of the current value of JGBs is actually just a tax receipt and that JGB buyers have actually already made a sizeable tax payment. That wealth stored in JGBs is functionally artificial. It doesn’t do anything and probably never will. If the older generation doesn’t plan to spend its wealth, then past investments were based on a false assumption of future consumption. In the aggregate, wealth is dual in nature. It is both the investment that people make at a certain point in time and the means by which they intend to pay for future consumption that would justify the investments in the first place. If they don’t intend to consume, then the wealth isn’t real and the investment was a bad one.


19

In Piketty’s framework, inequality is increasing if the return on capital (r) exceeds the rate of growth (g). But r>g is not a sustainable proposition insofar as the rest of the economy at some stage will not have the funds to pay for the goods and services that would justify the current wealth valuation. Both from this standpoint and from the perspective that the Japanese government probably cannot pay back its debts, it could well be that some portion of JGB wealth is indeed artificial. However, wiping out something that never existed doesn’t exactly help for the future other than cleaning the slate. There would still be a deficit problem. The retired population appears to have escaped the tax man. If Japan is to have any hope of shaking off its sickness, it must recognise that pensioners escaped prematurely. The budget needs to be reformed, as outlined in section 7, and wealth needs to be taxed. JGBs need a haircut. One problem with the BoJ swallowing up JGBs is that it spreads the burden of a default to the rest of the economy. The BoJ’s purchase of JGBs doesn’t necessarily lessen the burden of a default on the old population. It depends on what is done with the yen used to buy the bonds. But it certainly spreads the pain to the rest of the economy through inflation. In fact, the best way for the elderly to escape the pain is to dump their yen right now. That would spare them individually from the inflation that is the logical conclusion of ever-increasing monetisation of debt. But it would also hasten that self-same inflation, which would have to be borne by whoever is left in Japan.

Freya Beamish [email protected]


20

Further Reading “Japan’s reign of error”, LSR View by Charles Dumas, 11th June 2014

“Kuroda talks the talk, doesn't walk the walk”, LSR Daily Note, 30th May 2014 “Japan's Kuroda hesitates - is he lost?”, LSR Daily Note, 13th May 2014 “Japan - found in translation”, LSR Daily Note, 29th April 2014 “Japan's tax hike - Kuroda on his mettle”, LSR Daily Note, 28th March 2014 “BoJ whale in JGB pond”, LSR Daily Note, 25th March 2014 “Japan's real faltering yet to come”, LSR Daily Note, 17th February 2014 “Shunto in a dead end”, LSR Daily Note, 22nd January 2014 “Asia’s currency cold wars”, LSR Monthly Review, 29th May 2013 “Abenomics – another Japanese sink-hole”, LSR Monthly Review, 4th April 2013 “Japan: the coming collapse”, Brian Reading, 1992

Landmark LSR Reports Please click here to see the list of landmark LSR reports.


21

Since 1989 Lombard Street Research has provided the global investment community with independent, thoughtful and pertinent macroeconomic analysis, investment advice and asset allocation recommendations. Our clients value our genuinely global and fully integrated research, which is essential in the modern investment environment. Global-macro thinking drives all of our investment themes. For more information about our services please contact your local Lombard Street Research office.

Pellipar House, 9 Cloak Lane, London EC4R 2RU www.lombardstreetresearch.com

London

Tel: +44 (0) 20 7246 7870

[email protected]

New York

Tel: +1 212 367 7644

[email protected]

Hong Kong

Tel: +852 2521 0746

[email protected]