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Abenomics has yet to lift Japan credit quality

Abenomics' third arrow - structural reforms - has yet to hit its mark. Takahira Ogawa, Standard & Poor’s director of sovereign ratings, outlines the challenges.

Is Abenomics working?

The first two of the three “arrows" of Abenomics - quantitative easing and fiscal stimulus - raised the hopes of investors, corporate managers, and Japanese households. A depreciating yen, one of Abenomics' most significant by-products, has improved profits of some major exporting companies, though it hasn't yet generated a strong rebound in overall exports. However, the third arrow - structural reforms - has yet to hit its mark. Though a few initiatives have made a difference, they have been around the margins and haven’t lifted overall growth.

What is the biggest challenge for Abenomics?

Abenomics’ biggest challenge is to balance economic growth and fiscal consolidation objectives. For example, the increase in sales tax on April 1 might slow down consumer spending and thereby slow the growth momentum of the past year. The prime minister could have deferred it but decided to proceed in order to reduce the fiscal deficit instead.

Last-minute consumer spending ahead of the April 1 tax hike boosted Japan’s domestic demand in this year's first few months. However, the higher rate's negative impact on domestic demand will more or less offset that gain. Early indications show a relatively minor dip in retail sales, particularly in department and convenience stores. But sales of big-ticket items such as automobiles might have a harder time recovering to previous levels, after recording double-digit increases since September 2013. Housing construction, which was strong between May 2013 and January 2014, might also take time to recover.

Is fiscal consolidation too late to implement?

Fiscal consolidation in Japan could take a decade or even longer to implement. Total government spending remains high in fiscal 2014 because the government is mindful of the sales tax hike's short-term negative impact. For fiscal 2014, the central government budgeted expenditures of Y96 trillion (19% of GDP). However, revenue is likely to be only Y55 trillion (12% of GDP), even taking into account the anticipated Y4.5 trillion in higher sales tax revenue. As a result, the government will issue Y41 trillion in new bonds (43% of the total budget). No other developed economy finances such a high proportion of its budget.

It will be critically important for the government to use its new tax revenues wisely. Unfortunately, we think that some planned spending will have little economic benefit. For example, some government expenditures are classified as reconstruction related to the 2011 earthquake but have almost no substantive link to reconstruction. Spending on public works won’t assure future growth either because many projects are based on unrealistic cost-benefit assumptions.

If the government fails to maintain fiscal discipline and uses public funds inefficiently, it will be much harder to address Japan’s fiscal problems given how limited its fiscal flexibility is already. That will make the burden of fiscal consolidation in later years much more painful and the already very high debt burden less sustainable.

Why is Japan’s corporate sector important in revitalizing medium-term growth?

Once Japan’s corporate sector started deleveraging, net liabilities of private nonfinancial corporations fell to Y207 trillion (44% of GDP) in September 2012 from Y529 trillion (104% of GDP) in June 2007. During that period, private-sector investment stagnated, which in turn reduced domestic demand. This slowdown in corporate activity and household demand has forced the government to run large fiscal deficits to maintain economic stability.

Most Japanese companies have yet to start actively using their financial assets, particularly for domestic investments, which is another critical issue for both Japan’s economy and the country’s sovereign rating. Some companies could end up using their assets to pay for losses caused by business mistakes. Some could sit on their cash or use only a small amount--and lose their competitive advantage. If too many Japanese companies make such decisions, demand could stay flat, and the government would need to maintain its fiscal stimulus and continue incurring large deficits.

Higher growth could materialise if Japan’s household income improves. But both real and nominal household income has fallen in recent months because many of the benefits of recent economic growth have gone mainly to large exporting companies. Managers of many other companies aren't so sure that growth momentum will continue. So household income could rebound only slowly, even if reasonably good economic trends continue.

What can stimulate the corporate sector in Japan?

Fiscal stimulus will be difficult to maintain considering the government's large deficits. Left unchecked, these will at some point lead to a day of reckoning, such as rising yield on government bonds and the resulting snowball effect on the government debt burden. Aggregate demand in Japan was about 1.6 percentage points lower than the potential supply in the fourth-quarter of 2013, according to the government statistical office’s estimate.

This is why the third element of Abenomics, structural reform, is so important for medium-term growth. The government plans to enact a series of bills during parliament's current session, which will end June 22. These will aim to make employment systems more flexible, for example by extending the deadline by which companies have to convert contract workers to full-time workers; support scientific research and development, information technology, and medical innovation; and promote competition in power industries, among other things. The government has also designated six special economic zones to experiment with liberalizing regulations on various industries or types of activities, and is preparing measures to improve the productivity of agricultural sectors. However, even if the government successfully implements these changes, we expect it will take time before they improve Japan's growth.

What keeps Japan’s sovereign rating on AA- with a negative outlook?

Standard & Poor’s Ratings Services maintains a negative outlook on our 'AA-' sovereign rating on Japan, despite improved economic growth and a nascent trend of much-needed rising inflation and retreating deflation. This is mainly due to Japan’s uncertain long-term economic growth prospects and its slow progress toward fiscal consolidation (reducing its deficits and debt) in the next three to five years.

Predominantly, our sovereign rating on Japan hinges on the success or failure of the economic and fiscal policies of the Japanese government. Since the Liberal Democratic Party-led coalition took office 16 months ago, it has raised popular expectations for Japan’s economy. But such optimism is difficult to maintain, and even harder to satisfy. Indeed, we don’t yet see tangible evidence that Japan will be able to substantially improve its growth and consolidate its fiscal position in the next three to five years.

While the effect of Abenomics remains uncertain, what lies ahead of Japan’s economy and sovereign rating?

At this juncture, it's still difficult to judge whether the Abe government can improve Japan's medium-term growth. We expect that Japan will moderately improve its fiscal position in the next few years, mainly thanks to higher sales tax revenues. However, in our view, that alone won’t put Japan’s finances on a sustainable footing. For example, Japan’s social security system, including the cost of national pensions and national health insurance – which consumes 32% of the expenditures in the general account of Japan’s fiscal 2014 budget - is the single most constraining factor affecting the government’s ability to improve its finances. And there is no specific plan for to deal with this. Therefore, we'll continue to watch for signs of government policies that could improve growth as well as the country's finances. Japan's economy, and its sovereign rating, are riding on both.

The author of this article is Takahira Ogawa, Standard & Poor’s director of sovereign ratings.

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