Japan: An accelerating economy, though not quite at breakneck speed Global Economic Outlook, Q3 2017

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The Japanese economy appears to accelerating more robustly, with low unemployment, strong export growth, and positive monetary policy possibly contributing. Of course, a declining population is still a concern.

Rebound

While it would be an exaggeration to say that Japan’s economy is on fire, it is safe to say that it is doing unusually well. The Japanese economy appears to be turning a corner, accelerating to a more robust rate of expansion. Of course, given its declining population, it cannot be expected that Japan will ever again return to breakneck growth. Still, on a per capita basis, it is doing well. There are a number of indicators that point to progress:

  • • Industrial production was up 6.8 percent in May versus a year earlier, the fastest rate of growth since 2014. Moreover, the overall level of output is now the highest since 2008. The strength of industrial output has been driven by strong demand for Japanese exports. This is one of the several indicators that the economy is finally stabilizing at a decent rate of growth. Still, headwinds remain, including poor demographics, inadequate Japanese fiscal and regulatory policies, and potential US protectionist policies.1
  • Japanese exports grew strongly in May, although more slowly than some analysts had expected. Exports were up 14.9 percent versus a year earlier. In particular, exports were up 23.9 percent to China, 22.9 percent to South Korea, and 12.7 percent to North America. The strength of exports reflects the impact of a weak Japanese yen as well as accelerating global demand. Meanwhile, imports grew faster at 17.8 percent, reflecting an improvement in domestic demand as well as strong growth by manufacturers that needed components for their exportable products.
  • Retail sales in Japan grew 2.0 percent in May from a year earlier. This follows exceptionally strong growth in April, the fastest rate of growth in two years. Moreover, strong growth two years ago was artificially inflated by the rise in the national sales tax. Excluding that episode, retail sales are now rising at the fastest pace since 2012. The strength of retail sales is due to strong growth of spending at department stores and supermarkets. On the other hand, overall household spending grew modestly in May, up 0.7 percent from a year earlier. This was likely due to weakness in the growth of household income. In real (inflation-adjusted) terms, household spending was actually down from a year earlier. Thus the consumer sector of the Japanese economy remains uncertain.
  • Japan’s labor market appears to be strong. The unemployment rate rose to 3.1 percent in May after hovering around 2.8 percent in the previous two months. Still, this is a relatively low rate. Unemployment has been falling rapidly and steadily since it peaked at 5.5 percent during the global recession of 2009. Moreover, the tightness of the market is indicated by the fact that the ratio of job openings to job applicants is now 1.49, almost the highest level since 1974. This suggests a significant shortage of labor.

The tightness in the labor market is not only due to strong demand for workers, but also reflects a declining supply of workers. The working-age population is declining by about 700,000 people each year. Normally, one would expect that such a situation would generate considerable wage pressure, thereby boosting inflation. This is not happening, and it is not entirely clear why not.

Several explanations have been offered. First, an extended period of low inflation has trained businesses to offer modest pay increases. Old habits die hard. Second, many workers prefer to stay with one employer for a lifetime. As such, they are relatively immune to offers of higher pay from other employers. Third, some employers may prefer to invest in labor-saving technology rather than boost wages, especially if the available pool of labor lacks the skills needed. Fourth, there is an increasing number of women entering the workforce, thus removing some of the pressure on wages. Finally, the job market appears to be tightest in Tokyo, where the ratio of jobs to applicants for full-time work is now especially high. It is rather low in other parts of the country. This suggests a bifurcated job market in Japan.

The Japanese economy appears to be turning a corner, accelerating to a more robust rate of expansion.

Monetary policy

Japan’s central bank has lately left monetary policy unchanged, reflecting its confidence that the economy is on a favorable path of faster growth and higher inflation—even though core inflation remains at zero. The policy remains highly accommodative. Meanwhile, the International Monetary Fund (IMF) feels that the policy has been a success. It says that Japan has done enough to boost growth and inflation, and that the current policy of “Abenomics�? is a “success�? and should be continued.2

Recall that Abenomics refers to the policies undertaken by Prime Minister Shinzo Abe since he came to power. These include aggressive monetary policy, fiscal stimulus, and deregulatory reform. Only the monetary policy part of Abenomics has been implemented in a significant way. However, the government is likely to engage in more fiscal stimulus in the coming year. As for deregulation, the government hoped to use the Trans-Pacific Partnership (TPP), a free-trade agreement between Japan, the United States, and 10 other Pacific Rim nations, as a political cover for engaging in politically difficult reforms. Unfortunately for Abe, US President Donald Trump cancelled the TPP on his first day in office, despite Abe’s efforts to convince Trump otherwise.

Although the IMF expressed confidence in the current policy mix, it warned that the government ought not to allow a 2.0-percentage-point increase in the national sales tax, now scheduled to take place in 2019. The last time there was such an increase, it caused a temporary setback to economic activity. The IMF suggested that future increases take place more gradually.3 The government is keen to enact a tax increase in order to offset the rising cost of pensions associated with an aging population.

Demographics

Japan’s population is declining. In 2016, the indigenous population fell by 308,000, a record drop. This was partly offset by a 149,000 increase in the foreign resident population—an increase of 7.0 percent. The native-born population is falling because of a very low birth rate, which is not sufficient to offset the death rate. Meanwhile, the population continues to age, with a sharp decline in the working-age population partly offset by a rise in the elderly population.

This situation is creating a number of challenges for Japan. A declining working-age population means slower economic growth, which reduces Japan’s footprint in the global economy. It also means persistent excess capacity, which contributes to very low inflation. A combination of low growth and zero inflation has contributed to a very high debt/GDP ratio for the government. The decline in the ratio of workers to retirees means a higher cost of caring for the elderly. This is why the government is keen to ultimately boost the national sales tax, in order to fund pensions and health care for the elderly. Finally, the population continues to shift toward big cities. Tokyo’s population is rising, while that of many small towns is being quickly depleted.

What is the solution? First, more immigration would help—this is evidently taking place, but far more slowly than in most other developed economies. This is a difficult political issue in Japan, one about which politicians barely speak. Second, an increase in the rate of female labor force participation would help, and indeed the government has taken actions to encourage more women to work. Japan’s female participation rate is similar to that of the United States but far lower than that in Western Europe. Finally, faster productivity growth would help. However, this will require more business investment in new technologies, which might be encouraged if the government relaxes anti-competitive regulations in various industries. Freer trade would help as well.

Trade

Japan’s government is eager to be involved in trade liberalization, partly to gain more favorable access to foreign markets. Japan and the European Union have just reached an agreement on a free-trade deal, which was announced t the G20 Summit held in July. The deal will eliminate tariffs on 99.0 percent of goods traded between the two economic giants. Companies in each region will have access to public sector procurement in the other region. The deal will mean that European farmers gain access to the Japanese market, while Japanese automakers gain greater access to the EU market. This is hugely significant because the European Union and Japan are two of the four biggest economic players in the world—the others being the United States and China. This comes only months after the United States withdrew from the TPP.

Japan’s government is eager to be involved in trade liberalization, partly to gain more favorable access to foreign markets.

Such agreements will require the dismantling of non-tariff barriers such as onerous regulations. Abe hopes that the requirement to end such barriers will provide his government the political cover needed to implement difficult reforms, including liberalization of domestic markets. He had hoped that the TPP might provide such an opportunity. The new deal between the European Union and Japan is a way for both sides to sidestep the United States, which increasingly is turning inward in terms of economic relations with the rest of the world.