Interview: Naomi Fink on the Japanese

Economy
nalyst Naomi Fink on the Japanese economy and the outlook for Abenomics.

Image Credit: Naomi Fink

By Anthony Fensom-April 08, 2015

Japans economy limped out of recession in the December quarter, having posted zero
growth for 2014 after a consumption tax hike hit spending. With consumer inflation
recently falling back to zero and international forecasters seeing only modest growth
this year, can the worlds third-biggest economy get its groove back?

The Diplomats Anthony Fensom spoke to Japan analyst Naomi Fink, chief executive
of Europacifica Consulting, about the latest growth figures and Abenomics prospects
of overcoming deflation.
Japan has just emerged from recession with a modest expansion. What are you
expecting for the rest of this year?

Partially because the slump in domestic demand was greater and more prolonged than
expected and the recovery in the December quarter was anemic, I think there might be
a lot of latent demand this year. One of the reasons is corporate profitability, which
zoomed in 2014, and the Nikkeis performance reflected that. Of course stockmarkets
arent a perfect forward indicator, but theyre one in relation to corporate profits.
Weve also seen wages increase which is relevant to consumption and wages
expectations. So after the greater than expected slump we saw last year, we should see
a pretty good year.
Over the first half of this year, we will be doing some catching up, especially with better
profitability figures and better wage expectations, so I would expect growth to be above
the 2 percent mark on an annualized basis. Even over the second half, I can easily see
it staying above 1.5 percent.
Prime Minister Shinzo Abe and the Bank of Japan (BOJ) have declared war on
deflation what can we expect from the BOJ in terms of achieving its stated 2
percent inflation target?

What the BOJ and Japan want to achieve is sustainable reflation, so a sustainable
recovery in demand, not inflation for inflations sake. If domestic demand stays where
it is and commodities rallied again, that wouldnt be a good inflation profile. So the
most important thing above and beyond the 2 percent target is whether inflation stays
positive and whether its driven by domestic demand.
On the 2 percent target, the BOJ probably wouldnt be happy to hear this, but in my
mind the 2 percent target is much more important as a symbol than as a number. This
is because 2 percent is actually a pretty high inflation rate in recent history in Japan. If
anything, it symbolizes the BOJs aggressive commitment to continued easing until it
achieves stable reflation, so its set on the high side.
Is it achievable? Yes you look at the amount of liquidity in the system, all we need is
for price rises to start accelerating a bit more. Whether this target will be achieved this
year or not is still uncertain. On one hand, cheaper fuel and commodity input prices
are keeping overall prices subdued, which is one delaying factor, yet on balance a good
thing for real income and household demand. On the other hand, you look at
unemployment, were very near levels historically where prices have started
accelerating. So maybe its just a matter of time. Maybe its a little bit later than we

might have expected in another country such as the U.S. with this type of aggressive
easing, but more important is what happens when we get nearer there.
All types of inflation were not created equal if we start moving from demand-related
inflation to cost-push inflation, we start running into a situation where the BOJ might
have to move quickly from aggressive easing to tightening.
Given the latest data, will the BOJ have to do more?

If we do have a dip in inflation (more widespread than in fuel and commodity prices)
and more importantly, inflation expectations, then we cant rule out easing. Theyve
eased so much, they have such an inflated balance sheet that they want to realize the
impact of what theyve done, that would be ideal but you cant guarantee that.
If youve promised aggressive easing and you think inflation and inflation expectations
are going in an opposite direction to your target, then its hard to get away from that
easing. I wouldnt rule easing out, but keep in mind that the BOJ has quite a lot already
it has one of the most aggressive policies around, so the best thing in the BOJs mind
would probably be to wait until the effects of that easing to kick in and boost the
economy. But given they have an explicit target, should oil and commodity price
declines prove a greater force than inflationary forces such as rising wages, then they
may not have the luxury of waiting too long.
Some analysts have even speculated about the risk of hyperinflation, given the
level of monetary stimulus in Japan.

I would put into the risk category not hyperinflation but stagflation, which is much
more closely tied to the risk of fiscal crisis. If you start seeing cost-push inflation, we
would need to see an offsetting rise in domestic demand for tax revenues to increase,
in order to successfully inflate away debt. If that growth isnt there, and even if
inflation doesnt go to hyperinflation but is eroding away real growth, then its a bad
fiscal situation and we get closer to a crisis.
It might have been the necessary complement to the reflationary policy, by delaying
the consumption tax hike due this year. Still, from the moment when the government
delayed the hike to 2017, it came at a price of undermining the credibility of the
governments fiscal policy to some degree. We might say that the tail risk of crisis has
already risen since that point. About the tax hike in April 2017, any signal that it will be
delayed further, then the risk increases again.
Hopefully the growth will stay around for long enough for the government to start
inflating away debt and then make those hard structural decisions that you can only
make when the economy is doing well and people accept it. Otherwise, the risk is we
never get to a place where the recovery is strong enough so the government can take
decisive action and do things like cut spending in a certain area, such as social security,

or amalgamate the general and special accounts so theres a different structure for
regional payouts, to make regions accountable for a larger portion of their revenue as
well as spending. If we never get to that point, then the structural portion of Japans
fiscal balance wont improve and were left worse off than before as the debt levels are
bigger.
Looking at Abenomics, theres been much debate over the third arrow of
structural reform. What reforms are you expecting and what do you see as a
priority?

I came up with a specific framework to analyze structural reform in a quantitative

sense, yet those results dont appear to have been addressed by the Abe government,
and that worries me. For instance, one of the quantitative results that came from my
study is what we really need long term is improving total factor productivity, but
wheres total factor productivity weakest? Its not the manufacturing sector, so every
time we hear something about improving productivity in the manufacturing sector, its
off target. The manufacturing sector is already efficient; its the services sector that
needs to be improved.
We see things like the privatization of Japan Post; thats one small part, but the
structure of the privatization isnt such that the government cedes its exposure fully to
market forces its keeping a large portion and they dont seem to be creating a level
playing field. And that has implications for the insurance and financial sectors, in
which productivity is exceptionally low. It does not seem like an effective structural
reform, if we look at it from the basis of the quantitative study.
Also, I did some econometric studies on regulation and structural reform to reinforce
my point on manufacturing earlier. I broke down regulation into manufacturing and
non-manufacturing, and the striking result was that in non-manufacturing and
services, when you decrease regulation its consistent with a rise in productivity. Thats
not the case with manufacturing, where the coefficient is inverse. This means if you
decrease regulation its consistent with a decrease in productivity.
The long and short of it is if you start looking at special economic zones for
manufacturing, theyre targeting many of the wrong industries, and theyre not putting
enough emphasis on structural reform in the industries that really need it.
On wages, Toyota is leading the way on proposed pay hikes, but will it be enough
to spur consumer spending?

Expectations of continued wage rises are probably more important than just one wage
rise itself. If you have a one-off wage rise and you know its never going to reoccur,
what are you going to do? Youre going to save most of it.
Japans trade balance has improved recently, but how much of an effect can we

expect from a weak yen?

For years on end, Japans trade balances have diminished; even when the current
account was in surplus before the Tohoku disaster, investment income, not trade, was
a greater component. Capital flows, not trade, dominate the current account, and these
flows consist of companies direct investment overseas as well as portfolio investment,
the larger portion. So I would be inclined to agree when people downplay the effect of
the weak yen on exports. That said, the yen plays a larger-than-life role in the Japanese
economy, not only trade but also capital.
Every year you have a weak yen, then results of sales overseas improve (all else being
equal), and if you are a corporate, and dont think the weak yen is going to last for
much longer then you repatriate more. From an investor perspective it means greater
capital gains in yen terms; and on top of that, we also have a decent interest rate
differential, so you have higher currency adjusted gains, and that will persist so long at
the BOJ remains aggressive to other economies especially the U.S.
Currencies are affected by that rate differential as well, so in many ways the weak yen
reflects the rate differential now and expectations for some widening in the future. Of
course, with regard to importers, the weak yen is not a desirable development, but on
the other hand commodity prices have been declining and that has offset a lot of the
losses from importers exposed to rising dollar prices.
Womenomics aims to boost female participation in the workforce, but can it
overcome existing barriers?

I will have to be a bit skeptical. Europacifica presented recommendations for

Roundtable Japan that are presumably going to Japanese parliament, but from what I
can tell a lot of the recommendations fell on deaf ears. If you come up with a new
economic policy, one of the things you do is to survey intensely, gather as much
observational data as possible, then you start thinking about incentives. Nobody has
done this. Youll have to pardon me for being skeptical, but it sounds very glib for the
government to declare a new policy but do none of the groundwork for it.
For example, received wisdom says its due to a lack of childcare facilities. It is highly
probable that this is onedriver, but so far an unsubstantiated one, particularly for those
who claim it is the main driver. Im sure its a driver, but the way you design economic
incentives is to pinpoint as accurately as possible the various (and sometimes
conflicting) drivers of the behavior you are trying to change. The process is not as
complicated as it is made out to be you survey, then you analyze, then you tax
behavior you want to discourage, and subsidize behavior you wish to encourage .
So we are still behind on step one there remain many different analyses that can be
done but are not. Perhaps the analysis is being done somewhere in the bureaucracy,
but the process whereby such analysis influences policy is not transparent. As far as we
can tell, no such studies have been commissioned by the Cabinet Office, and the

absence of this basic step heavily undermines the credibility at all to whatever
Womenomics is meant to be.
Another way of boosting the labor market is immigration are you expecting
any developments in this area?

My worry here is that the plans for increasing immigration still seem below that of the
natural attrition rate from the labor force due to retirement, etc. Were not in a
situation of excessive wage inflation or labor capacity issues, but if reflation continues
we might get there, and if we have an immigration policy below the natural attrition
rate the question is how do we keep productivity going by increasing participation in
the workforce?
Part of this is female participation, but that alone is not enough. Theres probably
politics behind this the vested interests are in regional Japan, which historically has
been and remains politically conservative, and we cant see them giving up their power
for any kind of inclusive policy.
Japan is still a market economy and you dont just tell people to hire more women or
raise wages and it happens you need to give economic incentives, and I dont see any
evidence of anything but poor design of these incentives. Immigration is also one of
these cases politics are standing in the way of the best economic policymaking and as
long as thats the case its hard to find a lot of credibility in that type of policy.
Finally, Japans recent experience is often cited as a prelude for other countries,
such as Europe and even China in terms of aging and deflation. Is that fair and is
there still potential for Japan to get out of this current cycle?

I dont think the two things (Japan escaping its deflationary doldrums and other
countries learning from Japans mistakes) are mutually exclusive. Taking a look at the
lost decades, quantitative easing, and an aging population, there are many things that
countries, particularly developed countries, should be watching out for. This is neither
to say that Japan will be in the doldrums forever or that other countries will perfectly
mimic Japans fate.
But there are many commonalities in the questions raised by economies all over the
world over design of pension systems; worldwide theres been a lot of questioning over
whether current pension and social security systems in the U.S. or Europe are
sustainable. Even in Australia, some question the sustainability of the superannuation
scheme (so far viewed as largely successful).
Given the advanced age of the Japanese populace combined with the amount of
pension outlays and massive debt burden, it is possible that Japan may be one of the
first to experience problems that will become more widespread in the large economies
of the world. How Japan deals with this burden in the future will undoubtedly attract

global attention. Japans predicament is an extreme that provides an example (but

hopefully not a roadmap) for every developed economy with an aging population.
Posted by Thavam