Is Japan finally at an inflection point?

After more than two decades of sluggish growth and deflation or very low inflation, there are signs that the Japanese economy may finally be reaching an inflection point, with a number of structural changes under way.

External shocks due to the pandemic and the Russia-Ukraine war seem to have led to real changes in corporations’ price- and wage-setting behaviour, which may support a more sustained inflation outlook in Japan. If sustained, recent increases in employee compensation and corporate capital investment could lead to a Japan that is structurally different from the past few decades. Indeed, inflation expectations among businesses and households alike have moved up, with a tight labour market set to contribute further to upward pressure on wages.

Given Japan’s status as a US ally and its strength in some high-tech sectors, it could benefit from the on-going global supply-chain reshuffling against the backdrop of rising US-China tensions. In short, helped by extensive government financial support, Japan could attract more corporate investment given the trend toward ‘friend-shoring’. Also, Japan should benefit from its proactive participation in a web of economic and trade agreements, including the biggest ever trade agreement signed by the EU (in 2018). 

At the micro level, Japanese corporate profits have grown substantially since the mid-2010s, while labour productivity is also showing signs of improving. In addition, recent new initiatives by the Tokyo Stock Exchange to address listed companies’ low valuations will likely enhance both management quality and capital efficiency. Investor activism is also on the rise and may further contribute to corporate reforms.

Japan still faces considerable challenges—not the least of which is its rapidly ageing, shrinking population, which will limit the country’s growth potential. The sustainability of Japan’s public finances is another issue. Japan has the highest debt-to-GDP ratio in the world, and various attempts towards fiscal consolidation have been blown off course by external shocks. Furthermore, the Bank of Japan will face a daunting task if it wants to normalise its ultra-accommodative monetary policy without causing significant turbulence.

Nevertheless, after years of near stagnation, the conditions may be in place in Japan to sustain a virtuous cycle of endogenous growth, despite several important structural headwinds. In essence, the Japanese economy may have finally moved out of the shadow of a balance-sheet recession after decades of deleveraging. The possibility of a period of sustained inflation coupled with the right incentives and a changing geopolitical landscape together with evidence of a simultaneous increase in employee compensation and corporate capital investment could lead to a Japan that is structurally different from the past few decades.