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Japan’s Three Arrows―Will They Fly?

(Versions in 日本語l and 中文)

Discussions in Japan of the “three arrows” of Abenomics—the three major components of Prime Minister Shinzo Abe’s economic plan to reflate the economy—are rampant among its citizens as well as economists, journalists and policy-makers worldwide. Even J-Pop groups are recording paeans to the economic policy named after the newly-elected premier.  It is clear that "Abenomics" has been a remarkable branding success. But will it equally be an economic triumph?

We think it can be, and initial signs are positive.  But such success is not assured. It will require difficult decisions as the country moves into largely uncharted territory. And much will depend on changing expectations within the country.

Abenomics: Changing Minds

Following two decades of deflation, low growth and rising public debt, Japan is looking to make a clean break with its recent past.  Prime Minister Abe rolled out, in late-2012 and early 2013, a comprehensive approach to reviving the Japanese economy, summarized by three policy arrows: aggressive monetary easing, flexible fiscal policy, and structural reforms to raise potential growth.

The idea is this: An escape from deflation triggered by monetary easing and fiscal stimulus would lower real interest rates and stimulate investment, consumption and—with, at least temporarily, a weaker yen—exports. Structural reforms would contribute to confidence and ensure that higher growth is sustained. Lower funding costs and higher growth would improve debt dynamics. And a credible medium-term fiscal plan would curtail risks of a government bond rate spike and allow for a measured pace of adjustment. If all goes according to plan, a more dynamic Japan would emerge, which would be an important plus for the global economy as well.

What is being attempted under Abenomics is nothing less than a leap from a low-growth deflationary equilibrium to a new equilibrium characterized by positive inflation and higher sustained growth.  This will require a parallel shift toward more risk-taking, requiring changes in expectations by businesses, consumers and financial institutions, both about Japan's growth prospects as well as the government's ability to carry through with needed reforms. These changes will not be easy to engineer. To put it in perspective, a Japanese college student today has experienced deflation and low growth through her entire life, with nominal GDP at the same level as 1991.

An End to Incrementalism?

In early April, the first of the three arrows was fired, with the Bank of Japan announcing its new quantitative and qualitative monetary easing (QQME) framework to achieve 2 percent inflation in a stable manner within about two years. The sheer size of the planned asset purchases marks a clear departure from the incremental approach of the past, and forward guidance is aimed squarely at sending the message that QQME will continue for as long as necessary to achieve its goals. We think this new framework has a good chance of success.

But monetary policy cannot do the job alone--all three of Abe's arrows are required. The government recently put forward a broad growth agenda, but critical details remain to be fleshed out in the coming months. With the Upper House election now complete, all eyes will be on Tokyo to see whether the structural elements of Abenomics will also represent a decisive break from the past, by directing policies at the key underlying constraints to growth. Concrete steps to raise employment, increase labor market flexibility, deregulate agriculture and the services sector, and enhance the role of the financial sector in supporting growth, would be key.

A clear and convincing plan to reverse the long-term trend of rising government debt is also needed urgently. Net public debt has increased from 13 percent in 1990 to 134 percent today, the highest among advanced economies. This rise in debt has so far been financed without problem. But the experience in the European periphery makes it clear that investors' views can change quickly, and that reducing the debt burden will require both medium-term adjustment and higher growth. Moving forward, as planned, with the consumption tax hike next April would be a major step in the right direction.

Is it Working?

We see encouraging signs that the desired changes to the economy are beginning to take place. Growth in the first quarter rose by an impressive 4¼  percent (seasonally adjusted annual rate). Equity markets are up by some 40 percent for the year. Exports appear to be recovering. Credit growth has turned positive. Consumer and business confidence have picked up. And Inflation expectations are beginning to rise. Meanwhile, media reports abound with anecdotal evidence of recovery—it seems, for instance, that purchases of expensive tuna are now outstripping the more humble mackerel in sushi restaurants throughout Tokyo.

But the transformation is far from complete. In particular, higher investment and wages—two keys for ultimate success—are not yet observed. This should not be surprising, as businesses will need first to feel secure that the economy is moving to higher growth, while financial institutions are still sorting out the implications of recent changes for their business models. This process is also behind much of the volatility we have witnessed in Japanese financial markets in recent months.

Much can still go wrong. The global economy has been volatile and a downturn could create headwinds just as Japan's economy is taking off. But the bigger risk is domestic, that through complacency or political obstacles we get a partial version of Abenomics, missing one or more of its key elements and failing to convince that "this time is different."

But, for the first time in a while, there are good reasons for optimism in Japan.