This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Craig Botham, Emerging Markets Economist at Schroders considers the possibility that Abenomics might not work.
There is a risk that Abenomics could fail. In particular, we believe that the VAT hike due in Q2 2014 could tip the economy back into recession. This would necessitate even more aggressive action by the Bank of Japan (BoJ), which would step up asset purchases to further weaken the yen. The Abenomics fails scenario captures the risk of a much greater depreciation than in our baseline scenario, with the yen falling to 130. Assuming that Japanese companies use the fall in the yen to cut prices - rather than just boost profits through higher export revenues, those who compete with Japanese companies will feel a squeeze on their market share.
There are two trade channels to consider: a weaker yen will reduce Japanese demand for imports, so countries for whom Japan is a large export market will suffer. The second, as already indicated, is the competitive advantage a weaker currency gives Japan. For this, we need to consider competition by industry and by market. Even if Japan and South Korea are both big exporters of electronics, the damage to South Korea will be limited if their firms do not compete in the same geographical markets.
To measure export industry competition, we use the export similarity index.
We utilise a similar concept for geographical market competition, and then multiply the two together to give an overall “competition index”. Plotting this against the share of Japan in country exports gives us a picture of emerging market vulnerability in the event of the failure of Abenomics. As might be expected, emerging Asia is flagged as being most vulnerable, with the South-East Asian countries above average on both measures of vulnerability. The Philippines in particular is revealed as especially vulnerable. At the other end of the scale, Middle-East, emerging Europe and North Africa countries look well positioned within emerging markets, while Latin American countries lie somewhere in the middle.
While South Korea and the Philippines seem likely to perform well compared to the rest of the emerging economies when considering the export recovery and effects of tapering, there is a potential risk from Japan. Given that the consumption tax comes into place in Q2, and we see a strong BoJ response occurring in Q3 in this scenario, it may be that South Korea, the Philippines and Taiwan perform well only in the first half of 2014 before beginning to struggle.
However, policymakers in each are likely to take mitigating steps. Fiscal deficits are small or even non-existent in all three, and inflation is also low, particularly in South Korea and Taiwan. There is consequently scope for monetary and fiscal stimulus to combat the effects of further yen depreciation.
