The VAT increase on April the 1st has had a strong and negative impact on the Japanese economy. The inflation rate spiked to 3.4%, households’ purchasing power dropped dramatically and retail sales collapsed. On the manufacturing production side, the decline was significant.
These are mechanical effects of the higher VAT rate and this is a negative and persistent shock for the economy. In 1997 with already a VAT shock, the retail sales profile was the same than now and showed strong persistence. The impact was not only perceived in April but all along the year. Loss in purchasing power (see chart below) will not be reduced spontaneously and it is the trigger of this persistence.
The economy doesn’t seem to be able to counter-balance these factors. In fact, the labor market is unbalanced showing that the current dynamics is not sustainable in the absence of structural reforms. In other words, the jobs to applicants’ ratio is well above one. The labor force is not large enough to fulfill the labor demand. Until measures are taken to reduce this disequilibrium, this situation is not sustainable. The negative shock seen in April will drive the economy on a trajectory that is compatible with fundamentals.
The labor force is shrinking and that must be the major concern for economic policy in Japan. With lower labor force and less productive employees (this is the case with older labor force), it’s impossible to imagine a strong and durable GDP growth. Technical progress can limit their impact but cannot reverse it.
This can be a real setback for Abenomics. Why?
Abenomics’ target was to converge to a strong and sustainable growth rate. This is also a strategy to reduce public finance imbalances.
The strategy was threefold: 1 – A very accommodative monetary policy to exit from deflation and to change consumers’ behavior; 2 – A strong fiscal policy at the beginning with high public investment and then a tighter policy in fiscal year 2014 to put public finances on a sustainable path; 3 – Structural reforms to fix the economy on the strong growth trajectory.
The first two parts of the strategy worked well. Deflation became inflation and fiscal policy helped the economy to recover. The third part is still to come. Its role is to relax the constraint of the labor force. Japanese population is getting older and labor force is shrinking. How can it be possible to imagine a strong and durable recovery in these conditions? It is needed to increase the size of the labor force and that was the role attached to structural reforms. It can be attained by changing women’s role on the labor market and by opening frontiers to foreign workers. If there is no increase in size, short-term economic policies (the first two arrows) will only have short-term effects.
In April, the jobs to applicants’ ratio are above 1. There are jobs which are available but not enough people for them. With the negative shock coming from the VAT, the economy will lose steam and there will be no other mean to change the trend. In other words, structural reforms were expected to extend and reinforce the initial impulse from economic policy. This will not be the case.
Some says that an increase in wages can be expected. That would be positive by reducing the lost in purchasing power seen by employees but this will not change the downward trend in the labor force.
On monetary side, the yen has been deeply devaluated but the impact on exports has been limited. Is another 15 to 20 % necessary but will it change the labor force profile? No. Moreover the impact of the current devaluation on exports momentum has been low and has not created a strong impulse.
Abe is expected to announce measures on structural reforms in June. But it will probably be too late. The negative shock associated with the higher VAT rate has persistence and structural reforms need time to be implemented and to work.
In the months to come, economic dynamics in Japan will remain shaky as the negative shock will not be rapidly counter-balance by structural reforms.
The inflation rate surged at 3.4% in April
The inflation rate was at 3.4% in April after 1.6% in March. This directly reflects the higher VAT rate that has been put into place on April the 1st.
There will persistence in the higher inflation rate. For the city of Tokyo the inflation rate for May is already known. It is 3.1% after 2.8% in April and 1.6% in March. So a higher inflation rate can be expected for May at least. This will have a long-lasting impact on households’ purchasing power.
The last time that the inflation rate was so high was in August 1991.
Households’ Purchasing Power
One real issue with the Abenomics is that the higher inflation rate was not, for employees, matched by higher wages. This led to lower purchasing power and a loss of confidence in the government. Consumers’ confidence is lower now than when Abe was elected in December 2012.
The surge in the inflation rate in April has worsened the situation as it can be seen on the chart.
Retails sales was down in April: -4.4%
The chart below shows the impact of the VAT rate change on consumers’ behavior. They bought a lot in March but stay at home in April.
The comparison with 1997 is interesting. It shows that the shock associated with the higher VAT rate has persistence. We see that in December 1997, retail sales were still trending downward. We cannot exclude such a behavior in 2014 and a long-lasting negative impact on GDP growth numbers.
Industrial production is down by 2.5%
Last week PMI/Markit data said that in May the synthetic index was still below the threshold of 50. It was already below 50 in April at 49.3.
The manufacturing production index is down as orders were lower in April (see my post in French last week here)
In 1997, the index dropped in April but recovered during summer. Nevertheless, the persistent low consumption implied an index level in December 1997 lower than in April.Here again the impact can have a long-lasting effect.
Imbalances on the labor market
The jobs to applicants’ ratio is above one. This reflects a need to enlarge the labor force. That’s the reason for structural reforms.
The negative shock from VAT will have a strong impact on economic activity. The current imbalance on the labor market is a drag to a rapid rebound.
The labor force
Since the end of the eighties the labor force is shrinking. It’s a drag to a strong and long-lasting recovery. Structural reforms have to change this rapidly for the Abenomics to win.