Fragile recovery

Japan’s economic growth is expected to remain modest in 2022, and several downside risks could weigh on the outlook. After announcing a state of emergency thrice in 2021, with the third lasting nearly six months from April to September, the lifting of the emergency measures should boost domestic consumption (55% of 2019 GDP). According to PMI data, services business activity, which reflects domestic demand, expanded in October 2021, the first growth recorded since the pandemic’s start in early 2020. A high vaccination rate (80% of the population in early January 2022) also adds resilience to economic reopening efforts. Nevertheless, the pandemic in 2022 remains highly uncertain and therefore acts as downward pressure on services consumption and tourism (7% of 2019 GDP). Tight supply conditions would also likely constrain exports and industrial production growth, particularly in the automotive industry (12% of GDP). Major Japanese automakers have announced output cuts throughout the latter half of 2021 due to shortages in auto components. Merchandise exports (14% of GDP) have been a critical driver of Japan’s recovery from the pandemic and could come under pressure in 2022 due to sustained supply disruptions and China’s economic slowdown. The business fixed investment will be closely linked to industrial and trade performance. In the longer term, Japan faces significant structural risks to its long-run growth potential, with the most critical being adverse demographic changes. Limited monetary policy space and fiscal consolidation needs are also substantial risks.

Slow fiscal consolidation

We expect the reduction in the general government fiscal deficit (as % of GDP) in the fiscal year 2022 (FY22, starting April 2022) to be gradual due to higher expenditure needs, particularly health and welfare-related expenses, even as tax collections improve amid continued GDP growth. Combined budget requests for FY22 were at JPY 111 trillion, up 4% from FY21’s JPY 106.6 trillion, debt-servicing at over one-quarter of the total, and welfare spending at JPY 34 trillion (30% of the total). The final expenditure is likely to be even higher since the government routinely forms extra budgets each year since 2009, usually in the third or fourth quarter, which pushes back fiscal consolidation efforts. In November 2021, the government unveiled an extra budget for FY21 worth JPY 79 trillion, which is expected to raise new bond issuances to JPY 65.7 trillion, though still far lower than the JPY 112.6 trillion issued in FY20. Nevertheless, three rounds of heavy government stimulus since the onset of the pandemic are projected to push the level of outstanding long-term debt to JPY 1,212 trillion (USD 10 trillion) or about 217% of Japan’s GDP. However, over 90% of long-term public debt is owned domestically, with the Bank of Japan holding nearly half of the outstanding debt after years of massive bond buying.

The current account surplus is expected to remain in 2022, albeit slightly narrower, as a projected large positive income balance should offset a negative trade account. The upward trend in investment income since the mid-1990s, due to an increasingly positive net foreign asset (NFA) position linked to the rise in corporate saving, has helped offset a declining trade (goods and services) balance. A sustained global recovery in 2022 should underpin Japan’s investment income inflows. The trade balance is expected to remain in deficit as an estimated narrowing of services trade shortfall is likely offset by a smaller goods trade surplus. A gradual pick-up in travel-related services inflows on easing border restrictions and a modest rebound in international tourism should improve the services deficit. Meanwhile, a continued improvement in domestic demand would boost goods imports, thereby weighing on the merchandise trade balance, mainly when export growth (e.g., automobiles) is likely to slow amid prolonged supply chain disruptions and critical material shortages.

Factional politics constrain policymaking

New prime minister Fumio Kishida led the ruling Liberal Democratic Party (LDP) to victory in the 2021 general election, retaining a sole but more minor majority (56%) in the more powerful lower house. The ruling coalition controls 63% of the House of Representatives. However, the loss of LDP seats could mean that LDP may need to show more consideration to Komeito when making policies, especially in expenditure items. This is important ahead of the upper house election in the summer of 2022, where the LDP only held 45% of seats and had to rely on Komeito for a majority. Factional politics within the LDP could constrain the ability of Kishida’s administration for bold reforms, including generational renewal in the party. In the short term, Kishida will focus on domestic issues, particularly anti-pandemic measures, and economic recovery. An adroit ability to balance Japan’s relations with China and the United States will be a critical foreign policy challenge for Kishida. Meanwhile, relations between Japan and South Korea will likely remain tense.