PHOTOGRAPHY BY LORENZO BARASSI
1) Deflation
2) Deindustrialization and hollowing-out
3) Is Japan at risk to fall from net-saver/creditor nation to net-debtor nation?
4) Big government versus reform agenda
Basically, I expect the fundamental trends to improve relatively quickly for corporate Japan. The end of deflation has probably been brought forward while the shift towards more profitable off-shore production is set to accelerate. Moreover, the risk of Japan becoming a net drain on global savings is very small indeed. Japan has the financial and productive resources to rebuild, and to rebuild a better, globally more integrated and capital efficient Japan Inc. At the same time, I am more cautious on policy and social trends and worry that the disaster will turbo-charge the trend toward big government, more cumbersome regulation and higher taxes, at least in the immediate future.
The End of Deflation
Let us first of all look at deflation. Here there is a lot of good news and, in my opinion, the end of deflation will now come earlier than I expected before the disaster. Why? Most important, there has been a very aggressive monetary policy response. The Bank of Japan (BoJ) has not only added unprecedented short-term liquidity, but more importantly they stepped-up purchases of private credit and risk assets. Clear-speak: The disaster actually triggered the long-overdue aggressive monetary ease needed to get Japan out of deflation.
Note here that the BoJ is not acting alone, but in all-out coordination with the Ministry of Finance (MoF). MoF got explicit agreement from G7 to prevent imported deflation from a stronger yen. Japan did intervene in currency markets and the yen has actually depreciated since the disaster as a result. If, as I suspect, the trend of yen appreciation has been reversed, it definitely supports the end-of-deflation thesis.
Make no mistake about the importance of what has happened since the disaster on the policy front: monetary policy has opened up at least three inflationary transmissions channels—credit, assets, and exchange rate. In coming months, base money supply growth is set to accelerate by as much as 15-20 percent, more than five-times the growth rate the authorities tolerated over the past decade. Possible bonus: In my personal opinion the BoJ is likely to agree to directly underwrite part of the reconstruction budget. A switch towards more open debt monetization would send a strong, and much needed, message that, yes, post-disaster Japan is not just business as usual, but a clear start of a new Japan.
2011 is not 1995
There are sharp and fundamental differences between the economic outlook now and the forces that shaped Japan after the 1995 Kobe disaster. Yes, 1995 did mark the start of Japan’s deflation. However, at that time several powerful deflationary forces converged on Japan that were much more important than the Kobe earthquake disaster.
1995 was the start of hard-core labor market restructuring. Lifetime employment contracts were broken for the first time in two generations. Non-wage benefits were cut dramatically–many companies began to sell-off their corporate dormitories and the end of corporate housing started a deep-rooted fundamental change in not just young-workers’ financial well-being, but society at large. Also, it was in 1995 that corporate Japan began to hire part-time rather than full-time workers.
Clear-speak: On top of a cyclical downshift in employment income, Japan’s workers were forced to accept a previously unimaginable structural downshift in lifetime income expectations. This was a highly deflationary cocktail. In contrast, the current disaster is more or less ‘business as usual, (i.e. some cyclical adjustment, yes, but no new employment reality and added downshift to lifetime income expectations). If at all, the cyclical downshift in employment and wages is likely to be superseded by a quick uptick—if, as I suspect, the public-works reconstruction programs start kicking in. Public works construction has been one of the sectors with a very high surge in unemployment. This will now be reversed very quickly, in my opinion. In Japan, the infrastructure rebuilding projects really are “shovel-ready.”
Global Price Level
One final point on deflation: Today, Japan’s general price level is more or less in line with global levels. The Big Mac or Starbucks coffee index, for example, is close to parity, and expert calculations of purchasing power parity come to similar conclusions. In contrast, the mid-1990s saw a Japan with a domestic price level at a 20-30 percent premium to the rest of the world (note dollar-yen levels almost same now and then).
Now recall that in the mid to late 1990s Japan went through radical programs of import liberalization—literally a case of a previously closed economy with a higher-than-global price level beginning to open up. This allowed global price arbitrage in multiple sectors of the economy, fresh fruits to furniture to construction materials and steel. At the same time, this ‘deflationary’ dynamic was reinforced by the relentless rise of global competition. Asian producers in general, Koreans in particular, began to gain market share from their Japanese competitors in global markets.
As a key example, the structural decline of Japan’s consumer electronics industry started around the time of the Kobe earthquake, yet it clearly would be absurd to attribute any form of causality. The demise of Japan’s textile industry also started in the mid-1990s as well, and ditto for Japan’s steel industry, her concrete industry, and, to some extent, even her game software industry, to name just a few of the more obvious examples.
Of course, global competition remains fierce this time around. However, it all started de facto right around the time of the Kobe disaster. The net effect was pushing Japan into deflation. In contrast to the mid-1990s, global trends today are much more inflationary for Japan, in fact so much that most regions of the world economy–Asia, Europe, America–have already started, or are about to start, tightening their monetary policy because global demand is rising faster than global supply. Make no mistake, outside of Japan, the world has already become its most inflationary in over two decades.
Add to these global inflationary tailwinds the aggressive domestic pro-inflation policy push by the BoJ and MoF and you pretty quickly reach the conclusion that the disaster has actually brought forward the existing movement from deflation in Japan, in my view.
Japan Inc. Goes Global
The second Japan mega-trend has been deindustrialization and hollowing out: over the past three years, outward direct investment has been accelerating sharply. Japan Inc.—across all sectors, industry to services to food producers—has ‘followed the money’ and invested more and more aggressively in global production and distribution. Why? Remember, domestic margins in most industries are wafer-thin, while margins on offshore factories, logistics hubs, call centers, or research and design facilities are very high. Several government surveys suggest overseas operations may have profit margins that are on average five times higher than domestic margins. Moreover, long-term growth prospects outside Japan are significantly higher than at home and, finally, the global supply of young, dynamic workers, salespeople, managers, engineers and creators is clearly much more conducive to a high-growth strategy than the natural dynamics offered by Japan’s home demographics.
So in this case, the disaster is likely to accelerate the existing trend, Japan Inc. is set to invest even more aggressively overseas. Investment for growth goes to global, while local investment increasingly focuses on bare replacement and, to some limited extent, on productivity enhancement, i.e. capital deepening, but not much more, in my opinion. The disaster has highlighted everywhere that proximity to customers and markets, as well as global diversification of production centers and supply centers must become a bigger priority.
Indeed, there is a risk that global producers who depend on Japan Inc.’s superb quality of components and products may now demand greater global production diversification from Japanese suppliers. Due to the disaster, Japan country risk has gone up in the eyes of boardroom directors everywhere around the globe. The shift from “Made in Japan” to “Made by Japan” is poised to get turbo-charged now.
What’s good for Japan Inc. is not good for Japan?
If this is right, the net result of this accelerated hollowing out should actually be positive for corporate Japan; trend profit margins should be rising from here. I do not expect corporate Japan will wait for politicians to make up their minds on reconstruction and long-winded discussions about new urban planning designs for the affected area. More likely, corporates will act fast, forced so by the reality of global competition. Note here that the directly affected area is the poor and forgotten part of Japan. In terms of production, employment and value added, the 1995 Kobe disaster affected almost five times more of the national economy than the 2011 disaster. What this does mean is that private sector pressure on politicians to “get it right” and use the disaster as a trigger for change was huge in 1995. Now, all companies are already much more serious about assessing the opportunity cost of not going overseas more aggressively.
Clearly, this sets the bar a notch higher for Japanese policy makers: to counter a likely acceleration in deindustrialization and hollowing out should demand significant changes in rules and regulatory policies, as well as, in the final analysis, a more open and urgent debate about importing labor.
From net creditor nation to net debtor?
The third deep trend we need to consider is Japan’s net creditor status. Could the cost of reconstruction be so high that Japan becomes a net drain on global savings? Worries about Japan beginning to run a current account deficit and thus replying on global savings to fund its budget deficit, rather than funding other countries savings shortfalls, have been around for many years.
Obviously, the need to fund an additional supplementary budget for disaster reconstruction is fueling these worries even more. However, the empirical facts suggest this risk is very low. The shift to offshore production for higher profits has been accelerating, and with it so has the income generated on overseas assets. Japan shows all the signs of successfully becoming a “rentier economy,” living off her highly profitable overseas assets.
Moreover, if, as I suspect, the BoJ does begin to monetize fiscal debt more aggressively, the domestic savings investment gap should comfortably remain positive. Here is a trend that is likely to continue—global finance will worry about it, but the productivity and income of global Japan Inc. keeps on churning out hefty surpluses for the time being.
So on the fundamental economic trend side, I would suggest this disaster is likely to accelerate the trend towards a more global, more productive and more profitable Japan Inc. The flip-side of this development is likely to be reflected in more conservative, more ‘big government’ oriented policies from politicians who see themselves fighting an increasingly difficult battle against the globalization of capital, risk taking and entrepreneurship.
Welcome back, big government
Now, let us try and think about the medium-term policy challenges facing Japan’s elite. Clearly the disaster requires a unified and coordinated policy response. As outline above, first signs are good—the monetary authorities are out aggressively and well coordinated. On the fiscal front, politicians across all parties have pledged to push through a quick and decisive rebuilding program. For now, the deeply entrenched trend of policy paralysis appears to have been broken. However, the content of the response inevitably pushes Japan back down the road of big government and more public sector intervention in private sector affairs.
Specifically, Prime Minister Naoto Kan had actually launched an impressive program seeking agricultural liberalization so that Japan could possibly become part of the Trans-Pacific Partnership (TPP) by autumn of this year. Now that the disaster struck heavy in many farming-only areas, it will take a truly heroic effort to proceed with this very difficult program.
Moreover, the push for higher taxes on consumers—something advocated by the ruling Democrats—is poised to become stronger. Several policy makers have already suggested that part of the reconstruction budget should be funded by abandoning the extra child-support programs implemented by the Democrats last year. Clearly, Japan needs both: more children, and a rapid rebuilding of the destroyed infrastructure. Both work to lift the potential growth rate. In my personal view, Japan has the necessary savings surplus and financial wherewithal to afford both. Taking from Mr. Watanabe to pay for Ms. Suzuki is neither necessary, nor prudent in the current situation. In contrast, an all-out pro-growth strategy would be welcome, including a long overdue fundamental review of Japan’s rules and regulatory framework, in my view.
Will policy be creative, or standard? For example, a simple response to projected power supply shortage in Tokyo could be to enforce daylight savings time. Possibly as much as 5 percent of Tokyo’s power demand could be saved with one simple rule change. Pro-forma, past opposition to this had come from farmers who argued their cows and pigs could not adjust to the change, though in reality the utilities companies naturally prefer to see 30 million people switch on lights earlier rather than later in the evening. Either way, extraordinary times call for creative solutions. Could Japan’s government surprise us?
Yes, Reform dynamism is possible
It would be wrong to be too pessimistic on this front. Within little more than a year after the Kobe earthquake, Japanese politicians led two fundamental policy revolutions—the financial big bang was launched together with a radical program of administrative reform. Both were supported by the main stakeholders; the financial industry, domestic and global, wanted a better system (free, fair, global was the slogan of the big bang). The biggest proponent of administrative reform was the most powerful administrator itself—the MoF. This is because the MoF was very much in favor of more streamlined government, cutting administrative and regulatory red tape, as well as excessive administrative personnel costs.
In the end, the number of central government bureaucracies and agencies was cut by almost 25 percent. Make no mistake, these were radical changes, and there is no question that the bureaucratic incompetence exposed by the Kobe disaster helped focus the minds of the reformers. Chances are that, eventually, something similar will happen this time around as well. Patience.
Changing agricultural policy faces obvious big opposition from agricultural cooperatives, agricultural financial institutions, farmers, etc. However, there are also powerful advocates. Corporate Japan is pushing forward, as they know Japan’s failure to enter the TPP would be a further step towards relegation to second rate nation on the global power stage. Moreover, corporate Japan envisions sizable profit opportunities from supplying high-grade top quality food produce to the increasingly wealthy Asia gourmets. By one expert calculation, Japan could actually run a trade surplus in agricultural products if the right combination of agricultural reform and rural land reform is implemented. Also, the MoF should be much in favor as agricultural subsidies and farm support incur significant costs for the national coffers.
And finally, the impact of radiation contamination on food supply and food security is poised to trigger a positive shift in the domestic debate on food security. Clearly the merits and benefits of more open global sourcing and better quality and lower price global fresh food and produce are being demonstrated like never before as a result of the crisis.
In many ways, the unfolding debate and direction of agricultural policy and TPP may prove the real litmus test for how the country’s leaders respond to the challenges forced upon them by this disaster. Helping and supporting more aggressively to counter the unprecedented human tragedy is the first priority. And rebuilding of hard infrastructures and public services should prove relatively easy. From there, the reform and rethink of soft infrastructure—rules, regulations, as well as economic incentives and public support—is when the real test will come. That’s the real challenge to the “Samurai Spirit” facing Japan’s policy elite after the triple disaster. Chances are good, that the challenges will be met full-on before long. In my personal view, the new Japan will prove to be more integrated globally, more flexible domestically, and led by more decisive policy leaders.
