Economic Policy of the Shinzo Abe Cabinet under Globalization (Part I)

Elena Leontieva, PhD, Senior research fellow, The Primakov Institute of World Economy and International Relations of the Russian Academy of Sciences (IMEMO)

Annotation. Abe Shinzo administration came to power in the late 2012 strongly determined to stop deflation, to contain the outflow of capital and to put the economy on track of steady recovery. Three and a half years later, not all targets were met. The economy is widely exposed to external uncontrollable conditions. The policy of negative interest rate was launched by the Bank of Japan and unintendedly provoked revaluation of the yen. A victory over deflation was lost. Private consumption performs weakly. The big businesses prefer to internationalize their operations across multiple locations along global supply chains. Major social actors, corporations and households, are hampering implementation of the government's reform agenda.

Key words: deflation; excessive savings; budgetary deficit; negative interest rate; revaluation of the yen; quantitative and qualitative easing; global value added chains.

Savings and investments during deflation.

In economics, price deflation is considered an anomaly. It is accompanied by savings increase and investment and consumption reduction as the population expects further price drops and does not hurry to make major purchases, while private businesses hold back fixed capital expenditure. Deflation increases the debt burden and real interest rates on loans, which further constrains economic activity.

The Japanese economy was in such a state for 18 years (1997-2015), and over these years the country has lost the position of the second major power after the US (in regards to the share of world GDP and international trade). By 2010, China's economy made it to the second rank. Japan's share of the global world exports shrank from 9.8% in 1993 to 3.7% in 2014. Japan's international trade has shifted toward the Asia-Pacific region, which in 2015 had 51% of Japanese exported goods (compared to 45% in 2010).

At the same time its economic potential should not be underestimated. According to the living standard (GDP per capita here is US $32,485) Japan is in the same group with the UK, Italy, France and Finland.[1]

Japan has the second-largest reserves of foreign exchange and gold - $1262,6 billion compared to $3305,4 billion in China[2]. The Japanese yen is not a regional currency - it provides 23% of international payments - the biggest creditor of foreign governments. In 2016, out of $14 trillion of the US public debt $1.25 billion of public debt belonged to China and $1.15 trillion - to Japan[3]

Thus, the economy of deflation is characterized by a combination of the demand deficiency along with an excess of savings, but still not finding application in the economy. Financial flows are diversified differently in it is distributed differently than with inflation. For example Japan accumulates excess savings in the private sector. Consumers are holding savings; private corporations turned to borrowers into the creditors; banks lend to the government buying government debt. In 2012-2014. The financial surplus increased from 2.1% to 10.2% of the GDP (see. Table 1).

 "When Abe's government came to power, the country's economy was dominated by the expectation of chronic deflation... corporate managers and ordinary citizens have lost confidence and hope for the future... First-class technology could not find use. The financial resources of households and companies' internal resources could not be used in Japan" - is not an excerpt from a newspaper article, but a quote from the government document "Japan Revitalization Strategy"[4].

To stimulate the demand the Japanese government usually uses investments in the huge archipelago infrastructure - roads and communications, bridges, tunnels, dams, breakwaters, port facilities, lighthouses, energy and water networks and other objects, which are financed from the state budget, and do not bring immediate income. These costs do not provide immediate tax revenues and are financed by issuing loan stocks. Since 1975, the state budget deficit has reduced consistently. In 2010, the accumulated debt of the Japanese government reached an amount equivalent to two volumes of the annual GDP. This debt is enormous - $9,574 billion, but Japan is not threatened with a sovereign default, as foreign holders own only 9.8% of the state debt.

Table 1. Balance of annual savings and investments in the Japanese economy (billion yens in current prices,%)

Source: ESRI (Economic and Social Research Institute, Cabinet Office, Government of Japan), Quarterly Estimates of GDP, May 2016 http://ww.esri.cao.go.jp.; Nihon tokei nenkan 2016 (The Japan Statistical Yearbook),             Tokyo. 2016. Calculated by the author.

The financial overflow of the private sector (line "balance" in Table 1) - is money invested by population, companies and banks in real estate, stocks, bonds, retirement savings, insurance certificates and other instruments. They are spent on consumption, investment, government services; this money is used to fund investments abroad.

But even taking into account the capital outflow abroad fiscal surplus still exceeds the amount of expenditure shown in the National Accounts statistics. Unfortunately, this statistics does not reveal the structure and ways of using the financial overflow.

The goal of the economic policy of the Shinzo Abe Cabinet, who came to power in late 2012, consisted in stopping deflation, curbing outbound investment and "launching positive cycle of the economic growth". Excessively high level of private savings should be used to create demand - to increase consumer spending among the population and investments within the state.

The program proposed by Abe's cabinet at the beginning of 2013, involved the following sequence of actions. The tax reform would allow to "bring down" deflationary expectations of the population and entrepreneurs. Aggressive monetary policy should fill the accounts of financial institutions with additional liquidity and lower interest rates. This would help to reach the increase in consumer spending of the population and a small but steady price inflation - about 2% per year. Tax revenues will gradually compensate for the budget gap. Gradually (approximately in 2025), it will be possible to reach the primary deficit of the state budget, i.e. to get rid of the debenture issue. Retirement of issued bonds will be stretched for decades[5].

The political goal of "abenomics" is to avert the transition of Japan to a secondary role in a number of developed capitalist countries and to prevent the assignment of leadership in the Asia-Pacific region to China.

Abe called the three main directions of his policy "three arrows". The first arrow - is a "flexible attitude towards budget expenditure", in other words, tolerance of state power to the budget deficit. The second arrow - is an "aggressive monetary policy" i.e. pumping money into the economy with the help of the Bank of Japan. The third arrow is the development of a growth strategy that is the prerogative of the government.

The first results of the Shinzo Abe's program implementation

Economic Policy of the Shinzo Abe Cabinet turned three and a half years. It's time its interim results were summed up.

Which objectives of the Abe administration's program have been met for the past three and a half years, which have not, and what prospects for economic growth and deflation overcoming expect Japan in the coming years?

The first achievements of Shinzo Abe's Cabinet were the reform of the tax system, the revision of labor legislation (on this, see below) and agricultural policy[6] In April 2013, the rate of consumption tax was raised from 5% to 8%, which caused a buying spree that lasted less than a year and did not provoke growth of consumer prices (see. Table 2). The accumulated savings of the population increased from 1585 trillion yen to 1706 trillion yen, or 7.6%, and the average wage level has risen by only 2.9%. The tax rate on private corporations' profits was reduced from 37% to 32.1%, but still remained very high according to international standards[7], that gave corporations an impetus to export capital abroad.

In 2015, the economic situation was unstable. The year began with the rise: GDP grew by 9% on a year-on-year basis thanks to private investment and housing construction (their growth rates were respectively 12.2% and 8.4%) and a significant increase in exports (by 9.3%).

Market prices for consumer goods began to grow, making it possible to hope for the close end of deflation. However, the rise was not supported by the personal consumption of the population, and this made 2/3 of total demand.

GDP growth and industrial production slowed down already in the middle of 2015. Consumer spending and private investment declined, the exchange rate went up, and exports slowed down (see Table 2). The level of import prices increased due to the devaluation of the Japanese yen, while oil and gas prices on the world market fell by about 38%. On the domestic market the resulting force of these tendencies was in favor of energy prices. Therefore, the reliance on small inflation was not justified: the consumer price growth stopped due to decline of gasoline and natural gas prices and electricity tariffs.

According to data of the last quarter of 2015 and the beginning of 2016 the Japanese press hastened to draw a conclusion about the failure of government policy and the beginning of the recession [8].

Table 2: Main economic indicators (growth annualized,%)

Sources: ESRI (Economic and Social Research Institute, Cabinet Office, Government of Japan), Quarterly Estimates of GDP http://www.esri.cao.go.jp. Monthly Finance Review, Ministry of Finance October 2015; June 2016 http://www.mof.go.jp. Data in current prices.

* Preliminary data.

A natural question arises - what is the reason for such a sharp turning point?

The Bank of Japan's monetary policy and investment process

The break-point of the trend towards economic recovery was triggered by the monetary policy of the Bank of Japan, which for the sake of stimulating the demand announced the introduction of negative interest rates in the interbank market on January 29, 2016.

The Deputy Governor and Vice Chairman of the Bank of Japan Hiroshi Nakaso supplied following arguments to the business community of Japan in favor of this decision. In economics a favorable situation has emerged, there is a profit growth, almost full employment is achieved, and it is likely that during the 2016 the deflation will stop. However, it is necessary to consider the risk of instability in the world commodity and financial markets. The decision about the negative interest rate is taken to promote investment in capital stock and housing construction. It will not inflict damage on the economy, as the real interest rate (taking deflation into account) would be higher - about 0.5%[9].

President of the Japan Center for Economic Research Kazumasa Iwata suggested that with a low rate of lending interest rate, investors will invest more in marketable securities, stock market capitalization will increase and lead to the new cycle of investments. Individual investors will also invest more savings in capital issues[10] and spend more: the "wealth effect" will unleash consumers' wallets[11].

 Expectations of the Bank of Japan's heads did not come into life due to the difference in interest rates on interbank markets. At the end of January 2016 in London the LIBOR rate was 0.48%, the key rate of the US Federal Reserve - 0.38%, analogous rate of the European Central Bank was at zero, and Tibor rate on the Tokyo market - was at minus 0.10%. The difference between the key rates on money market acts as a lever: the global foreign exchange market dealers are buying currency of the country with cheaper short-term credit[12]. As a result of the massive buying of the Japanese currency, yen rose against the dollar by more than 10%. The revaluation of the yen reduced the cost of imported goods, that covered 18 - 20% of the demand on the domestic Japanese market, retail prices began to fall and export started to decelerate. Stock Exchange responded to the revaluation of the yen with reduction of share prices [13] (see Table 3).

Thus, the situation was affected by the external market factors, but not by those mentioned by Hiroshi Nakaso.

Сentral banks of industrialized countries are engaged in stimulating demand starting with the 2008-2011 crisis. The Bank of Japan conducts a policy of the so-called quantitative easing beginning from April 2013. It involves operations on the open market for the rapid increase in the quantity of money on accounts of financial institutions. Bank buys 40-50% of new issues of government debt bonds from commercial banks, insurance companies and pension funds, as well as ETF (exchange-traded certificates for the purchase of shares and bonds) and other private debt securities, up to commercial bills of exchange. The scale of these transactions increased from 60-70 trillion yens ($570-600 billion) in 2014 to 80 trillion yens ($825 billion) in 2015. The program will be completed when the level of annual inflation will be 2%.

As a result, an inverse relationship was established between the interest rate and the weight of money in circulation: the higher the money supply, the lower all rates are (see Table 3). Against the Bank of Japan's expectations there was a revaluation of the yen by 10% and reduction of the market value of the securities on the Tokyo stock market.

Cheap loans stimulate investment only as long as monetary authorities can control the exchange rate of the national currency. So what can they do?

The Japan Federation of Economic Organizations "The Keidanren", the main lobbyist structure of big business has demanded that the government intervened into the currency market - immediately bought dollars to "bring down" the overvalued yen. In the 1990s, while the yen was a regional currency, such interventions were carried out many times. But currently the yen is serving 23% of payments in the world currency market. This is the third world currency after the US dollar and the euro. Global foreign exchange market daily turnover amounts to $5.3 trillion, the yen accounts for an amount equal to $1219 billion[14]. No matter how much the Ministry of Finance and the Bank of Japan may buy foreign currency instruments for the replenishment of gold reserves (it bears reminding that it is equal to $1262.6 billion),[15] they could have "knocked down" the course not longer than for a few days.

Table 3. The amount of money in circulation, interest rates and price dynamics

Source: Statistical Bulletin of the Ministry of Finance of Japan Monthly Finance Review, August 2015; June 2016. http://www.mof.go.jp. Price statistics is shown according to the Bank of Japan http://www.boj.or.jp.

The Bank of Japan was not the first in the world to introduce the negative interest rate. Similar demand stimulus program were launched in Denmark, Sweden, Switzerland and by the European Central Bank a year and a half earlier. The Bank of Japan has introduced to its program a significant limitation: minus 0.1% rate only applies to new deposits of private commercial banks that they hold on accounts within the Bank of Japan. These accounts are used to carry out daily operations on the interbank market. But now banks have accumulated on these accounts three times more money than is required by the law on reserve deposits (see Table 4) [16]. Henceforth banks should not receive, but pay money for new deposits. In this way the Bank of Japan tried to force commercial banks to withdraw some of these funds to direct the excess savings in investment and consumption. The Bank expected that the increase in money supply will give inflationary effect, albeit with some time lag.

 The Bank's decision to introduce negative interest rates has shocked Japan's business community. The press even gave a nickname "ninja"[17] to the "cunning and insidious" Bank of Japan Governor Haruhiko Kuroda. However, this is an obvious exaggeration, as the Bank's decision will not be applied to deposits of companies and financial assets of the population.

In 2015, the government issued new bonds to cover the budget deficit in the amount of 39.9 billion yens. According to the program of quantitative easing in 2015, the Bank purchased bonds worth 80 trillion yens, including previous editions[18]. Government bonds lost in value, profitability of bonds with 10-year maturity (that occupy a major share of the market) has fallen below zero. Long-term investors - Japanese banks and insurance companies - started to refuse to buy them.

The monetary policy of the Bank of Japan aimed to get rid of deflation in 2016, and encourage investment. But the Bank's management had to revise the forecast and postpone the end of deflation to the 2017. The introduction of negative interest rates had a negative impact on private investment dynamics. Already in 2012-2014 due to the devaluation of the Japanese yen and growth of export, the corporate sector accumulated substantial profits. In 2014, the net profit of the companies was averagely 42.1% higher than a year ago[19]. In addition, higher capitalization of the companies as a result of stock market growth that led to cheapening of the bank credit, played its role.

But as shown by corporate quarterly polls conducted by the Bank of Japan in March and in June 2016, the majority of companies consider conditions unfavorable and during the 2016 plan to increase investment not more than on 2.5%[20]. At the same time investments are not directed in purchase of the new equipment, but to purchase land, real estate (office premises), software and develop new technologies and new products.

In addition, the corporate sector responds to an uncertain situation in the world economy, namely, to the economic slowdown in China, Western Europe and the United States. The International Monetary Fund cut its forecast for the global market growth on 0.4% in 2016 due to the decision of the British government to withdraw from the European Economic Community.

In such a volatile environment, companies preferred to wait and instead of buying government bonds with zero profitability, hurried to transfer their funds to savings accounts in banks[21]. Banks have no choice but to place these funds on the Bank of Japan accounts, for which they have to pay now. As a result, they accumulate excessive funds on these accounts (see Table 4).

Table 4. Funds of banks on deposit accounts in the Bank of Japan (billion yens)

The Bank of Japan data. http://www.boj.or.jp.

 Thus, the Bank of Japan's monetary policy has led to unexpected results: to the delay in the investment process and growth of financial excess, that cannot find application in the real economy.

The banking community discusses the need for a gradual shift from the pursued monetary policy since the Bank of Japan bears losses from the purchase of government bonds with negative profitability. Nevertheless, complete cessation of the quantitative easing program would plunge the government bond market into chaos.

After assessing the situation, on August 2, 2016 the International Monetary Fund issued a recommendation to "reset" the entire economic policy of the Abe Cabinet[22]. IMF warned the Government of Japan that long-term use of non-traditional means of monetary policy can lead the country to permanent loss of the liquidity of the government bond market and put financial stability at risk. Weak reaction of prices and salaries on the monetary policy decisions and decline in real interest rates prevent necessary growth of inflation expectations. Because of this, the Bank of Japan is losing trust of the business community, the IMF experts concluded[23].

Ministry of Finance, the Bank of Japan and the largest banks of the country work together to cover the state budget deficit. Their unit is called the Iron Triangle. Triangle started to burst at the seams, when large-scale purchases of the Bank began to threaten the liquidity of the government bonds market. The Bank works along with the association of 22 primary dealers, banks and brokerage firms that have right to discuss conditions of purchase of new issues of bonds before the auction with the Ministry of Finance. The biggest of them, Bank of Tokyo-Mitsubishi UFJ, declared its exit from the dealership club in protest against the policy of negative interest rates, as it started to lose profits[24].

End of Part I (To be concluded)

[1] Purchasing power parity according to 2016 data from the IMF. http://www.imf.org.

[2] April 2016 data from the IMF. IMF World Economic Outlook, April 2016. http://www.imf.org.

[3] The US Federal Reserve Rates. http://www.federalreserve.gov.

[4] "Japan Revitalization Strategy", June 24th, 2014. http://www.kantei.go.jp

[5] In Japan, bonds are issued with time for repayment from 1 year to 40 years. The majority of bonds have maturities of 5, 10 and 20 years. New issues are sold by tender to private banks, investment and insurance companies, pension funds. The Bank of Japan has the right to buy them on the secondary market.

[6] Achievements in Three Years of Abenomics. February 2016, Cabinet Office. http://www.cao.go.jp.

[7] The effective rate of the central tax with local taxes is even higher - 40.69%. The same income tax rate in Germany - 29.8%; France - 33.3%; in China - 25%.

[8] The Nikkei, November 21, 2015. Economists make conclusions about the recession based on the output data of at least three quarters.

[9] Address to business leaders on the island of Okinawa, March 3, 2016. The entry was posted by the Bank for International Settlements in Basel. http://www.bis.org

[10] Only 10.6% of the Japanese personal savings are invested in the stock market instruments. Flow of Funds - Overview of Japan, the United States and the Euro Area. The Bank of Japan, June 2016.

[11] "The Effectiveness of Macroeconomic Policy: Evaluation of the First and Second Arrow and Implications for Europe", JCER. 2014.

[12] Dealer departments of major banks, insurance companies, multinational corporations are speculative trading currency instruments, using short-term credit.

[13] Trading on the stock exchange is carried out with the provision of credit to dealers on a specified sum of money.

[14] Statistic data of the Basel Bank for International Settlements. Triennial Central Bank Survey, Report on Global Foreign Exchange Market Activity, 2013. http://www.bis.org.

[15] The gold and currency fund of Japan is on a special account of the state budget. Its funds are invested in state securities of industrially developed countries. Currency interventions are carried out by the Bank of Japan on behalf of the Ministry of Finance: sells or purchases relevant securities from their issuers (The Bank of Japan Law, 1998, Articles 40, 41). http://kantei.go.jp/

[16] Law Concerning Reserve Deposit Requirement System (Law No. 135, May 27, 1957; 1974).

[17] The Nikkei, February 4, 2016.

[18] Money Market Operations in Fiscal 2015. The Bank of Japan, April 2016. http://www.boj.or.jp

[19] Data from the Ministry of Economy, Industry and Trade of Japan. http://www.meti.go.jp.

[20] In 2014, these investments grew by 22.8%. Tankan Summary, September 1, 2015,

March 1 and June 1, 2016. www.boj.or.jp .

[21] The volume of corporate deposits in the bank accounts for the first quarter 2016 increased by 11%, The Nikkei, July 22, 2016.

[22] Following Article 4 of the agreements with the countries that joined the IMF, the Fund conducts regular analysis of their economic policy and presents conclusions to governments of these countries. The text of the document is published on the Funds' website http://www.imf.org

[23] How to Reload Abenomics. IMF Communications Department, August 2, 2016.

[24] The Nikkei, August 8, 2016.