Japan 2014: Abenomics arrows up in the air

The Japanese anti-deflationary revolution has completed its first year, one in which a radical shift in policies has led to a fresh yet still uncertain economic chapter in the country, characterized by the firm conviction that a 20-year + vicious deflationary cycle can be beaten and sustainable growth achieved.

Are the 3 arrows of growth headed to target?

The introduction of Japan’s Grand Plan in 2013 saw a surprising spurt of strong growth in the first half of the year, with Q2 up at an annualized rate of 3.8% , only to see momentum running out of steam in Q3 – down to +1.9% on a yearly basis - as exports and consumer spending started to show signs of weakness.

Prime Minister Shinzo Abe’s government has been able to stimulate the economy by introducing what is known as the 3 Abenomic arrows of growth, a courageous strategy intended to break away from a 2-decade long deflationary drama.

In general terms, the 3 arrows are described below.

Firstly, the BOJ vowed in April to double the monetary base in 2 years, committing, under its current policy, to become the buyer of 7 trillion yen (almost $70 billion) of JGBs a month, which equals to a staggering 70% of new government debt issuance.

Secondly, fiscal stimulus, amounting to around JPY5 trillion, and tax cuts, worth ¥1 trillion to boost business investment, were introduced, aimed at counter-attacking the possible recessionary effects that a 3% consumption tax rate hike (part of its third arrow) may have next year.

The ‘third arrow’ of Abenomics is by far the most challenging of all, as Japan will have to combine fiscal consolidation (including the approved sales tax) with economic structural reforms, and here is where most of the risks are, as a wide range of elements need to align in order to create the virtuous wealth cycle Japan's Prime Minister Abe so enthusiastically believes on.

Achieving its projected economic status, Japan faces a tough and perilous road in 2014, one in which the ability to create real core inflation, but most importantly, change the country’s mentality on wage growth, will play a critical role to boost Japan's economic engine. Below, we break down these themes one should pay attention to for 2014, with the outcome of each being critical to decipher a still uncertain ‘Abenomics’ puzzle.

Inflationary expectations hit a wall of reality

As previously noted, the BoJ is confronted with a tough mission ahead. Economic growth slowed sharply in Q3 and while inflation hit a 5-year high - mainly on non-core items such as energy and to a lesser extent food -, it remains significantly short of the BOJ's price target, but most importantly, the outlook is weakening and supporters at the helm of the BoJ have taken notice. The latest insights into monetary minutes outline growing signs of disbelief by some board members that the ambitious inflation targets may not be achieved in the stipulated 2 year time-frame.

While it has been less than a year since the Bank of Japan announced its radical shift in monetary policy, 3 out of 9 BoJ board members disagree in relation to the agreed 2% inflation target in a 2 year time-frame, a sign which sends a negative message to the markets, as the task to beat deflation is now perceived as more arduous than previously anticipated.

According to the WSJ: "Three of the nine members on the BOJ board have doubts about whether a 2% inflation rate can be achieved over the next two years. Board members Takahide Kiuchi and Takehiro Sato are both former private-sector economists, and they oppose the economic forecast that says there is a 'high possibility of the Japanese economy achieving a price increase of around 2% over the latter half of the projection period.' By the end of 2014, these views have strengthened, if anything. There is also a wide consensual view among economists on the same ' inflationary over-optimistic' line of thinking.”

Japanese wages must rise - Watch the ‘spring offensive’

Another headache for Abenomics is the historical low growth of Japanese wages, which makes the accomplishment of price targets even harder, as without pay increases, households’ purchasing power will weaken gradually. During 2013, Japan’s salaries remained depressed - the most since 2010 -, resulting on lower confidence for sustained inflation to be achieved as it creates a potential squeeze on households, as mentioned. What is more, the planned 3% sales tax hike next April 2014 is thought to contract consumer spending by over 4%, despite Prime Minister Abe’s commitment of a 5 trillion yen in stimulus to support any setback.

Etsudo Honda, a close aide to Japan's PM Abe has been repeating in varies occasions how wage gains are essential for the success of Abenomics, noting "companies should raise wages more than 1% in 2014." In order to provide incentives for companies to increase salaries, Honda advocates for corporate tax cuts of around 29% to help bolster growth, but Prime Minister Shinzo Abe has yet to introduce legislation on this important matter.

“The key for the success of Abenomics is whether companies will raise wages,” Norio Miyagawa, a Senior Economist at Mizuho Securities Research and Consulting Co. in Tokyo, said, cited by Bloomberg. “Companies still aren’t confident enough that growth will be sustained and will probably hesitate to raise wages, especially base salaries, for the time being.”

Willingness for wage increases, however, have so far hit an ungenerous corporate's executive wall. A Bloomberg article from Nov 26 speaks by itself:

"A Nikkei survey of chief financial officers from 241 listed major companies released Nov. 25 tells the story. Companies are flush with cash, but are reluctant to share it with workers. Executives are plenty keen on capital spending and research and development, but not on upping salaries. The bad news: Only 7% of respondents said they may use some of these reserves to raise salaries. "On the whole, however, major companies remain cautious about upping wages," Nikkei said. And for that, Abe must bear some of the blame, as roughly half of CFOs believe his government's green light to raise consumption taxes from 5 percent to 8 percent in April will hurt bottom lines."

Negotiations between trade unions and corporate's management teams to increase salaries, known as “shunto,” or the spring wage offensive, will take place around March 2014, a key phase on the Abenomics plan. Jerry Schiff, the IMF mission chief for Japan, said earlier in 2013 that the negotiations “will be one clear point at which there is a chance to either show that something new is happening or raise further doubts; It’ll be important to get wages to begin to rise soon.”

Another critical change is the introduction of labour deregulation, however, as Economic aide Mr. Honda notes: “Next year will be too early for us to decide; we need another one and half years so we can at least get out of deflation and reach an inflationary macroeconomic environment, then the conditions would be ready for us to revise regulations that protect regular staff.”

The BoJ stance – JQE2 chatter on the rise

Bank of Japan Governor Kuroda has pledged to do all within its reach in order to meet inflation targets. However, since the introduction of Japan's new era of cheap money practices, they have remained in a 'wait and see mode', simply maintaining the monthly pace of asset purchases until carrying out further studies over the impact that the sales tax increase may have on consumers.

That means that in the short term there is no sense of further easing being imminent until mid/late Q2 2014, time when major policy announcements are expected to be made. The board might start to consider fresh stimulus, the officials with knowledge of BOJ thinking say, if data from July onwards shows that the tax hike is hitting the economy harder than expected.

"Easing too soon would destroy the BOJ's current QE framework, which is based on the assumption the bank won't act incrementally," the former top BOJ official said. "They won't move now, but they will before the April consumption-tax hike," former BOJ board member Nobuyuki Nakahara, a confidante of Prime Minister Abe, told Reuters. "I think they'll want to do them as close together as possible."

What lies ahead for the Yen?

The ability for the Japanese currency to continue its sustained weakness path will be very much dependable on the next set of monetary policies announced by the BoJ in 2014.

At this point in time though, with prospects of inflation growth failing to meet expectations, the risks for the BoJ to engage in a longer-than-expected easing cycle, dubbed "JQE2", continues to see Yen risks skewed to the downside.

Technically, it is worth highlighting that USD/JPY saw what many technicians in the Far East may have perceived as the ultimate confirmation that the Yen bear trend is one to stay for the years to come, after the pair finally broke a monthly bearish kumo cloud, a technical development not seen since 2007.