To­wards a real Ja­panese shake-up

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

In­ter­na­tional in­vestors, oth­er­wise dis­posed to em­brace Ja­pan’s re-rat­ing story, face a real dilemma. Al­most 30 months af­ter Shinzo Abe launched his bold re­fla­tion­ary ex­per­i­ment, Ja­pan’s eq­uity mar­ket has more than dou­bled in value and the yen (on a trade-weighted ba­sis) has de­val­ued by -30%. And yet, through­out this pe­riod, eco­nomic growth has con­tin­ued to dis­ap­point. With two sig­nif­i­cant re­forms in the off­ing, we reckon that could be about to change.

Given that Ja­pan has a shrink­ing work­force and a highly in­debted gov­ern­ment, there was never any real prospect of a swift re­turn to growth. What was needed was rad­i­cal struc­tural re­form, of the type hyped up by Abe at the out­set of his term as a “third ar­row”. Ab­sent an eco­nomic cri­sis, this proved hard to achieve and Ja­pan has con­se­quently mud­dled along with­out ever grasp­ing the net­tle of change en­vis­aged in Abe’s grand re­vi­tal­i­sa­tion plan. A po­ten­tial gamechanger is the likely im­mi­nent agree­ment on the US-led Trans-Pa­cific Part­ner­ship (TPP) trade deal. With Congress hav­ing granted Pres­i­dent Obama trade pro­mo­tion author­ity, it seems in­creas­ingly likely that Abe will be able to se­cure an agree­ment in time for his US visit which takes place this week­end.

The im­por­tance of the TPP to Abe’s broad re­cov­ery plan can­not be over­stated. Its sig­nif­i­cance lies in be­ing able to break down bar­ri­ers to trade in ser­vices and re­lated in­vest­ment.

As with any ma­ture econ­omy, Ja­pan’s best growth op­por­tu­ni­ties lie in ser­vices, which also hap­pens to be the most pro­tected and least ef­fi­cient part of its econ­omy. A TPP deal could un­lock much needed pro­duc­tiv­ity gains across great swathes of fusty crusty Ja­pan: one do­mes­tic think tank es­ti­mates the im­pact of TPP on in­creased for­eign di­rect in­vest­ment, higher ser­vice pro­duc­tiv­ity and stronger ex­ports will re­sult in an­nual GDP growth ris­ing by 0.5-0.7pp.

The good news is that the stakes are ev­ery bit as high for the US. A set­back will be a ma­jor blow to its weak­ened for­eign pos­ture in Asia. De­spite an avowed pivot to the re­gion, most re­gional ac­tors see a na­tion that is pre­dis­posed to dis­en­gage rather than lead. Wash­ing­ton’s rather petu­lant ob­jec­tion to the Bei­jing-led Asian In­fra­struc­ture In­vest­ment Bank seemed to con­firm China’s sta­tus as the lead­ing player in the re­gion. As such, Wash­ing­ton has a huge in­cen­tive to make a deal stick which would draw Ja­pan and a broad group of Asian na­tions into a mul­ti­lat­eral sys­tem dis­pro­por­tion­ate in­flu­ence over rules in­vest­ment.

The other big pos­i­tive is gov­er­nance re­forms at Ja­panese firms, which are them­selves partly the re­sult of the TPP ne­go­ti­a­tions and Ja­pan’s at­tempt to pre­pare it­self. The change in be­hav­iour in Ja­panese board­rooms for once looks to be real—last year saw com­pa­nies in­crease div­i­dends by 19%, while share buy­backs rose by 55%. Such ini­tia­tives may where it of trade has and not have an im­me­di­ately ben­e­fi­cial im­pact on pro­duc­tiv­ity, but the pur­suit of higher re­turns on cap­i­tal, and hor­ror of hor­rors, share­holder value, au­gurs well for im­proved cap­i­tal al­lo­ca­tion. Ul­ti­mately, such a vir­tu­ous cir­cle of re­form lead­ing to in­creased ROE is one way to break out of the de­fla­tion­ary trap.

In this re­gard, Ja­pan has long paid a high macroe­co­nomic cost for cor­po­rates hoard­ing cash. Over the last decade, listed com­pa­nies’ cash-on-hand av­er­aged a re­mark­able 40% of their mar­ket value. That is a full 13pp higher than even thrifty Ger­man firms, which rank next among G7 coun­tries. New board­room be­hav­iour is be­ing driven by re­forms such as the rec­om­men­da­tion for com­pa­nies to have at least two out­side di­rec­tors.

An­other pow­er­ful tool to change be­hav­ior has been the launch of the JPX-Nikkei 400 in­dex, where com­pa­nies are screened on the ba­sis of ROE and other met­rics con­ducive to im­proved share­holder re­turns. Agen­cies such as the Gov­ern­ment Pen­sion Fund are us­ing this in­dex as a tool for stock pur­chases and now pri­vate sec­tor life in­sur­ers are fol­low­ing suit, which ups the in­cen­tive for com­pa­nies to gen­uinely man­age in the in­ter­est of share­hold­ers.

It is too early to judge whether plans to re­duce cash hold­ings will trans­late into in­creased spend­ing and in­vest­ment. How­ever, we find it en­cour­ag­ing that cor­po­rate cash de­clined in 1Q15 for the first time in more than two years. If Ja­pan can sus­tain both struc­tural re­form, via trade lib­er­al­i­sa­tion, and on­go­ing gov­er­nance im­prove­ments it is pos­si­ble that the com­bined ef­fect of th­ese mea­sures morphs into a ben­e­fi­cial cy­cle of ris­ing wages and i mproved in­vest­ment. As such, we could fi­nally see the orig­i­nal prom­ise of the Abe­nomics pro­gramme be­ing de­liv­ered.

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