Notes from Nippon: May-Jun 2014

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During our recent Japan visits , we held discussions with policy-makers, private sector corporates and investors, academics and think tanks, alongside our participation in the Roundtable Japan conference.  We provide below summary highlights of our key observations following the trip:

The consensus on Abenomics: As we posited in November 2013 (for those who did not see the original presentation), the success of Abenomics is path-dependent, and policy credibility determines the path.  It seems as though the consensus is starting to acknowledge this path-dependency.  As such, even the numerous optimists seem aware of the asymmetrical tail risk associated with the first arrow (monetary). Concerns arise specifically when in regard to debt monetization and its impact upon perceived policy commitment. Optimists prevail among financial market players, though a minority of market economists are much more cautious.   As such, even the optimists are at least receptive to notes of caution, though are divided in their capability to model the risk.

Japanese policy-makers on the balance express confidence so far that the policy mix has demonstrated an unexpected degree of success so far (thanks to appreciation in risk asset markets) alongside the credibility boost offered by the (so far) uneventful implementation of the April consumption tax hike from 5% to 8%.

Why the current account hypothesis for USDJPY just isn’t useful
While watching overseas developments, policy-makers are now less concerned about forex levels than other factors influencing global markets.

Flows: foreign investors, Japanese firms M&A: I posited in 2012 that Japanese firms’ domestic M&A bears better return in subsequent years than overseas M&A.  As corporate Japan has started to take advantage of recovering risk appetite, low yields and yen strength to invest abroad, opinions on valuation of Japanese overseas acquisitions among listed firms have now begun to diverge substantially between foreign investors in listed Japanese stock and private equity/venture capitalists.

Academics emphasized the correct estimation of one particular factor, alongside the importance of BOJ forward guidance alongside lengthening maturities of BOJ bondholdings in the “qualitative” portion of QQE.

Tighter jobs and inflation: From a macro standpoint, the consumption tax hike appears to have lent firms additional pricing power, even as they face a looming skill shortage, particularly in the services sector.  It is possible that policy-makers might have over-estimated potential output, and hence economic slack.

Output gap: We have discussed at length the most appropriate measure of the Japanese output gap (for policymaking purposes) and posit that this measure is likely the most appropriate to consider as a monetary policy input.

 

What really matters: focus on credibility amid uncertainty, expectations
Again, amid arguments regarding the pros and cons of Abenomics thus far, we noticed that many financial market players have once again brought into question the ability of private sector economists’ forecasts to provide new information on expectations (above and beyond those already contained within financial markets).  Surprisingly, academia weighed in strongly on one important issue upon which we remain fixated, namely how to handle the tail risk in the context of increasingly divergent potential outcomes.

One policy maker posed this question in regard to productivity in high-productivity tradable sectors.

We discovered while speaking to academics and BOJ researchers one series containing an historically significant expectations indicator, which might likely prove unexpectedly important in the BOJ’s policy decisions.

 

Structural reform and productivity:  Our own in-depth research of Japanese total factor productivity demonstrates the widening gap between the manufacturing and services sector (alongside one even greater sectoral gap).  This gap could be one of the greatest candidates for change, so long as recovery remains intact.  As one private equity investor points out, protecting under-performing sectors might have been wise in deflationary times (to keep unemployment from ballooning) though as reflation returns the need for productivity to restrain costs could present an argument for reform in the worst-performing sectors.

Actual measures of structural reform:  We also spoke to buy-side investors about the difficulties facing the scope rather than the likelihood of GPIF reform.  Likewise, one policymaker expressed similar doubts (on implementation rather than likelihood) of perhaps the most touted structural reform measure to date, agricultural reform.   The greater likelihood of realpolitik meanwhile returning to Japanese energy policy remains for us one potential upside factor.  Meanwhile, we presented a roadmap for greater female workforce participation and leadership with the objective of enhancing Japanese potential output.

Contact tfp@europacifica.com for in-depth analysis of Japanese total factor productivity by sector.

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