Abe’s 3rd Arrow: Flying or Dying?

Abenomics can already take a great deal of the credit for Japan’s recent economic successes. Since Shinzo Abe returned to office, Japan’s GDP has grown by more than 4%, the strongest rate in the G7. And while still shy of the 2% target, underlying inflation has risen to its highest level in more than fifteen years. The hike in the consumption tax in April, meanwhile, represents an important step to restoring health to the public finances. Business confidence, meanwhile, remains high suggesting that the hit to growth from the tax increase will prove short lived.

Given Japan’s woeful economic performance over the preceding 20 years, these achievements are not to be sniffed at. But they are the result of Abe’s first two arrows – aggressive monetary easing and active fiscal policy. There has been a lot less to shout about where Abe’s third arrow is concerned – structural reforms to boost longer-term GDP growth. But is that a cause for concern? And with the latest structural reform strategy approved by the Cabinet today, is the third arrow now about to fly?

Slow progress in launching the third arrow was inevitable and in some ways desirable. Generating sustainable economic growth and inflation had to come before tackling many longer-term structural issues – and that was the job of the first two arrows. But, as noted yesterday by Kuroda, recent growth means that diminishing spare capacity should soon generate wage and price pressures. So, a ‘golden opportunity’ arguably now exists to press ahead with measures to boost potential growth.

But it is also not entirely fair to suggest that the government has been inactive. Admittedly, there has been far more talk than legislative action. But having set numerous worthy high-level targets, recent months have seen modest progress. There have been initial reforms to the electricity sector and corporate governance, the establishment of six strategic economic zones, and, in April, a first reduction in the corporate tax burden via the abolition of the reconstruction levy. These represent baby-steps in the right direction.

The latest third-arrow strategy has the potential to go much further. In particular:

  • Reforms to the GPIF public pension fund, not least to increase the share of investments in higher-risk/return assets, including in firms with higher governance standards, could improve the allocation of capital and help push investors out of their deflationary mind-set. 
  • Further attempts to improve corporate governance should help promote improved profitability and increased incentives for firms to put their absurdly high, and ever-increasing, stock of deposits to better effect. 
  • A commitment to cut the combined corporate tax rate over coming years from one of the highest in the OECD by about 5ppts, to the German equivalent rate close to 30%, would reduce one disincentive for firms, particularly foreign-owned, to invest in Japan.   
  • Efforts to boost labour supply – of female workers through increased child-care provision and tax changes, and (remarkably) foreign workers in certain sectors – could alleviate slightly the 0.5ppt negative drag on annual GDP growth from adverse demographics. 
  • Agricultural sector reforms, including to land-ownership rules and the stifling role of co-operatives, could help to shake up one of Japan’s most moribund sectors, while also helping to facilitate broader trade liberalisation under the Trans-Pacific Partnership (TPP) – probably the most powerful way to boost productivity across the economy.

Of course, we would not pretend that the strategy offers a text-book approach to reform. And it merits familiar criticism. Most notably, the commitments remain predictably vague and the devil will be in the detail. In many areas, political obstacles to meaningful progress – notably the influence of the agricultural lobby – have yet to be resolved. Any TPP deal, meanwhile, is ultimately out of Japan’s hands with political barriers in the US arguably as high as those at home. Practical constraints persist too, not least how to find the extra revenues to fund meaningful reduction in the corporate tax burden without jeopardising fiscal sustainability. And many other desirable measures – such as a significant easing of job protection legislation – remain taboo.

Nevertheless, the broad thrust of Abe’s strategy is in the right direction. And given Abe’s continued strong popularity its goals are achievable too. If the measures are implemented in the right way over coming quarters, they might well boost investment, employment and productivity – and hence GDP growth – over coming years. And by helping to boost confidence and demand too, they need not be deflationary.

Structural reforms do not deliver short-term growth miracles - that remains the job of macroeconomic policy. But if Abe’s third arrow is indeed now set to fly a little further, there is the potential for trend GDP growth to rise back above 1% per year eventually. And, given some of Japan’s knottier structural problems – not least its ageing population – that would be a further notable achievement for Abenomics.  

Abe’s 3rd arrow: Selected policies

Growth Strategy June14

Source: Office of the Japanese Prime Minister and Daiwa Capital Markets Europe Ltd. (Click to view chart at full size)

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