Demographics are destiny

Global population

“Abenomics,” the economic policies introduced by Prime Minister Abe of Japan in December 2012, hit the world like a freight train and continued to move forward like a juggernaut in the first months of 2013. That perpetual motion phenomenon appears to have come to an abrupt halt since May 23rd. As of June 13, the Nikkei was down -20% from its high1 and the yen’s downward trajectory relative to the U.S. Dollar appears to be coming to an end2.
Will this be the pause that refreshes, or is it the harbinger of worse things to come?
Truth is, I do not know. But an examination of the factors that have slowed this train may provide some clues as to which issues may determine the future path of the Japanese economy and market. Let’s start by reviewing what the principal elements of Abenomics entail:

  • Accommodative monetary policy – “double the money supply in two years”
  • Stimulative fiscal policy – government spends a lot of money
  • Structural reforms

For the first six months of Abenomics, the markets have focused almost exclusively on the first two strategies, which drove Japanese equities (as measured by the Nikkei) higher and higher and the yen lower and lower against the U.S. Dollar. Early indications are that the current economic data (for example bank lending)3 out of Japan are strengthening.

I would argue that the third plank in the plan is now, finally, getting the attention it deserves. Putting the pedal to the metal on the monetary and fiscal policy fronts can create a flurry of initial economic activity. But that momentum is unsustainable if the fundamental sources of long-term real economic growth are not sufficiently present. That is what reform has to be about.
Japan’s economy has been stagnant for the last two decades primarily because of the country’s demographics and productivity. Why these two factors? Because in the long run, a country’s real economic growth rate is determined by two things and two things only: population growth and productivity increases.

Real GDP growth rate = (population growth) + (productivity increases)

The population of Japan is not growing at all. According to the World Bank, from 2003-2011 the Japanese population growth was .04%4. Note, that is not an annualized number. It is the total cumulative population increase over the last eight years. The only way you fix this is to have more babies and let more people immigrate into your country. Japan has been reluctant to promote either approach. Worse yet is that the World Bank demographic trends have Japan’s population declining by 0.3-0.4% per annum over the next decade.

With regard to productivity, I talked to my friend and colleague, Andrew Pease, Russell’s Global Head of Investment Strategy. His take is, “a very rough measure of labor productivity growth for Japan is real per capita GDP growth. Population growth has, as you point out, been close to zero over the past decade and the employment population ratio has been flat point-to-point.” Per capita GDP growth in Japan was 0.7% per year over the last 20 years5.

So, let’s plug these numbers in to calculate Japan’s real GDP growth from 1993-2012

Real GDP growth = (zero population growth) + (0.7% productivity gains), 0+0.7% = 0.7%
In reality, Japan’s real GDP growth rate over that time was slightly better than zero. It was 0.7% annually. Admittedly, this would probably still feel a lot like zero if you lived in Japan.
I’m not alone in believing that massive reform needs to take place in Japan, particularly in the areas of corporate governance and labor which currently represent massive hurdles to change – and hence productivity. Capital, both in its financial and human forms, simply is not free-flowing in the Japanese economy.

Unfortunately, in mid-June, Prime Minister Abe seemed to water down his reform objective in the face of political unpopularity. In my view, that would be a step back in terms of the significant reforms Japan needs to tackle.

Andrew captured the political tension nicely: “In my assessment, Abenomics is mostly about moving from deflation to inflation – there isn’t much in the way of structural reform being proposed, unless you count the proposed consumption tax increase. This is no small thing. I believe deflation is just about the worst thing you can do to an economy – it generates high real interest rates, makes banks unwilling to lend and squeezes domestic profit margins because prices fall faster than wages. Inflation of 2% will be a good thing if Japan can get there. It needs inflation so that the denominator of the debt-to-GDP ratio has a chance of growing faster than the numerator.”

The political issue down the road comes when all those retired Japanese government bondholders realize that Abe has sold them financial repression – inflation that eats away at their Japanese government bond purchasing power. At least under deflation they were better off every year.
So, my concern is that, if Japan doesn’t reform and instead sticks with its current birth rate and immigration policy, then Demographics are Destiny – and this Abenomics experiment is likely to end very, very badly.

1Nikkei 225 Index data from May 22, 2013 through June 13, 2013
2Bloomberg: US Dollar-Japanese Yen exchange rate, 106.13 on May 22, 2013 down to 95.37 on June 13, 2013
3Reuters: “Japan upgrades economic outlook as Abe’s policies take hold,” May, 2013 databank
5International Monetary Fund: Data and StatisticsNikkei 225 is a price-weighted index comprised of Japan’s top 225 blue-chip companies on the Tokyo Stock Exchange.
Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.
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