Japan: Domestic demand growth leads the economic expansion

Economic growth in Japan accelerated to unexpectedly high levels in 2017, with GDP growth reaching an estimated 1.7 per cent. The robust economic growth is prompted by the continuously accommodative macroeconomic policy stance, and is led by a rapid expansion of domestic demand. Steady external demand growth from Asia and North America also contributed to the growth.

The present momentum is expected to taper off over 2018 and 2019, as the impact from fiscal stimulus measures ease. GDP is forecast to grow by 1.2 per cent in 2018 and 1.0 per cent in 2019. Consumer price inflation is estimated at 0.3 per cent in 2017, well below the Bank of Japan’s (BoJ) inflation target of 2 per cent. Nevertheless, consumer price inflation is projected to rise to 1.4 per cent in 2018, and 1.8 per cent in 2019, due to upward pressure on wage levels as well as the proposed sales tax hike in October 2019. Despite the Government’s commitment to fiscal consolidation, particularly to lowering its debt dependency, the fiscal policy stance remained accommodative in 2017. The implementation of public investment projects introduced in the supplemental budgets in the 2016 fiscal year provided a significant stimulus to Japan’s economic expansion over the first half of 2017.

The BoJ has continued to maintain a set of unconventional monetary easing measures — Quantitative and Qualitative Monetary Easing (QQE) — and is committed to using the balance sheet to expand the monetary base at the present pace. However, compared to the speed of monetary base expansion, the growth of broad money stock remains sluggish. The year-on-year growth rate of broad money stock, M2, has only gradually accelerated and reached the 4 per cent mark in February 2017 for the first time since August 2015. Nevertheless, the recovery in broad money growth reflects an accelerated growth in bank lending, particularly for investment purposes.

Through its intervention, the central bank effectively set an upper bound on the 10-year Japanese Government Bond (JGB) yield at 0.1 per cent. The BoJ asserted controls over rising yields in the market in February 2017 and July 2017 by announcing fixedrate purchase operations. This intervention measure, known as the Yield Curve Control component of QQE, resulted in a widened yield spread between 10-year JGB and United States Treasury bonds. Over the first nine months in 2017, the yield spread averaged 226 basis points, up by 37 basis points from the 2016 average. This intervention has helped stabilize the value of the Japanese yen against the US dollar. The yen/dollar exchange rate was around 112 for the first nine months in 2017. In 2016, the exchange rate fluctuated between 121 and 100.

Industrial production and operating profits in Japan
Industrial production and operating profits in Japan

Japanese industrial operating profits were strengthened by competitiveness gains related to the lower value of the Japanese yen (figure III.4). Industrial production continued to grow in 2017, albeit at a moderate pace. Estimates for inventories in the second quarter of 2017 signalled the start of an inventory buildup phase, which may last until mid-2018. Rising industrial production, inventory accumulation, and profit growth will support the growth momentum into the first quarter of 2018.

While consumer confidence improved during the first half of 2017, growth in household expenditure was held back by low growth in average real wages. Japanese labour markets have been in a paradoxical phase since 2011. The decline in the unemployment rate has coincided with a decline in the real wage rate (figure III.5). However, the real wage level bottomed out in 2016. The labour market has tightened, as the unemployment rate reached 2.8 per cent in July 2017, the lowest level since 1994. In light of the robust growth in industrial operating profits, real wages will likely come under increasing upward pressure in the coming quarters.

Unemployment rate and real wages in Japan
Unemployment rate and real wages in Japan

The main downside risk for the Japanese economy in the short run is an abrupt appreciation of the Japanese yen. Since the current exchange rate has been bolstered by the BoJ’s intervention, abandoning its yield curve control measure, for either financial or political reasons, could lead to a rapid appreciation of the yen. This would reduce competitiveness, restrain industrial operating profits, and reverse progress towards defeating deflation, all of which would drive GDP growth down. Japan also faces structural challenges that weigh on its potential growth. These include a declining population and persistently high public debt, with limited room to expand tax revenue.

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