Japan’s trillion-dollar experiment with ‘Abenomics’ is now running out of steam, and more monetary stimulus may be inevitable if the economy is to avoid recession.

That is the warning from Robeco’s chief economist, Léon Cornelissen, as the all-important ‘third arrow’ of economic stimulus by Japanese Prime Minister Shinzo Abe – structural reform to a deeply entrenched economy – appears to falter.

Following the VAT hike last month which was designed to stimulate spending in the first quarter, Abe is now running out of options, says Léon Cornelissen. This raises fears that Japan could fall back again into deflation, which was a key factor in Japan’s ‘lost decade’ in the 1990s. Deflation means goods become cheaper in the future, so people defer spending, triggering recession.

Cornelissen cites Japan’s recent failure to strike a bilateral trade agreement with the US as an example of how hard it is to reform Japan. A deal was necessary to rekindle negotiations that would enable Japan to join the 12-nation Trans-Pacific Partnership, which promotes tariff-free trade between members. However, Abe wanted to retain import tariffs on farm products, which hurt US producers, as he didn’t dare to put too-heavy burdens on Japan’s highly protected farmers.

Third arrow misses target for structural reform

“This failure to strike a deal is symptomatic for the lack of progress on the so-called third arrow of ‘Abenomics’ – supply side reform to increase Japan’s structural growth rate,” says Cornelissen. “It could be argued that the third arrow of ‘Abenomics’ is a long-term issue and therefore not relevant for the short-term growth prospects of the Japanese economy.”

“But lack of reform could mean that the world would have much more difficulty in accepting a further weakening of the yen. Japan’s position has been dubbed by the International Monetary Fund as an ‘over-reliance on monetary stimulus’ which could hinder a rebound of investment by Japanese companies in their country. This in itself is a necessary condition for self-sustaining growth and the ultimate success of Abenomics.”

“Lack of reform means more difficulty in accepting further yen weakening”

Cornelissen says few concrete measures have been announced to support the third arrow, including the legislation needed to create special economic zones. Tax reforms, labor market deregulation and corporate governance reform could all support investments. An increase in the female labor participation rate and a relaxation of immigration requirements would also be welcome, but progress has so far been limited, he says.

Abenomics was launched in 2012 on the back of stronger exports, due to the weaker yen, and strong private consumption growth that was caused mainly by the boost to national wealth from higher equity prices. However, share prices have weakened this year (the Nikkei is down 8%) and the yen is stabilizing at around 102 to the US dollar.

IMF and central bank downsize growth forecasts

The IMF in April lowered its growth forecast for Japan for 2014 from 1.7% to 1.4%. The Bank of Japan (BoJ) also cut its growth forecast for the current fiscal year in its semi-annual report in April, now predicting that GDP will grow by 1.1 per cent in the fiscal year to March 2015 instead of the 1.4% forecast in January. The central bank blamed “sluggishness” in emerging economies for Japan’s muted export performance, though it admitted that the steady shift in production overseas has also been a factor.

“The VAT hike from 5% to 8% on 1 April is an important step towards fiscal consolidation,” says Cornelissen. “That is why it is supported by the BoJ, despite its negative impact on growth. Abenomics has so far been very successful in raising inflation and inflationary expectations, due to the dramatic monetary loosening by the central bank.”

“But inflation expectations now seem to have leveled off. This could be a reflection of continuing doubts that Abenomics will not be more than a temporary stimulus to the Japanese economy.”

“Inflation expectations now seem to have leveled off”

Wage developments are key

Cornelissen points out that in contrast to recent price developments, wage rises have been disappointing. Average monthly cash earnings rose only a meagre 0.7% on a yearly basis in March, and in real terms they are declining.

“The sluggish wage growth is partly due to structural developments, such as the shift from full-time to part-time workers,” he says. “However, it also suggests caution by employers who in general apparently remain unconvinced that Abenomics is having more than a temporary impact, and are therefore reluctant to raise fixed personnel costs. The outcome of the current wage bargaining round is of critical importance.”

“And so the eventual success of Abenomics at this stage remains in doubt. Key variables to watch are wage developments and investments. I believe that the overly optimistic Bank of Japan will be forced into additional monetary stimulus, probably in July, leading to a weaker yen vis-à-vis the US dollar.”