Forecasting Japan (III): The Failure of Reform

Stratfor Global Intelligence, 30.09.2015


Since the end of the Cold War, the Pacific Rim has seen China rise and Japan stagnate. However, Japan is approaching an epochal shift that will enable it to challenge the current order

As the strategic situation in the Pacific changes, Japan will be forced to adapt. Tokyo will need to pull the Japanese economy out of stagnation and cultivate a dynamic set of new industries while luring back businesses that have gone overseas. Current Japanese Prime Minister Shinzo Abe has an ambitious plan to do just that – but the strategy has so far foundered, and in the long term it will likely fail.


"Abenomics" aims to revive Japan's economy through three measures: monetary easing to devalue the yen, fiscal stimulus, and structural reforms. By devaluing the yen, the prime minister hopes to revive consumer spending by reversing consumer expectations of continually falling prices after years of stagnant-to-negative inflation. A weaker yen would also make Japanese exports more globally competitive and increase the value of overseas corporate earnings repatriated to Japan. Fiscal stimulus will include direct government investment into infrastructure development, defense and other sectors. The measures would also include corporate tax cuts and reforms aimed at stemming the flow of investment overseas while attracting greater foreign investment.

The last set of initiatives, structural reforms, aim to improve worker productivity by loosening the regulation of full-time workers, deregulating protected sectors such as agriculture and power to increase competition domestically, and expanding international free trade agreements, including the Trans-Pacific Partnership. In addition to the "three arrows," the Abe administration is trying to encourage the autonomy and competitiveness of Japan's different regions and cultivate a startup culture.

Abenomics is still in its early stages. The next two years will be critical in determining whether Abe's plan will succeed. But there are numerous factors that will constrain Abenomics and could derail the program completely.

The Japanese economy's most serious problem for the next decade will be high and rising underemployment. For 20 years, this has been the key driver behind declining average household consumption and a drag on consumer spending. Weak consumer spending, combined with expected population decline, limits the Japanese government's ability to boost corporate investment at home.

Each of the arrows has aspects meant to raise employment. Monetary easing seeks to boost the value of Japanese corporate earnings overseas to raise earnings for major conglomerates and free up bandwidth for them to invest domestically if they choose to do so. As part of fiscal stimulus, Abe aims for corporate tax cuts to create stronger incentives for these conglomerates to invest capital domestically rather than put it into savings or reinvest it abroad. Finally, structural reforms seek to ensure that when companies invest domestically, they are free to do so in ways that will maximize productivity and profitability, even if it means cutting back on long-standing workforce privileges.

Insufficient, Unpopular Measures 

This strategy will fail for a number of reasons. The simplest is that Abenomics will not compel Japanese companies to sufficiently expand domestic investment. Companies went abroad to avoid the extremely high cost of manufacturing in Japan, much of it due to high labor costs. China is both a key market for the products produced by these companies and has a strong production base with low labor costs.

To date, Abe's policies (particularly monetary easing) have done as much damage to ordinary Japanese consumers as they have helped, simply because they have raised prices. The main reason that this damage has not politically crippled the administration is that low energy prices have given consumers a boost. Large corporations with overseas operations have benefited from a weak yen, but ordinary Japanese consumers and small businesses with domestic operations have only experienced rising costs. Base-pay hikes at major Japanese companies will help boost consumer spending in the second half of 2015, as will the recovery from last year's consumption tax hike, but given Japan's employment situation it is unlikely that these wage hikes will make a significant, lasting difference in consumption levels. At the same time, demographic decline will drive down the number of potential consumers more quickly each year.

Abenomics will also likely fail to boost domestic investment by Japan's industrial conglomerates. One solution would be to bring in investment from non-Japanese companies overseas. This would require the deep deregulation of long-protected industries, a relaxation of labor controls and the uprooting of deep cultural norms. It would also require Japan's accession to the Trans-Pacific Partnership and the rapid development of a Japanese Silicon Valley. Together, such radical moves could be enough to draw substantial investment away from the United States, Europe, South Korea and China in just over a decade. Such a scenario, however, would need measures much broader by far than anything Abenomics has considered. It would mean a revolutionary break with the post-World War II order and truly profound adjustments. Such changes would encounter substantial opposition from the industrial keiretsu (Japan's powerful integrated business groups) and key electoral constituencies. More likely, overseas investment into Japan will remain around current negligible levels: $2.3 billion in 2013 compared with $135 billion in outbound investment.

Laying aside the need for more ambitious measures, several short-term factors could undermine even the basic reforms that Abe wants to roll out. The Bank of Japan is currently purchasing bonds at a high rate. It is unclear how much longer this can continue before the market tightens to the point of dysfunction. If the Bank of Japan is forced to pull back before inflation reaches the 2 percent target, Japan could experience a return to deflation. If the Bank of Japan's rapid purchase of debt leads to a debt default or some other catastrophic event, it could well trigger the fundamental break in Japan's current order that Stratfor anticipates. However, a default is unlikely.

But more pressing than these financial considerations is the potential erosion of public support for Abenomics and for the administration itself. Without a surge in corporate investment and a hike in full-time jobs to counterbalance it, Abenomics will have primarily negative effects on the population's quality of life. The initiatives would reduce the value of savings, raise the cost of living, contribute to perceptions of rising inequality and leave the workforce vulnerable to layoffs. The last of these will most acutely harm the very corporate employees that form the backbone of the Liberal Democratic Party's "organized vote." The electorate is already uneasy about the prime minister's reforms and many voters have continued to support the Liberal Democratic Party only because the opposition is hopelessly fragmented. Their negative perceptions will only grow given the outlook for corporate investment and consumer spending. Thus, Abenomics in its current form probably will not last beyond 2017.

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