Japan: Decent economic growth in first half of 2019, central bank weighs options

According to the first estimate of Q2 GDP, growth came in at 0.4% compared to the previous quarter. Moreover, Q1 growth was upwardly revised by 0.1pp to 0.7% q/q. As such, Japan's economic growth experienced a pretty strong performance in the first two quarters of 2019 (Figure 1). Private consumption was the main contributor to Q2 growth, together with other domestic contributors such as business investments and government consumption. The second estimate of Q2 growth will be released on September 9[1].

[1] See Table 2 at the end of this economic update for our current forecasts for Japan, including the preliminary estimate of GDPQ2 growth. The final estimate of GDPQ2 will be included in the forecasts of our quarterly economic outlook, due mid-September.

Looking ahead, we see a mixed picture on the domestic front for the third and fourth quarter of this year, mainly due to the planned VAT increase on 1 October 2019. As a result of this sales tax hike, we expect that certain expenditure components, such as household consumption, will be pre-emptively brought forward. But so far, this effect has been quite invisible in the first two months of Q3 (Table 1). In the fourth quarter, we then expect moderate or even negative growth, despite some higher fiscal measures to offset the negative effects resulting from the sales tax hike.

Despite the relatively strong growth contribution from domestic demand, net trade acted as a drag in the second quarter. Growth in real exports was almost flat while imports increased by 1.6% q/q, laying the ground for a negative net trade contribution. In terms of exports, since late 2018 there is a clear split visible between exports to key regional trading partners on the one hand, and to the United States on the other (Figure 2). Given the cooling down of global trade volumes as well as the Chinese economy, the escalating trade war between the United States and China and rising tensions with South Korea (see below), these developments are a clear thing to watch for the period ahead.

Unsurprisingly, the Bank of Japan (BoJ) confirmed its current policy stance after a 7 to 2 vote at its last monetary policy meeting on July 30th (see here for the policy statement and summary of opinions). As a result, the BoJ is maintaining its combined policy of a -0.1% short term policy rate, a yield curve target of 0% ±20bp on 10 year Japanese government bonds (JGBs), and large-scale asset purchases. So as yet there have been no changes in BoJ’s ultra-accommodative policy, while other large central banks such as the Fed and the ECB have already suggested or even announced more stimulus. And although the consensus is increasingly shifting towards additional stimulus policies, the big question is when and how this will happen. Not in the last place because there seems to be some disagreement among policymakers. Opponents of additional stimulus through adjustment in policy rates and/or the yield curve target point to increasing financial stability risks. As a result of the central bank’s highly expansive policy, profit margins of commercial banks have fallen sharply, which could be detrimental to financial stability.

The central bank has been purchasing less JGBs lately, despite its policy of yield curve control. This policy is aimed at ensuring that the yield on 10-year JGBs fluctuates in a range of 0.2% around zero. The reason for the lower purchases is that the yield on 10-year JGBs has fallen below the lower bound of -0.2%, following a global decline in yields (Figure 3). Going forward, depending on further downward pressure on yields, it seems likely that they opt for a change in the lower bound, for example from -0.2% to -0.3% and/or lower JGBs purchases further. Overall, if one looks at the recent policy meeting’s voting behaviour (7-2), there is still a large majority in favor of the current setting. But the summary of opinions of the last meeting shows once again that policymakers would not hesitate to take action (i.e. even more monetary stimulus) in the event of more economic headwinds or the further absence of higher price pressures towards the inflation target of 2%.

Japan remains struggling with weak inflation dynamics as core inflation remained weak, although stable, at 0.6% y/y in July. Moreover, a stronger yen (JPY) leads to less pressure on prices from the import side. If the yen strengthens further, this results in a weaker inflation outlook (Figure 4). The JPY remains the safe haven of choice for financial markets on any sharp deterioration of risk appetite towards Asia, particularly with respect to geopolitical news. If one takes these factors into account, the BoJ at least has no other option than providing more clarity on its forward guidance or any policy steps at its next meeting on 18-19 September. Based on the most recent surveys and taking all the former into account, it seems logical that any next policy step will be a dovish one.

In terms of politics, there are a number of issues, namely the results of the July upper house elections, trade talks with the US, and rising tensions with South Korea. The July upper house elections yielded the expected victory for the coalition of prime minister Abe. Still, the PM failed to win the two-thirds majority needed to enable him to revise the country’s (pacifist) constitution. There was some speculation about a so-called double election in July. In that case, in addition to elections for the upper house, there would also be snap elections for the lower house. One key reason why this did not happen after all was related to the risk for Abe of losing the two-thirds majority that his LDP party coalition already has in the lower house. All in all, domestic political stability has been confirmed if one looks at this latest election victory.

On the external front, the risk of a direct trade confrontation with the US has eased, at least in the short run. The US and Japan reached an agreement on a draft trade deal at the most recent G7 summit. To put it briefly, Japan pledged to buy more US agricultural products, and in turn received some tariff reduction on manufactured goods, which in essence are quite low already. Therefore the US is seen as the main beneficiary of the deal, which is expected to be finalized before the end of September. The looming deal potentially helps Japan avoid tariffs being imposed on car exports to the US. But given that this is not explicitly part of the deal, it is far from certain that this threat is off the table.

In the meantime, diplomatic and trade tensions with South Korea have been escalating further over the last months. What started with a trade boycott, is now escalating on other fronts as well. Both countries have now taken each other off the preferential list of trading partners, and South Korea has terminated a military intelligence pact with Japan. Although exports to South Korea have been on the weak side recently, South Korea remains Japan’s third export destination after the US and China. As such, any further escalation of tensions would additionally deteriorate Japan’s external outlook. Any further escalation between the two countries will not only have harmful economic consequences; it also creates further geopolitical instability in an already unstable region.