Abenomics Can Resolve Some of Japan’s Structural Problems and Boost Equities
by Jason Mitchell
Like the protagonist in Samuel Beckett’s The Unnamable who concludes “You must go on, I can’t go on, I’ll go on,” Japan has persevered through its own sometimes existential course of conflicting visions. It seems particularly relevant to Shinzo Abe’s incoming government where near-fatalistic pronouncements have followed his re-election as Prime Minister this past December.
Since then, Japan has been cast as the flashpoint and instigator of beggar-thy-neighbour politics in a brewing currency war while Japan market specialists largely discounted the incoming Abe administration as another, inevitable disappointment in a loop of similarly-failed policy experiments. No doubt, Japanese indices, among the best performing year to date (+20%), the weaker Yen and the reflationary mandate under new BOJ governor, Haruhiko Kuroda, have stoked these calls.
What is unequivocally clear is that Japan remains hamstrung by factors requiring stronger policy responses which should be considered in the context of economic self-help and not solely in the style of a neo-mercantilist currency war. In effect, this time has to be different for Japan because coinciding circumstances have created the friction to warrant difficult policy changes.
While some of these anxieties are extreme—think of last year’s extrapolative alarmism over a Japanese soft extinction by 3000 AD—other fears appear well-grounded. The accumulated pressures of an ageing society, deflationary economy, dependency on energy imports, newfound geopolitical anxiety with China, failings in corporate governance and the effects of a zero interest rate policy on pension sustainability are converging into a tipping point for reform. Call it PM Abe’s Thatcherian declaration that there is no alternative, these pressures have the potential to render many Japanese economic stereotypes irrelevant.
PM Abe’s re-ascension also arrives at a particularly dangerous intersection of oncoming economic, geopolitical and societal pressures. The dispute with China over the Senkaku/Diaoyu Islands has made this more delicate, stirring anxiety around Japan’s national self-identity. Though it is too early to determine the scale of commitment behind the US ‘Asia Pivot’ strategy, certainly the shock of a more brazen China provides a much-needed economic reality check for Japan. As Joseph Nye has pointed out, Japan’s aggressive nationalism may simply be a product of its weak domestic economy; if that is the case, reflating the economy should help defuse regional tensions. There is an old investment adage that warns against fighting central banks and we think this is doubly true for the BoJ and Abenomics. If the required reforms can be sustained – and we think they will be – then Japanese equities will remain a key beneficiary.
Japan’s ageing population is a well-known problem, yet its long-term implications on productivity growth and the sustainability of its social security programs and pension funds are still far from fully understood making it a litmus test for other countries also struggling with shrinking replacement rates and expanding dependency ratios. Since Japan’s working-age population peaked 20 years ago, the mix of baby boomer retirement, declining birth rates and poor architected policies have translated into a deflationary headwind as both consumption and savings have moderated.
Source: National Institute of Population and Social Security Research in Japan, 2012.
If forecasts prove right, Japan’s population by 2030 will return to its 1980 level in a scenario with 3.5x more elderly and almost 55% fewer children.
Source: National Institute of Population and Social Security Research in Japan, 2012.
What makes Kuroda’s BOJ governorship so interesting is his challenge to deeply-entrenched, institutional thinking about the causal roots of the deflation. Abenomics tests the axiom that a shrinking population and its natural decline in productivity growth play a structural role in persistent deflation. The Abe government is already reframing deflation and yen appreciation as monetary phenomena, a stark reversal from Shirakawa’s BOJ. The paradigm shift would be significant, given other countries like Germany, Italy and Hong Kong experiencing their own long-term population declines.
The real economy impact of Japan’s ageing workforce is also producing countereffects like wage inflation in employment-intensive areas like the Postal Service and construction which undergo periodic labour shortages (Fig 3). Despite unemployment of more than 2.7 million, Japan’s labour force is also expected to shrink by 2 million in the next five years, placing greater demand labour scarcity and upward pressure on wage growth.
Source: Japan Ministry of Economy, 2012.
But, in a sign that PM Abe’s push for higher consumption through wage growth is heard, companies including Lawson, Seven & I and FamilyMart are selectively increasing salaries and bonuses between 1.5% and 3%. For some, these mark the first hikes in four years with other industries like the auto manufacturers following suit.
Moreover, widening socio-demographic cleavages are exacerbated the situation by stratifying the Japanese electorate and swaying policy outcomes. In a disproportionality already recognized by Japan’s Supreme Court, a single vote in an older prefecture now carries more voting impact than two votes in younger, urban areas. Left unchanged, the composition of Japan’s ageing voter base will simply reinforce its policy interests—protecting and expanding social welfare spending—making the reduction of inter-generational transfer payments more difficult and backend loaded.
Source: Association for Promoting Fair Elections, 2012 (Fig. 5), and OECD Social Expenditure Database, 2009 (Fig. 6).
While data for December’s election has not yet been released, previous voting patterns by age group underscore the issue of an overrepresented electorate voting to sustain or increase pension, welfare and medical benefits. Where the demographics of 1980 had meant that seven working-age people indirectly supported the welfare benefits of a single retired person, this ratio now falls burden-like to fewer than two people per retiree by 2030.
So the larger challenge for Japan remains the sustainability its national and corporate pension plans when returns have struggled under the BOJ’s zero interest-rate policy. With Japanese investor inflation expectations (BEI) running above 10-year JGB nominal yields, Japanese pension funds face greater pressure to reallocate away from negative real-yielding government debt. All of this sets a course for a broader program of tax and pension reform driven by a renewed urgency to incentivize housing savings to move from a majority mix of cash and deposits into more productive, higher yielding assets like newly-introduced individual savings accounts (ISA). Wealth transfers like tax-exempt amounts for education and lower tax rates on gift amounts for children and grandchildren are combined with broader tax reforms on capital gains, dividends, estate and inheritance in an effort to redistribute the burden of social welfare costs more proportionately.
It is also clear that Japan’s shift away from nuclear as a carbon-light energy alternative following the 2011 Fukushima Daiichi nuclear accident has produced a number of unintended consequences. These range from an immediate vulnerability to global energy supply/demand volatility to undermining its longer-term ability to meet its Kyoto Protocol targets.
The most significant change has been economic. Japan has gone from trade surplus to trade deficit nation on an annual basis. Greater dependency on higher cost energy imports like LNG as a power generation substitute has produced persistent trade deficits not seen since 1980. In 2012, fuel cost growth, driven by LNG, accounted for more than half of the incremental trade deficit.
In effect, energy prices have turned inflationary within a deflationary CPI basket (Fig. 4). As a result, utilities are adjusting to the higher cost energy import mix and greater price volatility recouping these costs as tariff increases between 3% and 5% since 2011. But the real test lays in the utilities getting regulatory approval to earn back the higher volume-related cost of fuel imports. Depending on delays to a limited nuclear restart, rates could ultimate increase between another 8.5% and 12%, amplifying the inflation asymmetry.
Source: Japan Ministry of Economy (2012).
Legacy gas contracts and pricing mechanisms are partly culpable. Despite its position as the largest global LNG importer, Japan is paradoxically bound by its artificially high JCC indexation. Since the emergence of the US shale gas advantage, US Henry Hub spot price trade at one fifth the value of JCC contracts. Even European utilities have exploited Japan’s LNG demand, reselling their unused gas delivered under a long-term contract into the Asia market to arbitrage the JCC price premium.
For Japan, access to US LNG through Trans-Pacific Partnership (TPP) participation would go a long way in containing escalating fuel import costs. So it is not surprising that Japan has announced its intent to launch the first global LNG contract market as a way to force price convergence between Henry Hub spot prices and its legacy JCC mechanism.
Japanese utilities and buyers including Osaka Gas, Chubu Electric, Mitsubishi Corp, Mitsui, Tokyo Gas and Sumitomo Corp. have already committed to long-dated supply contracts for more than 14.7 million tons per year beginning in 2016. However, these volumes are predicated under the assumption that Japan receives free trade agreement (FTA) status with the US, and that additional export permits are approved by the US Department of Energy.
Source: Bloomberg, 2013.
Despite the recent history of scandals like Olympus and Diao Paper as well as a banking sector that is notorious for its kabushiki mochiai or cross shareholding structures, Japanese corporate governance has proven remarkably resistant to reform. Poor shareholder accountability, little or no external board director representation, weak enforcement and embedded interests remain pervasive criticisms. If Abenomic reflation succeeds in provoking a sustained rotation from household savings into domestic equity markets, stronger forms of governance are even more critical given the potential fragility of Japan’s national and corporate pension funds.
Since the prospect of governance reform has proved illusory in the past, Japan willingness to reform without the urgency of crisis remains a test. Sceptics already see the combination of a weaker Yen, stronger markets and greater government spending ultimately as undermining the current urgency to change governance standards. Under the previous DPJ government, the Ministry of Justice maintained a hands-off approach while the Keidanren—the Japan Business Federation—obdurately opposed steps toward improved governance. The result has been a poor DPJ reform record that included watered-down efforts to revise areas like the Companies Act in 2012 which would have mandated the appointment of at least one outside director. While the practice is already recognized by China, Korea and Korea, only 59% of the Nikkei 300 companies have appointed external directors.
Yet, some positive signs are materializing. Issuing a set of Policy Proposals at the end of 2012, the LDP appears actively pushing an accelerated corporate governance reform agenda as a complement to structural reform like deregulation and trade barriers. In a recent Industrial Competitiveness Council meeting, the newly appointed LDP Minister of Justice, Sadakazu Tanigaki, reiterated the goal of mandatory external director participation. Tanigaki’s support builds on some of last year’s gains before reform stalled out. In May 2012, Hitachi elected a new board made up of to six internal and seven independent directors, including two foreign external directors. Last month, Toyota’s President Akio Toyoda named its first three independent directors to its board.
We expect Japanese corporate pension funds, under pressure to generate higher returns in a reflating economy, to push domestic managements toward greater total shareholder remuneration. Japanese food producers like Ajinomoto, Kikkoman and Kirin have undergone radical transformations in outlining to ROE/ROA targets and committing to defined shareholder returns policies.
Share buybacks have started 2013 on a ¥4.7 trillion annualized run rate, well above the ten year average of ¥2.5 trillion. Average dividend payout ratios have also trended higher, from 25% in 2007 to nearly 30% of net profit. With currency weakness yet to drive up utilization levels for many Japanese companies, we expect higher shareholder returns will be a dominant theme in 2013 before managements begin to reinvest in capacity expansion and M&A activity.
If December’s Lower House election results carried any message, it was that policy inertia under the DPJ government was unacceptable and only compounded Japan’s deflationary drift. While the combination of economic, demographic, energy, governance and security-related pressures have returned PM Abe and the LDP to power, it signals greater urgency to convert electoral commitments into hard reforms. It has also embedded the notion of sustainability as omnipresent meme to describe the fragility of Japan’s economic, demographic and security balance.
Abe has already made effective use of the first two of his three policy arrows within the Abenomics quiver to proactive direct BOJ monetary easing and to outline a fiscal stimulus program. The greater challenge now is to use this third arrow to target growth through structural and supply-side reforms, incentivising private sector investment.
To be sure, Abenomics will not be a painless process. It will uproot embedded interests and traditionally protected sectors. But if Abe sticks to his reform agenda, he can leverage his popularity, the current pickup in economic sentiment and the Yen weakness to resolve some of Japan’s structural problems. He may also preside over the most significant stock market rally for a generation.
 Kinmont, Alexander. “Special Comment: The Real Thing.” Milestone Asset Management. Feb, 2013. Pg. 11-12.
 Nye, Joseph. “Japan’s nationalism is a sign of weakness.” Financial Times. Nov. 27, 2012. http://www.ft.com/cms/s/0/c6b307ae-3890-11e2-981c-00144feabdc0.html#axzz2OVJSxPib
 Replacement ratio represents the average childbirth per woman. A static population requires a replacement ratio of 2.1 children per woman, the 0.1 allowance for infant mortality.
 CLSA Asia-Pacific Markets, United Nations, 2012.
 National Institute of Population and Social Security Research in Japan, 2012.
 Motani, Kousuke. “The Real Face of Deflation.” Kadokawa Publishing Co., Ltd. June 10, 2010. See also Hamada, Koichi. “Advising Abenomics.” Peterson Institute for International Economics. Feb. 15, 2013.
 Shirakawa, Hiromichi. “Japan Economic Analysis Issue No. 35: ‘Abenomics’ and Issues” Credit Suisse Securities Research. Jan. 23, 2013.
 Kenji, Abe. “Japan Equity Strategist: Abenomics gets going”. Citibank. Mar. 8 2013: pp. 8.
 Sieg, Linda. “Japan Election Rulings Show Influence of Elderly on Policy.” Reuters. Mar. 26, 2013. http://www.reuters.com/article/2013/03/26/us-japan-politics-electoral-idUSBRE92P0CV20130326
 National Institute of Population and Social Security Research in Japan, 2012.
 Ministry of Finance.
 JCC represents the Japan Customs-cleared Crude or Japan Crude Cocktail is the average price of Japanese oil imports used to set the price of LNG contracts.
 Japan Association of Corporate Directors. “2011 Survey on Corporate Governance of Listed Corporations.” Oct. 4, 2011. http://www.jacd.jp/en/resources/111004_2011-survey-on-corporate-governance-of-listed-corporations.html
 Board Director Training Institute of Japan. “The LDP's ‘Policy Proposals’ to Reform Corporate Governance, Issued Just Before the Election at the End of 2012”. Apr 1, 2013. http://bdti.or.jp/english/node/619.
 BofA Merrill Lynch, “Japan Investment Strategy”. January 17, 2013.
We thank Jason Mitchell and GLG Partners LP (a member of Man Group plc) for this new article.
We look forward to the comments of our readers!
The beautiful woman in kimono comes from Garance Dore's trip in Japan.