Japan's Economy in 2014: Bear or Bull?

The Japanese economy has been underperforming for several decades. After almost catching up with the US during the boom in the 1980’s, Japan seems to have been stuck at approximately 70% of the US level of income per capita (figure 1).  The election of Shinzo Abe and the combination of easier monetary policy, fiscal expansion and promises of deeper structural reforms have significantly improved the outlook for Japan. This article explores alternative scenarios for Japan in 2014, developed using our global macroeconomic model (Euromonitor International’s Macro Model – EMM).

Figure 1: GDP per capita in Japan relative to the US, PPP adjusted

Source: Euromonitor International from IMF,OECD
Note: USA=100%

Baseline Forecast and Alternative Scenarios

Like other forecasters, we have significantly raised our growth estimates for Japan in 2013 and 2014 during  this year. Our baseline forecast is now for real GDP to grow by 1.8% in 2013 and by 1.6% in 2014. For the rest of the decade, Japanese growth rates are likely to return to a slower pace of around 1%. In our optimistic scenario Japan undergoes an economic boom in 2014 with a GDP growth rate of 3.2%, followed by growth of 1.9% in 2015. In our more pessimistic scenario, Japan faces a recession with GDP falling by 2.1% in 2014, followed by almost no growth in 2015.  We assign both scenarios a probability of around 5-10% in 2014.

Table 1: GDP Growth Forecasts for Japan and Other Key Economies

Source: Euromonitor International (Macro Model)

Japanese Boom Scenario

Our Japanese boom scenario assumes the successful implementation of several structural reforms as part of the third arrow of Abenomics. The Japanese government claims that its planned reforms can boost GDP growth to 2% a year over the next 10 years (IMF article 4, 2013). There are several reasons to be skeptical about the feasibility of this target. First, the scope for a large long run boost in the growth rate is limited by the fact that the Japanese economy has not been stagnating so badly after all in comparison to other countries. GDP per capita relative to the US in recent years has been roughly at the same level as other large developed economies such as France or Germany. Second, the current long-run GDP growth forecasts of around 1% are actually quite similar to  the forecasts for the US in terms of GDP per working age person (Figure 2). Most of Japan’s slow growth is simply due to faster population ageing and the end of catch-up growth once it became an advanced economy.

Figure 2: GDP per Working Age Person in Japan and Other Advanced Economies

Source: Euromonitor International from UN
Note: Forecasts start in 2013

Japan has similar structural problems  to some large European economies. It ranks 24th on the World Bank’s  “Doing Business in 2013” ease of doing business index. The services sector is overregulated and hard to enter for new competitors (Hoshi and Kashyap, 2011).  Female  labour force participation is significantly below the OECD average (IMF article 4, 2013). Population ageing puts strong constraints on labour supply and raises  the need for large increases in distortionary consumption and labour  taxes over the coming years. The experience of European economies suggest that implementing  major reforms to deal with these issues is quite a difficult objective, due to political constraints and opposition from various special interest groups.

Our scenario features modest reforms such as the creation of several special economic  zones with low regulation, increased incentives for business creation and R&D, and a 2 percentage points increase in the  female labour  force participation rate. We see the combination of these measures as generating a medium size permanent positive shock to potential GDP, together with a moderate and  temporary rise in business and consumer confidence. The reforms would lead to an increase in Japan’s long run GDP level of around 2.5%. In this scenario, Japan’s GDP increases by 1.6% in 2014 and by a further 0.7% in 2015 relative to our baseline.  Inflation rises modestly by about 0.1% relative to the baseline in both 2014 and 2015. The Bank of Japan responds to the unexpected boom by raising interest rates by about 0.25 percentage points in 2015.

Spillovers to other economies from this scenario are moderate. China’s gdp growth would be higher by 0.5 percentage points in 2014, and South Korea’s GDP growth would also increase by 0.4 percentage points in 2014. We do not foresee significant effects on other major economies outside Asia.

Japanese Recession Scenario

Our Japanese recession scenario is based on the possibility of a sovereign debt market panic in 2014. Japan’s gross government debt is projected to exceed 240% of GDP in 2013, the highest level among advanced economies. Net debt to GDP is closer to 140%, but other unfunded liabilities must be set against the Japanese government’s assets, and those assets are only partially liquid (IMF Fiscal Monitor, October 2013, Fatas, 2010). As of 2012 around 95% of Japan’s government debt was held by domestic bondholders, who are more willing to accept low interest rates than foreign bond holders (Hoshi and Ito, 2012). However, the availability of domestic savings is likely to fall in the coming years.

The next phase of population ageing is likely to strongly reduce Japanese willingness to save, as older households start consuming their retirement savings. Japan’s national savings rate has declined significantly in recent years, and according to some estimates is unlikely to exceed 5.2% over the rest of the century (Braun et al, 2009). Meanwhile, calculations of the tax increases required to stabilize Japan’s debt to GDP ratio in the face of rising pension and medical expenses suggest that the consumption tax rate may eventually have to increase to 33-35% (Braun and Joines, 2012, Hansen and Imrohoroglu, 2013). Despite the planned consumption tax increase next year, the budget deficit in 2014 is forecast to be 6.8% of GDP. In addition, Japan will have to refinance maturing debt amounting to 51.3% of GDP during 2014 (IMF Fiscal Monitor, October 2013). These estimates suggest that despite the current low interest rates, Japanese government debt is vulnerable to sudden sovereign debt scares with temporary increases in estimated default probabilities and government bond yields.

Our scenario assumes growing doubts about Japan’s ability to avoid some debt restructuring starting in the first quarter of 2014. These doubts lead to an initial cut back in loans by Japanese banks and a decline in business and consumer confidence. The initial growth slowdown is amplified in the second quarter by a sudden increase in long term government bond yields of around 150 basis points. Due to the critical role of government bonds as collateral in financial markets, the spike in government bond yields causes a credit crunch in 2014/2015 and further drops in confidence. GDP falls by 2.1% in 2014 and stagnates in 2015. The Bank of Japan has limited ability to counter the recession due to the zero lower bound on its policy interest rate, and the already unprecedented extent of the existing quantitative easing programme. Inflation drops by 0.4 percentage points relative to the baseline in 2014 and by 0.7 percentage points in 2015.

Eventually, uncertainty in financial markets starts declining, and renewed commitments by the Japanese government to increase revenues allow confidence in Japanese government bonds to recover. This leads to a partial economic rebound in 2015-2018, though GDP is still 2.1% below our baseline forecast in 2018.

The international spillovers of a Japanese recession on Asia are more significant than those of a boom. Chinese GDP growth would decline to 6.2% in 2014 and 6.6% in 2015. South Korea’s GDP growth would drop to 2.5% in 2014, and 3.4% in 2015. Effects on the US economy would be modest, as long as there is no strong contagion effect on investors’ sentiment about US government bonds. Our Japanese recession scenario assumes modest financial spillovers from Japan to the US. In this case, US GDP declines by 0.6% relative to our baseline forecast over 2014-2015. In the worst case scenario, the financial stress in Japan spills over into a similar sovereign debt scare in US financial markets. This leads to a recession in which US GDP growth in 2014 could drop to -0.8%, followed by a sluggish growth rate of 1.3% in 2015. However, at this stage we do not consider full contagion from Japanese to US debt markets as the most likely outcome.

Japan in 2014 - An Improved Outlook, but Watch Out for Tail Risks

Our baseline forecast calls for above-average growth of 1.6% in Japan in 2014. However, we can also imagine a more positive outlook with Japan’s economy growing by 3.2% in 2014 due to successful structural reforms efforts. On the downside, Japan’s unprecedented levels of government debt make it vulnerable to a sovereign debt scare that could lead to a recession, with GDP falling by 2.1% in 2014.

References

1. R. Anton Braun, Daisuke Ikeda and Douglas H. Joines, The Saving Rate in Japan: Why it has fallen, and why it will remain low, 2009, article in International Economic Review

2. R. Anton Braun and Douglas H. Joines, The Implications of a Greying Japan for Public Policy,2012, working paper,
http://www.canonigs.org/event/report/report_120601/pdf/120601_braun_presentation.pdf

3. Antonio Fatas, Gross Debt, Net Debt (and future debt), 2010, blog article,
http://fatasmihov.blogspot.com/2010/03/gross-debt-net-debt-and-future-debt.html

4. Takeo Hoshi and Takatoshi Ito, Defying Gravity: How Long Will Japanese Government Bond Prices Remain High, 2012, working paper,
http://www.nber.org/papers/w18287.pdf?new_window=1

5. Takeo Hoshi and Anil Kashyap, Why Did Japan Stop Growing, 2011, working paper,
http://faculty.chicagobooth.edu/anil.kashyap/research/papers/Why_Did_Japan_Stop_Growing.pdf

6. Gary Hansen and Selahattin Imrohoroglu, Fiscal Reform and Government Debt in Japan: A Neoclassical Perspective, 2013, working paper
http://ideas.repec.org/p/nbr/nberwo/19431.html

7. IMF, Japan Article IV Consultation, August 2013, IMF country report,
http://www.imf.org/external/pubs/ft/scr/2013/cr13253.pdf

8. IMF, Fiscal Monitor, October 2013,
http://www.imf.org/external/pubs/ft/fm/2013/02/pdf/fm1302.pdf