TOKYO – The idea of a “K-shaped” recovery has gained loads of attention in the Covid-19 era. It’s when the wealthy get richer and things get worse for those in all tiers below.

Along comes Japan to customize this dreaded scenario: Covid-19 infections surging, while the deflation Tokyo worked hard to defeat these last eight years is trending downward, and worrisomely so.

These divergent trends throw cold water on the theory – or hope, in some quarters – that Japan might be following China into the economic recovery room.

Gross domestic product (GDP) reports are always ancient history by the time they hit the tape. But Japan’s batch of numbers – which bounced back to the 5% range in the third quarter – take this economic truism to entirely new levels as Covid-19 cases go on an unwelcome resurgence.

In the last several days, Asia’s No 2 economy set records for daily numbers of coronavirus cases, one after another. That puts Prime Minister Yoshihide Suga under pressure to impose fresh shelter-at-home edicts – or take even more drastic steps as cities from Sapporpo to Osaka to Shizuoka report renewed outbreaks.

Though it has not happened at the time of writing, the first casualty will likely be a suspension of, or end to, Japan’s “Go To” campaign of government subsidies to incentivize domestic tourism.

Longer-term, though, the bigger victim is a national economy that has been losing its footing for a year now.

Posters of “Go To” Travel campaign are displayed in Sapporo, Hokkaido on November 21, 2020. Photo: The Yomiuri Shimbun via AFP Forum

The stumble began with a self-inflicted sales tax hike in October 2019. Scores of economists warned then-Prime Minister Shinzo Abe that tighter fiscal policy might slow Japan’s exit from deflation.

In fact, it did something worse and the resulting 7.3% contraction growth between September and December put Tokyo in a remarkably weak position as the pandemic hit.

Since then, the ruling Liberal Democratic Party has thrown more than US$2.2 trillion – about 40% of gross domestic product – of stimulus at the fallout. The second wave of Covid-19 infections has Suga’s newly-minted government mulling another rescue spending package.

It also has investors betting on additional easing moves by the Bank of Japan.

Land of the rising yen

Adding to the sense of urgency is a rising yen, itself a product of a recurrent habit of Japan Inc.

The yen tends to rally when punters pivot to “risk-off” bets on the global economy. This safe-haven bid is exacerbated by Japan Inc’s penchant for repatriating overseas profits back home to shore up domestic operations when national growth slows. It’s an added headwind as 2021 approaches.

The trouble is, Japan may be out of ammunition to revive demand. It can surely spend more. Yet Asia’s No 2 economy has long since passed the point of what economists call “diminishing returns.” This is when conventional stimuli – such as public works projects – lose potency.

The BOJ is in a similar bind. For 21 years now, the central bank has held interest rates at, or below, zero. And since 2001, a succession of BOJ governors has experimented with quantitative easing.

Bank of Japan Governor Haruhiko Kuroda. Photo: AFP/Yomiuri Shimbun

Enter current BOJ head Haruhiko Kuroda, who since 2013 has been supersizing Tokyo’s QE efforts.

Since then, Kuroda cornered the government bond market. He commandeered stocks via massive exchange-traded fund purchases. His team gobbled up mountains of corporate debt and asset-backed securities. It even pushed government debt yields negative. By late 2018, the BOJ’s balance sheet surpassed the size of Japan’s entire $5 trillion economy.

While Kuroda & Co have been reluctant to pump more stimulus into the economy, upward pressure on the yen may force its hand. 

The 4.5% rise in the yen so far in 2020 is a clear and present danger to Japan’s export engine in 2021. Earlier this month, BOJ and government officials began telegraphing concerns about the strong yen.

Typically, that’s code for additional BOJ liquidity or even possible intervention should the yen approach the psychologically important 100 per dollar level, from 103 now.

The external sector is hardly conducive to a stronger exchange rate. The only thing surging in the US is Covid-19 – more than 12 million cases and counting. Europe is suffering its own second wave of infections.

As several of the globe’s biggest economies crater, the feedback effects will weigh on Asia’s biggest exporting powers, including China. It does not mean Chinese growth will flatline. It does, however, constitute another headwind with which President Xi Jinping’s team must contend.

‘Saw-shaped’ macro curve

Japan’s domestic scene is not much better as Suga scrambles to stabilize growth. Part of the problem is the myriad challenges Suga inherited from his predecessor Abe.

Yoshihide Suga (L) and former Prime Minister Shinzo Abe. Photo: AFP/Kazuhiro Nogi

After nearly eight years in power with firm majorities in both houses of parliament, Abe put few notable reform wins on the scoreboard. For the most part, Japan remains the same aging, uncompetitive and highly-indebted nation Abe pledged to revolutionize in 2012.

Now, it falls to Suga to mull ways to revive Japan’s structural upgrade process while opening the short-term stimulus spigot a bit more. If that weren’t already challenging enough, Suga’s government confronts a fresh coronavirus outbreak that may necessitate another state-of-emergency declaration that is sure to slam growth anew.

“This is clearly a risk we need to be aware of, with the potential for a return to national or regional emergencies a distinct possibility,” warns economist Robert Carnell at Dutch bank ING.

Economist Saisuke Sakai at Mizuho Research Institute adds that Japan is on a “saw-like recovery curve” – in other words, pulled abruptly back and forth with each Covid wave.

The risk is that Tokyo once again acts too slowly to contain the crisis. During the first wave, Abe took a page from US President Donald Trump and prioritized the stock market over public health.

Japan’s comparatively low case count of fewer than 2,000 deaths is in considerable part thanks to a responsible, proactive and mask-wearing populace. Japan has done well containing Covid-19 not because of Tokyo, but in spite of its low-energy response.

On Sunday, economy minister Yasutoshi Nishimura said Japan may re-impose attendance limits for sports and other large events. If that’s all Tokyo has on the table, then investors driving the Nikkei 225 Stock Average to the highest levels since the early 1990s have good reason to reconsider.

Will bulls retreat?

The bull case for Japanese shares is predicated on buoyant corporate earnings and overseas demand as Suga steps up moves to reduce bureaucracy, internationalize labor markets and encourage increased startup activity.

“The Suga administration’s push for structural reform will encourage more overseas investors to invest in Japanese stocks,” says strategist Kenji Abe of Daiwa Securities, who expects the Nikkei to reach 30,000 by the end of 2021, from about 25,500 now.

And the bull is clearly running.

A 2020 Summer Olympics promotion at the Metropolitan Government Office Building in Shinjuku, Tokyo, Japan. The Games are now set to be held next year. Photo: AFP

In the week ended November 6 alone, overseas punters bought nearly $11 billion of yen-denominated equities and futures. In the view of Daiwa’s Abe, investors looking Japan’s way are animated by Suga’s pledges to digitalize the economy, reinvigorate the small-and-medium-size companies, create a greener growth model and pull off the postponed 2020 Tokyo Olympics, now scheduled for July 2021.

But to achieve any of these changes, Suga must stay in power for longer than 12 months. Though Prime Minister Abe had seven-plus years in office, the six previous governments all came and went within a year with little progress to show.

Suga, in power since September 16, has resisted the urge to call a snap election to ensure he’s not another short-timer. That is starting to look problematic.

Pundits like Jeff Kingston, the head of Asian studies at Temple University’s Tokyo campus, reckon Suga hoped to put a noteworthy reform win or two on the books before facing voters.

And there are steps he could be taking now to kick-start his reformist momentum.

Some sweets for Suga

Suga could, for example, revoke Japan’s last sales tax hike, even the one before that, too. At a minimum, rolling back the October 2019 consumption tax increase 10% could boost household and business confidence. The same goes for scrapping, or suspending, the 2014 increase to 8%.

Both were characterized as necessary steps toward fiscal consolidation. Yet in both cases, Tokyo had to increase borrowing to offset the fallout. These steps, in other words, backfired.

Finance Minister Taro Aso arrives at the prime minister’s office in Tokyo on August 28, 2020. Photo: Kazuhiro Nogi / AFP

Next, Suga should set up a Covid-19 economic task force. Japan’s 80-year-old Finance Minister Taro Aso is plenty skilled at making gaffes about women, foreigners and the Olympics. Shepherding big reforms into fruition? Not so much. Putting a more energetic and creative team on the case could jumpstart Suganomics.

Since 2012, the LDP relied on stimulus sugar highs, while promising epochal upgrades that never arrived. To overcome this reformists-who-cried-wolf rap, Suga must roll up his sleeves and go big on ambitious and clearly targeted reform steps.

One particularly promising area is catalyzing a startup boom in the energy space. Suga recently announced plans for carbon neutrality by 2050. His government should be working up an ambitious mix of tax incentives, regulatory loosening and even government-backed financing if need be.

Suga also could turbocharge the BOJ’s stimulus efforts. Rather than reaching the BOJ’s 2% target, inflation is again trending negative. To revive pricing power, Suga’s party should empower the BOJ to start making regular cash payments directly to households.

It could deposit allotments of, say, 100,000 yen ($965) that won’t be replenished unless the full amount is spent.

Urgent action is needed as the coronavirus cases flare up anew. It’s bad enough the surge “could derail Japan’s fragile economic recovery,” says economist Yoshiki Shinke of Dai-ichi Life Research Institute.

Worse could be ahead. The pandemic could just make deflation a semi-permanent feature of modern Japan as China leaves it further behind.