The Journal The Authority on Global Business in Japan

Lead1

For more than 40 years, Japan has been secure in its position—alongside the United States and China—as one of the world’s three largest economies in terms of real GDP. This is even despite the past 20 years of anemic growth.

According to a 2016 report, Japan’s level of economic freedom, as ranked by the Index of Economic Freedom—and measured according to 10 components—had been on the rise following the report’s inception in 1995.

However, since the 2008 Lehman shock, the ranking of Japan’s economic freedom has remained lackluster, and the country is falling behind competing nations.

What is economic freedom?
Economic freedom rankings are based on the average score of 10 components that reflect fixed aspects of a country’s economy. Over the long term, factors that foster or hinder economic freedom can affect substantially a nation’s GDP growth.

The 10 components evaluated in the annual index are: property rights; freedom from corruption; fiscal freedom; government spending; freedom in terms of business, labor, and monetary policy; as well as trade, investment, and financial freedom.

Countries where it is relatively easy to open and close a business, for example, or where labor mobility is high, would be favorably scored according to the components of business and labor freedom.

Meanwhile, excessive taxing and rampant government spending would lead to a reduced score in the fiscal freedom and government-spending components.

The information that goes into the Index of Economic Freedom is collected from a variety of sources, including the Organisation for Economic Co-operation and Development, the International Monetary Fund, and the Asian Development Bank (ADB).

How does Japan rank?
In the 2016 index, of 178 world economies, Japan ranks 22nd, with an aggregate score of 73.1 out of 100. This places Japan’s economy in the category of mostly free.

There are five rankings possible in the index: free, mostly free, moderately free, mostly unfree, and repressed. This year only five economies—four of them directly competing with Japan in the Asia–Pacific region—were ranked free: Hong Kong, Singapore, New Zealand, Switzerland, and Australia.

These nations have achieved top rankings in the survey nearly every year, with Canada and Ireland occasionally also figuring in the ranks of free economies, instead of the mostly free category where they rank in 2016.

Japan ranks sixth among all Asian nations, just behind Taiwan, which scored 74.7 out of 100.

Japan’s numeric score places it above 90 percent of the countries surveyed in the Index of Economic Freedom. But, when individual components are examined closely, specifically government spending and fiscal freedom—which typically reflects consumer and corporate tax rates—Japan scores far below the world average.

The 2016 world averages for government spending and fiscal freedom are 65.7 and 60, respectively; Japan scored 46.2 and 48.8 in said categories.

In addition, Japan’s level of monetary freedom, a component reflecting inflation rates and price stability, has continued to fall over the past 10 years. The country’s score in this category is likely to drop below the current world average of 75.7 sometime in the near future.

Japan currently scores 81.2. Greater central bank intervention, rather than market dependence, tends to have a negative effect on monetary freedom.

Meanwhile, compared with other countries, Japan has flourished in such areas as improved freedom in business, labor, and trade. It is still relatively easy to set up a business in Japan, with only eight procedural hurdles to overcome, according to the World Bank Group’s Doing Business 2016 report.

Then there is the fact that Japan has the typical labor components of a free developed country: good labor force participation (59 percent), relative ease of hiring, and severance pay.

As an island nation, Japan has increasingly focused on bolstering trade relations. Japan’s average tariff rate is 1.2 percent, versus 1.5 percent for the United States.

Source: The Heritage Foundation’s 2016 Index of Economic Freedom.

Source: The Heritage Foundation’s 2016 Index of Economic Freedom.

Competing economies
Over the past few years, in a bid to maintain its ranking among the index’s top 20, Japan has been neck and neck with a number of European countries, including Iceland, Austria, and Sweden.

In the Asia–Pacific area, some of Japan’s largest trading partners, including South Korea and Malaysia, are catching up in the rankings (27th and 29th, respectively) as they look to increase fiscal and financial freedom.

Economic freedom will grow as other countries in the region deregulate domestic markets, a more stable environment is created by placing greater emphasis on the rule of law, and where government is less intrusive in markets than in Japan.

Countries such as the Philippines and Vietnam have freed up their economies dramatically in recent years, by increasing trade freedom and regulatory efficiencies.

And the potential economic gains are already being seized, as is seen from increased foreign direct investment (FDI) in those countries, and broader investments in the nations by multinational organizations such as the ADB.

In 2014, the Philippines and Vietnam had net FDI inflows of $9 trillion and $6 trillion, respectively.

Investment will continue to expand in the region, as China’s Asian Infrastructure Investment Bank, which opened for business in January 2016, looks to begin investing in projects in developing countries such as Indonesia.

The burden of monetary policy
Much like its economy, Japan’s economic freedom is stagnating. Even before Abenomics, the Bank of Japan (BOJ) continued its near-zero (.05 percent) interest rate policy for almost two decades.

Only now, additional quantitative easing has been integrated into monetary policy, with the BOJ buying government bonds to increase the monetary base by anywhere from ¥5 trillion to ¥7 trillion a month.

Of Prime Minister Shinzo Abe’s three arrows of structural reform, one and two were always seen as quick and easy solutions to getting Japan out of its economic stagnation. The difficulty lies in the implementation of the third arrow, including the enactment of promised structural reforms.

In many aspects, Abenomics’s third arrow began a Goliath transformation of the nation’s business environment. Japan’s implementation of a Stewardship Code in 2014 essentially redefined corporate governance nationwide.

Abe’s goal to include more women in the workforce and his administration’s accession into international trade initiatives such as the Trans-Pacific Partnership have reflected positively on the nation’s reputation abroad.

In addition, Abe’s stated aims to lower the corporate tax rate to below 30 percent by 2020 and further deregulate industrial sectors such as agriculture bode well for FDI. Abenomics 2.0 has made broader promises to tackle the issues brought on by an aging society.

Still, many of these policy changes are slow to take effect. Innovation takes time, and society as a whole is weighed down by the higher social and regulatory costs associated with doing business in Japan, rather than in some emerging free economies.

Because of the relatively short implementation time required for changes in monetary policy and government spending, the government returns to these measures to spark growth. In doing so, however, it stacks the deck against future generations, who will have to deal with the increasing burden of a graying society.

Japanese households aren’t directly profiting when the BOJ purchases government bonds, as monetary policy has a trickle-down effect. Businesses in Japan today are retaining greater profits, while real wages remain stagnant. Part of this is also reflected in the low job mobility rate, despite an increase in the number of jobs.

Add to this the nation’s near-zero interest rate policy, a fixation on a 2 percent inflation target, and the occasional consumption tax hike, and it is no wonder households are suffering under the first and second arrows’ regulatory burden.

Buy more things, please
Policymakers continue to blame the economy’s lackluster growth on Japan’s low consumption. They use this argument to defend the 2 percent inflation target and planned increase in consumption tax. The rationale is the need to jump-start the economy by forcing people to spend now rather than later.

For households, though, consumption has remained strong over the past 20 years. It’s hard to imagine this increasing any further, given the current state of Japan’s economy and stagnant wages.

Household investment has also steadily decreased in recent years. Japanese households just aren’t saving as much as they once did, which puts downward pressure on potential future household consumption, irrespective of another consumption tax increase. Meanwhile, government consumption remains strong.

Considering its current monetary policies, Japan should brace itself for more short-term recessions. It has had at least four recessions over the past 10 years, although it had no post-war recession until 1990.

With bond purchases increasing and interest rates diving ever further into negative territory, recessions may become more frequent.

That said, Japan should experience economic gains from the structural reforms accompanying the implementation of Abenomics’s third arrow, although in the near term, any such gains should not be expected to offset the malaise brought on by monetary policies.

One would be remiss to omit reference to Japan’s growing debt when discussing its fiscal and monetary policies. Certainly Japan is less susceptible to global interest rate movements than are other nations, since most of its sovereign debt is held domestically.

But no, this doesn’t mean it should continue paying little or no attention to its public debt. After all, the figure is at least double the nation’s total GDP.

Bond purchases of debt look nice when interest rates are low, and the lower the interest rates fall, the better the prospects appear. But this continues to play into the catch-22 situation that Japan has created, by selling promises today at tomorrow’s price.

The interest rate policies established to date essentially have trapped bondholders. Any rise in interest rates will create a massive loss of wealth for those holding sovereign debt.

Where there’s hope, there’s a way
Japan’s economy is a paradox. The nation holds enormous wealth with a high per-capita GDP, but real GDP has hardly increased since 1997. Japan has the potential to be innovative and the ability to keep from crashing hard.

The question is whether the policies now in place can prepare Japan for the future, or whether Japan’s economy will continue to drag along, as neighboring countries become more economically free and ripe for investment.

Many Japanese investors are already looking offshore for gains. The value produced by Japanese across the world, relative to simply the value produced domestically, has been increasing each year for the past 30 years.

In the 1990s, the gap between gross national income and GDP increased to about 1 percent annually, while in the 2000s the difference edged to about 2 percent. It’s now closer to 3 percent. In 2013, Japanese made almost ¥17,900 trillion more abroad than they did at home.

The trend is also reflected in foreign investment figures. Seeking to reap greater value for its money abroad, over the past few years Japan has invested roughly three times more in the United States than the United States has invested in Japan.

In 2014, US investment in Japan came to $108 billion, while Japanese investment in the United States totaled $373 billion. In fact, investment into Japan has just barely returned to pre-Lehman shock levels.

The good news is, however, that Japan’s economy isn’t at risk of corruption or having property rights taken away from its citizens, unlike other countries in the region. Social and regulatory hurdles will continue to negatively affect job mobility, however.

It will take time for such traditions of the working environment as seniority-based promotions and long working hours to reach levels on par with global norms.

Abenomics’s third arrow has set in motion commendable reforms that could make Japan better suited for international investment. Japan is already a leader in pioneering and implementing tech-based programs, such as greater automation through robotics and the Internet of Things.

But there is still room for improvement, with increased deregulation on a national scale and a decrease in government-related inefficiencies.

The questions that must be answered now are: Should the monetary and fiscal policies that have persisted over the past 20 years continue? Will the government and BOJ continue to risk tomorrow’s economy for possible gains today?

And will Japan be able to keep its economic freedom on par with that of competing regional and first-world economies?

Source: Cabinet Office Annual Real GDP (calendar year)

Source: Cabinet Office Annual Real GDP (calendar year)

Originally from Alexandria, Virginia, Riley Walters is a research assistant at the Heritage Foundation, a public policy research institute, who has lived in Japan.
Japan’s average tariff rate is 1.2 percent, versus 1.5 percent for the United States.