3 Economic Challenges Japan Faces in 2019

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By Joshua Kennedy

Japan’s economy has struggled with deflation since its bubble economy peaked in
1989. In 2013, Prime Minister Shinzō Abe launched a serious effort, known as
Abenomics, to help end the country’s deflationary struggle. Abenomics has been
structured as a series of stimulus and reform packages.

The 2013 initiative continues to be carried out with three critical factors of ongoing
focus. To bring on a sustained recovery, economists are steadily monitoring: wage
growth creation, the right value-added tax (VAT) rate, and support for appreciating
the value of the Japanese yen.

Fast Fact
In June 2018, real wages marked their fastest annual increase in more than 21 years,
with a 2.8% year-over-year increase.

Wage Growth
Throughout his reign, Abe has placed an emphasis on raising wages for workers.
Continuously pressuring Japanese companies to raise wages for workers, he believes
wage increases create a virtuous cycle of increased consumer spending followed by
higher corporate profits that lead to more latitude for further wage increases. His
policies finally seem to be showing some positive results. 

In June 2018, real wages marked their fastest annual increase in more than 21 years,
with a 2.8% year-over-year increase. Household income also marked its fastest gain in
three years with a 4.4% rise over the same time period. Signs of rising wages are
encouraging for Bank of Japan policymakers, who have long been struggling to
accelerate inflation to an elusive 2% annual target. 

Value-Added Tax
In 2014, Japan increased its value-added tax from 5% to 8% which many economists
believe to be a reason for consumer spending struggles. Japan uses the VAT as an
important source of revenue to help make payments on its enormous amount of
national debt.
As of 2018, the country’s national debt to gross domestic product (GDP) was 238.2%.
While the government would be helped by raising the VAT, it has postponed increases
as a spending stimulus measure. The VAT was scheduled to increase to 10% in 2017
but that increase was postponed until October 2019.

International Monetary Fund chief Christine Lagarde is urging resolutions to ensure

that the VAT tax hike does not hurt the country’s economic growth. Lagarde stated:

We believe that the higher consumption tax will help fund growing health and
pension expenses, and support fiscal consolidation. However, we also
recommend that the 2019 consumption tax increase be accompanied by
carefully designed mitigating measures to protect near-term reflation and
growth momentum. We believe that the fiscal stance should certainly remain
neutral at least for the next two years.

Many economists predict the planned increase might trigger a wild swing in private
demand that will put the brakes on the world’s third-largest economy, as happened in
2014.

The Value of the Japanese Yen

From 2012 to 2016, the value of the yen against the U.S. dollar declined approximately
30%, which was a boon for corporate profits. The decline helped to make its products
more attractive than many of its top manufacturing competitors in Korea, Taiwan,
and China. As a result, its products were more compelling globally.

However, since 2016 the yen has steadily regained against the dollar but its
fluctuations have remained difficult to predict. Analysts at ING point out that the
value of the yen is closely pegged to the geopolitical environment, especially
headlines related to US-China trade ties and emerging market geopolitics.

Abenomics Must Deliver

Japan’s economy is relying on Abenomics to deliver meaningful reform. It has already
reported many milestones including the liberalization of the electricity industry,
participation in the Trans-Pacific Partnership, and the implementation of changes
in corporate governance. However, followers are still expecting more. In addition to
improvements from the three key metrics, economists are also hoping for
improvements in the areas of labor regulation and immigration.

While some great strides have been made, many critics of Abenomics feel the time is
growing short. The exorbitant national debt continues to be a big challenge while
opportunities to postpone big policy decisions are diminishing. As such, many believe
2019 will be a critical year for determining Japan’s global economic positioning.

The Japan Opportunity

Many investors may be looking to capitalize on the potential for Japan to overcome its
deflation problems through the Abenomics initiative. For those investors, two
exchange traded funds (ETFs) have become popular. Both the iShares MSCI Japan ETF
(EWJ) and the WisdomTree Japan Hedged Equity ETF (DXJ) provide the opportunity to
profit from the country’s possible deflation escape. EWJ is not currency-hedged, while
DXJ is hedged.

For those that expect the yen to weaken further, DXJ protects from losses associated
with the currency. Alternatively, EWJ incorporates all of the yen's gains or losses into
its return.