‘Japanification Risk’ Returns in the Eurozone
Despite the global recovery in 2017-18, inflation in the advanced economies has proven to be the ‘dog that didn’t bark’ and with the recovery now giving way to a slowdown, price pressures look to be diminishing.
Against this background, the risk of ‘Japanification’ – economies sinking into a long period of low growth and low or negative inflation – has returned to the economic agenda.
This risk looks especially acute in parts of the Eurozone. Our synthetic ‘Japanification’ index, based on ten indicators (see note at the end for details), shows the highest risks being in peripheral Eurozone states like Greece, Italy, Spain, and Portugal (See Chart 1).
Several factors are spurring ‘Japanification’ risk in the Eurozone such as, persistently slow price growth, weak demographics (as described later), high private debt, high levels of bad loans at banks, low potential GDP growth and excessive savings by corporates (a positive corporate financial balance).
The good news is that Japanification risk overall looks lower than it did in 2016. Among the riskiest Eurozone countries, only Greece has retained its 2016 score, with the others improving. The biggest improvement has been in Italy, although its score remains elevated.
A key factor easing Japanification risk in the Eurozone since 2016 has been a strengthening of asset prices, with both housing and stock prices more firm. From 1998-2012, asset prices in the Eurozone showed a disturbingly similar downtrend to those in Japan in 1988-2002. However, since the ‘whatever it takes’ speech by the ECB’s Draghi in 2012 and the shift to a more expansionary policy stance (including QE), the trend in asset prices has become more favourable (See Chart 2).
Growth in nominal GDP in the ‘peripheral’ Eurozone has also picked up from very low levels in 2008-14. All the peripherals have done much better than Japan did in the decade or so after 1997 – with the striking exception of Greece (See Chart 3). The pick-up in growth in recent years has also helped curb the growth of bad loans at banks.
But the Eurozone is not out of the woods yet. Eurozone stock prices remain well below their peaks of 2000 and 2007 (as do house prices in the peripherals), the rate of inflation is still low, and the economic recovery of 2015-2018 has fizzled out.
The recent sensitivity of Eurozone growth to weaker world trade is itself a possible symptom of ‘Japanification’ – Japan’s growth has become increasingly dependent on fluctuations in external demand as domestic demand growth has been held back by weak demographics and excess corporate savings. The Eurozone could be going the same way.
Two especially important long-term weaknesses in the Eurozone are poor demographics and low productivity growth.
The population of working age in the Eurozone is dropping by around 0.2 per cent per year and this will persist and indeed worsen in the 2020s. Recently, the Eurozone has been defying this demographic drag to some extent, with the labour supply and employment growing at a reasonable pace. Retirement reforms are likely to have helped here. However, there may also be a cyclical element (better growth dragging people formerly outside the labour force into it), which won’t persist.
The weakness of productivity growth in the Eurozone looks very worrying. It was respectable in the 1990s but slumped in the 2000s after the dotcom bust, and has deteriorated even more since 2007. Across a range of estimates, it averaged just 0.1 per cent from 2008-18. This is worse than Japan, even in its worst period of deflation in the 1990s and 2000s (See Chart 4).
These long-term weaknesses, plus the global economic slowdown, appear to be feeding into a renewed slide in long-term inflation expectations. The probability of inflation staying below 1.5 per cent year over year from the survey of professional forecasters has risen to close to the peak level seen in 2016 (See Chart 5).
In addition to the similarities noted, the Eurozone and Japan have significant differences. Eurozone economies tend to be more open to foreign trade and have a different trade orientation (e.g. Japan’s trade is more oriented towards China’s). The Eurozone has also avoided some of the policy errors that Japan made in the 1990s and 2000s (such as allowing the yen to appreciate strongly).
Overall though, despite some improvement since 2016, the similarities between parts of the Eurozone and Japan in the 1990s remain uncomfortable with low growth and inflation as well as risk of sliding into deflation.
A deeper global downturn, perhaps combined with a renewed slide in asset prices, would intensify this risk. It is worth noting in this regard that Japan only clearly moved into deflation after a series of financial shocks in the 1990s; one more negative shock in the Eurozone could put it on the same trajectory.
Japan’s experience also shows that policy actions needed to halt deflation, once it begins, may need to be extreme. Rates remain at zero across the curve in Japan, the central bank owns over 40.0 per cent of government debt (more than double the share the ECB holds in the Eurozone) and the real exchange rate has depreciated by 30.0 per cent since 2011 and 50.0 per cent since 1995.
It is unclear if such policy efforts could be mounted in the Eurozone. Public debt levels are well above Japan’s in 1991– especially in the peripherals. Debt/deficit rules would constrain a fiscal response, as well. It is also unclear if QE could be expanded and sustained at Japanese levels for several years. Additionally, a lack of policy space could increase ‘Japanification’ risk in the event of further financial shocks and/or a deep recession.
Oxford Economics’ ‘Japanification’ indicator
The Japanification indicator is based on ten variables, each of which is given a score of one or zero depending on whether it exceeds or undershoots a key threshold. These thresholds are based on the Japanese values for the variables in 1998. Therefore, the total score ranges between zero and ten, with ten indicating the highest risk of ‘Japanification’. The list of variables, with thresholds in brackets, is as follows:
GDP deflator growth 2014-18 (1.0 per cent p.a. or less)
Private debt/GDP, per cent 2018 Q3 (over 160 per cent)
Working-age population growth 2016-20, per cent p.a. average (<0)
Working-age population growth 2012-21(F), per cent p.a. average versus 2002-11 (down 0.5 percentage points or more)
Total factor productivity growth 2013-18, per cent p.a. average versus 2001-12 (down 0.5 percentage points or more)
Non-financial corporate financial balance 2018 (>0)
House prices (latest) versus 2007/08 peak (down 5.0 per cent or more)
Stock prices (latest) versus 2007/08 peak (down 5.0 per cent or more)
Potential GDP growth 2016-25 (1.0 per cent p.a. or less)
Non-performing bank loans as per cent of all loans, latest (10.0 per cent or more)
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This update was researched and written by Oxford Economics, 121 St. Aldates, Oxford, OX1 1HB, England, as of 10 July 2019.