Saturday, April 20, 2013

Can Japan break the deflation cycle?

With deflation the major drag on growth and the biggest long-run economic threat, pressure was growing on the Bank of Japan to respond. And it did – with yet another round of quantitative easing and by announcing an inflation target of 1%. But then, are these measures enough to bring the Japanese economy back on track?

At a time when major economies across the globe are finding it hard to rein in galloping inflation, the Bank of Japan (BoJ) has stunned the world by announcing its intention to hit a newly established (for the first time ever) near-term inflation target of 1%. Economic growth, currency devaluation, or drag on productivity: what’s the motive?

The reason is simple. To break the deflation cycle and a strong yen, both of which have been choking off Japan’s economic growth over the past 15 years. In fact, the two problems are interconnected. Typically when central banks pump liquidity into markets following recessions, businesses and consumers borrow, growth picks up and eventually inflation rises. This is not the case in Japan, where deeply entrenched deflationary expectations and other factors weigh on loan demand. The combination of deflation in Japan and inflation elsewhere pushes up the purchasing power of the yen relative to other currencies. A strong yen in turn weighs on exports, the main driver of growth in the Japanese economy. And that’s exactly what is happening in the “Land of the Rising Sun”. Japan’s economy shrank for the third time (between October & December 2011) in the last four quarters. The first estimate of Japan’s fourth quarter GDP showed the economy contracted 0.6%, significantly worse than consensus forecast of a 0.3% decline. This is equivalent to a 2.3% fall in GDP on an annualised basis. Further, while Japan’s monthly trade deficit widened to ¥613 billion in January, following December’s ¥569 billion shortfall, yen sits high at ¥80.30 against the dollar.

Sadly, deflation also adds to the real burden of public debt, which is a major problem for Japan. With a public debt figure to GDP ratio hovering around the 200% mark (The Bank of International Settlement projects that even under “a best case scenario” Japan’s debt could zoom past 400% by 2040!), its situation is worse than even the most recent citadel that fell – Greece. Interestingly, all the while the country’s GDP hasn’t moved an inch. Japan’s nominal GDP is almost the same as it was about 15 years ago ($5.58 trillion today as compared to $5.24 trillion in 1995). Unbearable debt amidst close to zero growth in over 15 years puts Japan in an awkward macroeconomic situation!

Thus, to get out of this status quo Japan is once again relying on a technique called quantitative easing (QE). As opposed to flooding the money supply with newly printed currency, the BoJ has announced to pump 10 trillion yen ($130 billion) into the economy through purchases of government bonds by the end of 2012. But while the QE will lift the supply of money, policymakers face a greater challenge in trying to get households and businesses to borrow. So, will the BoJ’s latest move succeed in breaking the deflation cycle?

Previous bouts of quantitative easing and currency intervention did not have a sustained downward impact on the yen, lift inflation, or provide a meaningful boost to the real economy. Agrees Matthew Circosta, the Sydney based Economist at Moody’s Analytics as he tells B&E, “These policies have been rendered useless because of the deflation mind-set embedded in Japanese consumers and businesses.” Excluding the oil-induced inflation spike before the 2008 crisis, core inflation hasn’t reached 1% since 1997.


Source : IIPM Editorial, 2013.
An Initiative of IIPM, Malay Chaudhuri
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