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Japan’s Radical Pursuit of Revival

Nov. 9, 2017 The “Abenomics” experiment remains inconclusive, both at home and abroad.

Deep Dive

|November 9, 2017

Summary

Japan is positioned to become East Asia’s foremost economic and military power in the coming decades, but it’s traveling a bumpy road to get there. Growing strategic challenges in its backyard related to China’s rise give it little choice but to push for a dominant role in the region, and it has the underlying fundamentals needed to do so. Yet at the same time, it is locked in a decades-long economic slump and is contending with a worsening demographic crisis – factors that could hinder its rise as a regional leader. And it is only beginning to shed the self-imposed pacifistic constraints that have blunted its military ambitions since World War II. Thus, at the moment, early indicators of Japan’s ascendance must be balanced against signs that it’s merely spinning its wheels.

Japan’s ambitions to break free from its internal limitations have become particularly acute under Prime Minister Shinzo Abe’s government, which won re-election last month. Under Abe, Japan has been laying the groundwork to take a more decisive role in regional affairs by, for example, pushing to revise war-renouncing clauses in its pacifist constitution and modernize the military. Underpinning this strategy is a policy platform known as “Abenomics” — a radical and risky attempt to shock the economy out of the doldrums and, as a result, give Japan the capacity to develop true military clout.

This report takes stock of Japan’s unorthodox attempt at economic revival and examines how it fits into Tokyo’s geopolitical strategy — both its efforts to counter China’s growing economic and political influence in East Asia and its pursuit of a more robust military presence in the region. It makes the case that the Abenomics approach, particularly its focus on aggressive monetary easing, is already bolstering Japan’s regional influence, despite only mixed success at reviving the economy at home. However, the pace and scale of Japan’s remilitarization will hinge on the economy’s ability to exit stagnation without triggering a debt or financial crisis.

Japan cabinet Shinzo Abe
Japanese Prime Minister Shinzo Abe (front row, center) and his Cabinet members walk down the stairs following their first Cabinet meeting at Abe’s official residence in Tokyo on Nov. 1, 2017. KAZUHIRO NOGI/AFP/Getty Images

Abenomics Explained

If Japan appears to be throwing a Hail Mary under Abe, it’s because the country has been mired in an interminable economic slump triggered by a massive asset bubble collapse in 1990 — an extended period of stagnation that has made a mockery of its original moniker, “The Lost Decade.” Between the mid-1990s and mid-2000s, economic growth flatlined as Japanese banks tightened credit, average land values plummeted by some 70 percent, and a deflationary cycle set in. Powerhouse electronics and auto exporters lost ground to competitors from emerging neighbors such as South Korea. And just when Japanese growth was returning to pre-crisis levels, the economy was slammed by the global financial crisis beginning in 2008. By 2012, real wages were still roughly 5 percent below their 1995 peak.

Meanwhile, Japan has been grappling with an inexorable demographic crisis. The country has had the world’s oldest population since the mid-2000s, and the problem is only getting worse. Last year, annual births fell below 1 million for the first time, while deaths reached a postwar high of around 1.3 million. Over the next 40 years, Japan’s population is expected to fall to just 92 million people, down from a peak of 128 million in 2015. Retiring workers aren’t being replaced, hurting productivity and weighing on consumer demand. It also heightens the strain on Tokyo’s coffers, with a greater share of the budget having to go to pensions and health care. Moreover, the Japanese public has historically been staunchly opposed to opening the country to immigration, making it difficult to fill gaps in the workforce.

Abenomics aims to address some of these problems. It is based around three “arrows.” The first is aggressive monetary easing, with the Bank of Japan printing yen and buying its own sovereign bonds at a breakneck pace to keep the currency weak (and thus support domestic exporting industries), ensure firms have ample access to credit and boost inflation to a healthy level (to encourage consumers to spend). The second arrow is fiscal stimulus, using targeted government spending to promote consumer demand. The third is a sweeping set of structural reforms, including labor, tax and regulatory overhauls, with the goal of boosting the competitiveness of Japanese firms against foreign rivals and softening the demographic crisis by, for example, nudging women into the workforce.

In practice, however, Abe has leaned most on the first arrow: monetary easing. This is, in large part, because it’s the easiest policy to implement. Abe’s government, via his like-minded central bank chief, Haruhiko Kuroda, has been able to prime the pump at will since 2012. The central bank’s buying spree of Japanese government bonds has left it with a balance sheet with more than 500 trillion yen ($4.4 trillion) in assets. At the beginning of 2016, Japan introduced negative interest rates on some commercial bank deposits, and it has kept 10-year bond yields at about zero, to push savings into the real economy.

In comparison, structural reforms tend to be long-term projects that inevitably face resistance from affected interest groups. Or they conflict with cultural norms and thus can fall victim to more immediate political concerns. The government can do only so much to improve labor mobility, for example, in a culture that places high value on career-long loyalty to a single employer. Convincing people to have more babies is not exactly in any government’s wheelhouse.

Similarly, since fiscal stimulus measures also must be passed through Japan’s parliament, they likewise are subject to getting twisted for political aims, watering down their potential economic impact. Stimulus spending is also constrained by concerns over Japan’s soaring debt, which is forcing Tokyo to devote an increasing share of the budget to debt servicing. In 2014, for example, Abe’s own Ministry of Finance balked at plans for additional stimulus spending, leading instead to a 2 percent consumption tax hike that largely undid the wage gains of the previous two years and sent the economy into recession. This year — despite it being an election year — focus has again returned to paying down debt.

The result has been a tangible but fragile recovery. Corporate profits hit a historical high in the first half of this year, accompanied by a surge in corporate capital expenditures. A tightening labor market has pushed unemployment below 3 percent. The economy has grown for seven consecutive quarters, its second-longest growth streak since World War II, and there are signs that inflation is on the verge of finally ticking upward.

But this has yet to translate into success by many of the government’s own metrics. Inflation remains well below the central bank’s target of 2 percent. And the bank admits it is unlikely to get there until a tightening labor market pushes up wages and the costs are passed onto consumers; this is how modest inflation occurs in a healthy economy. The labor market has tightened somewhat, but wages have shown only scant signs of increasing, and household spending remains low. Moreover, with government debt hovering around 250 percent of gross domestic product, the Abe government feels it has little choice but to finally move forward with another consumption tax hike, from 8 percent to 10 percent. Though its debt risk is somewhat mitigated by the fact that most of the debt is held by the domestic market or the central bank, Tokyo is playing a costly game that’s eating into government coffers and exposing the market to more violent swings whenever rates begin to rise again. Meanwhile, Japan’s labor force isn’t getting any younger.

Still, time and again, Japan has shown a remarkable resilience to crisis, as well as a remarkable ability to take on radical transitions without collapsing into major social upheaval. Even the slump of the past quarter century has been notable as much for its social stability as its stagnation – a resilience that countries like China deeply envy. Despite the depth and longevity of the Lost Decade, Japan has yet to lose the confidence of outside investors. And Japanese firms remain world leaders in artificial intelligence research, automation and robotics, the sorts of technologies that will help the country sustain productivity amid the demographics crunch. This is why Tokyo has been emboldened to take such extreme measures in the first place. Our bet is Japan finds a way to pull through on the homefront yet again.

Reaching Abroad

Abenomics was never solely about reviving the domestic economy. And on the foreign policy front, there’s an overlooked ancillary benefit of this approach, particularly the emphasis on monetary easing: It plays directly into Japan’s regional strategy.

Simply put, between the abundance of cheap credit and sky-high corporate profits, Japan’s economy is awash in capital. With Tokyo doing everything it can to discourage savings, much of this liquidity needs to go somewhere, and the Japanese consumer market and industrial footprint can absorb only so much. Thus, a record amount of Japanese capital is heading overseas, at a time when Tokyo is keen to help weaker states avoid becoming overly dependent on China’s surging foreign aid and outbound investment. Annual Japanese outbound foreign direct investment has increased nearly 58 percent since 2011, according to figures from the Japan External Trade Organization and the Organization for Economic Cooperation and Development. Meanwhile, overseas mergers and acquisitions by Japanese companies hit an all-time high in 2015, according to Thomson Reuters.

Japan’s neighbors have not been the only beneficiaries; a majority of Japanese investment over the past seven years has gone to either the U.S. or Europe, as well as adjacent manufacturing hubs like Mexico. But East Asian economies, particularly in Southeast Asia, have certainly enjoyed a hearty slice of the pie. Japanese FDI in members of the Association of Southeast Asian Nations tripled from 2011 to 2015, to more than 20 trillion yen. Through the first half of 2017, this figure was up again by around 2.3 percent, compared to the same period a year earlier. The heaviest focus has been on Singapore, Thailand, Malaysia, Vietnam, the Philippines and Indonesia — all either parties to the South China Sea dispute or historical contributors to the U.S.-alliance structure in the Western Pacific. Japan is also investing heavily in Myanmar, which is at the center of the burgeoning competition between China and India, as well as India itself. Meanwhile, as Japanese firms have been increasingly moving operations out of China over the past decade, the largest share of them have headed to Southeast Asia.

The Japanese corporate sector is uniquely equipped to put this money to use in the region. Japanese supply chains have crisscrossed the globe for half a century, as Japanese firms were among the first to move operations to countries with lower labor costs. The stresses of the Lost Decade only cemented Japan’s outbound strategy as it sought to reduce the dependence of its economy on the domestic consumer market. (In fact, though Japan’s economy remains heavily dependent on exports, it has been increasingly relying on earnings from investments abroad. Its primary income account, which gauges how much Japan profits from FDI, has soared by as much as 65 percent since 2012, while its trade surplus has been more volatile.)

As a result, Japanese firms play outsize roles in emerging economies like those of Southeast Asia, with Japan’s aims largely seen as complementary to those of regional governments. This is because Japanese firms are viewed as critical job creators and inherently supportive of local efforts to move up the manufacturing value chains and build a middle class. (Japanese investment fueled the modernization of Singapore, Thailand and Malaysia, in particular.) Moreover, the high-tech Japanese products being assembled in middle-income countries, particularly electronic components and auto parts, don’t usually compete with goods made by local firms – unlike lower-end Chinese goods – easing Tokyo’s ability to strike favorable economic pacts with Asian governments. Japanese firms aren’t viewed as a threat to local workers for importing their own – a common, if overstated, accusation against Chinese firms. And Japanese technology and expertise in areas like high-speed rail is viewed as unmatched, giving Japan an edge (albeit hardly a decisive one) in Southeast Asia, a geographically fragmented region that, according to the Asian Development Bank, needs to spend some $60 billion on infrastructure annually until 2030 to sustain its economic growth.

Compared to their Chinese competitors, Japanese firms also don’t have to contend as much with ethnic complications in countries like Indonesia and Malaysia, where minority ethnic Chinese populations are often scapegoated by populist political movements. (On the flip side, the dominance of ethnic Chinese populations over various local sectors in Southeast Asia can often give mainland Chinese firms a substantial leg up against other foreign competitors.) Lingering memories of Japanese imperialism notwithstanding, Japanese firms also do not face political blowback related to territorial disputes, unlike, for example, the Chinese businesses that were the target of South China Sea-linked riots in Vietnam in 2014.

To amplify the political influence accrued through FDI, Tokyo has long actively relied on official development assistance, or ODA, to channel funding to sectors prioritized by partner governments, particularly infrastructure. (It uses its influence in the Asian Development Bank, every president of which has been Japanese, for similar aims.) And under Abe, coordination of ODA with the private sector has increased substantially and taken on a more strategic bent. From a commercial perspective, private sector involvement in ODA is becoming particularly important to Japanese firms’ ability to remain competitive in certain sectors, since Beijing is encouraging Chinese state-owned firms to underbid competitors – even at terms likely to prove unprofitable – on big ticket road, rail and port projects that support China’s strategic imperatives.

Abenomics and Hard Power

It’s difficult to gauge how much soft power tools such as aid and investment really matter on the geopolitical stage. Even relatively poor countries like the Philippines rarely willingly subsume their core security imperatives to their economic interests, even if their military weakness leaves them with little choice but to try to exploit regional competition between stronger powers for economic benefit. Cultivating political influence through aid and investment is only one part of Tokyo’s regional strategy. Japan’s ability to ramp up defense spending and security assistance to the region matters more. But this requires Tokyo to find a way to put its economy on sound long-term footing.

Since 1961, Japan has spent no more than 1 percent of its GDP on its military annually. Its budget is nothing to sniff at – in 2016, it was seventh-highest in the world in dollar terms. And it has given the military sophisticated defensive capabilities, such as a world-class submarine fleet (designed for operations in Japan’s near abroad), missile defense systems and a burgeoning fleet of F-35 fighter jets. But Japan’s military has little in the way of expensive offensive capabilities, particularly in the maritime realm, despite steps in this direction over the past decade.

For the time being, at least, it can continue to lean heavily on the U.S. to cover its deficiencies. (In fact, by allowing Japan to limit defense spending for decades following World War II, U.S. security guarantees contributed directly to the postwar economic dynamism Japan is now trying to revive.) But going forward, we expect emerging threats in Japan’s backyard, along with its perpetual uneasiness with tying its fate to U.S. defense guarantees, to compel Tokyo to shed its pacifist political and legal constraints on taking greater responsibility for its defense needs. This spring, in fact, Abe’s government formally scrapped the 1 percent of GDP cap on defense spending. And this summer, the Japanese Defense Ministry requested another 2.5 percent increase in spending for the 2018 fiscal year, to $48.1 billion, with an eye on defensive-oriented assets such as additional ballistic missile defense systems, fighter jets and anti-mine ships.

Over the long term, Japan will push to address its vulnerabilities farther afield as well, particularly in the maritime realm. Its dependence on the free flow of energy imports through the Malacca Strait and South China Sea makes mitigating threats to the waters, whether from new Chinese warships or dinghy-bound pirates, a matter of existential importance for the Japanese. Toward this end, Japan is gradually ramping up security assistance to weaker states locked in maritime disputes with the Chinese, particularly the Philippines, Vietnam and Malaysia. It is also boosting maritime cooperation with like-minded regional powers Australia, India and Singapore to prepare for the possibility that the U.S. becomes tied down with a crisis and cannot play its role as guarantor of seaborne trade.


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All this costs vast amounts of money. Building from the ground up a bluewater navy capable of securing the Malacca and potentially coming to the aid of India or Southeast Asian states would be particularly expensive. A capital-rich economy will aid in this endeavor to a degree as the appetite for investment in Japan’s indigenous arms sector grows. Japan’s high-tech sector has certainly given the country the technological skill base and industrial footprint needed to develop top-end defense systems at home, thus allowing it to rely less on arms imports and even develop a more robust arms exports industry of its own. (Abe formally lifted a ban on Japanese arms exports in 2014.) In this environment, a greater share of Japanese defense spending would be recycled through the broader domestic economy.

Nonetheless, the ability to shovel money into defense in perpetuity requires not just cheap credit but also a fiscal outlook that can accommodate the military’s needs alongside the yawning demands of Japan’s elderly and its public debtholders. And the political and economic fallout of a financial crisis triggered by the debt risks that accompany the Abenomics approach could very well stall Japan’s remilitarization altogether.

The Abenomics experiment remains inconclusive, both on the homefront and abroad. Thus, the trajectory of Japan’s fledgling re-emergence as a dominant regional power is also uncertain. But Japan’s history of radical transformation, industrial edge and social cohesion give us pause before counting the country out. We’ll dive deeper into each of the pivotal variables we outlined in this report – particularly the demographic crunch, Tokyo’s defense spending capacity, and its vulnerability to renewed crisis if the debt load proves unmanageable – in the future, as we track Japan’s peculiar revival.