International investors observed the ending of Quantitative Easing in the United States last month. This was good news for more traditional economic voices around the world. However, at the same time Quantitative Easing (QE) has gained new impetus in Japan over the past week. QE which is the long term asset purchase by a central bank, will soon be vastly expanded in Japan. Starting next year, the Bank of Japan will increase its balance sheet by 15% of Gross Domestic Product (GDP) on a yearly basis. The bond purchase period will also be extended from 7 to 10 years.
The recent move made by the Japanese, was the result of the country’s GDP declining by 1.8%, in the second business quarter of this year. On an annualized basis, the Japanese economy shrunk by 7.1% in the period from April to June from the first business quarter. Many analysts attribute this to the increase in the Value Added Tax (VAT) from 5% to 8% earlier this year, and the resulting slowdown in consumer spending. The worry in Japan is that the country will soon descend, into a new deflationary spiral.
The Bank of Japan (BOJ) had previously set a target of 2% inflation, which is unlikely to be achieved this year. The reason for the low inflation is that the Japanese economy is contracting faster than was expected. The Japanese are still claiming that the economy will grow by a total of 1% this year. This is increasingly looking unlikely in 2014. The low rate of capital expenditure made by businesses in Japan despite the rise in revenues, is somewhat to blame for the recent slowdown. This occurred regardless of the government stimulus policies to boost investment and hiring. The reluctance of business to expand operations could well be the consequence, of the overall lag in consumer spending.
The $1.1 trillion USD (United States Dollar) Government Pension Investment Plan (GPIF) in Japan also announced intentions to increase its equity holdings from 24% to 50%. This comes along with the reduction in domestic bond holding for the institution from 60% to 35%.
The combination of the enlarged asset purchase by the Bank of Japan ($712 billion USD yearly total) and the GPIF shift in asset allocation to equities, is introducing a vastly expanded new phase in QE. Relative to the size of the Japanese economy it is a much larger asset purchase program than attempted before, by any other major economic power. It will have enormous consequences for Japan and the world economy. Upon the BOJ announcement the Nikkei stock index rose 5%. This was the highest level since 2007. More foreboding, was the decline in the yen which dropped to its lowest level in 7 years. The yen is now reaching some of the lowest parity levels with the American dollar and the currency has already lost 1/3 of its value, in relation to the Euro.
A great monetary experiment is about to take place in Japan, far beyond what was done in the United States and the United Kingdom. The debate to what extent QE has worked beyond inflating stock markets, is still ongoing. The original intention of expanding liquidity was to encourage lending by reducing borrowing costs. To date, the results have been mixed.
What happens in Japan has tremendous implications for the world economy. As the world’s 3rd largest economy, the effect on international investment and finance cannot be overstated. The country has the largest electronic business and the 3rd largest automobile industry in the world. The modern Japanese economy has always ranked high in competitiveness and efficiency with export related sectors.
The economic events of the last few years, have also demonstrated the much lower productivity that exists in agriculture, distribution and services.
The BOJ intends to triple its purchases of Exchange-Traded Funds known as ETFs and Real-Estate Investment Trusts (REITs) as well as buying longer dated debt. The addition of ETFs purchases, goes beyond what was attempted in Europe and the United States. It is much riskier, because these particular investments do not have a fixed value.
In contrast to Japan, the European Central Bank (ECB) continues to avoid sovereign bond purchases. This hesitancy to do so, is mostly because of the reluctance of Germany, to have their domestic taxpayers on the hook if things going awry. The ECB instead has focused on purchases of covered bonds and asset backed securities known as ABS.
The recent economic contraction was the biggest since the January to March 2009 period, when the global financial crisis had arrived in Japan like a tsunami. At the time, the country’s exports and factory output took a major dive. The pattern is now repeating itself with domestic consumer spending. Adding to the problem in Japan, is the slowdown in the service sector in August. This is being blamed on weather conditions, but the result is the same despite the cause. The decline in household spending in the third business quarter will make the Japanese GDP report due later this month, even lower.
The decline in private consumption matters tremendously, because this sector comprises 60% of the Japanese economy. It is already dealing a blow to employment in the country. Unemployment rose to 3.6% in September from 3.5% the month before. A proposed raising of the VAT in 2015 to 10% will only make matters worse, if one looks at the results of the rise in the consumption tax this year.
In addition, the Japanese trade deficit widened in September. Although exports increased 6.9% on a year to year basis, imports grew by 6.2% despite the weakening of the yen. The decline in the value of their currency, makes imports more expensive to Japanese consumers.
Japan had run consistent trade surpluses from 1970 to 2010. This changed from 2011 on-wards with the increased cost of imports, as the yen continued to decline in value. Part of the trade deficit can be attributed to the greater purchases of coal, natural gas and oil. This had become necessary because of the loss of nuclear power as a result of the earthquake and tsunami that occurred that year.
In 2013 for example, Japan ran trade deficits with Australia, China, Russia, Saudi Arabia, United Arab Emirates and Western Europe. The trade surpluses with Hong Kong, Singapore, South Korea, Thailand and the United States did not make up the difference.
Sales to Asia alone, account for more than 50% of the country’s total exports. A further slow down in growth in this area of the world, will be quite detrimental to the Japanese economy.
The recent action of the Japanese government indicates the failure of QE in its present form. Despite the efforts of the Bank of Japan, consumer and corporate demand continues to falter. Now with declining oil and natural gas prices, inflation is falling even further. It may even dip below 1%, in the present business quarter and going into 2015. Further rises in taxes like the VAT, to help with the increasing problem of unfunded government expenditures, only compounds the unfriendly business environment in Japan.
The question for Japan as in Europe and elsewhere, is how to return to regular economic growth? An endless expansion of the money supply through asset purchases and artificially low interest rates, is not the answer. Adopting policies that favor business expansion in the traditional manner, is the only real solution. Markets must be opened up to greater competition, so productivity can ultimately increase. Needless regulations and protections of labor classes along with certain sectors of the economy, damage the larger market place and retards trade on a global scale. Practical, capitalist reforms are needed almost everywhere.