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Oil price fall set to push Japan back into deflation

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By Paul Hodges on 03-Nov-2014

Japan CPI Nov14Could Japan actually go bankrupt at some point in the future?  This was the question left hanging in the air after Friday’s panic at the Bank of Japan, when its Governor forced through his new stimulus policy on a 5 – 4 vote.

Financial markets’ first reaction was to assume this was a coup de théâtre on his part, meant to ‘shock and awe’.  But central banks typically try to be as boring as possible, and very predictable.  Also, Japan is the land of consensus.

Clearly something is not right.  And Governor Kuroda’s press conference spelt out the issue – the return of deflation

“We are at a critical moment. There is a risk that victory over deflation may be delayed.”

Nor is it difficult to see why Japan might be about to topple back into deflation.  As the chart shows:

  • It has been in deflation for 2/3rds of the period from 1995 – 2013, 150 months out of 19 years
  • It was only out of deflation very briefly during this period – in 1996-8, 2006 and 2008
  • The latest increase, to 3.4%, took place in April this year, after sales tax was increased from 5% to 8%
  • Already the rate is turning down, and the impact of the sales tax will disappear from the index next April

Against this background, it would only take one “shock” for Japan to move back into deflation.  And, of course, just such a shock has occurred with the collapse of oil prices and other commodities over the summer:

  • Japan is the world’s 2nd largest importer of fossil fuels, after China
  • The Fukushima tragedy means it has been the world’s 3rd largest oil consumer and importer since 2012
  • Since June 16, the oil price has fallen 26% from $116/bbl to $86/bbl on Friday
  • On its own, this is highly likely to push Japan back into deflation

In addition, of course, the whole Asian region is seeing slower growth as China leads the Great Unwinding of policy stimulus.  There is little that Premier Abe or Governor Kuroda can do about either of these external developments.

The problem for Japan is that the Abe-Kuroda policies are highly risky for its economy, as I discussed last December:

  • It has the oldest population in the world, with a median age of 46 years
  • According to the OECD, 42% of the adult population are over 65, and this percentage is rising
  • One in two adults are in the New Old 55+ generation, when spending declines quite sharply

There is therefore no chance that the new policies, known as Abenomics, could work.

The OECD also calculate that Japan’s net relative pension level equals only 38% of net average earnings, so the drop in spending power on retirement is profound.  In addition, the collapse in fertility rates since 1955 means Japan’s population is already declining, from 127m today to 108m by 2050 according to UN Population Division forecasts.

So its GDP must now be on a declining trend, especially as Japan’s consumer spending is nearly 2/3rds of GDP.

Even worse, however, is that the so-called ‘3rd arrow’ of Abenomics policy – structural reform in the economy – has never been fired.  For example, female employment levels are just 63%, far lower than in other rich countries, and Abe has done nothing to change this.  Instead, he has focused on the other two arrows:

  • Massive monetary easing to push up stock market prices and create a ‘wealth effect’
  • Major government spending increases to try and boost demand
  • One key aim has been to devalue the currency to boost exports and create inflation
  • The yen has fallen by 1/3rd versus the US$ since Abe took office, from Y84 in December 2012 to Y112 on Friday

Friday’s announcement was more of the same.  The Y127tn ($1.14tn) Government Pension Investment Fund (GPIF) has been told to increase its stock market holdings by Y34tn, and to sell Y30tn of its government holding to the Bank of Japan.  The news led to an astonishing 3% fall in the value of yen versus the USD, from Y109 to Y112.

Kuroda’s policy announcement also showed he was aware of the bankruptcy risk.  Clearly no foreign investor would buy Japan’s government bonds – interest rates are near 0%, and they face a near-certain exchange rate loss.  This must be why the Bank of Japan will be buying the GPIF’s bonds.

But this type of manoeuver is essentially sleight of hand – Japan’s borrowing was in real yen, and will have to be repaid in real yen.  Similarly, its growing army of pensioners cannot live on electronic money.  They need real cash each week if they are to eat and to keep their homes warm in the winter.

And when deflation returns, it will increase the real value of the debt created by Abe-Kuroda, and so create a further headwind for economic growth.  Japan’s debt was already $80k for every man, woman and child back in March.  Abe-Kuroda’s policies are increasing this level on a daily basis.

Japan has not yet got to the point where bankruptcy has become a real risk.  But time is running out for it to accept demographic reality.  It needs to return to the sensible policies of Kuroda’s predecessor as Governor, Masaaki Shirakawa.  He understood very well the threat posed by current policies when warning in 2012:

“The implications of population aging and decline are also very profound, as they contribute to a decline in growth potential, a deterioration in the fiscal balance, and a fall in housing prices.”


The weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:

PTA China, down 24%. ”End-users who are in the re-export business were seeking cargoes”
Naphtha Europe, down 21%. “Naphtha supplies lengthened further this week, with petrochemical buyers continuing to opt for LPG”
Brent crude oil, down 18%
Benzene Europe, down 13%. “Sluggish derivative demand meant that some length was growing.”
¥:$, down 10%
HDPE US export, flat. “Traders said prices need to drop at least 10 cents/lb more to compete with China and Asian values”
S&P 500 stock market index, up 3%