Abe’s Three Arrows Or Japan’s Hail Mary Pass?

“You cannot bring about prosperity by discouraging thrift.”

Margaret Thatcher is said to have carried a piece of paper with this and two other lines attributed to Abraham Lincoln in her famous handbag.

Needless to say, Bernanke is not carrying such reminders in his wallet. The most powerful unelected man on the planet wants people to spend, not save. Our Central Bank wants Americans to spend on consumer products and to spend on “investments”. The latter supposedly creates a “wealth effect”, which in turn encourages the former. This thinking has now caught on in Japan, with a twist.

Broadly speaking, the industrialized world has opted for three different economic solutions to the lingering crisis. One, the US is inflating assets and “temporarily” monetizing public debt. By avoiding a recession at all cost, America hopes to muddle through to the next up cycle.

Two, Europe ( i.e. Germany ) does not mind a recession. Teutonic discipline and short-term pain is needed for long term-gains. Using the currency union, Europe is imposing long-needed structural changes on the laggard countries commonly known as the Club Med nations. Incidentally, France did not get the message.

A third economic policy has recently been initiated by Japan and is best described as “all the above”. The new policy has been dubbed Abenomics. It consists of three “arrows”: fiscal stimulus, money printing and structural reform.

This Time is Different.

Stock markets in the US and Europe keep hitting new highs. Paper wealth is indeed being created even though the underlying economies are not doing as well. The US economy stubbornly refuses to take off, no matter how much fiat money Bernanke throws at it. Europe is still suffering from chronic recession disease.

Therefor some investors are rightfully turning to Shinzo Abe’s Japan. This time Prime Minister Abe has not disappointed, at least not so far. In his second attempt at governing, Abe is showing uncharacteristic boldness. He has managed to awaken animal spirits and Japan has gotten its mojo back. The Nikkei is soaring. GDP is rebounding. Optimism is returning.

For more than two decades, Japan has tried to stimulate its economy with the usual Keynesian programs. But many bridges to nowhere and a record public deficit later, the economy remained in the doldrums. The immediate solution was clear to some veteran observers: devalue the currency. More reform of structural rigidities would help too.


Enter a very unlikely savior. Abe-san, whose first stint as PM did not last a full year, has managed to reinvent himself with a very aggressive economic plan.

First, he launched the usual fiscal stimulus package. This is an old trick that helps the well-connected and lies behind Japan’s 240% debt-to-GDP ratio. This time however, he combined these goodies with a raid on the formerly independent central bank. He put likeminded Kuroda at the head of Japan’s Central Bank with a clear mandate: print money as if there were no tomorrow. Depreciate the yen, reflate the economy and create the now-fashionable “wealth effect”. If needed, buying stocks is permissible too.

Having shot these first two arrows, Prime Minister Abe now needs to accomplish the most difficult part of his strategy. He needs to follow through by making good on the promised supply side reforms. Without reforms, the recovery will fizzle.

According to The Economist magazine, “Mr Abe talks of ending the protection enjoyed by Japan’s farmers, doctors and pharmaceutical companies; breaking open the labour market’s rigidities; improving education; cutting through boundless regulation; opening utilities up to competition; encouraging innovation and spurring business investment.” (1)

For good measure, Abe also threw a few tax incentives for corporations in the mix. All this may prove a challenge. One might doubt that Abe’s “third arrow” will land anywhere near its target. Even the very popular maverick Prime Minister Koizumi failed to implement any meaningful reform. So, what is different this time?

Trans-Pacific Partnership.

Prime Minister Abe needs to follow up on his recent landslide victory in the Lower House with another clear win in the coming Upper House elections. This will give him the undeniable mandate to carry out real reform. Remarkably, he is not hedging his bets. He is campaigning on reforms that will upset his historical constituencies, including farmers. But polls show it might actually work. Japan is fed up with business as usual.

Even a strong mandate could prove to be insufficient, though. Changes come slowly. Entrenched interests are hard to overcome in any democracy, let alone consensual Japan. That’s where joining the Trans-Pacific Partnership (TPP) comes handy. Shinzo Abe has learned from the Europeans.

Remember it was the popular idea of joining the common market that gave European politicians the courage to implement long-needed reforms. Spain, Greece or Italy, for example, had to open up their economies to be part of the club. They privatized companies, slashed tariffs and non-tariff barriers, merged corporations, reduced taxes and social benefits all to comply to the shared ambition of a European union. No politician would have accomplished these changes without committing their country to a higher and popular ambition. When implementing difficult reforms, they had – and still have – the convenient excuse of being forced by the union’s requirement. The ECB is a good lightening rod in hard times. In good times, politicians will know how to take credit.

The Trans-Pacific Partnership is not as ambitious as the European Union. But it is clearly inspired by it. It could similarly be the catalyst to supply side changes.

Economic Growth.

The weakness of the yen is good for exporters. Toyota (TM) or Komatsu (KMTUY) were profitably exporting cars and excavators at 80 yen to the dollar. With the currency hovering around 100, margins are exploding.

For decades, an overvalued currency relentlessly pushed Japanese blue chips to lower their cost base and to increase the value-added element of their products. It was tough, but the hardiest remained competitive. Others lost ground. Today’s devaluation of the yen will rescue some of the latter and put the former in a doubly strong position.

But exporters are not the only winners. Lifted by renewed optimism, the overall economy rebounded at an annualized 4.1% in the first quarter. Consumers are feeling more upbeat too. Be it thanks to gains in the stock market or anticipation of better times and wages, there are strong signs that Japanese consumers’ attitudes are already changing. Corporate investment will follow.

Avoid Banks and Insurance Companies.

Mr. Kuroda is determined to create inflation through a doubling of the monetary base in two years. That’s not good news for bonds. Financial companies replete with JGBs, mainly banks and insurance companies, will have to take large right offs if this scenario unfolds.

Two and a half years ago I wrote about Japanese banks’ addiction to government bonds. (Click here to read.)

I argued at the time that the government was siphoning too much capital out of the real economy. Banks were financing a gargantuan public debt at the expense of the corporate sector. We can expect this trend to reverse now. Kuroda’s Bank of Japan is picking up the slack. Newly printed money will take care of the debt (yes, Japan too can monetize it) and banks will need to redirect their loans to the private sector.

The Kuroda Put.

Japanese stocks have come a long way over the last 6 months. The Nikkei rallied back from the 8,000 level in no time. It reached 15,000 before pulling back momentarily. Such a rally may scare some investors off, but let’s not forget that the Nikkei was trading just below 40,000 a quarter of century ago. It is still 60% below its all-time high reached in 1989. In spite of the rally, the market price/earnings ratio is well below 20. Yet, if the yen drops to 125 to the dollar, today’s earnings estimates will have to be substantially revised up and PE’s will fall.

And then, there is the Kuroda put. Kuroda-san is committed to doubling the monetary base in two years. In the process he will not shy away from supporting the stock market as well as the bond market. QE programs, after all, are about manipulating asset prices. That includes bonds, mortgages, equities and currencies.


Of course, nothing is without risk. The proliferation of fiat money around the world could lead to uncontrolled inflation. The fact that it has not happened yet does not mean we can keep doubling down forever.

Japan does not operate in a vacuum. Highly leveraged hedge funds can momentarily derail the yen’s trajectory. With the carry trade back in vogue, these managers borrow cheaply in yen. They leverage to the wazoo and invest that money in high yielding bonds in a strong currency. When all works fine, they cash in the interest rate differential on top of a currency profit.

Sometimes, as we have seen recently, the one-way bet backfires and they all run for the exit at the same time. How else does one explain the dramatic correction from 103 to 95 to the dolllar in less than a week?

On the political front, one can also expect a backlash in Asia. Chinese, Korean and Taiwanese exporters are all directly affected by the currency war started in Tokyo (or was it earlier in Washington?). It is difficult to believe these countries will sit quietly.

All in all, Japan’s weight in any international fund should be increased. The sun is rising again, albeit over a very cloudy horizon.

(1) “Once More With Feeling”, The Economist of May 16, 2013

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