For most of the last 30 years since Japan's bubble economy peaked in 1989, the Japanese economy has struggled with deflation, the stagnation or decline in the prices of assets and many goods. In 2013, Prime Minister Shinzō Abe launched Japan's most serious effort to end Japan's deflationary struggle, a series of stimulus and reform packages collectively known as Abenomics. The general consensus is that three critical factors must be addressed to bring on a sustained recovery to Japan's economy: creating wage growth, finding the right value-added tax rate and boosting the value of the Japanese yen.

Wage Growth

Since he became prime minister, Abe has pressured Japanese companies to raise wages for workers, which he believes will create a virtuous circle of increased consumer spending, resulting in higher corporate profits that will create room for further wage increases. His policies finally seem to be showing some positive results. In June 2018, real wages marked their fastest annual increase in more than 21 years with a 2.8 percent year-over-year increase. Household income also marked its fastest gain in three years with a 4.4 percent rise over the same time period. Signs of rising wages are encouraging for Bank of Japan policymakers, who have long been struggling to accelerate inflation to an elusive 2% annual target. 

Value-Added Tax

Consumer spending has struggled recently, in part, due to the 2014 increase in Japan's value-added tax (VAT), from 5 to 8 percent. Japan's national debt is enormous as a percentage of gross domestic product (GDP), at nearly 250 percent, and the government needs to raise revenue where it can. The VAT was scheduled to increase further in 2017 to 10 percent, but that increase was postponed until October 2019 as consumers struggled mightily with the original 2014 increase. 

International Monetary Fund chief Christine Lagarde is urging measures to ensure that VAT tax hike does not hurt the country’s economic growth. “We believe that the higher consumption tax will help fund growing health and pension expenses, and support fiscal consolidation,” she said. "However, we also recommend that the 2019 consumption tax increase be accompanied by carefully designed mitigating measures to protect near-term reflation and growth momentum. We believe that the fiscal stance should certainly remain neutral at least for the next two years."

Many economists predict the planned increase might trigger a wild swing in private demand that will put the brakes on the world’s third-largest economy, as happened in 2014.

The Value of the Japanese Yen

From 2012 to 2016, the value of the yen against the U.S. dollar declined approximately 30 percent, which was a boon for corporate profits. Japanese manufacturing competes primarily with Korean, Taiwanese and Chinese companies, and the value of the yen is a significant factor in the price competitiveness of those products. The weaker yen made Japanese products more compelling overseas, and profits earned in U.S. dollars or euros convert back into greater amounts of yen, boosting locally denominated profits.

However, since 2016, the yen has steadily gained against the dollar, but its fluctuations have remained difficult to predict. Analysts at ING point out that the value of the yen is closely pegged to the geopolitical environment, especially headlines related to US-China trade ties and EM geopolitics.

Abenomics Must Deliver

Abenomics has already delivered some meaningful reforms. Of note are liberalization of the electricity industry, participation in the Trans-Pacific Partnership, and the implementation of changes in corporate governance. Critics maintain there is much more to do, particularly in the areas of labor regulation and immigration. Because of Japan's graying demographic profile and enormous national debt, time is growing short, and opportunities to postpone big policy decisions are diminishing. As such, 2019 will be a critical year to determine if the Japanese economy can rise again.

Two popular exchange-traded funds (ETFs) for capturing the potential for Japan's escape from deflation are the iShares MSCI Japan ETF and the WisdomTree Japan Hedged Equity ETF. The iShares MSCI Japan ETF is not currency-hedged, while the WisdomTree Japan Hedged Equity ETF is hedged. If you expect the yen to weaken further, the WisdomTree Japan Hedged Equity ETF protects you from losses associated with the currency, while the iShares MSCI Japan ETF incorporates the yen's gains or losses into your return.