ISA Briefing: Key economic questions for China and Japan

Looking ahead

• Western commentators have generally been disappointed at China’s lack of bazooka stimulus to reinvigorate the economy. The Chinese government’s approach has been to instead focus on smaller stimulus measures or targeted policy shifts. We believe that even if all these supportive actions fail, China still has many options it can implement to boost the economy. In our view, there is a high probability that the Chinese economy could reach its 5% GDP growth target by the end of the year. 
• China’s mild economic recovery and slowly improving business and household confidence suggest the demand recovery for income-producing real estate in China could be modest in the near term. Net absorption of major sectors including office, logistics, retail and rented multifamily in the next 12-18 months is likely to be below the levels seen in 2021.  
• Troubled for-sale residential developers may continue to offload assets to repair their balance sheets. Over the past decade, Chinese developers have built large portfolios of commercial real estate, mainly composed of offices, retail malls, and hotels. A small number of these developers also own assets in our favored sectors, such as multifamily rental and logistics. Distressed sales at attractive prices could continue to surface in the next 6-12 months. 

The path of Japanese monetary policy

The Bank of Japan (BoJ) remains an outlier among global central banks, as it continues to maintain ultra-accommodative policy in the form of yield curve control (YCC). The BoJ introduced YCC in 2016, with the intent to keep 10-year government bond yields low to stimulate consumer spending and business investment. Over the past year, speculation has mounted as to whether this policy would be sustained, with volatility being triggered around moments of policy adjustments or speculation that YCC would be abandoned.

Most recently, on September 22, the BoJ kept the YCC policy unchanged with a unanimous vote. The 3-month rates used a reference for borrowing costs have been bouncing around -0.2 to -0.1%, while the 10-year Japanese government bond (JGB) yields have increased to 0.73% since the BoJ’s surprise tweak to the YCC in December last year [LMQ page 7].⁵ Inflation in Japan has been running above the BoJ’s two percent target over the past 17 months,⁶ which in theory could be a catalyst for the BoJ to make more tweaks to its YCC policy or even exit it in the near term. But the answers to complex questions about the trajectory of rates in Japan aren’t so simple; policy actions and capital market reactions are inherently difficult to predict, but are likely to be less dramatic than feared.

Q: Isn’t the BoJ under pressure to change policy to tackle above-target inflation? 

A: The two percent inflation target is likely to be achieved in the short term, but the BoJ is focusing on whether the target can be achieved sustainably.

The latest BoJ inflation projections and Tankan survey results⁷ suggest that inflation could remain above the BoJ’s 2% target at least over the next 12 months [LMQ page 19]. Wages in Japan, a key component of inflation, grew by 2.3% y-o-y in July 2023 due to a tight labor market.⁸ Employment conditions are expected to tighten further in the near term,⁹ potentially reaching levels last seen in 1990s. The 2024 Shunto (spring) wage negotiation is the next key event to monitor. Hence, it is as yet uncertain whether wage growth in Japan could remain consistently above its 2% target.

Inflation and core inflation in Japan

Source: The Japan Statistics Bureau (historical inflation data), as of August 2023. The Bank of Japan (inflation projection for fiscal year 2023 and 2024), as of July 2023. 

Inflationary pressures do not exist in a national vacuum. Thankfully, inflation is now declining in other developed markets [LMQ page 12], potentially giving the BoJ more time to evaluate the prospects for inflation in Japan. Many central banks, following the lead of the US Federal Reserve, are seen to be at or near the end of their tightening cycles as inflationary pressure tapers. That said, global central banks are highly unlikely to cut interest rates sharply any time soon, unless economies fall into deep recession. Therefore, we expect the interest rate differential between Japan and the US to remain wide but may narrow somewhat in the near term. Moderation in the interest rate differential could help the weak yen to regain some ground, which might also alleviate some pressure on the BoJ.

Q: How do you read the political tea leaves around BoJ’s policy? 

A: Policymakers will tread carefully as they do not want to upset the labor market and the financial system.

Inflation in Japan has been outpacing wage growth, putting pressure on Prime Minister Fumio Kishida’s approval ratings, according to a poll conducted by the Asahi Shimbun newspaper on September 18. There is a strong political impetus for Kishida and the new cabinet to ensure wage growth consistently exceeds the inflation rate. Moreover, as more than 70% of the mortgage loans in Japan have floating rates,¹⁰ there is a strong incentive for the BoJ to keep short-term interest rates relatively low. BoJ measures that could derail Japan’s economic recovery or disrupt the capital markets could be considered politically risky and thus less likely.

Looking ahead

• Forward markets indicate that 3-month interest rates are expected to enter positive territory but remain below 0.2% over the next two years, which implies that borrowing costs in Japan would remain much lower than those of other developed economies. Leveraged real estate yields in Japan remain higher than unlevered yields, in contrast to many other markets where real estate debt is now priced at levels that lead to “negative leverage” at today’s pricing. Japanese real estate debt costs could remain relatively low if the forward markets’ prediction is accurate.
• Yields on 10-year JGBs have increased sharply by Japan’s historical standards since the BoJ loosened the YCC in December 2022. The forward markets imply that 10-year JGB yields could increase to close to 1.1% by September 2025, near the level last seen in the second half of 2011. Such an increase would be modest by global comparison but could be viewed as a step closer to interest rate normalization. Given “the math” of rate rises when the starting point is low in absolute terms, even a modest increase in 10-year JGB yields could have some impact on Japanese real estate valuations, a risk that investors should anticipate and plan for accordingly.
• Nonetheless, there are still wide gaps between JGB yields, current yields on other asset classes and real estate yields. This makes income-producing Japanese real estate investments attractive, especially for domestic investors, who dominate the market. With a uniquely wide positive spread between borrowing costs and cap rates, we expect Japan to continue to remain the most liquid institutional real estate market in Asia-Pacific for the foreseeable future, albeit with some volatility at times.