* Govt commitment to fiscal discipline, BOJ independence key to success
* Yen weakness here to stay, at least through spring
* JGB yields seen contained by domestic appetite, for now
* Move in right direction, details and political will crucial
* Deflation seen hard to beat, giving reprieve to bond yields
By Chikako Mogi
TOKYO, Jan 9 (Reuters) - The Japanese economy is expected to recover a little in 2013 if Prime Minister Shinzo Abe’s policies of massive fiscal spending, aggressive monetary easing, and a weaker yen produce the momentum needed to lift Japan from stubborn deflation.
Analysts say recovery in the first half of 2013 may also be boosted by a pickup in the world economy, and could then accelerate later in the year as consumers rush to buy before a sales tax hike planned for April 2014.
The real GDP growth rate will probably average around 1 percent, with some economists seeing the “Abenomics” stimulus packages possibly pushing growth as high as 2 percent in a drive to pull Japan from a decade and a half of nearly uninterrupted deflation.
Investors on the whole believe Abe recognises politics is both Japan’s best hope and biggest risk, and will display strong resolve to spur growth.
The key for the Abe government to succeed - where past governments with a similar set of prescriptions failed because they flip-flopped - is to stay the course of economic stimulus while cutting public debt and preserving the Bank of Japan’s independence.
“Failure by the government to pursue its policies thoroughly until it is fully confident of the recovery is the biggest risk,” said Takao Hattori, senior investment strategist at Mitsubishi UFJ Morgan Stanley Securities. “This is Japan’s last chance.”
Japan’s nominal GDP is estimated to have fallen to around 470 trillion yen ($5.4 trillion) in 2012 from a 1997 peak of 523 trillion yen.
The BOJ’s powerful easing is expected to help ease the yen’s prolonged strength, bolstering exporters’ global competitiveness while improving corporate earnings. Public works spending is expected to underpin the economy in the meantime.
But not all commentators are convinced that the tried-and-trusted strategy of monetary easing and big public works programmes of Abe’s Liberal Democratic Party will be up to the task.
“The key for Japan’s economy in 2013 is how the new government can map out a growth strategy and implement it rather than relying heavily on monetary easing and fiscal stimulus,” said Yasuo Yamamoto, a senior economist at Mizuho Research Institute.
“Quantitative easing alone would not help beat deflation, and spending big on public works could backfire if it involves more borrowing,” Yamamoto said, referring to Japan’s ballooning debt that already amounts to nearly 237 percent of GDP.
Sources familiar with BOJ thinking told Reuters the central bank would assent to doubling its inflation target to 2 percent - as Abe has demanded - at its next rate review meeting on Jan. 21 to 22, and fend off a challenge to its legal independence in setting monetary policy.
Analysts say there is nothing wrong with the government seeking an accord with the BOJ to achieve growth, but they warn the government of a severe market backlash in the form of “Japan selling” if it pushes too far.
“What is at stake is that both sides do their utmost on their part, the BOJ on monetary policy and the government in boosting the potential growth rate, not one or the other,” said Nobuyasu Atago at Japan Center for Economic Research.
Analysts and traders see the dollar ranging between 80 and 90 yen in 2013, supporting the Nikkei above 10,000 to around 12,000. Ten-year JGB yields will likely trade between 0.8 and 1.0 percent with the curve steepening to reflect premiums on deteriorating fiscal health, as more bonds will be issued to finance public spending.
Traders expect the yen to stay pressured until April at least, when a new BOJ governor who is expected to advocate for Abe’s reflationary policy is appointed.
“The world is quickly realising that Abe is serious about his pressure on the monetary policy of the BOJ,” said Neal Gilbert, market strategist at GFT Forex, who believes the yen may weaken to 94 against the dollar by the end of 2013.
The yen’s strength is seen limited to around 80 to the dollar, as institutional investors may want to sell the yen mainly due to Japan’s worsening trade balances.
Limitless money printing risks quickly transforming the current favourable yen weakness to “Japan selling”, however.
A 10 yen drop may theoretically boost consumer prices by 0.5 percentage points but in reality it will probably only add 0.1 or 0.2 percentage points, analysts say, because there is a limit to what printing money and a weak currency can do to beat Japan’s deep-rooted deflation caused by an acute lack of demand.
“It’s important the BOJ continues its powerful easing to beat deflation and, when necessary, take further action ... It’s very dangerous to think that once we have inflation, everyone will be happy,” said Eiji Hirano, a former senior BOJ executive.
Atago at the Japan Center for Economic Research said temporary spikes in JGB yields in the past had been limited to around 100 basis points: Markets have yet to experience the real effect of widening fiscal premiums, thus making it hard to predict what market reaction might be when public trust in the value of money is lost. But waiting for it to happen will be too late.
“A commitment to restoring fiscal health must accompany fiscal spending and bold monetary policy. The government should be mindful of the risk of the yen selling transforming into ‘Japan selling’ from a mere correction to yen strength,” he said.
Analysts also fear market retaliation if the government delays the planned rise in the consumption tax next year, a key litmus test in the country’s drive to fiscal consolidation.
To avoid repeating past mistakes, the government must concurrently pursue deregulation and tax reforms to spur improvements in the labour market and higher wages.
“Abe’s policy direction is right but public works-centred spending is worrying. If inflation rises and wages don‘t, it will only chill consumer spending and undermine the economy,” said Takeo Okuhara, fund manager at Daiwa SB Investments. “The consumption tax hike is inevitable, but the key is that its revenue is used to restore fiscal health and not wasted.”
A 44 trillion yen cap on new bond issuance is scrapped under Abe’s policy, but investors see neither runaway inflation nor yields shooting up.
“Two percent inflation is very hard to achieve. Structural changes are necessary for inflation accompanied by wage rises to take hold, but they are a multiyear task,” said Toru Yamamoto, chief fixed income strategist at Daiwa Securities.
JGBs have greeted Abe’s policy statements with a steepening curve that reflected concerns about supply as the government aims to sell over 5 trillion yen in new bonds to fund the budget.
But expectations the BOJ will expand its asset purchasing programme by extending the maturity of JGBs it buys to up to five years are putting downward pressure on yields while demand from key investors such as banks remains strong for 10-year bonds.
“Japanese investors will keep buying 10-year JGBs given the market’s deep liquidity and their very strict risk management that shuns active investment overseas. Domestic investors will continue to support the JGB market,” said Daiwa SB Investments’ Okuhara.
Risks to the main scenario are the United States delaying a fundamental solution to its fiscal crunch, elections in Italy in February and Germany in September that could change the tone for the euro zone’s push for fiscal reforms and preserving the currency union, and China’s economic prospects. Optimism that these factors will not pose a significant danger to the world economy has helped to encourage yen selling.
“Recovery in the U.S. economy is very important. Japan exports a lot of capital goods, so its exports are closely correlated to capital expenditure trends overseas,” said Masayuki Kichikawa, chief economist at Bank of America Merrill Lynch Securities in Tokyo. ($1 = 87.1300 Japanese yen) (Reporting by Chikako Mogi; Additional reporting by Tokyo Markets and Tokyo Economics teams; Editing by Eric Meijer)