Japan’s “seniors’ moment”

Torrens read somewhere that Japan’s working age population is set to decline by something like 17% over the next 17 years (though data  from OECD says it’s more like 14%). This can be seen by the shift from the green distribution to the red.


Regardless of whether its 17% or 14%, it got him thinking about what the implications would be for the world’s third largest economy from such a significant decline in its workforce. The prospect of an aging Japan is starting to worry investors.  And, to borrow from Paul McCartney, TH reckons Mrs Suzuki might now be wondering whether financial markets will still love her when she turns 64? (Mrs Suzuki was the hypothetical representative Japanese investor that Canadian economist Kenneth Courtis used to use to animate discussions like this).

The demographic shift gives us two main issues to think about.  On the one hand, there is the effect on the labour force and the underlying structure of the economy.  On the other, there is the effect on savings.  In practice, the two issues are different sides of the same coin, but it helps to think about them independently.

The structural shift in Japan’s economy

First, it probably means that the labour force will contract, even if people like stay at home mums (or dads) are encouraged to enter the work force.  Second, given that Japan is a relatively high cost manufacturing location, it probably won’t be able to attract investment in quite the same way that China, Korea or Vietnam can. Put these two pieces together and it becomes fairly obvious that Japan’s GDP growth might well turn negative simply because the supply of productive resources (the amount of capital and labour) will be shrinking.  And unlike China, which can import productivity improvements from advanced economies, Japan which is on the technology frontier and may struggle to boost productivity growth in the future (though enhancing technology is something the Japanese clearly excel at).

Second, unless there are some other adjustments, most of the decline in productive capacity is likely to be in Japan’s labour intensive services sector rather than the capital intensive manufacturing sectors.  That is, the declining labour supply will likely result in a fall in the supply of services relative to manufacturing.

A savings shift

During the last 40 to 50 years, the Japanese have been notoriously thrifty.  It has consistently sold more onto world markets than it bought and saved the difference.  As a result, it is now the world’s largest net creditor. Its net international investment position was around 60% of its GDP in 2011. As its population ages, it will start running down those savings and it will start to spend a larger share of its income.

The increase in spending will probably go on both goods and services, but to the extent that the spending is likely to be age related, the mix is more likely to be on services than at present.

Bippity Boppity Boo

So put all this together and what do you get?  If this analysis makes sense to you, then you will likely conclude that over the next 17 years, demographic change in Japan will result in an increased demand for services at a time when the supply of services starts to decline.  As a result there will be an excess demand for services relative to goods, and one should expect the price of Japanese services to start rising (or alternatively the price of goods will start falling).

There are two ways this adjustment in relative prices can happen: either through inflation, or an appreciation of the exchange rate.   Until the recent dramatic change in policy regimes in Japan, it was the exchange rate that was appreciating.  Going forward, given the new monetary stimulus, inflation could play more of a role than previously expected (especially services prices).   Arguably, the sharp yen appreciation during the financial crisis and the shift of Japan’s trade deficit into surplus is an indication that these forces are already at work.

So why the worry about Japan?

By itself the forthcoming adjustment should not be a major source of concern so long as markets are able to adjust and clear the excess supplies and demands, all should be OK.  So why is everyone so worried about Japan these days?

The answer has to do mostly with the savings shift.  You see, despite Japan’s sizable holdings of foreign assets, it is widely believed that Japanese investors have a strong bias for Japanese assets. A phenomenon called home bias. Such a bias tends to mean that the price of these assets is driven up and correspondingly the yield on these assets is driven down.  In this respect, home bias has been a good thing for the Japanese government, which has issued a lot of debt (in net terms, it’s just under 140% of GDP).

Essentially, the Japanese government sold bonds to its high-saving, middle-aged population with the promise that future generations would repay them (you could imagine that one of them was Mrs Suzuki).  Now, instead of raising taxes (or cutting spending) to repay its debts, the government (with a budget deficit of around 9% of GDP) is borrowing heavily and rolling-over its existing debts.

But with Japanese saving less, the Japanese government will have to start relying more heavily on foreign investors to hold its bonds, and these investors are not likely to be as kind as Mrs Suzuki was to the Japanese government.  Increasingly, the marginal buyer of Japanese bonds won’t have a strong bias for Japanese assets; they will treat them just as they would any other asset and so the yield on Japanese government bonds is likely to start to rise.

Age related mis-calculations

Additionally, when fundamentals change (as they are in Japan), there is the chance that people (including policy makers) don’t recognise the changes that are underway and make decisions that are inconsistent with the new reality. In this case, the natural slowdown that the Japanese economy is experiencing might be misinterpreted as a lack of demand. Policy makers may be tempted to engage in too much stimulus for two long, creating excessive burdens of government debt and credit growth.

From Torrens Hume’s perspective, an aging population, increasing financing costs and excessive credit growth sound like a combination of factors to take pause over.

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