Donald Markwardt
Senior Research Analyst, International Finance and Macroeconomics Research
Capital Flows and Systemic Risk
Donald Markwardt is a senior research analyst in international finance and macroeconomics at the Milken Institute. He studies topics relating to systemic risk, capital flows and investment. Concentrating on systemic risk assessment in the financial system, his recent work focuses on liquidity and financial stability in the asset management industry.
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Is Abenomics the best thing since sushi?
By: Donald Markwardt
August 21, 2013
Since the announcement of Abenomics this spring, much attention has been focused on whether the program can resurrect a Japanese economy that has suffered two lost decades. The fact that it relies heavily on quantitative easing aEUR" on steroids aEUR" has been well-noted by market participants and policy wonks alike. For now, Prime Minister Shinzo AbeaEUR(TM)s program has gained the approval of equity investors, with the Nikkei 225 index advancing nearly 35 percent since the beginning of the year. GDP growth is the best itaEUR(TM)s been in years, despite slipping to 2.6 percent at an annual rate in the second quarter. Consumers seem more confident, while businesses indicate their willingness to increase capital investment in hopes of expanding their global market share if the yen weakens further, as expected. Although the results of the program so far can be viewed as exceeding most expectations, naysayers remain undeterred, given the long history of policy failures. The majority of skeptics focus on the promise of structural reforms to complement ongoing fiscal and monetary stimulus efforts. Removing protective labor laws, promoting female workforce participation and easing immigration restrictions on skilled workers are widely seen as some of the many reforms required to bolster long-term growth prospects. Critics also warn that the recent momentum in consumer confidence could eventually grind to a halt if Japan goes ahead with its plan to double the consumption tax. A similar hike was implemented in 1997, with severe economic repercussions. However, JapanaEUR(TM)s financial system may be healthier and better able to withstand higher taxes today, but Abe hasnaEUR(TM)t made a final decision on the question. Nevertheless, AbenomicsaEUR(TM) real Achilles heel could be a rise in inflation, triggering a flight of Japanese bondholders to foreign debt. Intermediate Japanese government bonds (JGBs) yielding south of 1% arenaEUR(TM)t so bad during deflationary times, but they become considerably less attractive if inflation picks up and their real yields turn negative. One of the Bank of JapanaEUR(TM)s (BOJ) explicit goals is to lift Japan from its deflationary mire by doubling its monetary base and achieving 2 percent inflation. This appears right on target, with inflation expectations increasing significantly and CPI readings finally turning positive. The question is whether domestic bondholders will be content to sit on JGBs if inflation picks up as is likely, or dump them in favor of higher-yielding foreign assets. July witnessed the largest net purchase of foreign bonds by Japanese residents in three years, led by banks. If investors abandon JGBs for greener pastures, it may be hard for the BOJ to contain interest rates all on its own aEUR" most of its monthly purchases are needed to accommodate JapanaEUR(TM)s high fiscal deficits. The government could find itself in a difficult position of generating revenue to offset its rising debt service, which already absorbs 30 percent of tax income even at low interest rates. For this reason, the IMF recently advised Japan to follow through with its sales tax increase to avoid a potential crisis. As Abenomics tries to supercharge JapanaEUR(TM)s economy and achieve escape velocity, the governmentaEUR(TM)s challenge is to keep its debt and servicing costs under control without resorting to policies that dampen near-term growth. Uncertainty or a loss of confidence in the JGB market can also be problematic for Japanese banks, which have accumulated sizeable JGB holdings. Unwinding those purchases risks stirring bond market volatility and pushing up rates in a self-reinforcing cycle similar to JapanaEUR(TM)s 2003 bond market shock, when yields tripled from 0.5% to 1.6%. Fortunately for banks back then, their bond exposures were not as large as they are today. The BOJ estimates that a 100 basis point rise today would wipe out 35% of regional banksaEUR(TM) Tier 1 capital, plus 10% at major banks. Clearly, continued low JGB yields are crucially important for JapanaEUR(TM)s government and banks alike. But the significance of AbenomicsaEUR(TM) outcome is not limited to Japan. World leaders and central bankers are watching intently, wondering whether AbeaEUR(TM)s grand experiment will triumph or flop. The answer could greatly influence the direction of global economic policy.