Abe’s absent arrow: Slow reform in Japan

Despite hopes of a further rally, long-term worries abound

Japan’s Nikkei 225 index enjoyed a strong rally last week, climbing from Tuesday’s low of less than 13,754 to almost 14,405 on Friday (markets were closed yesterday). While tied to volatility surrounding the US debt ceiling debate, these gains came amid news that Japanese machinery orders jumped to ¥819.3bn (£5.2bn) in August – the highest level since 2008 – raising hopes that the country can build on its second quarter GDP growth of 0.9 per cent.

But such confidence contrasts with uncertain long-term prospects. The first two “arrows” of Prime Minister Shinzo Abe’s economic revival plan, a massive fiscal stimulus and aggressive monetary easing, have helped Japan boost growth and bucked its deflationary spiral. They have also led the Nikkei to gain over 40 per cent year-to-date.

Now, as the government moves towards fiscal consolidation with a 3 per cent consumption tax hike due in April 2014, worries over the recovery being thrown off course have intensified. Moreover, Abe’s “third arrow” of vital structural reforms has seen little concrete progress to date. Coutts recently scaled back its “optimism on Japanese equities until there are clearer signs that measures to help the economy are being brought back on track.”

Not everyone is so gloomy. In a recent note, Masayuki Kichikawa of Bank of America Merrill Lynch (BoAML) argued that, while “the consumption tax hike is likely to hurt spending and housing investment,” continued increases in business investment may help to offset this. BoAML forecasts an investment uptick of between 4 and 5 per cent in 2014, helping to offset headwinds from falling consumption.

Brenda Kelly of IG, meanwhile, sees a further depreciation of the yen as key, helping to boost exports and improve competitiveness. The yen strengthened against the dollar amid political uncertainty in Washington. But this trend looks set to reverse, with dollar-yen recovering from below ¥96.70 last Monday to over ¥98.20 yesterday. “If we see a break above the ¥99.85 level,” Kelly says, “this could be the start of protracted dollar strength, benefiting Japanese exporters as well as the Nikkei.”

Many analysts agree that Japanese equities are likely to strengthen in the short term, with a recent poll by Reuters finding a median year-end forecast for the Nikkei of 15,200 – a sharp rise from current levels just over 14,400 (see graph).

But the picture beyond this period remains far less certain. “Many investors will have expected more detail on plans to lower corporation tax by now,” says Gary Dugan of Coutts. At 38.01 per cent, Japan’s corporate tax rate is among the world’s highest, and many see a cut as necessary to offset the rise in the consumption rate. “We have also seen little progress on plans to change agricultural tariffs, perhaps indicating a lack of political consensus that these reforms are a priority,” Dugan says.

Under the grand heading “reinforce human resource capability and reform the employment system”, Abe and his cabinet have acknowledged the necessity of relaxing laws on hiring and firing, and improving childcare to encourage more women in the workforce. But policy is yet to materialise.

And with Japan placed at 24th in the World Bank’s global ease of doing business rankings, falling outside of the top 100 for starting a new business and paying taxes, the detail is urgent. “A recent stream of positive data has helped to paper over some serious problems,” Dugan says. “But as more time passes without concrete plans, the chance of investors removing their money at the sign of bad news is rising – especially those with memories of the 1990s.”