Japan’s economy has struggled with deflation since its bubble economy peaked in 1989. In 2013, Prime Minister Shinzō Abe launched a serious effort, known as Abenomics, to help end the country’s deflationary struggle. Abenomics has been structured as a series of stimulus and reform packages. The 2013 initiative continues to be carried out with three critical factors of ongoing focus. To bring on a sustained recovery, economists are steadily monitoring: wage growth creation, the right value-added tax (VAT) rate, and support for appreciating the value of the Japanese yen.

Wage Growth

Throughout his reign, Abe has placed an emphasis on raising wages for workers. Continuously pressuring Japanese companies to raise wages for workers, he believes wage increases create a virtuous cycle of increased consumer spending followed by higher corporate profits that lead to more latitude 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% year-over-year increase. Household income also marked its fastest gain in three years with a 4.4% 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

In 2014 Japan increased its value-added tax from 5% to 8% which many economists believe to be a reason for consumer spending struggles. Japan uses the VAT as an important source of revenue to help make payments on its enormous amount of national debt. As of 2018, the country’s national debt to gross domestic product (GDP) was 238.20%. While the government would be helped by raising the VAT, it has postponed increases as a spending stimulus measure. The VAT was scheduled to increase to 10% in 2017 but that increase was postponed until October 2019.

International Monetary Fund Chief Christine Lagarde is urging resolutions to ensure that the 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%, which was a boon for corporate profits. The decline helped to make its products more attractive than many of its top manufacturing competitors in Korea, Taiwan, and China. As a result, its products were more compelling globally.

However, since 2016 the yen has steadily regained 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 emerging market geopolitics.

Abenomics Must Deliver

Japan’s economy is relying on Abenomics to deliver meaningful reform. It has already reported many milestones including the liberalization of the electricity industry, participation in the Trans-Pacific Partnership, and the implementation of changes in corporate governance. However, followers are still expecting more. In addition to improvements from the three key metrics, economists are also hoping for improvements in the areas of labor regulation and immigration.

While some great strides have been made, many critics of Abenomics feel the time is growing short. The exorbitant national debt continues to be a big challenge while opportunities to postpone big policy decisions are diminishing. As such, many believe 2019 will be a critical year for determining Japan’s global economic positioning.

The Japan Opportunity

Many investors may be looking to capitalize on the potential for Japan to overcome its deflation problems through the Abenomics initiative. For those investors, two exchange-traded funds (ETFs) have become popular. Both the iShares MSCI Japan ETF (EWJ) and the WisdomTree Japan Hedged Equity ETF (DXJ) provide the opportunity to profit from the country’s possible deflation escape. The EWJ is not currency-hedged while DXJ is hedged. For those that expect the yen to weaken further, DXJ protects from losses associated with the currency. Alternatively, EWJ incorporates all of the yen's gains or losses into its return.