Green shoots in Japan's economy

Putnam Fixed Income team, 03/29/21

  • The economy, damaged by the pandemic, is showing signs of recovery amid higher consumption and exports.
  • Japan's high-tech sector could attract new investments from China.
  • The Bank of Japan fine-tunes policy to allow wider fluctuations on 10-year bond yields.

Japan's economy, the world's third largest after the United States and China, remains fragile but continues to show resilience, in our view. Government stimulus, high savings rates, and a rebound in overseas demand should help support growth over the medium term.

Fragile growth and deflation

The economy grew 2.8% during the October to December period, for an annualized growth rate of 11.7%. It was Japan's second consecutive quarter of growth. But that was slightly weaker than the preliminary estimate of 12.7% annualized growth and 3% from the previous quarter, according to government data. The economy was boosted by private and government consumption, a jump in exports, and investments. Private consumption, which accounts for more than half of GDP, rose 2.2%, and capital spending grew 4.3% from the previous quarter. Overseas demand, especially in China and the United States, boosted exports.

However, we believe that the growth remains fragile in the short term. The economy is likely to contract in the first quarter of 2021 (January to March) as the services sector will be disrupted by the government's state of emergency. The services sector has weakened in the last two months and remains in contraction territory. The au Jibun Bank Japan Services Purchasing Managers' Index (PMI) was a seasonally adjusted 46.3 in February, staying below the 50 level that signals contraction. That said, the outlook for small businesses has improved, in our view, although small-business sentiment dropped in February.

Inflation chart

A bright spot was manufacturing

Japan, a leading exporter of manufactured goods, saw its Manufacturing Purchasing Managers Index (PMI) advance amid robust demand for goods. However, container shortages, as well as cost hikes, are likely to start weighing on activity, according to press reports. This is in addition to the short-term supply chain disruptions stemming from the earthquake in the Fukushima area.

Japan has been struggling with deflation for more than two decades. Recent nationwide and Tokyo Consumer Price Index (CPI) data rose slightly while staying in deflation. The suspension of the "Go To Travel" campaign contributed to the smaller decline in prices from previous months. "Go To Travel" was started by the government and had provided travel discounts to encourage domestic tourism. If the government lifts the state of emergency in April and the travel campaign resumes, the downtrend in CPI is likely to accelerate in the spring. Cuts to mobile phone fees will also be temporarily deflationary.

Vaccinations lag the United States and the United Kingdom

The country's economic outlook is expected to improve as Covid-19 infection rates decline, provided mobility restrictions are not extended beyond March. Japan has lagged other major economies, including the United States and the United Kingdom, in rolling out vaccines.

We expect economic activity to accelerate in mid-2021 as the vaccine rollout gathers steam.

The government only started inoculating its population with Pfizer-BioNTech shots in February. We expect economic activity to accelerate in mid-2021 as the vaccine rollout gathers steam. The Tokyo Olympics will be held in the summer, but without international spectators, the games should only marginally add to growth.

Households with disposable income

Japan, like the United States, has boosted household savings with various fiscal measures during the pandemic. In an aging society like Japan, it remains to be seen how much of this "excess savings" will be spent as the economy reopens. In our view, the extra cash should bolster domestic growth for a while. In addition, the government's relief program for small and midsize companies hit by the coronavirus pandemic remains in place.

Over the medium-term, the key factor affecting Japan's outlook will be overseas demand. Expected acceleration in major economies should be supportive of Japanese growth as well. Beyond this acceleration phase, demand from China is likely to stay strong. China's new five-year plan envisions increased investment in high-tech manufacturing. This type of development plan depends more on the imports of high technology tools and machinery. Therefore, under this new cycle, Japan should benefit relatively more than commodity exporters.

Central bank sets wider fluctuations for bond yields

In March, the Bank of Japan (BoJ) said that it would keep its current interest-rate targets while allowing more flexibility for long-term rates, increasing the band to 0.25%. The measure will essentially allow the 10-year Japanese government bond (JGB) to fluctuate a little more widely. The central bank previously allowed 10-year bond yields to rise and fall 0.2% in each direction around its 0% target. The central bank maintained its effective policy rate at -0.1%.

When the economy improves, interest rates naturally rise. However, under the BoJ's yield curve control regime, JGB yields do not move freely. When global interest rates increase, to allow the JGB curve to move with global rates, the BoJ tends to widen the band slightly.