July 12, 2019
Japan brought us the USB, the PlayStation, the first futures exchange (Dōjima Rice Exchange in the 1730s), candlestick charts, the camera phone, emojis, QR codes and karaoke. The country has long been at the forefront of new technology and is considered a world leader in innovation. However, where its innovative streak may have fallen short, is in designing a monetary policy tool that shakes its economy out of its long slumber. For the best part of two decades, Japan has registered low growth and low inflation, despite the prevalence of ultra-low interest rates and other monetary stimuli. Now, with other parts of the western world exhibiting similar symptoms, the term ‘Japanification’ is trending amongst economic and political commentators. Will this phenomenon be Japan’s next big export?
The Japanese Economy
From 1980 until today, the GDP growth rate in Japan has averaged 0.49%
Japan’s lackluster economic performance traces back to the late 1980s, after the signing of the Plaza Accord under which the US dollar was depreciated against the Japanese yen (and the Deutsche mark). This caused Japan’s currency to appreciate sharply, to the detriment of its export-oriented economy. The Bank of Japan (BoJ) responded by lowering interest rates to 2.5%, an action that was complimented by fiscal packages. Japanese stocks and real estate prices then started to inflate and eventually a bubble formed, which subsequently burst in 1990-1, resulting in a financial crisis. The banking sector was left with a surfeit of non-performing loans (35% of all loans), and the corporate sector teeming in excess debt.
Throughout the 90s, in order to try and reverse the course of the economy, Tokyo embarked on various fiscal stimulus packages. In this decade alone, it spent around $2 trillion on infrastructure, resulting in ‘bridges to nowhere’ and 70% of the coastline being covered in concrete.
The Bank of Japan – Bending over backwards
Despite fiscal injections, in 1999, the country was still grappling with stubbornly low growth, compelling the BoJ to cut interest rates to zero. Since then, it has used a hatful of unconventional monetary magic to try and resuscitate the economy and achieve its 2% inflation target. Measures have included:
- Negative interest rates – The BOJ adopted negative interest rates in January 2016. At its June 2019 meeting, the rate was left unchanged, still at -0.1%. Reuters estimates that since inception, negative rates have cost banks on average around 95 billion yen in interest paid on reserves, even with a deposit tiering system in place.
- Bond buying (quantitative easing (QE)) – After first experimenting with this in 2001, the BoJ has been buying large volumes of fixed income assets in order to lower long-term bond yields. In theory, this encourages borrowing and pushes up consumer prices.
- Equity buying – The BoJ purchased bank stocks to protect financial stability: 2 trillion yen in 2002-2004 (during the domestic banking crisis) and 400 billion yen in 2009-2010 (following the global financial crisis).
- ETF Buying – stock-buying through exchange-traded funds began in 2010. The purpose was to increase aggregate demand and thus inflation, as well as to encourage savers to take on more risk by buying equities. The BoJ, who bought a record 6 trillion yen ($52.9 billion) in exchange-traded funds in 2018, is sometimes dubbed as the “Tokyo whale” because of its outsized influence on the country’s stock market. This has been deemed ‘distortive’, largely due to the issues it causes in the realms of price discovery and corporate governance.
- Yield curve control – In September 2016, the BOJ said it would allow 10-year bond yields to trade around zero percent with a new policy called yield curve control. This helped pull 10-year yields out of negative territory, but the BOJ would only allow 10-year yields to move in a narrow range.
Despite all of these measures which have resulted in a topsy-turvy, Alice-in-Wonderland environment of negative yields and artificially high asset prices, inflation is still the elusive white rabbit: the BoJ expects it to be at least 2020 before inflation broaches its 2% goal, and this timeline could be extended still. Rates will be held steady until at least spring 2020.
The long-term risk of this is a liquidity trap in which interest rates are low and savings rates are high, rendering policy ineffective as investors always shy away from insufficient returns, or the expectation of higher rates in the future. This ultimately weighs on the economy and a loop forms which becomes difficult to escape. A good way to visualise the liquidity trap is by comparing the economy to a car, driven by central banks. When the central bank presses the accelerator, it allows more petrol (money) to flow to the engine, giving more thrust. However, if the car is its maximum speed, pressing the pedal down further doesn’t result in a higher velocity. The economy becomes submerged in excess money which is no longer effective in pushing down interest rates.
Drawing Parallels with Japan: QE forever?
Low growth and inflation are by no means specific to Japan, despite efforts by the global central bank collective to stimulate the economy. Thus, many are starting to float the idea that the concept of Japanification could be spreading, especially to Europe.
In the US, the Fed held the federal funds rate near zero for over seven years and vacuumed up longer-term securities. Despite its largesse, real GDP growth has been modest at best. Simultaneously, long-term interest rates declined during easing whereas measures of longer-term inflation expectations were relatively stable. The result was lower real long-term interest rates.
A similar scenario played out in Europe under the ECB’s efforts. Like the Fed, the ECB has so far failed to coax inflation up towards the 2% level, even during the period of ‘synchronized global growth’ that played out during 2017. With inflation below target during this time, central banks could hardly justify policy tightening and now it seems that they have missed their chance to wean the economy off of their prescription, as global growth slowly fades. European inflation expectations (as measured by 5y5y swaps) recently declined to 1.12% – a new all-time low, unseen even in 2016, when the euro was flirting with deflation.
The Fed did manage to raise its rate to a range of 2.25-2.5% (the neutral rate at which it neither stimulates or restricts growth is thought to be around 2.5%), but, at the same time it nurses a $3.8 trillion balance sheet which it still has the colossal task of unwinding. The ECB’s main policy rate has not budged from -0.4% and its balance sheet is worth around €4.7 trillion.
Low rates are now pervasive across most of the western world and it looks like they are here to stay. At their June meetings, both the ECB and the Fed opened the door to more easing, should we not start to see swift improvement in the macro picture. This sent German 10-Year Bund yields to historic lows, whilst the French and Swedish equivalents turned negative for the first time. A record $13 trillion worth of global debt now carries a negative yield.
All this considered, it’s no wonder that many are now questioning whether Japanification is the ‘new normal’ that we can expect to prevail moving forward. In the next sections, we take a look at some of Japan’s symptoms following the ‘91 crisis. We compare this to the current experiences in Europe and the US to get a clearer picture as to whether Japanification is underway.
Japan’s economic stagnancy is often pinned on structural factors, primarily an ageing population. Japan is one of the world’s oldest societies and its working population (those aged 15-64) has been declining since the mid-nineties. The IMF has said that ‘a rapidly ageing population and shrinking labour force are hampering growth’ and that ‘the impact of ageing could potentially drag down Japan’s average annual GDP growth by 1% over the next three decades’.
With the advancement of medical technology, developed economies around the world are facing somewhat of a ‘demographic time-bomb’, in terms of ageing populations. Like Japan, the US and western Europe have reached the “tipping point” when the numbers of people in work compared with old and young dependents has peaked.
Europe’s working age population peaked around 2008, similar to how Japan’s peaked around 1991. Over the next 30 years it is projected to decline -15%, mimicking the trajectory of Japan.
The Fed itself said in 2016 that longer lifespans and reduced birth rates render central banks powerless to raise long-term interest rates. The paper writes that ‘demographic factors alone account for a 1.25% decline in the natural rate of real interest and real gross domestic product growth since 1980’ in the US. It concluded that: ‘Our results further suggest that real GDP growth and real interest rates will remain low in coming decades, consistent with the US economy having reached a “new normal.”’
But not only is Japan’s population getting older, it’s also shrinking. By 2065, the UN expects Japan’s population to fall by 22% (28m people). A shrinking population means a smaller domestic market with fewer people buying goods and services, whilst fewer houses are built. Europe is on a similar trajectory, and is dependent upon migration to compensate for natural population decline. Likewise, US population growth hit an 80-year low in 2018.
Therefore, it could well be that as the Baby Boomer generation fades out, around the world, slower growth may be the ‘new normal’, regardless of stimulus. In this sense, central banks may be like Sysyphus, trying to roll the boulder up the hill forever, when growth is destined to slow.
2. Persistently Low Short-Term Rates
Ageing populations tend to save more, as a greater share of the population prepares for retirement, which results in higher national savings, putting downward pressure on interest rates. Europe, like Japan, has had an excess of savings over investment and rates have been floating at the zero lower bound for a prolonged period.
In Japan, this phenomenon began after its crisis in 1991. At that point, short-term interest rates fell sharply and then lingered near zero levels. We saw the same pattern in Europe after the 2008 crisis. In both economies markets priced-in a return to normal levels right after the recession, and subsequently experienced some notable ‘false dawns.’
One supposition is that households, still scarred from the financial crisis and its damaging effects across the globe, prefer to save more. Even in the US, household savings rates have been puzzlingly high in recent years. Usually, when household wealth increases, savings rates fall and vice versa. Based on the historical relationship, they expect US households to be saving around
1% of their income, but in reality they are saving around 6%. In Europe, some analysts argue that the prevalence of negative rates may even push people to save more, as it sends an ominous message about the future, plus with lower expected return one needs to save more to reach the same amount of capital at retirement. This links back to the previously mentioned idea of a ‘liquidity trap’.
3. Banking sector woes
According to Deutsche Bank, as a rule of thumb, a well-functioning banking system should allow banks to make 1% on their assets. US banks are very close to this mark. In contrast, European and Japanese
banks both return under half a per cent on their assets – below pre-crisis levels.
Low interest rates weigh on bank profitability. On this dimension, following Fed rate hikes, US banks are in better shape. However, European bank stocks have so far tracked their Japanese equivalents with the same 17-year lag (i.e. the time span between their respective two crises). In both economies, the banking sector suffers from a high percentage of non-performing loans and has required government intervention in the form of large capital injections.
In both places, corporates exhibit an overreliance on banks, using them for three-quarters of their financing needs. That is double the proportion seen in the US, respectively (partly due to the fact that there, it is more common to tap capital markets). This is concerning because ailing banks are propping up the real economy.
In Japan, monetary policy has been maintained at ‘ultra-loose’ levels, decaying bank profitability, but has not meaningfully improved the country’s economic prospects. Some argue that the central bank’s adherence to low rates is why Japanese banks fail to cover their cost of equity.
And the same could be happening in Europe, where bank returns are looking increasingly unsustainable. However, the ECB argues that this is not the case because of its inherent heterogeneity across the continent. The central bank is considering a tiered-deposit rate system whereby banks would be exempted in part from paying the 0.4% annual charge on excess reserves, in order to somewhat mitigate the negative impact on profits.
4. Government debt
After Japan’s crisis, its Government debt started expand at an alarming rate. It expanded by more than 25% of GDP during the bust period of the 1990s. Today, government gross debt to GDP sits at a staggering 253%. In the US, this figure is 105%, in the eurozone it is 85%. As Deutsche Bank argues, moving forward, it is unlikely that Europe reaches the same level of government debt as Japan, without a fresh crisis and new fiscal rules for the continent. In this sense, Japan’s profile is quite unique. However, populist parties across Europe are arguing for higher spending funded by increased debt and some are even promulgating a new ‘Modern Monetary Theory’. This relates to a new economic model under which governments print money freely to spend on fiscal policies with the end goal of achieving full employment.
It is worthwhile noting that as much as the above factors acted as an anchor on economic progress in Japan, the country has also had a unique streak of bad luck, exacerbating its problems. It has faced a series of unfortunate events during its recovery including: the Asian crisis in 1997/1998, the bursting of the dot-com bubble in 2000-1 and the global financial crisis of 2008/2009. Whenever it looked as if the Japanese economy had finally bottomed out, the next external shock came along.
Another key difference is the fact that equity and real estate prices in Japan have never recovered their pre-crisis levels in nominal terms. Whilst Europe may have had a ‘lost decade’ after the financial crisis, prices eventually came up out of their trough. In Japan, the ‘lost decade’ has been a lot longer than a decade and even today, people are still out of pocket for assets and real estate that they bought in the eighties and the debts accumulated to make those purchases are often still unpaid. This puts added restrictions on the BoJ when it comes to raising rates.
So, whilst Western nations, particularly Europe are starting to bare resemblances with Japan, these economies have their own intricacies and are subject to their own set of risk factors, that will mean they take their own paths. However, all the signs do point to lower rates for longer.
Japan’s tale has shown that without a strong economic recovery, globally, releasing the economy from low rates is very challenging. Indeed, if the BoJ ever manages to remove the monetary medicine that its economy has become so addicted to, without a return to deflation, it will be the Houdini of central banks. The ECB is now in a similar sticky situation, whereby their measures have failed to stoke sustainable growth, and removing stimulus in an already-slowing economy seems to be an impossible feat. This means that it does not have a lot left in its policy jar to deal with future downturns. At the same time, if current loose policy continues, its balance sheet could continue to balloon, potentially to the point where a major fiscal package is required.
However, to finish on a more positive note, Japanification doesn’t necessarily need to be all bad and perhaps it’s not too late for the innovative Japanese to show the rest of the world the way forward. Tokyo desires that Japan becomes the first country to prove that it is possible to grow through innovation, even when the population is declining. Japan is rapidly moving toward a new goal entitled ‘Society 5.0’ , defined as ‘A human-centered society that balances economic advancement with the resolution of social problems by a system that highly integrates cyberspace and physical space.’ If it comes to fruition, this will essentially add a fifth chapter to the four major stages of human development: hunter-gatherer, agrarian, industrial and information. In this new ultra-smart society, all things will be connected through Internet of Things (IoT) and all technologies will be integrated, dramatically improving the quality of life.
Japanification could still be a glass half full situation…
Author: Group Investment Office