Three Strikes on Inflation Spur Calls for Overhaul of Abenomics

  • Sumitomo Mitsui sees tax hike delay and downgrade risk
  • Japan breakeven rates signal BOJ's 2% target distant

The third time inflation has fallen to zero in Japan this year persuaded some market watchers that Abenomics needs to be taken back for an overhaul.

The government will be forced to delay an increase in the sales tax scheduled for April 2017 and the Bank of Japan won’t be able to taper its unprecedented bond buying as envisaged, according to Sumitomo Mitsui Banking Corp. Only one economist in a survey by Bloomberg from July 27 to Aug. 3 said inflation would reach the BOJ’s goal in its target six-month period through September 2016. A majority of the 37 respondents see the BOJ boosting monetary stimulus.

China’s economic slowdown, tumbling oil prices and a rally in the yen are all conspiring against Governor Haruhiko Kuroda’s effort to reflate the world’s third-biggest economy. While more BOJ bond buying would keep government yields close to record lows, any delays in overhauling taxes and reviving growth raise the risk of a rating downgrade for Japan, which has the world’s biggest sovereign debt burden.

“Deflation is the biggest problem for Japan,” Junko Nishioka, the chief economist at Sumitomo Mitsui, the nation’s second-biggest bank by market value, said in an interview on Aug. 26. “We are entering a difficult phase of balancing the BOJ’s inflation target, Japan’s second sales tax hike and sustaining global economic growth. A delay could prompt a ratings downgrade."

Consumer prices excluding fresh food were unchanged in July from a year earlier, the Statistic Bureau said on Friday. The bond market is signaling that inflation will average around 0.9 percent in the next 10 years, below the BOJ’s 2 percent target, according to the so-called break-even rate.

Japan wants to cut a debt burden that is more than twice the size of economic output, without damaging growth by moving too rapidly with spending cuts or tax increases. A sales-levy hike in April 2014 pushed the nation into a recession and prompted Prime Minister Shinzo Abe to postpone another planned increase until April 2017.

“The fundamental problem is that Japan’s government is struggling to both reflate the economy and establish a semblance of fiscal credibility,” Nicholas Spiro, managing director at advisory firm Spiro Sovereign Strategy, wrote in an e-mail on Aug. 27. “It’s the worst of both worlds: no meaningful growth and no credible fiscal consolidation.”

Japan’s debt is unsustainable and could climb to almost three times the size of its economic output by 2030 unless the government does more to cut its budget, according to the International Monetary Fund. The nation’s primary budget deficit will be 6.2 trillion yen ($51 billion) in the year starting in April 2020, smaller than a projection in February but still not the surplus the government is aiming for.

Global Risk

Stocks worldwide tumbled last week amid concerns that China’s economic slowdown will jeopardize global growth. The Japanese government cut its assessment on the global economy for the first time since August 2012 last week, citing weakness seen in some areas such as Asian emerging nations. Japan’s industrial production unexpectedly fell in July, trade ministry data showed Monday, sapping a rebound in the economy from a slump last quarter.

“Fiscal constraints keep Japan’s reliance on unprecedented monetary easing and that’s likely to continue and make tapering quite difficult,” said Tsuyoshi Ueno, a senior economist at NLI Research Institute in Tokyo. “The economy needs support to weather the sales-tax hike impact while concerns about China weighing on growth may raise pressure against the tax hike.”

The benchmark 10-year Japanese government bond yield has been on a declining trend over the past 20 years despite the nation’s growing debt, driven in part by the central bank’s accommodative policy. The notes, predominantly owned by domestic investors, yielded 0.38 percent on Monday after plunging to a record low of 0.195 percent in January.

Demographic Challenge

“Yields would normally climb if the market sees a retreat in the fiscal rebuilding policy, but if the economy is so bad that the sales tax can’t be raised, monetary easing will need to be prolonged,” said Ueno. “An exit from the current unprecedented stimulus is nowhere in sight.”

Japan also faces demographic challenges, Sumitomo Mitsui’s Nishioka said. Social welfare took up about a third of the budget this fiscal year in one of the fastest-aging nations in the world, while debt redemption and interest payment costs made up 24 percent, according to Finance Ministry figures.

A bright spot for the economy is that Abe’s reflationary policies have boosted corporate profits to a record, leading to the highest tax revenue since fiscal 1993 last year.

“Japan faces ballooning social security costs with the aging and shrinking population,” Nishioka said. “That means it’s essential for the government to bolster inflation and nominal tax revenue through monetary easing to enable financing the pension and medical expenses in the future.”

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