Ever since Abenomics was announced in late 2012, we have explained very clearly (for example here, here, here, here, here, here and here) that the whole “shock and awe” approach to stimulating the economy by sending inflation into borderline “hyper” mode in a country whose main problem has to do with an aging population demographic cliff and a global market that no longer thinks Walkmen and Sony Trinitrons are cool and instead can find all of Japan’s replacement products for cheaper and at a higher quality out of South Korea, was doomed to failure.
Very serious sellsiders, economists and pundits disagreed and commended Abe on his second attempt at fixing the country by doing more of what has not only failed to work for 30 years, but made the problem worse and worse.
Well, nearly two years later, or roughly the usual delay before the rest of the world catches up to this website’s “conspiratorial ramblings”, the leader of the very serious economist crew, none other than Goldman Sachs, formally admits that Abenomics was a failure, and two weeks after Goldman also admitted that now Japan is informally (and soon officially) in a triple-drip recession, begins the scapegoating process when in a note by its Naohiko Baba,it says that Abenomics failed because all along it was based on two faulty “misconceptions and miscalculations.” Ironically, the same “misconceptions and miscalculations” that frame the Keynesian “recovery” debate in every insolvent developed world country which is devaluing its currency to boost its exports and economy, when in reality all it is doing is propping up its stock market, allowing the 1% of the population to cash out and leaving the 99% with the economic collapse that inevitably follows.
So what happened with Abenomics, and why did Goldman, initially a fervent supporter and huge fan – and beneficiary because those trillions in fungible BOJ liquidity injections made their way first and foremost into Goldman year end bonuses – change its tune so dramatically? Here is the answer from Goldman Sachs.
Blind spot from the outset in “weak yen = export recovery” scenarioA weak yen boosts export price competitiveness, fueling a recovery in export volume that supports a sustained economic recovery via improved corporate earnings, capex recovery, and wage growth. At least, this was the scenario painted when bold monetary easing was launched as the first arrow of Abenomics to induce yen depreciation. Government officials and market participants alike believed for a long time that the yen’s rapid depreciation thereafter would at some point drive an export recovery. However, a tangible recovery in export volume is yet to materialize.Actually, this is not the first time a weaker yen has failed to revive exports. Since the 1990s, Japan has experienced four phases of yen appreciation followed by depreciation, but in none of those phases was there any clear correlation between exchange rate and export volumes. Equating yen depreciation with export recovery would appear to invite multiple misconceptions and miscalculations (see Exhibit 1).Firstly, a weaker yen does not necessarily result in lower export prices (on a local currency basis). Since a weak yen also increases exporters’ input prices, it is unlikely that export prices will fall at the same rate that the yen declines in value. Export prices also have a more limited impact on export volume than global demand, making the latter a more important determinant for exports.
Odd: nobody could think of any of this before Abenomics was launched resulting in the largest domestic misery in Japan in over three decades?
The combination of these two misconceptions has led to a miscalculation about the latest phase of yen depreciation. Export prices have not decreased as much as in past yen depreciation phases and global demand has lacked vigor. Fiscal austerity, chiefly in the US and Europe and implemented around the same time as Abenomics, has weighed on activity, resulting in a muted global economic recovery. This alone is a key factor behind the miscalculation of the export recovery scenario, in addition to which Japan’s export volume has been less responsive to global demand than before.
Let the scapegoating begin: here are the two misconceptions why, according to Goldman, Abenomics failed:
Misconception 1: Export prices do not fluctuate as much as forexIt appears to be commonly accepted that a strong yen increases export prices and lowers export volume, negatively impacting the Japanese economy, whereas a weak yen lowers export prices, raising the price competitiveness of Japanese products and in turn spurring an export recovery, with positive implications for the economy. We see two misconceptions here. First is that export prices do not fluctuate as much as forex. When the yen is strengthening, prices of Japanese products rise on a local currency basis and price competitiveness falls, while the opposite is true when the yen is weakening. However, in past yen depreciation phases, export prices on a contract currency basis have only fallen by around 30% of the rate of yen depreciation. Looking at the 12-month average, excluding extreme forex movements, the fluctuation in export prices is minor (see Exhibit 2).Given that imported input costs fall and that hiking export prices undermines competitiveness when the yen is strong, the gap between the rate of yen appreciation and the degree of increase in export prices is large. In phases of yen depreciation, yen-based input prices rise, so covering higher costs does not require export prices to fall as much as the yen declines in value.Miscalculation 1: Export prices have not fallen as much as in past phases of yen depreciationOne miscalculation regarding the current phase of yen depreciation is that the decline in export prices relative to how far the yen has weakened has been milder than in past phases of yen depreciation. This is because rising crude oil prices and other fuel-related costs have inflated manufacturers’ input prices by 6.1% on aggregate since September 2012 and manufacturers have not been able to lower export prices and at the same cover the higher input costs. When the yen weakened in 1995-1998 and between late 1999 and early 2002, manufacturers’ input prices fell only marginally despite higher import prices driven by the weak yen. This made it easy for manufacturers to lower export prices to factor in the weaker yen. Conversely, when the yen depreciated between 2004 and 2007, manufacturers’ input prices rose 20% on aggregate on sharply higher crude oil prices, and they were able to hike export prices (see Exhibit 3).We see other factors behind the narrower decline in export prices this time. One is external considerations regarding government-led efforts to rapidly weaken the yen since the launch of Abenomics. The US has supported the BOJ’s quantitative and qualitative easing as a means of helping Japan escape deflation. However, concerns about the yen’s sharp depreciation are evident within the US. In January this year, US Treasury Secretary Jacob Lew made comments seeking to curb excessive yen weakness, saying that Japan would not see long-term growth if it overly relies on the forex rate. More recently, on September 22, William C. Dudley, president of the Federal Reserve Bank of New York, said that if the US dollar were to gain substantially in value then trade figures would worsen, impacting economic growth. Partly because US midterm elections are looming, there is consideration on the Japanese export industry side not to cause trade friction by using the weak yen to lower export prices and provoke a backlash from the US auto industry and other exportrelated sectors. We believe this stance is also intended to give Japan an advantage in remaining negotiations with the auto sector in the final stages of Trans-Pacific Partnership (TPP) talks. Therefore, we think one reason the 25% fall in the value of the yen has not led to lower export prices is foreign diplomacy and trade friction considerations.It is also possible companies have not ventured to lower export prices. The Development Bank of Japan (DBJ) has conducted a survey asking manufacturers why they have chosen to keep manufacturing functions in Japan. Interestingly, 54% of respondents cited mother factories (for production of core components) and 27% high-value-added production as key factors after management and R&D. Mass production of commodity products was a low 7.6%. An even higher percentage, more than 60%, cited product and service quality and performance as sources of their competitiveness, while a mere 1% said the currency afforded them a competitive advantage. Products still manufactured in Japan for export tend to offer high-value-added with strengths in terms of quality and performance, or are essential core components with high price and volume elasticity (i.e., products whose sales volumes increase if local sales prices fall), as opposed to mass-produced items. We think Japanese companies may also feel they can preserve the brand image of Japanese products as offering high-value-added and high performance by maintaining a certain local sales price. For the above reasons, we think Japanese companies in the latest phase of yen depreciation have likely adopted a strategy of securing yen profits arising from the currency’s lower value without cutting export prices (See Exhibit 4).Misconception 2: The key determinant of export volumes is global demand, not pricesThe second misconception is the commonly held belief that export volumes will recover if prices of Japanese products fall in export markets. Even in past yen depreciation phases the correlation between export prices (contract currency basis) and export volumes has changed from time to time, meaning lower export prices do not always translate into higher export volumes. From the end of 1999 in particular, although export prices dropped sharply as the yen weakened due to the BOJ’s zero interest rate policy and quantitative easing, export volumes also slid in the face of cooling overseas demand resulting from the bursting of the IT bubble.In short, overseas demand is the key determinant of Japan’s real exports. Indeed, exports and our Global Leading Indicator (GLI), a gauge of global economic trends, are closely correlated (see Exhibit 6).Miscalculation 2: Elasticity of export volume versus global demand falls, global demand softensA major miscalculation in the latest phase of yen depreciation is that global economic recovery has been muted owing to fiscal austerity undertaken mainly in the US and Europe during 2013. That the export volume reaction to global demand has been weaker than in the past has acted as a further headwind against the Japanese export recovery scenario. Comparing our export volume model calculations, in which export prices and GLI are explanatory variables, with actual export volume, we note that the latter has been constantly below the former since around the March 2011 earthquake (see Exhibit 7).We see several reasons why Japan’s export volume has not kept pace with the global economy: (1) Japanese companies have offshored production; (2) Japanese products are now less competitive than overseas products from other Asian economies and elsewhere; and (3) Japanese companies have adopted a strategy of emphasizing quality and brand and decided not to lower prices to gain global share (see Exhibits 8 and 9).We think exports have failed to recover during the latest yen depreciation phase due to several misconceptions and miscalculations: (1) Yen weakness does not necessarily result in a decline in export prices and this has been the case more so this time; (2) the impact of lower export prices on export volume is far more limited than global demand (GLI) in the first place; (3) despite the correlation between GLI and export volume, the offshoring of production and lower competitiveness of Japanese products have resulted in export volume being consistently below GLI since the March 2011 earthquake; and (4) the lackluster US and European economic recoveries have raised the risk of a further slowdown.
There is more, but the point is clear: we hear your apology loud and clear, Goldman, and we accept it – after all you couldn’t possibly tell the truth two years ago when this Keynesian insanity, which incidentally is being tried everywhere around the globe and will have the same results, was about to begin.
And now, where is Abe’s Imodium? He is going to need it.