Yves Nosbusch


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Japan: the moment of truth is getting closer



In Japan, the hike in the VAT rate from 5% to 8% on 1 April should have two immediate effects: a mechanical rise in inflation and a significant slowdown in growth. It will also mark a key stage for Abenomics, the sweeping economic programme launched just over a year ago by Prime Minister Shinzo Abe. Following a lengthy period of deflation and slow growth since the early 1990s, the government formed after the December 2012 general election indeed announced an innovative programme based on three strategic pillars.

Abenomics: mid-term report

The first pillar is an expansionary monetary policy: the Bank of Japan has embarked on large-scale bond purchases to boost the money supply and bring inflation back to moderate levels. In 2013 the amount of total bond purchases was equivalent to some 13% of GDP. Meanwhile, the yen fell sharply, losing more than 20% of its value against the dollar in 2013.

One of the initial consequences of the depreciation of the yen was to drive up import prices, which helped kick-start inflation. With an inflation rate of 0.3% for 2013, Japan seems finally to have broken free from its deflationary spiral. In 2014 inflation is even likely to climb to around 3% on the back of the April VAT hike. Nevertheless wage growth remains subdued for the time being.

Another result of the yen's loss of value has been an increase in exporters' profits. However the total quantity of exports did not increase, contrary to expectations. This is partly due to a rise in domestic consumption ahead of the April increase in VAT. This trend is likely to shift into reverse with the new rate coming into effect, and consumption is bound to be sluggish in the coming months. One key question is whether exports will pick up the slack from domestic consumption.

The second pillar of Abenomics is a traditional fiscal stimulus. The government has launched a major public programme to build and renovate infrastructures, lifting public spending by 3.8% in 2013. To cushion the negative effects of the recent VAT hike, the government has announced an additional fiscal stimulus for 2014, equivalent to some 1% of GDP and focused once again on construction. Nonetheless, growth is likely to slow in 2014 and could ultimately slip below 1% from the 1.5% level reached in 2013.

It is now time for the government to move ahead swiftly on the third pillar of structural reform or risk undermining the positive results on growth and inflation. The many issues to be addressed include restructuring the farming sector, overhauling labour law, and taking measures to encourage business investment.

One key question

Longer term one key question will arise. If Abenomics reaches its targets of boosting growth and getting inflation back to moderate levels, then long-term interest rates are likely to experience upward pressure. Consequently, interest costs on government debt could skyrocket unless the central bank intervenes. The government debt burden is indeed very high by international standards, at some 230% of GDP. In this scenario, the Bank of Japan would probably have to extend its bond buying programme to keep the lid on long rates.

Whatever the outcome, Japan's economic experiment should prove highly instructive for the rest of the world. Christina D. Romer, professor of economics at the University of California at Berkeley and a world expert on the role of monetary policy during the Great Depression of the 1930s, put it like this in 2013: “Rather than rehashing the old arguments about why they can't do anything about deflation and low growth, Japan is trying a grand experiment. I don't know if the Japanese experiment with monetary regime change will have the desired effects. But I am confident that we will learn a great deal because they had the nerve to try”.


Article completed on 11 April 2014 by Yves Nosbusch, Chief Economist of the Bank

Published in the Luxemburger Wort (in French) on 11 April 2014