After the BOJ left policy unchanged on Wednesday, the Nikkei 225 fell 5.16% in local terms, which would have been worse without a market holiday on Friday. The currency fared little better. The JPY lost almost 5% against the USD and now sits back at September 2014 levels.

We have been, and continue to be, bears on Abenomics. The “three-arrows” of fiscal stimulus, monetary easing and structural reforms have failed individually and collectively, leading to negative GDP growth in 5 out of the last 9 quarters. We summarise our views by answering three questions:

Why has Japan failed?

• Fiscal Policy:
  • Abenomics started with a fiscal spending package that saw the budget deficit break 11% in 2013. However, burdened with a debt-to-GDP ratio of circa 230%, the government soon lost its nerve, announcing a sequence of consumption tax hikes (next due April 2017).
• Monetary Policy:
  • The Bank of Japan continue to buy assets at an unprecedented pace (QE is 3x larger than in the US and 2x larger than in Europe). The central bank therefore now owns 35% of all Japanese Government Bonds (projected to reach 50% within 18 months) and, according to Bloomberg, is a top 10 shareholder in 90% of Nikkei 225 companies via equity ETFs. However, this has failed to spark inflation and, in turn, growth.
  • To understand this failure, we must consider the channel by which QE acts on the economy. It is a signalling tool, through which a central bank can commit to generating inflation via increased liquidity. However, that signal needs to be credible; if the accompanying inflation target is too low or “forward guidance” is inconsistent, then investors will expect policy to reverse at the first sign of price increases. This is a problem globally, but nowhere worse than Japan where the bank is unpredictable and changes policy justification on a whim.
• Structural Reform:
  • The favourite promise of politicians, Japan has so far failed to deliver any material structural measure.

What happens next?

• It’s old news, but Japanese government debt is unsustainable. Actually, it’s worse than that – the country is insolvent; no amount of stimulus will allow them to “grow” out of the problem. Instead, the government needs to engineer a pseudo-default by embracing inflation. This is a horrible policy, with savers paying the price of debtors’ profligacy, but is the only politically viable option to exit stagnation. Despite the failure, so far, to generate price increases, we think it is easily possible. The first method is a more credible commitment – higher inflation targets, nominal GDP targets and unlimited policy measures taken without blinking. The second is the nuclear option – “helicopter money” whereby the BOJ permanently monetises government debt. The risk here is losing the credibility of the currency; there can’t be a free lunch where governments indefinitely print money to fund themselves.

What are the takeaways for the rest of the world?

• Currencies have lost faith in QE:
  • We saw it earlier in the year after the ECB failed to cut rates but boosted asset purchases, leading to a sharp rally in the EUR. Now the relentless buying by the BOJ has seen no weakening of the JPY in 21 months. Policy now needs to innovate to keep market belief.
• Persistent Intervention and Lack of Cohesion breeds Stagnation:
  • Japan is a story of decades of disjointed policy, with imperfectly delivered stimulus creating a monumental influence of government institutions on market prices, but with little benefit. Europe fits a similar mould – the structural failings of the Euro (monetary union without fiscal union) leading to slow and confused policy.