The Outlook for Abenomics

The outlook for Abenomics: Implications for financial markets

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June 2013

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Summary Abenomics, Prime Minister Abes bold new plan to revive Japans economy, is based on three arrows:

1. rapid implementation of effective monetary policy;

2. bold fiscal policy; and

3. growth strategies to support private investment.

The key criteria for the success of Abenomics are: 1) closing the nations negative output gap by ending the trend of actual GDP consistently falling short of potential GDP; and 2) re-igniting inflation and achieving moderate wage growth

Our base-case scenario is that Abenomics will be Successful. Under this scenario, the negative output gap narrows slowly but does not necessarily turn positive and inflation reaches 1% versus the Bank of Japans 2% target. We believe this would represent sufficient improvement to convince businesses and individuals that the deflationary trend has turned.

Various risk factors could cause Abenomics to be Unsuccessful. These include:

1. external overseas economic slowdown or geopolitical tension;

2. internal implementation of the proposed consumption tax hike in 2014 or disappointment with the third policy arrow; and

3. financial markets significant stock market decline, yen appreciation or rising Japanese Government Bond yields.

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IntroductionAfter the Liberal Democratic Party (LDP) won a landslide victory in Japans December 2012 House of Representatives Election, Prime Minister Shinzo Abe formed his second administration. Abe was quick to announce that his government aims to revive Japans economy via an economic policy that has come to be known as Abenomics. Abenomics is based on three arrows: 1) rapid implementation of effective monetary policy; 2) bold fiscal policy; and 3) growth strategies to support private investment. Japans financial markets seem to have responded vigorously to the implementation of Abenomics: the yen has depreciated rapidly versus most major foreign currencies and share prices have risen dramatically.

The practical implementation of the three arrows of Abenomics has consisted of:

1) Rapid implementation of effective monetary policy In January 2013, Bank of Japan (BoJ) Governor Masaaki Shirakawa announced a 2% inflation targeting policy, which is quite ambitious in light of Japans prolonged deflation trend. Two months later Haruhiko Kuroda, a former Asian Development Bank (ADB) governor, replaced Shirakawa as BoJ governor and, in a surprise move, long-term BoJ critic Kikuo Iwata, a Gakushuin University professor, was installed as deputy governor. At the first Monetary Policy Committee meeting after Kurodas appointment, held on 3 and 4 April 2013, the BoJ introduced its bold Quantitative and Qualitative Monetary Easing policy, which aims to double Japans monetary base over two years. The implementation of this policy was quite remarkable, as the BoJ has historically maintained that monetary policy easing would not help the country escape deflation.

2) Bold fiscal policy In February 2013, Japans House of Representatives passed a supplementary budget bill for FY12 that includes 13.1 trillion in spending, most of which falls under a 10.3 trillion economic stimulus package. This is nothing new in and of itself, as fiscal spending has long been the LDPs preferred tool to boost GDP. However, combined with the implementation of aggressive monetary policy, this round of spending is likely to be more effective.

3) Growth strategies to support private investment The cabinet introduced a policy menu that targets supporting growth in three key areas: industrial revival, creating strategic markets and promoting internationally focused businesses. However, it

is uncertain how effectively this arrow will be implemented as the proposed policies (eg, structural reform in agriculture and creating more career opportunities for women) have been debated for years but progress has been scant.

As global attention to Japans financial markets is at an all-time high, Manulife Asset Management Japan has conducted an in-depth scenario analysis of how the implementation of Abenomics could play out.

Our base-case scenario: Abenomics will be SuccessfulOur definition of success for Abenomics is based on two economic parameters: the output gap and inflation. In our view, the degree of success of Abenomics can be determined by judging: 1) whether or not the country escapes from its trend of actual GDP consistently falling short of potential GDP (ie, closing the negative output gap); and 2) whether or not inflation climbs (ie, prices rise) as a result of narrowing the negative output gap and moderate wage growth follows. As for inflation, given Japan has experienced at least a decade of deflation, we set 1% as the threshold for success rather than the 2% targeted by the BoJ. In this regard, our base-case scenario is that Abenomics will satisfy our two criteria and qualify as Successful.

Japans negative output gap which is currently estimated to be around -2% is likely to gradually narrow on the back of the first arrow alone (ie, drastic BoJ monetary policy easing). As various consumer and business sentiment indices have already shown significant improvement, there is little doubt that the Japanese economy is benefitting from monetary policy driven yen weakness. We believe the economy will continue to reap the benefits of export growth on the back of yen weakness and global economic recovery, particularly in the US.

The positive export-driven momentum that has emerged should also accelerate domestic economic activity, helping place Japan on a sustainable growth path and ultimately driving higher inflation and upward pressure on wages. Consumer Price Index (CPI) readings for Tokyos 23 wards turned positive to 0.1% year-on-year growth in May 2013, implying that prices are likely to increase moderately in the second half of 2013. These assumptions lead us to believe that inflation of about 1% is an appropriate threshold for success even though it would fall short of the BoJs official target of 2%. Our lower threshold for success reflects the

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fact that: 1) the starting line is a continuing deflationary trend (average prices have fallen 0.4% per annum in each of the past three years); and 2) rapid inflation over a short period of time could harm the real economy. In our view, achieving 1% inflation would be significant enough to convince businesses and individuals that the deflationary trend has turned, reinforcing already cautiously optimistic economic sentiment.

As for the second and third arrows, although the second would boost 2013 GDP growth, its effect cannot be expected to continue much longer than that due to fiscal constraints. In terms of the third arrow, we were disappointed to learn that it is unlikely to include policy measures that would immediately affect the economy, such as a lower corporate tax rate. However, we must keep in mind that the third arrow is designed to raise potential GDP, which is invariable a long-term proposal and will not be immediately apparent. As such, while the growth strategy may seem to fall short of initial expectations, causing some disappointment, we do not consider it a critical flaw in Abenomics as long as the economy continues to grow. As we mentioned above, the keys to success are closing the negative output gap and raising inflation, both of which are immediate and measureable. Thus, in our view, the first arrow is more important than the other two.

Abenomics: Scenario analysisTable 1 outlines four potential scenarios for how the implementation of Abenomics could play out: 1) Very successful; 2) Successful; 3) Unsuccessful; and 4) Failure.

As we discussed above, our base-case scenario is that Abenomics will be Successful (Scenario 2), mainly as a result of the first arrow. That being said, various risk factors must be carefully monitored. Primary among these is the potential for economic slowdown overseas, which could derail the initial success of Abenomics. This is a key contributing factor for Scenario 3, Unsuccessful: overseas economic slowdown leads to deteriorating risk sentiment, driving heightened demand for the yen as a safe-haven currency and initiating significant decline in Japanese stock prices, which have surged since late 2012 on the back of yen depreciation. A higher yen and lower stock prices would likely significantly dampen domestic consumer and business sentiment, leading to disappointment in Abenomics.

However, we believe that the economic effects of external risk factors can be largely prevented via central bank policy support. For example, if the US economy shows signs of slowing growth, we believe the Federal Reserve (the Fed)

would step in with further monetary easing measures, avoiding serious economic consequences. US inflation remains subdued, meaning that policy support could be implemented without this being a concern.

Moreover, amid current concern over the potential for the Fed to begin tapering quantitative easing (QE), negative economic news has a silver lining as it could postpone QE tapering, benefitting risk assets. If the Fed decides to initiate QE tapering, it would have to do so very carefully so as not to slow economic recovery by causing confusion in financial markets. Indeed, we believe that clear communication would be of paramount importance to ensure the market that QE tapering is not necessarily the first step toward policy tightening and that additional easing will be implemented when necessary. On the European front, although the euro zone economy remains on a downward trend, its financial markets have been stable since the European Central Bank (ECB) launched its bond buying program last summer.

There are also domestic factors that could serve as catalysts for Scenario 3. The immediate focal point is whether or not a consumption tax hike should be implemented in 2014. As BoJ Governor Kuroda has indicated his support for the proposed increase, a delay could send the message that the government and the BoJ are not a united front, which could undermine the credibility of Abenomics. This is a very tricky issue, as raising the tax would be negative for the economy, but not raising the tax could have the unintended side effect of raising Japanese Government Bond (JGB) yields due to heightened fiscal risk. We expect the Abe administration to raise the consumption tax in the fall of 2013 while extending fiscal support to offset the negative economic impact.

Another domestic risk factor arises from the debate over a proposed revision to Japans constitution regarding the right of collective self defence. The revision will be debated after the July 2013 Upper House election. This issue could significantly impact Japans relations with its neighbours, and China in particular, which could in turn affect the output gap due to potentially lower exports.

Of course, financial market volatility is also a risk factor. As of this writing, the Nikkei 225 had shed almost 20% from its 22 May peak of 15,627. This significant decline is widely associated with disappointment with Abenomics, particularly with the third arrow. We believe that deterioration of risk sentiment due to speculation over potential QE tapering in the US also played a role, as global stock prices declined and credit spreads widened in parallel with the selloff in Japan. Whatever the underlying reasons, sharp stock market decline is negative for Abenomics as it would negatively affect the real economy. While the recent

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selloff is widely considered a temporary correction after an extraordinary rally, further significant decline would fuel concern over the potential negative side effects of Abenomics. However, we do not expect this to be the case as the Fed is maintaining accommodative policy and is not likely to risk stalling economic recovery by raising financial market uncertainty. Thus, even if QE tapering begins, we believe the Fed will manage its policy stance very carefully to ensure it does not negatively affect the economy. The bottom line is that without a sell-off in global stock prices, we see limited potential for downward pressure on Japanese stock prices due to internal risk factors alone.

Overall, we will continue to monitor the key internal, external and financial market risk factors that could work against Abenomics. That being said, we believe that

Scenario 2, a Successful outcome, is much more likely than Scenario 3, Unsuccessful.

As for Scenario 1, we see little chance of the conditions emerging to support the ambitious criteria for a Very successful outcome within the next few years and we believe the BoJ is aware of this. Meanwhile, if Scenario 1 were to come to pass, it would probably be due to an unexpected rapid increase in potential GDP that could be attributed to the third arrow. As for Scenario 4, Failure, while the risk of capital flight due to sovereign risk could theoretically emerge in any country, the possibility of capital suddenly fleeing Japan which has its own floating-rate currency, posts a current account surplus and has an enormous international investment position seems remote.

Table 1: Four scenarios for how Abenomics could play out

Criteria for success Economic assumptions

Outcome Probability OverviewCPI growth

(% yoy) Output gap Japan Overseas

#1 Very successful(Base-case scenario for the government and the BoJ)

15% Growth and inflation meet or exceed the BoJs forecast.

2% in FY15. From -2% to positive.

The weak yen and economic recovery overseas raise Japans exports, leading to rapid increase in capital investment and bank lending. Wages rise due to increasing inflation expectations.

Economic growth accelerates globally, Europe exits recession and Chinas downside risk declines. The real global economy is so strong that it is not affected when monetary policy tightening begins.

#2 Successful (Manulife Asset Managements base-case scenario)

50% Growth and inflation fail to meet the BoJs forecast, but show signs of recovery and keep positive sentiment afloat.

Fails to reach 2% in FY15, but approaches 1%.

Improves from -2% but does not turn positive.

The weak yen and economic recovery overseas raise Japans exports, leading to rapid increase in capital investment and bank lending. Wages rise due to increasing inflation expectations.

Global economic recovery remains moderate, particularly in the US. Continued easing supports international economies.

#3 Unsuccessful 30% Deterioration in overseas demand and the consumption tax hike in Japan stop the output gap from shrinking and forestall inflation. Market sentiment collapses.

Deflation continues.

Remains around -2%.

Declining overseas demand and renewed yen strength worsen market sentiment. In FY14, the consumption tax hike decreases demand and lowers inflation expectations, keeping wages on a downward trend.

The global economy slows.

#4 Failure 5% Domestic investors, primarily banks, sell off JGBs and households convert yen-denominated deposits into foreign currency holdings in anticipation of hyperinflation.

Inflation surges due to rapid yen depreciation.

The negative gap widens.

Confidence in the Japanese government and currency plummets.

Source: Manulife Asset Management

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Financial market assumptions underlying scenariosTables 2, 3 and 4 outline the basis for the range of financial indicator assumptions that underlie our four scenarios.

Table 2: 10-year JGB yield

Scenario 1

Anticipation of quantitative easing being scaled back and policy rates being hiked would likely create pressure for higher yields. That being said, BoJ Governor Kuroda would likely take a more cautious stance on monetary tightening than was the case when QE was discontinued in 2006. Also, given that consumer spending is expected to fall in FY14 in response to a consumption tax hike, the 10-year JGB yield is not expected to climb as high as the 2.0% level seen in 2006.

Scenario 2

The JGB markets underlying structure would likely consist of conflicting pressure for higher yields (due to economic recovery and inflation expectation) and lower yields (BoJ support for bond supply and demand via large-scale bond purchases). In this environment, US Treasury yield trends would have a major impact on JGB yields and the key market driver would likely be the Feds decision on whether or not to taper asset purchases and how financial markets respond.

Scenario 3In addition to anticipation of an extended period of accommodative monetary policy, Scenario 3 assumes that disappointment with Abenomics would cause a sharp fall in stock prices, fuelling downward pressure on yields. If the BoJ abandons its policy of paying 0.1% interest on its excess reserves, the two-year JGB yield would likely return to a one-digit figure.

Scenario 4

The possibility of capital suddenly fleeing Japan which has its own floating-rate currency, posts a current account surplus and has an enormous international investment position seems remote. On the other hand, aside from the extreme scenario of capital flight, continued interest rate rise due to increasing JGB market volatility would run counter to the BoJs intention of lowering real interest rates, posing a risk factor for the success of Abenomics.


Table 3: Foreign exchange

Scenario 1

The JPY/USD exchange rate would be determined by the balance between US Treasury yield appreciation, a factor that supports yen depreciation, and JGB yield appreciation and larger current account surpluses, both of which support yen appreciation. Under Scenario 1, we would expect to see the yen weaken versus the US dollar as the Fed would likely prepare to tighten its policy stance at an earlier point in time than the BoJ.

Scenario 2

In the absence of market expectations of an interest rate hike, there would be no major change in the nominal yield spread between JGBs and US Treasuries. However, the real yield difference would expand due to an upward bias on US real yields in anticipation of QE tapering off and BoJ policy support for lowering real JGB yields. Thus, we expect yen weakness versus the US dollar would continue under this scenario.

Scenario 3

Scenario 3 would see: 1) significant yen appreciation due to heightened demand for safe-haven currency amid fear of economic slowdown; 2) pressure for a weaker US dollar amid lower expectations for QE tapering; and 3) disappointment with Abenomics. In particular, since the JPY/USD rate has considerably discounted future inflationary trends in Japan, the degree of yen appreciation as a result of disappointment with Abenomics would likely be significant.

Scenario 4For the same reasons outlined under Scenario 4 in Table 3, the probability of Scenario 4 coming to pass seems low. Scenario 4 assumes that the yen would be sold to a level that cannot possibly be explained by the nominal or real yield spread between JGBs and US Treasuries.


Table 4: Stock prices

Scenario 1Because of improved exports due to the weaker yen and increased sales due to production growth, companies earnings per share (EPS) would continue to rise and their price-to-earnings (PE) ratios would remain high. This scenario assumes that stock prices would eventually exceed 2007 highs.

Scenario 2Stock prices would remain high backed by market anticipation of moderate economic recovery. Although expected QE tapering in the US would cap Japanese stock prices, the market would remain bullish, supported by belief in the success of Abenomics.

Scenario 3Yen strength due to disappointment with Abenomics would drive stock prices lower. Stock price gains since November 2012 have largely been due to yen depreciation and, therefore, yen strength would likely lead to substantial stock price declines.

Scenario 4 For the same reasons outlined under Scenario 4 in Table 3, the probability of this scenario coming to pass seems low.


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How would financial markets react to each scenario?Each of the four scenarios outlined above would have a distinct impact on the 10-year JGB yield, the JPY/USD rate and the Nikkei 225. Table 5 presents our assumptions for each scenario, and summarises the likely implications for Japans current account balance and primary balance.

Table 5: Scenario implications for Japans financial markets and macro parameters

Financial markets (assumed ranges) Other macro parameters (assumed ranges)

10-year JGB yield JPY/USD Nikkei 225Current account balance

(annual)

Central governments primary balance to GDP ratio

(general accounts basis)

#1 1.00-1.50% 110-130/USD 15,000-20,000 Surplus of 10-20 trillion Likely to meet mid-term target (halve the federal governments primary balance deficit by 2015)

#2 0.50-1.25% 95-115/USD 10,000-16,000 Surplus of 5-10 trillion Deficit improves from -4.8%

#3 0.40-0.70% 80-95/USD 8,500-11,000 Surplus of 0-5 trillion Deficit remains around -4.8%

#4 1.5-5.0% 150/USD or more 8,500 or lower Deficit Deficit grows


Conclusion

We believe the BoJ and the government will successfully implement the three arrows of Abenomics rapid implementation of effective monetary policy, bold fiscal policy and growth strategies to support private investment and successfully manoeuvre the Japanese economy back onto an inflationary path. Indeed, we believe that economic conditions in Japan and in major economies around the world make these achievable

goals. However, given Japans decade-long trend of deflation, we do not see Abenomics achieving all of its stated goals and meeting the criteria to be judged Very successful. Rather, we believe that the BoJ, the government and the market would be very satisfied with achieving Success as defined by the criteria set out in Scenario 2: achieving 1% annual inflation and improving the output gap from its current -2%.

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Appendix 1 Risk factors

Given the fluidity of the situation, the following is an overview for how several specific factors could play into our four scenarios.

Consumer Price Index

Because yen-denominated import prices have risen alongside yen depreciation, year-on-year CPI growth is likely to turn positive during the second half of 2013. In fact, the latest CPI readings for Tokyos 23 wards turned positive to 0.1% year-on-year growth in May 2013. That being said, higher wages are essential if CPI growth is to exceed 1% in 2014 and beyond, a condition that will be difficult to satisfy. However, given the fact that average prices in Japan have fallen by 0.4% per annum for the past three years, we believe it is appropriate to assume that, even if Scenario 2 comes to pass, the Japanese economy will successfully escape its deflationary trend. If rapid cost-push inflation emerges in the absence of wage hikes, as was the case when commodity prices rose sharply in the summer of 2008, it is highly likely that the 2% goal would be achieved. However, since cost-push inflation would have a negative effect on the real economy, such inflation would be negative for the prospects of Abenomics.

Output gap

According to the most recent IMF estimates, Japans output gap was -2.12% for 2012 (the Cabinet Office estimate is -3.0% for October to December 2012). There is a high possibility that the output gap could begin to improve by end-2013 due to continued yen weakness, improvement in business and consumer sentiment and economic stimulus effects under the supplementary budget. The IMF forecasts that the output gap will gradually improve and turn positive in 2017, but if it were to shift to the positive earlier than this, ie, in FY15 as described in Scenario 1, Abenomics would have to be judged Very successful.

The pace of improvement in the output gap is subject to risk factors. For one, external demand could be affected by ongoing discussions over the potential for cutbacks to QE in the United States in the second half of 2013 and its effect on financial markets. In addition, domestic demand could decline in response to the consumption tax hike planned for April 2014. Another risk factor emerges from the debate over a proposed revision to Japans constitution regarding the right of collective self defence, which will be debated after the July 2013 Upper House election. This issue could affect Japans relations with its neighbours, and China in particular, which could in turn affect the output gap due to potentially lower exports.

Current account balance

Ongoing yen depreciation has yet to show up in the form of trade balance improvement as yen-denominated import prices have also increased (after seasonal adjustments, the April 2013 trade balance showed an annualised deficit of 9.2 trillion). However, real exports have definitely shown signs of improvement. Going forward, it is highly likely that the trade balance will show improvement as export quantities increase (due to the so-called J-curve effect), easing concern over the potential side effects of Abenomics, including the risk of running a current account deficit, which would potentially lead to excessive yen depreciation. If the trade balance improves to the level it was at before the March 2011 Japan earthquake caused energy related imports to increase ahead of the tragedy the trade balance surplus was about 5 trillion, the income balance surplus was about 15 trillion and the current account surplus was about 17 trillion on an annualised basis Abenomics could be considered Very successful. However, the reality is that even if Japan can just escape the trade balance deficit of the past 26 months, Abenomics will have to be judged Successful. Risk factors arising from exports include overseas factors such as the risk of an economic slowdown overseas or an increase in geopolitical tensions in Asia. As for imports, risk factors include rising prices for commodities such as crude oil and an increase in Japans energy import volume, which would also be affected by the governments stance on whether or not to restart nuclear power stations.

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Table 6: Other risk factors

Item Expectation Implications for Abenomics

June 2013: Tokyo Metropolitan Assembly election (preliminary skirmish ahead of the July 2013 Upper House election)

There is a high possibility of a big win for the LDP due to the high support ratio for Prime Minister Abes cabinet.

No major impact

June 2013: Cabinet approval of the comprehensive plan to restore fiscal health

Primary balance expected to decrease by half by FY15 and to move into the black by FY20.

No major impact

June 2013: Announcement of a growth strategy The impact on the economy will be less than that of monetary easing. On the other hand, as anticipation of the announcement is high, there is room for disappointment.

Potential for slight disappointment, but no major impact

July 2013: Supreme court decision on the constitutionality of the 2012 Lower House election

If the election is declared invalid, the Lower House election could be held over.

No major impact

July 2013: Upper House election (possibility of a double Upper / Lower House election)

Although the proposed revision of Article 96 of the constitution will be the focal point, there is a high possibility of a big win for the LDP due to the high support ratio for Prime Minister Abes cabinet.

No major impact

August 2013: Mapping out a medium-term fiscal plan

Concrete figures and progress schedule to be announced. No major impact

October 2013: Final decision on whether or not to raise the consumption tax from April 2014

If the consumption tax is raised, FY14 economic conditions will take a negative hit. However, if the tax hike is postponed, the financial risk premium could increase.

Slight volatility possible


Primary balance

The primary balance of Japans general account (initial budget) for FY13 forecasts a -4.8% deficit versus nominal GDP. Even though tax revenues are likely to improve due to the planned consumption tax hike, unexpected fiscal outlays are also possible, meaning that we cannot count on significant primary balance improvement. The risk involved in this scenario is that economic deterioration due to weak external demand leads to lower tax revenue, rising fiscal expenditures to stimulate the economy and lower nominal GDP, driving further decline in the primary balance as a percentage of nominal GDP. Moreover, if the consumption tax is not raised, annual revenue will not increase. In this case, in addition to seeing little improvement in the primary balance, concern over public finances could cause interest rates to rise.

Political risk

Considering the Cabinets high level of public support, we expect Japans July 2013 Upper House election to return a big win for the LDP, which means the implementation of Abenomics should not face significant roadblocks. Thus, the immediate focal point domestically is whether or not the consumption tax hike should be implemented in 2013, which has significant implications for the success of Abenomics. In terms of overseas influences, key upcoming events include a general election scheduled for Germany in September and discussions regarding who will succeed Fed Chairman Ben Bernanke in January 2014. These events will both impact the pace of global economic growth by affecting policy direction in their respective economies.

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The Outlook for Abenomics