Factors behind deflation and policy responses required of the government and Bank of Japan(No.174 Update)

Japan to see real GDP growth of +1.8% in FY12 and +1.2% in FY13, nominal GDP growth of +1.0% and +0.9%

  • Mitsumaru Kumagai
  • Masahiko Hashimoto
  • Tsutomu Saito
  • Shotaro Kugo


◆Economic outlook revised: In light of the second preliminary Apr-Jun 2012 GDP report (Cabinet Office), we have revised our economic growth forecasts. We now forecast real GDP growth of +1.8% y/y for FY12 (previous forecast: +2.2%) and +1.2% for FY13 (+1.4%). Expansion of Japan’s economy has slowed slightly compared to our previous outlook, and risk of a downswing has increased.

◆Factors behind deflation and policy responses required of the government and BOJ: In this Outlook, we examine factors behind persistent deflation in Japan and investigate policy responses required of the government and the Bank of Japan (BOJ). Contrasting with BOJ’s optimistic price outlook, we anticipate that deflationary tendencies will persist for the time being. Our analysis of core CPI indicates that narrowing of the GDP gap and stable trend of inflationary expectations are factors augmenting prices and that sluggish employee compensation and slower growth of corporate goods prices are factors placing downward pressure on prices. Policies will be needed to increase employee compensation through higher sales and an improvement in the current low labor productivity of the nonmanufacturing sector (stemming from a low capital-labor ratio). Specifically, the policy authorities will need to firmly pursue economic policies to restore the economy centering on four points: (1) there should be consistent policies based on a firm vision (national vision and philosophy) of the top leaders, (2) instead of focusing only on domestic demand and the demand side, economic policies should be implemented that are well balanced and that embrace foreign demand and the supply side, (3) government finances should be rebuilt by raising the consumption tax and reducing expenditures centering on social security costs, and (4) the government and BOJ should work together more closely. Regarding the last, based on an analysis using the Granger causality test, a weaker yen and higher stock prices ensuing from further monetary easing by BOJ would be effective in ending deflation.

◆Examination of Japan’s export competitiveness: Examining Japan’s export competitiveness in comparison with Germany and South Korea, we found that the export competitiveness of Japanese companies has declined substantially centering on the electrical machinery industry. Japanese policy authorities should establish, in a balanced manner, three bulwarks against a strong yen: (1) BOJ should ease monetary policy further to brake the appreciation of the yen, (2) the economy’s ability to withstand a strong yen should be strengthened, and (3) policies should be actively implemented that take advantage of a strong yen. Also, Japanese companies will need to learn how to build brand equity from Germany and how to strengthen marketing power from South Korea.

◆Main scenario for Japan’s economy: Despite the existence of downside risks, as our main scenario we believe that Japan’s economy will continue to expand gradually, supported by three factors: (1) reconstruction demand related to the Great East Japan Earthquake, (2) pickup of the US and Chinese economies, and (3) further monetary easing by BOJ.

◆Risks facing Japan’s economy: Risks that will need to be borne in mind regarding Japan’s economy are: (1) any deepening of the European sovereign debt crisis, (2) a surge in crude oil prices stemming from geopolitical risk, (3) further appreciation of the yen, and (4) the current account balance turning negative in the future. With regard to (1), there is a striking difference between the situation surrounding Argentina in 2002, when the economy recovered dramatically after moving to a floating exchange rate system, and the current situation surrounding Greece. Given its high degree of dependence on exports to EU nations, should Greece leave the euro, its economy can be expected to be dealt a devastating blow. We believe the probability of Greece leaving the euro is between 30% and 40% and of the eurozone experiencing a full-fledged financial crisis between 10% and 20%.

◆BOJ’s monetary policy: BOJ is expected to leave its policy interest rate unchanged through at least FY14. Should concern intensify regarding an economic downturn, BOJ may decide on further easing.

【Our assumptions】

◆Public works spending will grow +6.6% in FY12, and -5.2% in FY13; the consumption tax rate will be increased in April 2014

◆Average exchange rate of Y79.3/$ in FY12 and Y79.0/$ in FY13

◆US real GDP growth of +2.2% in CY12 and +2.1% in CY13

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