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‘Abenomic’ hopes and fears

by Shinji Fukukawa

“Abenomics” is now a buzzword at home and abroad. Even before taking office, Prime Minister Shinzo Abe had strongly demanded that the Bank of Japan take action to end deflation and set an inflation target that would drive the yen lower.

He had gone so far as to suggest that if the central bank refused to cooperate, he would be ready to revise the BOJ Law or replace the BOJ governor. After his Cabinet was inaugurated, his demand resulted in the signing Jan. 22 of an agreement between the government and the central bank that the central bank would aim for annual inflation of 2 percent, up from its previous loose goal of 1 percent.

The Japanese economy has long agonized under the impact of a strong yen and persistent deflation. The yen hit ¥75.85 against the dollar on Oct. 28, 2011 — the highest level since the 1985 Plaza Accord — and the rate hovered between ¥70 and ¥80 per dollar until November, all the while weakening Japanese industries’ international competitiveness and adding to the nation’s economic woes.

Abenomics helped push the yen lower, all the way to ¥92/dollar early this month.

There are expectations and worries about Abenomics. While skeptics question how close the central bank can get to achieving a specific inflation target, business circles lay their hopes on the prime minister’s initiatives and welcome the moves.

In the first place, there are expectations for an end to deflation. Since the Abe Cabinet was launched, a bullish atmosphere has returned to the market; share prices have turned upward. The Nikkei index, hovering in the 8,800 range in October, topped 11,463 on Wednesday — the highest level in 52 months. The upsurge could cheer the public to the point of spurring more household spending and an upturn in commodity prices.

Second, industrial sectors expect the yen’s depreciation to improve export profitability and increase export volume, likely resulting in a substantial improvement in earnings for the business year ending March 30.

Optimism is not warranted in many of Japan’s export markets. While there are hopes of bright spots in the U.S. economy because of the agreement to avert the “fiscal cliff,” European economies remain under a cloud, and concern lingers over slowing growth in China. Under the circumstances, a weaker yen would likely bolster prospects for Japanese exporters to some degree.

The third expectation is that Abe’s moves could trigger improvement in the overall policy environment. Japan’s fiscal health is rated the worst among major industrialized economies, but a change in monetary policy may pave the way — though slightly — for wider fiscal policy options. In fact, there has been talk of tax cuts to promote technological innovation, and there are also hopes that public spending for post-Great East Japan Earthquake reconstruction will expand and be fully implemented.

Still, some concerns prevail. One is that Abe’s moves raise doubts over the central bank’s independence. The notion that a central bank’s neutrality must be protected comes from lessons learned from the severe inflation experienced in the early part of the 20th century by Western governments, including Germany, that then intervened in their central banks’ policies.

Given that history, Japan’s Public Finance Act stipulates that the issuance of deficit-covering bonds must be based on legislation. The BOJ Law revised in 1997 provided for the central bank’s neutrality. Whether they like to admit it or not, politicians tend to be influenced by populism that leans toward expansionist policies. Therefore, the danger exists that politicians can become uncontrollable once they are allowed to interfere with the central bank’s independence.

Criticism has already emerged among major economies that Abenomics is in fact a veiled policy to artificially drive the yen lower. If distrust of Japan builds among central banks of the major powers and international policy coordination is disrupted, the damage could be enormous.

The second concern is that the yen’s weakening, if it goes beyond a certain level, could start driving up costs at home. Japan relies heavily on imports of food, natural resources and energy supplies. The economy is so structured that demand for such imports does not change much even when prices fluctuate. An increase in import prices would push up costs in Japan.

Since the Fukushima nuclear power plant disaster, Japan has relied even more on fossil-fuel energy sources such as liquefied natural gas. Domestic costs will increase if rising import costs are passed on to domestic prices. This would require Japanese firms to cut expenses even further, including keeping workers’ wages low.

The third worry is the possibility that the policies could create a mini-asset bubble boom, which in turn would push up interest rates. Although sufficient liquidity already exists in the domestic market, interest rates will naturally rise if inflationary expectations drive up the stock market and land prices — as evidenced by Japan’s bubble years from the late 1980s to the early 1990s.

An upturn in the interest rates will result in a heavier interest-payment burden on the nation’s coffers. Currently the interest burden is in the range of ¥10 trillion because the yield on government bonds is stable at around 1 percent. If the yield should rise to 5 percent, the annual interest payment burden on the government could exceed tax revenues. Japan’s financial institutions hold large volumes of government bonds in their portfolios, and their financial health would rapidly fall if the bond market crashed.

So, Abenomics has been greeted with a mixture of expectation and worry. Speculators in international financial markets are watching for fluctuations in currency exchange rates and sovereign bond prices. Instability in the Middle East and disruptions to the oil supply and demand could severely disrupt the markets.

I do believe that Abenomics has already fulfilled some of its intended roles. It seems about time for the prime minister to shift his policy priority to measures that steadily address structural problems such as promoting innovation and deregulation.

Shinji Fukukawa, formerly vice minister of the Ministry of International Trade and Industry (now the Ministry of Economy, Trade and Industry) and president of Dentsu Research Institute, is currently senior adviser of the Global Industrial and Social Progress Research Institute.