Japan Gains Speed, But Sales Tax Hike Will Test Changes

Bolstered by record profits, Toyota Motor (TM) recently agreed to lift base pay for Japanese workers for the first time since 2008. The average employee will earn an extra 2,700 yen, or $26, a month — a small amount, but a sign that Prime Minister Shinzo Abe’s bold reforms continue to take root, if unevenly, after two decades of economic stagnation.

Fourteen months into one of the world’s most ambitious economic experiments, “Abenomics” gets mixed albeit cautiously optimistic reviews. But a key test looms next month, when Japan’s sales tax begins to rise.

Most analysts expect the economy to falter, though after years of deflation Japan sorely needed some kind of jolt.

Three Arrows

“This is a seismic shift in the history of Japan,” said Allen Sinai, chief global economist for Decision Economics.

“To me, it was a do-or-die situation. Japan knew it was becoming a fading presence on the world stage. The land of the rising sun had become the land of the setting sun.

Abe took office in December 2012 promising to enact a multipronged strategy of monetary, fiscal and structural reforms, often called the “three arrows.” Working with the Bank of Japan, he also set an explicit 2% inflation target.

The first arrow, monetary policy, has flown “straight and true,” as Robert Kahn, senior fellow at the Council on Foreign Relations, wrote in a December note.

The central bank pumps money into the economy at a yearly pace of $589 billion to $687 billion. “If you’re going to support growth, it’s better than fiscal spending,” Kahn said in a recent interview.

In fact, Japan’s ability to lift the economy via fiscal policy is mostly tapped out, though it unveiled a $50 billion spending package last year.

Its aging population, rebuilding costs from the 2011 Fukushima disaster, and lingering effects of the global economic downturn have left it with a debt load about 245% of gross domestic product, or GDP, according to Moody’s.

That massive debt overhang, and the recognition that more social spending is inevitable, prompted the 2012 passage of the country’s first consumption tax hike in decades, to be implemented in April. The tax will rise to 8% from 5%, and another hike to 10% is possible in 2015.

Wage increases, like the one Toyota agreed to, thus far haven’t been enough to offset the negative impact from the tax hike, said Harumi Taguchi, IHS Economics’ principal Tokyo-based economist.

But Taguchi points out that the mere advent of the first wage increases in years has already prompted consumers to open their purses. Household spending rose 1.1% on the year in January, accelerating from a 0.7% rise in December.

Implementing a policy that might freeze demand just as it starts to show signs of life will be tricky. If demand wavers, additional easing wouldn’t necessarily be a bad thing, Kahn said, but it’s not riskless either.

The yen plunged 20% against the dollar in 2013, and further monetary easing could push it down even further, potentially destabilizing other currencies.

“In the past we expected them to falter, but here I think they’ll double down,” Kahn said.

In addition, despite the weak yen, Japan’s trade deficit is soaring to record levels as imports, mostly of energy, have outpaced exports. The country’s nuclear capacity, which previously accounted for about 29% of its energy needs, remains shuttered following the 2011 disaster.

The looming tax hike has also helped generate some demand, and the Bank of Japan expects consumers will help boost economic growth in the first quarter as they rush to spend ahead of the tax increase.

Mum On Structural Reforms

The third arrow — structural reform — may prove the thorniest to enact, in part because it encompasses everything from removing trade barriers to liberalizing labor rules.

Abe has yet to spell out what it might mean, perhaps because the government is still trying to convince corporations to boost wages despite difficulty cutting them and in laying off workers.

Still, the sales tax hike showed that Abe is willing to make tough decisions, and his full-court press to get the economy pumping again leaves Sinai “absolutely” optimistic about the country’s prospects. “That’s a picture of the leaders of Japan all on the same page that I have not seen in Japan in decades.”

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Japan Gains Speed, But Sales Tax Hike Will Test Changes
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