The Dark Side of Abenomics

Ever since Japanese Prime Minister Shinzo Abe took office, investors have cheered “Abenomics,” his plan to end Japan’s long-running funk through fiscal stimulus, monetary easing and structural reform. Japanese stocks are up 22.5% since the December 16 election, and the world’s eagerly waiting to see how incoming Bank of Japan (BoJ) Governor Haruhiko Kuroda does “whatever it takes” to reflate the yen.ⁱ

Yet all is not sunny in the Land of the Rising Sun. For one, it’s not clear how successful Abe’s plans will be: Structural reform—the lynchpin to future economic success—is on hold, and he’s deferring policy proposals to new committees dominated by keiretsu chiefs (the old guard of Japanese commerce and the source of many of its latent problems). And now, it seems, his plans for aggressive monetary stimulus are bringing an unforeseen side effect: The Government Pension Investment Fund (GPIF) is considering rebalancing away from Japanese bonds.

On the surface, the potential rebalance seems innocuous enough. The fund, which has a roughly 60% weighting in Japanese debt, has long sought to boost returns, and increasing its holdings of so-called “risk assets” is one way to do that. Problem is, that’s not what GPIF’s considering. According to fund President Takahiro Mitani, the board doesn’t plan to increase the fund’s risk profile—they likely won’t swap bonds for stocks. Instead, they’re eyeing overseas investments with roughly the same risk profile as Japanese sovereigns (developed-world water and rail-infrastructure assets), but better yield potential.

In my view, that’s a tacit indictment of Abe’s monetary plans. Until now, GPIF, Japanese banks and other domestic investors have found Japanese debt perfectly satisfactory. Nominal yields may be ultra-low, but real yields are fine thanks to deflation. Once the yen reflates, however, that changes, and Japanese sovereigns look a lot less attractive—especially considering GPIF may have to pay higher benefits once prices start rising. Higher interest rates might make newly issued debt desirable, but this would hurt the total return of the fund’s existing holdings. GPIF could very well be trying to lower its Japanese debt exposure before this happens.

And if GPIF does this, banks could follow. Japanese banks own about ¥162 trillion in government debt (¥278 trillion if you include the state-run banking behemoth, Japan Post)—roughly 12% of the total outstanding. Like GPIF, banks will need to provide customers a higher rate of return once the yen reflates, and to do this, they’ll likely have to diversify away from Japanese debt. One happy consequence would likely be higher lending—banks’ tendency to park funds in Japanese debt and at the BoJ as excess reserves instead of lending enthusiastically bears much of the blame for persistent deflation. But it would also rob the Treasury of a key funding lifeline.

Since the 1980s, Japan’s debt has skyrocketed to about 230% of GDP (that’s what successive rounds of fiscal stimulus will do, absent private-sector growth). So far, the total burden’s been relatively manageable—domestic demand is high thanks to the banks, GPIF and others, and yields ranging from 0% to 0.7% on 2- to 10-year bonds make debt service plenty affordable. For the moment, Japanese debt isn’t the ticking time-bomb so widely feared—Japan’s not Greece. But if rising inflation causes domestic demand to falter, or if yields rise and debt service becomes more expensive, the Treasury will be in a sticky situation.

At some point, if they haven’t already, Abe, Kuroda and Finance Minister Taro Aso will likely realize this, and they’ll have to make tough choices about their aggressive easing plans. And if they act prudently, those hoping for massive monetary stimulus will be mighty disappointed.

On the bright side, that doesn’t mean all is lost for Japan—there is a way back to growth, and one that shouldn’t wreak havoc on Japanese bonds. Structural reform: Addressing waning productivity, weak demographics, narrow labor markets, high barriers to market entry (caused by a negative feedback between keiretsu monopolies’ bank holding companies and unprofitable subsidiaries), outdated agricultural policy and state-owned companies—all of which have hindered growth. Reform won’t bring economic improvement overnight, but over time, it should help boost the velocity of money—the real culprit for Japan’s deflation. And as money flows faster and economic activity picks up, the private sector should get a new lease on life, with dynamic new firms and entrepreneurs taking over for aging, stagnant, unprofitable keiretsu subsidiaries. Sustainable economic growth would return to the former Asian powerhouse, and that economic prowess would keep investors plenty confident in the sustainability of Japanese debt, buying the government time to get fiscal policy in check and embark on a credible long-term debt reduction program—ideally, one where high growth would beget higher tax revenue without a hike in rates.

This may seem like a pipe dream, but I can’t help feeling the paradigm in Japan may be shifting a bit. With 70% approval ratings, Abe has more clout than any Japanese Prime Minister since Junichiro Koizumi, and structural reform, though dormant, is on his agenda. That agenda may be beholden to the keiretsu for now, but in other aspects, he seems willing to modernize: He’s joined Trans-Pacific Partnership trade talks, and he’s suggested he’ll be willing to drop many of Japan’s long-standing tariffs to join the trade bloc. Until now, entrenched agricultural interests have prevented Japan’s leaders from dropping trade protections. If Abe can turn the tide here, he can likely do the same in Japan’s corporate sector—provided he has the appetite. I have a hunch shrinking demand for Japanese sovereigns would give him that appetite. Whether he gets it before Japan’s revolving prime ministerial door turns again is another question—but Abe seems to have learned from mistakes during his first term. He just might have some staying power this time.

It will take months—even years—to see how all this plays out, but one thing’s for sure: Japan’s getting mighty interesting.