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Japan’s turnaround still on solid ground

International investors keenly await Prime Minister Shinzo Abe’s next round of reforms, the ‘third arrow’ of Abenomics

By: TERRY CAIN

Date: May 29,2014

One of the biggest stories on world financial markets in 2013 was Japan’s sudden turnaround. The storied nation broke out of a 20-year slump, thanks to a bold plan to turn around its economy and financial system. But there are now signs progress may have stalled, and investors are wondering whether Japan will be able to keep its momentum in the rest of 2014 and beyond.

Japan was mired in one of the longest economic slumps ever seen for a modern economy. The country’s economic growth began sliding in 1990, after its speculative real estate and stock market bubbles burst. Growth hit zero in 1992, and the nation’s gross domestic product stagnated for a full 20 years.

Japanese officials seemed paralyzed by the country’s multiple challenges, including flat economic growth, increasing government debt, falling trade surplus and the persistently strong value of its currency.

The situation changed in December of 2012 with the election of Shinzo Abe as prime minister. Under his leadership the country introduced “Abenomics.”

Abenomics is a bold, multi-part strategy designed as a response to these challenges. It combines bold fiscal stimulus, aggressive interest rate cuts from the Bank of Japan, and structural reforms to boost Japan’s competitiveness. These tactics are often referred to as the “three arrows” of Abenomics.

The plan has enjoyed significant success. Economic growth has picked up, jumping to an annualized rate of 5.9 per cent in the first quarter of this year. Investors around the world have cheered the moves, with the Tokyo Nikkei stock index soaring by more than 80 per cent in 2013.

“I think the plan is spot-on,” says Eileen Dibb, a portfolio manager at Fidelity Investments who manages three funds: the Fidelity Japan Fund, the Fidelity Far East Fund and the Fidelity AsiaStar Fund.

“Abenomics is a stepping stone to the next stage for the country – a return to economic growth,” Ms. Dibb says. She has been impressed by the progress Japan has been making, but feels there is more work needed on the “third arrow” of Abenomics – structural reforms for Japan’s economy.

Izumi Devalier agrees. Ms. Devalier is the Japan economist at the Hong Kong and Shangahi Banking Corporation (HSBC). “There is still much work left with regard to the third arrow,” she says. “Structural reforms have been disappointing. The reforms announced so far have failed to address the biggest supply side obstacle: labour market rigidity. The government has yet to promote policies to improve the ease of hiring and firing.”

Ms. Devalier says the Japanese government has pinned its hopes on National Strategic Economic Zones, which are considered a way for reforms to be tested before being introduced more widely. She is also looking ahead to a fresh version of the overall government growth strategy in June, with additional reforms including a road map for further tax cuts and changes to the 120-trillion-yen government pension fund.

Ms. Dibb is also looking ahead to the next round of reforms.

“When the next policy initiatives start to come on, people will start to get interested in Japan again,” Ms. Dibb says. “There was a net outflow of foreign investment in the first quarter of this year. There has been a ‘policy lull,’ and international investors are impatient.”

The market stats bear out this point. After the sizzling 2013, the Nikkei stock index is down so far this year.

“Investors are beginning to realize that reform in Japan proceeds at a very slow pace,” Ms. Devalier says.

The biggest recent development in Japan’s turnaround program is a hike in the country’s consumption tax. The move is designed as a way to help bring the government budget into surplus by the year 2020. The impending tax hike caused consumer spending in the first quarter of this year to rise at the fastest pace since 1997. Business spending jumped by the most since 2011. Of course there will be a dropoff to follow, with overall gross domestic product expected to contract in the current quarter. However most experts expect the economy will have enough momentum to recover.

“The effect of the consumption tax has not been as bad as feared,” Ms. Dibb says. “I think over the next quarter or two international investors will take a second look.”

Ms. Dibb favours some specific sectors of the Japanese market. One is retail businesses, especially those focused on the domestic market. “Consumption has been dampened for so long, these businesses are positioned to capitalize as the mind-set changes,” Ms. Dibb says. She also sees some good signs in real estate, and notes that if the yen continues to weaken, the export sector is potentially attractive, particularly autos and machinery.

There is still a chance the Abenomics reform plan could fail, or be abandoned before it can be fully implemented. As well, Japan faces other challenges, such as its aging population and strict immigration policies. But the slump seems to be truly broken, and Japan appears to be on its way to reclaiming its place as one of the world’s most dynamic economies and financial markets.

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