Towards a real Japanese shake-up
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.