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Japan’s Abenomics: Time to Take Stock

Almost one year ago, the term Abenomics first surfaced in Japan. The idea of a coordinated policy effort to revive Japan’s economy and end deflation seemed a bold idea, but also a long-shot. Back in February, several young investment bankers told me that ending deflation within the next few years stood at most, a 20 percent chance.  They noted that they had never experienced rising prices in their lifetimes. By June they had upped the chances of success to 40 percent. With Abenomics approaching the one-year mark, is the new strategy working?

Lot of policy action

The year started with a flurry of new policy initiatives: in January, the Bank of Japan (BoJ) adopted a 2 percent inflation target, followed by new fiscal stimulus, and a decision to join  negotiations over the  Trans-Pacific Partnership (TPP), a proposal for a free trade agreement spanning countries from Australia, Brunei, to Chile, Canada, and the U.S.  Shortly after,  Haruhiko Kuroda took the helm at the Bank of Japan and introduced  Quantitative and Qualitative Monetary Easing—an aggressive plan to reach 2 percent inflation in about 2 years mainly through large-scale bond purchases. Just, a few days ago, the government agreed to go ahead with the consumption tax increase in 2014 and announced further fiscal stimulus to soften the growth impact. Discussions on growth reforms are next on the agenda, with a special Diet session starting this month. Plenty of action, but has this whirlwind of activity paid off?

Signs of a turnaround

The strength of the recovery in the first half of this year has surprised many. The rebound in equity markets, yen depreciation, and new public spending all contributed to a remarkable turnaround, with growth reaching almost 4 percent in the first six month of the year. That said, the transition to a private demand-led recovery is still at an early stage. Private investment has not taken off and labor markets, while tighter, have not generated much wage growth. A good start, yes, but not a homerun.

What about prices? Inflation turned positive in June helped by higher energy import costs, and long-term inflation expectations have risen. But most core prices are still falling and monetary easing is slow to transmit to the economy: most of the liquidity pumped into the economy is flowing right back to the BoJ in the form of growing bank reserves. Some banks have begun to rethink their investment strategies and bank lending has begun to rise, but in aggregate the new easing has not lead to substantial portfolio rebalancing or capital outflows, contributing to a relatively stable exchange rate since July.

Probably the most noticeable achievement has been continued low and stable long-term interest rates, despite the rise in inflation expectations and a steepening of yield curves, overseas, especially in the US. This has helped bring real interest rates down.

But Abenomics has still a way to go

The truth is that there is no clear benchmark against which Abenomics can be assessed. Japan’s history of mild deflation and subdued growth makes it very hard to predict a path to recovery. But if Abenomics is to succeed, progress along several dimensions should be expected.

Key milestones are: self-sustaining growth propelled by investment, employment, and earnings growth; a re-anchoring of inflation expectations at 2 percent and a steady rise in headline inflation driven by price increases of non-food and non-energy items; finally, successful Abenomics should lead to falling real interest rates as monetary easing keeps nominal interest rates low. Against these metrics, Abenomics has done well, but it also has some ways to go.

Growth reforms are needed

For Abenomics to work, Japan’s long-term economic problems need to be tackled in a convincing manner. In other words, strategies for raising trend growth and reducing public debt need be put in place. The consumption tax increase has sent a clear signal that the government is serious about fiscal reform. A similar resolve is needed on growth reforms—the third arrow of Abenomics. Discussions have been underway for some time on a new growth strategy, including labor market reform, deregulation, and efforts to revamp the agricultural sector. While these are all important areas, there is now a premium on concrete action.

Japan needs a signature initiative similar to the consumption tax increase on the fiscal side. The upcoming special session in Japan’s legislative arm, the Diet, this October provides an opportunity to take action and keep the reform momentum going.

Just one year ago, Japan was entering its third recession in 5 years, and the outlook seemed bleak. To avoid getting stuck again, the rapid pace of reforms needs to continue and, especially, extend to structural reforms. While there is no guarantee that it all will work, Abenomics has generated—for the first time in a long time—a real chance to bring Japan back on the road of sustained growth.  And Japan’s economic prospects will be among the issues  discussed at an IMF sponsored seminar “Abenomics approaching its one-year mark" taking place in Tokyo on October 29.