Exploring the Economic Landscape of Japan

Date of publishing: 20.02.2023

Executive Summary

Japanese inflation is at the highest rate since 1981
Commodity import prices rocketed over the past year, putting pressure on the economy

Yield curve control mechanism broke through the 0.50% target peg in January 2023

Mortgage rates are still low, whilst home supply and prices increase

Country Overview

When taking a closer look at Japan, a few distinct aspects attract one’s attention. For one, the economic growth of the nation is constantly tumbling around the 0-percentage mark. One of the most striking factors influencing this development are Japan’s deflationary tendencies over the past decades. We will go further into that topic later in the article. Apart from that, the median age of the whole population is currently at 48.4 years. This is roughly 20% higher compared to the UK and around 27% higher than in the USA. Historically speaking, the spending behaviour of elderly people vastly differs from younger generations. Especially retired citizens tend to have lower consumption levels, which in further consequence impacts GDP negatively.

Japanese Industry

There are few economies in the world that can be compared to the Japanese. For one, the cooperation between governments and firms is very strong. Moreover, Japan implemented a system called “Keiretsu” which intends to promote long-term stability and growth through cooperation and mutual support among its member companies. When working together, participating entities can reduce risks, share resources, and access new markets, which can lead to increased competitiveness and profitability. While “Keiretsu” can offer many benefits, it can also be exclusionary and limit competition, which has been a subject of controversy over the past years.

Japan is home to many globally significant enterprises, mainly across the following industries: Automobiles, Consumer Electronics, Computers, Semiconductors and Copper, Iron and Steel manufacturing.

Economic Overview

Snapshot of GDP

Japan, like most developed countries, has faced certain difficulties and issues over the last years that significantly impacted its economic development. In the context of the COVID-19 outbreak in 2020, Japan was one of the countries that reacted in a mostly organized and cautious way, given the experience with previous epidemics. However, this did not prevent their economy from being largely affected by a global shift in demand and consumption as well as severe supply chain issues. This means that GDP dropped by 4.6% in 2020 and slightly grew again by 1.6% in 2021.

While imports and exports traditionally had been in a somewhat even relation to one another, Japan has now been confronted with a negative foreign trade balance despite the rather weak yen. Looking at the domestic demand, consumption has taken up again and is expected to further increase in the following time. This may also correspond with a decreasing household savings ratio that had risen during pandemic times, when restrictions on public life led to less spending.

The Labour Market Trap

As expected, the small increases (compared to other OECD countries) in unemployment rates in 2020 and 2021 were a symptom of the circumstances under COVID-19. However, it is expected to decline back to old levels of below 2.5% and to stay there over the coming years – depending on the country’s monetary and economic policies. Here, it is important to note that unemployment in Japan has a long history of particularly low rates compared to other OECD countries (see Figure 2). Reasons for that lie within the inflexibility of the labour market which is not only due to demographics but also a highly different work and business ethic (at least for “westerners”). Beyond that, important reasons are increasing labour shortages and large amounts of government subsidies to employers that are supposed to ensure the stability of the job market. Despite these efforts and low rates, the underlying factors might lead Japan into a “trap” in which businesses just cannot adapt to the macroeconomic environment anymore – resulting in Japan being surpassed by others.

The Fiscal Policy Trap

Beyond these direct metrics of economic prosperity, public debt plays an important role in supporting a country’s stability and policy agenda. Over the last 30 years, Japan has constantly expanded its government debt to all-time highs in 2021 of more than 242% of GDP in order to revive the economy after the market crash in 1990 and combat deflationary tendencies. In the early 2000s, it manifested itself that monetary and fiscal policies were effectively adapted to one another as the central bank started to continuously buy Japanese government bonds and keep interest rates low. As a result, Japan was overall stabilized and economic growth was fostered. However, as of today, Japan is among the countries with the highest government debt to GDP. In the context of an upcoming stagflation scenario, it remains unclear how Japan’s central bank will be able to act upon these tendencies regarding interest rates and money supply. Consequently, the developments of the last years have maneuvered both the government and the central bank into another “trap” where major policy changes would lead to unpredictable consequences. Looking at future projections on fiscal policy, there is no clear positive trend with respect to the government’s financial balance – in the context of it still being at -5.5% of GDP in 2021 compared to -9.0% in 2020.

Inflationary Pressure

Over the past decades, Japan’s inflation and deflation development was arguably the most noteworthy worldwide. In the following, we will cover the corresponding history and current situation regarding boosts and downturns in the country’s price development.

Inflation History

Between 1960 and 1989, the Japanese economy experienced nearly double the GDP growth of the US, which quickly made it the second largest financial system worldwide. The negative aspect of this rapid development only began to show in 1986 in the form of a massive asset price bubble, which eventually burst in 1991. In the following years, GDP growth declined further and further, reducing the inflation rate to negative 1%. Since then, the economy has not been able to pick up past development rates, resulting in long periods of deflation up until 2022.

Current Situation

The last deflationary period was recorded between September 2020 and August 2021. After that, the aftermath of COVID and rocketing energy import prices started to inflate Japan’s CPI. As of December 2022, the country’s inflation rate was at 4.0% YOY. However, according to the current Bank of Japan governor Haruhiko Kuroda, this development is only temporarily propelled by energy and other costs and will have no long-term effects on price changes within the nation.

Monetary Policy

Since 2016, the Bank of Japan is making use of the yield curve control (YCC) mechanism with the aim to peg the 10-year government bonds at 0%. But the BoJ changed the peg target from 0% to 0.5% for 10-year government bonds, along with a negative short-term benchmark rate as high as -0.1%, even though inflation keeps surging to the fastest since decades. In Figure 5 the yield of the 10-year Japanese government bond is compared to the 10-year yields of the US, UK, and Germany. It is noteworthy that the yields of US, UK and German bonds rallied during the plotted timeframe, whereas the yield of Japanese bonds remained at levels between 0% to 0.5% given the YCC mechanism of the Bank of Japan.

The Japanese central bank owns 73% of debt due in 7 to 10 years, which is up from 55% compared to the end of the year 2021. This creates troubles for liquidity, for example the benchmark 10-year government bond was untraded for four straight sessions in October, which was the longest run since 1999 and this might strengthen bets for a shift in the current YCC policy. With its ongoing purchases of government bonds, the BoJ is reaching “near-full” ownership, meaning these bonds will stop trading in their entirety and the market will simply cease to exist.

As mentioned before, the current governor of the BoJ stated, with respect to the current levels of inflation, that these price gains are not sustainable and are only temporarily being propelled by energy and other costs. But it is important to note that these pressures are not only coming from inflation, but also from a rapidly decreasing yen. Two reasons why the BoJ doesn’t want to change its current policy path are because they think it’s too early with respect to shortcomings of the Covid-19 pandemic but also out of fear about the deflationary era in Japan.

Japanese retail foreign currency deposits at domestic banks rose to $182bn at the end of August, up 8.3% since the start of the year. That was the largest YTD August increase since 2015. This is very unusual, because normally Japanese investors tend to buy foreign currency when the yen is strong and sell when it is weak. The huge build-up of non-yen deposits is another wave of cash that could potentially lift the yen in a more favourable domestic interest rate environment.

Current Measures

The BoJ’s grip on the sovereign debt market is growing as it continues to ramp up purchases to keep yields within a targeted range. In Q4 of 2022, already fighting for months to control the yield curve, the BoJ had raised its holdings of Japanese government bonds to over $820.9bn. This is mounting fear among markets that an orderly retreat may be impossible. The BoJ is hoping that national and international outcomes will solve its most pressing problems: sizeable wage increases by Japanese companies, the onset of “good” inflation, visible stability in the yen, a soft US recession and an interest rate pivot by the Federal Reserve.

To fight the negative impact of inflation, the government unveiled a $200bn stimulus package, roughly 30% of this amount are spent on measures to fight inflation.

The question “Does Japan have to fight it alone?” is arousing, and the answer is most probably yes, because its main partners generally don’t like countries to set or influence exchange rates and want market forces to do the work. The yen’s current weakness is driven partly by a combination of continuing BoJ monetary stimulus and the Fed rate hikes. In that sense, it could be seen as a Japan-driven event, and that may weaken the case for action.

For the first time since 1998, the BoJ intervened in the USD/JPY currency market in September, the intervention took place close to the 146 level. In October the yen passed the 151 mark, which led the BoJ to conduct its biggest intervention to support the yen, worth $37bn. Compared to previous currency interventions the BoJ is now using a new playbook, before the central bank intervened in markets to weaken the yen but now it is intervening to strengthen their domestic currency. It is interesting to remember Kuroda’s statement from May, where he mentioned that it is meaningless to conduct currency interventions, which could have a short-term effect on the yen, but can’t be carried out indefinitely.

By buying yen to support the currency, liquidity is taken out of the Japanese financial system, but at the same time the BoJ is injecting liquidity through its continuing bond purchases. The widening interest rate differential between Japan and the US means few market participants are yet confident where the yen will find a natural floor.

The BoJ might see itself obligated to change their current policy path, if inflation is permanent and domestically driven, the yen keeps weakening despite currency interventions or if bonds maturing on either side of the targeted maturity now trade with yields materially higher than the cap.

"Uedanomics"

As current Bank of Japan Governor Kuroda is set to step down in April, Japanese Prime Minister Kishida’s surprising choice for Kuroda’s successor is Kazuo Ueda, a university professor, and former Bank of Japan board member. People familiar with the matter expect changes in monetary policy but in a slow manner. If domestic inflation accelerates, Ueda might start to act and change the current path of the Bank of Japan, which will then likely strengthen the yen and would also lead to a surge in government bond yields.

International Trade

Overview

Japan was isolated from the rest of the world until the start of the Industrial Revolution. The country has virtually no natural resources and has been dependent on trading with many Asian countries, primarily China, ever since then. For example, Japan needs to import tremendously inflated energy to satisfy local demand. It becomes apparent that its dependency on the supply of other countries has vastly negative effects on the country’s trading portfolio.

Trade Balance

Japan has had a negative trade balance for 18 months in a row as of mid-February 2023. This gives the first indication of the current state of Japan’s trading economics. The latest data shows a negative trade balance of more than $26bn. This is even worse than the previous lowest low with a negative trade balance of $21bn in September 2022. Figure 6 shows that the current trade balance is by far the lowest one in years and disrupts the trend of recovery over the previous four months. The export and import prices shed more light on this decline.

Export and Import Prices

The long-lasting negative trade balance can be explained by the continuous increase in import prices, less significant increase in export prices as well as a higher level of import prices in general. This is shown in Figures 7 and 8. Japan had a term of trade of only 75.64% in January 2023. In other words, Japan can cover around three-fourths of their Imports with the earnings generated from their exports. What is more, the volume of Japanese imports has been higher than Japan’s export volume for the past three years now.

Japan’s government leaves much of the essential trade to the private sector. Hence, the higher import prices get passed on to consumers in form of inflation.

Composition of Trade

China is Japan’s biggest export partner, making up roughly 21% of Japanese exports. Followed by the US with 17.9% and other Asian countries with a share of 7.2%. Together only three countries made up almost half of all exports by Japan. The top exports were motor cars, electronic circuits and motor vehicle parts. All exports can be summarized as processed items. Figures 9 and 10 represent the data in form of graphs.

On the other hand, Japan once again imported primarily from China (24%) and the US (10.7%) in 2021. Also, there were significant imports from Australia and other Asian economies. The four countries also make up almost half of all Japanese imports. The top imports were petroleum oil, petroleum gas and electric apparatus. We can see that Japan desperately needs oil and gas to cover their energy demand (together around 14% of imports) but also that it imports items to process them further. Figures 11 and 12 show the data described above.

All in all, the country still shows clear dependencies on trade with other countries. It is reliant on a few, namely China and the US, in terms of imports and exports.

Trade Agreements

Japan has three noteworthy trade agreements. Namely with the United States, the European Union and six other countries including Australia, Singapore and Vietnam (CPTPP). These trade agreements are important strategic assets as they facilitate trade with countries, Japan is dependent on anyways. Lastly, Japan has the lowest average applied tariff rate in the world. The tariff rates especially favour countries that it trades a lot with. However, there are some protectionist measures for less favoured countries. For example, only locally registered firms can act as an importer and many goods need to be approved by local authorities for unfavoured countries.

Markets

Japanese equities tend to be less volatile than other markets. The TOPIX has remained resilient compared to other major market indices since the beginning of last year. However, over a longer period, we can observe underperformance. In the near future, the upside potential is supported mainly by the weaker yen, accommodative monetary policy and offset by concerns over fiscal tightening.

In 2022, we witnessed a significant depreciation of the yen which was mainly the result of the policy divergence between the BoJ and the Fed. The Fed started tightening whereas the BoJ kept its stance on its loose monetary policy. The relationship between the USD/JPY exchange rate and the 10-year government yield spreads illustrates this policy divergence over time very well. Additionally, the fact that the BoJ is continuing its fixed rate operation for the 10-year government bond at 0.5% resulted in extremely low break-even inflation expectations which do not seem realistic under current market conditions.

Real Estate

The Japanese real estate market has some unique characteristics which are not common in most western countries. The share of new homes compared to the total number of homes sold is high. The reason for this is that unlike in many other countries, in Japan, houses are consumable goods, they don’t double as an investment. The average lifespan of a house is 30 years. Therefore, after the relatively quick depreciation time, most houses just stay vacant. That is the reason why 14% of homes are vacant in the country and why they constantly need to build new ones.

Another unique characteristic of the Japanese market is that there is an increasing supply of real estate, decreasing demand while at the same time the prices are still increasing. To break down this surprising relationship we need to look at the causes separately. Decrease in demand happens because of demographics, the population is decreasing and aging, which is expected to continue in the future. Fewer people equal less need for housing. However, prices and supply of new homes are still increasing, which can be mainly explained by the fact that people move from rural areas to large cities where apartments are a lot more expensive (mainly because they actually double as an investment) and there are not enough of them. Additionally, mortgages are affordable. Currently both variable and fixed-rate loan interest rates are very low. Although fixed rates are starting to rise, most loans have floating rates which have not changed yet. At the time of the article Flat35 housing loan rates are between 1.65% and 3% while variable rates range from 0.5% to 1. Furthermore, the average household spends only around 15-20% of its income on mortgage payments. Another small point, just like with their monetary policy Japan is also very accommodating with its building code. The rules are very relaxed and land that has a building on it also receives a tax benefit. But this is just a small incentive, the main reason for the price increase is the population rise of large cities and cheap credit.

Disclaimer The information set forth herein has been obtained or derived from sources generally available to the public and believed by the authors to be reliable, but the authors do not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with WUTIS – Trading and Investment Society e.V.