What’s next for Japan?

Anyone who has visited Japan is usually impressed with their clockwork efficiency, especially concerning public transports, and exception quality of their customer services. However, this does not belie the fact that Japan remains mired in sluggish economic growth.

Source: Bloomberg

* Subdued growth outlook calls for more stimulus support

* BOJ may have to do more, to complement fiscal stimulus

* USD/JPY is still vulnerable to downside, while equities are weighed by a strong yen

The Japanese economy expanded more than expected in Q1, with the final estimate coming in line with consensus, revising upward to a seasonally adjusted and annualized 1.9% QoQ from 1.7%. While an improvement in business investment is positive for the economy, JPY strength and weak foreign demand may lead businesses to be more cautious about spending. Moreover, the relatively flat output compared to a year ago points towards an economy which is not doing well.


Subdued growth outlook calls for more stimulus

The Abe government is well aware of the dim growth prospects and renewed risks of deflation. This prompted Prime Minister Abe to not only announce a fiscal stimulus package but also delay the planned sales tax hike for a second time, to October 2019 from April 2017.

The Nikkei newspaper reported that the PM plans to propose a fiscal spending of JPY 5-10 trillion ($90.7 billion), which is 1-2% of Japan’s nominal GDP.
He will seek the second supplementary budget after the upper house election on 10 July. Securing a majority of the upper house seats will make it more likely to obtain approval for the fiscal stimulus package.

The fiscal boost will certainly pump-prime growth, but Abe still faces a challenging task: convincing fiscal hawks of the stimulus. Nonetheless, his track record can provide him with some leverage. Japan has done well to reduce its fiscal deficit. In the fiscal year of 2014, the nation’s fiscal deficit shrank from 7.7% of nominal GDP to 5.5%, which  was the steepest fall in nearly 20 years, according to Morgan Stanley.


BOJ has to do more

The Bank of Japan (BOJ) is expected to adopt a wait-and-see approach at the 16 June policy meeting, amid a growing dissent within the central bank. BOJ board member Takehiro Sato was critical about the positive impact of quantitative easing and negative interest rates, and remains opposed to a further reduction in the benchmark interest rate.

However, there is renewed pressure for BOJ to do more now as hopes for the Federal Reserve to raise rates at the June FOMC are dashed after a sharply lower US payrolls headline. In addition, intervention risks to contain JPY gains have also risen. Even if there is no further easing in June, we are likely to see a dovish tone from governor Kuroda.

Moreover, things will get more interesting in July. Should the upper house elections outcome be favourable to PM Abe, he may be able to push through the fiscal stimulus budget. This would reduce the need for more monetary support. In other words, further cuts to the interest rates may be off the table as a result. The other argument is that BOJ may seize the opportunity to guide inflation to its 2% target by easing further, to boost the impact from the fiscal support.


USD/JPY still vulnerable to downside

The uncertainty surrounding BOJ’s future action is stoking risk aversion trades. The USD/JPY has fallen to 18-month lows, trading at mid-106 levels. Further deterioration in market sentiment may keep the JPY bid. However, there is likely to be strong support at the 105 area. BOJ is also likely to defend aggressively if the pair falls below 105.


A stronger yen will add pressure to Japanese equities given the tight inverse correlation the two have. That said, even if the JPY weakens thereafter, investors may not be overly keen to buy into Japanese shares. According to the Financial Times, overseas investors have sold about JPY 10 trillion of Japanese stocks over the last 12 months, despite record payouts to shareholders, a potential sizable stimulus, buy-backs from BOJ, GPIF and corporates. If these are seen as desperate emergency measures, then foreign investors will likely steer clear of Japan. This means that the market will need to see fundamental improvements in corporate Japan to be enticed.

For now, USD/JPY remains vulnerable to the downside, while Japanese shares may face significant headwinds in the months ahead. The Nikkei 225 has recovered over 10% from the February lows, but remained lower on a year-to-date basis.

One last thing to note, the combination of massive monetary easing and chronic budget deficits is a de facto helicopter money drop. The Bank of Japan (BOJ)’s bond purchases are financing the government’s deficit spending. The implication is that there is an increased risk of downgrades for Japanese government bonds and volatility in the FX and bond markets, should this situation persists.

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