The year began with the yen rallying due to global concerns over China’s economy and faltered expectations of a Fed hike. It dropped in the first week of February based on the Bank of Japan’s (BOJ) surprise monetary easing, but rebounded again later in the month. In March, the yen has been marginally dampened but remains steady against the major currencies as it moves against the dollar with the new range between 111 and 115.
We suspect the yen will not be kept steady in the second quarter of 2016. Japanese officials have been eager to keep the yen weak and Japanese investors have few ways to find good opportunities without expanding under the BOJ’s negative rate policy. Given risk-off sentiments have cleared, the yen should weaken.
The Japanese economy continues to be stagnant. GDP contracted 1.1% on SAAR in the fourth quarter, mainly due to weak consumption and exports. Private consumption dropped by 0.8% q/q to the lowest since the third quarter of 2011. Weak real wages have curbed private consumption as the real total wage index has been below 1% y/y growth since July 2014. Consumer sentiments have worsened since the second half of 2015, with Japan February consumer confidence dropping to 40.1, the lowest since January 2015. Most Japanese firms are reluctant to raise base salary due to slowing global growth and tepid domestic demand. Part-time workers will continue to crowd out full-time workers, lowering average nominal wages, and causing the Japanese real wage to grow at less than 1% this year.
Japanese firms have been reluctant to increase business investments, even with steady profits. Most are still suffering from excess capacity and want to be prepared for the next economic downturn. Exports have decreased mainly due to the Chinese economic slowdown and a steady yen.
Prime Minister Abe’s approval rate has fallen below 50% due to the stagnant economy and political scandals in the Liberal Democratic Party (LDP). The government and the LDP seem to judge that a steady yen and lowering stock prices will keep weighing on his approval rate. Most think Abenomics should be bolstered ahead of the national election for half of the seats in the upper house, perhaps in July.
Japan’s parliament enacted a JPY 3.3 trillion supplementary budget for fiscal year 2015 in January, resulting in the total budget reaching JPY 99.2 trillion yen. The supplementary budget will be spent to bolster the economy through enhanced welfare services and a more competitive farm sector. The fiscal year 2016 budget will be passed at the end of March and will be JPY 96.7 trillion. This is the largest budget ever passed, but less than the total size of fiscal year 2015’s budget. Some members of the LDP have called for additional economic stimulus measures in 2016, even before the passage of the budget. Finance Minister Aso said that he would not rule out a stimulus package in 2016. The Shanghai G20 meeting also pushed the Abe government towards more fiscal stimulus.
The government could set JPY 4–5 trillion as the size of the supplementary budget for fiscal year 2016. It may increase the maximum mortgage tax break, which is currently an annual maximum tax deduction of JPY 0.4 million or JPY 4 million over 10 years and also enhance tax breaks for purchasing eco-friendly cars. Public investments are not expected to be largely increased. The construction industry has a shortage of skilled workers and budget implementation has become delayed. Additional household expenditures should be a nice way to raise approval rate.
Abe continues to favor proceeding with the sales tax hike, from 8% to 10.5%, in April 2017, while Chief Cabinet Secretary Suga said it should not be raised if it will cause revenue to fall. We think Abe will continue to delay the tax hike ahead of the upper house election. The government could postpone the tax hike by two years to April 2019. To make up for the lost revenue, the government may cut expenditures for social securities. Abe failed in the mission to completely bail out the deflation due to the first sales tax hike on April 2014. Lackluster growth in the first quarter of this year, released in the middle of May, could push Abe to a more dovish side. Co-ruling party Komei, which is mainly supported by lower middle class, will agree with delaying the sales tax hike.
Even after delaying the sales tax hike, Abe is likely to announce the government has not given up on its primary balance goal: achieve a government primary budget surplus by fiscal 2020. As Suga said, Abe will insist that the Japanese fiscal condition should continue to improve under strong nominal growth.
Some point out that Abenomics has failed, but that is not true. The Japanese potential growth rate is slightly above 0%, which means actual growth could be negative. Fiscal expanding and aggressive easing by the BOJ and the second arrow in Abenomics, increased labor demands, has supported consumer sentiments, boosted stock prices and heightened inflation expectation. Abe still has a chance to break away from a deflation mindset and achieve the 2% inflation target. Delaying the sales tax hike might lead to risk-on sentiments in Japanese stock markets.
We do not expect Abe to gamble on a snap election with the upper house. Abe said revising Japan’s constitution could become a key issue in the upper house election in July, but Komei disagrees with having both a double election and changing the constitution. The LDP also does not want to take a risk to reduce seats as it has had difficulties in double elections due to a stagnant economy and political scandals in the past. Rumors about a snap election might be hinted by Abe’s group in order to make the LDP continue to brace for the upper election.
The BOJ has started a negative interest rate policy following on a 5–4 vote in January and kept its monetary policy unchanged in March. The surprised easing in January suggests the BOJ’s action heavily depends on market movements, in particular the yen and Japanese stock prices. The BOJ warned it will cut rates further into negative territory and expand asset purchasing. The BOJ could ease more on April 28 when the outlook report will be released, but we think the trigger for monetary easing is not a change in its outlook, but stronger yen and/or a large drop in Japanese stock prices.
The negative interest rate policy with QQE successfully lowered yields in Japanese government bonds (JGB) -- Japan’s yield curve is negative through 9-10 years. In spite of volatility in JGB markets, Japanese banks can continue to safely purchase JGBs with negative yields. The BOJ has pledged it will continue to expand its monetary base via purchasing JGBs and Japanese banks could sell JGBs with deeper negative yields. Lowering JGB yields should lead to wider rate differentials between the US and Japan, which supports weakening yen against the dollar.
Given the BOJ’s negative rate policy, the Japanese banks will continue to suffer from an influx of cash. The banks cannot expand loans under persisted weak money demands and are virtually prohibited to charge negative rates or fees to retail depositors because of BOJ policy. Some banks may consider charging fees to corporate customers while the largest bank in Japan has ruled it out. The market could see a heavy flow of withdrawals to avoid negative interest rates and profits in the Japanese banks are likely to be depressed.
Japanese investors will continue to buy foreign assets. Given lower long-term JGB yields, Japanese asset managers and life insurance firms will have to purchase more foreign bonds and stocks in order to secure steady income flows. Japanese current accounts in 2016 remain at a surplus of approximately JPY 17–18 trillion yen but it will be fully offset by money outflow by Japanese investors. Japanese investors bought more foreign bonds and equities in the first quarter of 2016 than the same quarter of 2015.