Forbes: Tax hike will put Abenomics to the test

Investors in Japan with long memories – and all investors in Japan have long memories, since they are usually somewhat scarred – remember what happened last time Japan decided a period of recovery should be followed with a new tax. It was 1997, and it killed the recovery stone dead, pushing the country into a deep recession.

But Shinzo Abe has shown sufficient bull-headedness this year to demonstrate that he will not be swayed by history. And so, earlier today, he risked impeding the impressive recovery Japan has made under his so-called Abenomics policy by committing to an increase in the national sales tax.

Why do this now? After all, Japan is in a period of confidence the like of which has scarcely been seen for 20 years. Ever since he announced a new period of expansionary policy, coupled with a commitment to loose monetary policy by the Bank of Japan, in April, Japan has – to put it bluntly – mattered.  It is relevant again in world markets.

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After many years of negligible growth and deflation, Japan has expanded GDP at an annualised 4% in the first half of its fiscal year. That’s twice the rate of the US, and out of sight of any recent level of performance by Japan itself. The Bank of Japan’s quarterly study of business confidence, known as the Tankan survey, was also released today, and it showed confidence among large and medium companies to be at its highest level for six years. Although it has been volatile, the currency has fallen considerably, assisting exporters. And, while the Bank of Japan’s goal of 2% inflation by 2015 is looking challenging, there is unquestionably a sense of momentum.

So why risk it by pushing the sales tax from 5 to 8% from April – and on to 10% a year later, if the plan is implemented in full? Why not let recovery take root, and companies show tangible evidence of growth, before hampering the consumer with a reason not to buy?

The reason is that Japan’s financial position is far more precarious than simply not growing. Japan’s debts are vast. They were vast already. Abenomics has made them vaster still. Even before Abe’s policies, the debt to GDP ratio in Japan was by far the highest in the developed world. It is now approaching 2.5 times: that is, debt is almost two and a half times the size of the entire Japanese economy. The Y10.3 trillion economic stimulus package Abe announced in January has been followed by a further Y5 trillion in new public works spending and other stimulus measures, announced today. This, to state the obvious, comes at a cost.

Japan has been able to get away with this preposterous level of debt because of the tremendous loyalty of Japanese investors towards Japanese Government Bonds (JGBs) despite the miserly yield they pay. Over 95% of JGBs are held locally, and the whole lot could easily be covered by domestic savings if the Ministry of Finance wanted it that way. But if Japan’s financial fundamentals were to become so alarming that there was a loss of confidence in JGBs, that could quickly set off an extremely damaging cycle: fleeing capital would mean rising yields, which would make it almost impossible for Japan to service its own debts, and the situation would spiral from there.

Abe knows this, and understands that he must pull off a challenging double act of kick-starting a torpid economy while reducing that overhang of debt. Today he said, in televised remarks: “We have no choice but to accomplish economic recovery and fiscal consolidation at the same time.” It is stated government policy – something Abe was elected on – to halve Japan’s budget deficit (ex-interest payments) by 2015 and eliminate it by 2020. This may prove too big an ask, particularly now that Tokyo will be hosting the Olympics in 2020, but that’s not really the point: there is a need to see a sense of direction, evidence of small progress.

Both Japan and the world investment community have so far been far more positive than negative about Abenomics, and have largely embraced the efforts to breathe life into an economy that has been listless for far too long. If that enthusiasm can survive tax hikes, and whatever else is necessary to get Japan’s national debts under control, then Abe really will have achieved something few thought possible. He’s not there yet.