Construction Sector Growing In Strength Over The Near-Term

BMI View: Japan's construction sector continues to grow from strength to strength and we believe this could continue over the near term due to several factors - namely the stimulus package announced in January 2013, renewed demand for Japanese real estate, the growing use of thermal generation for electricity, the LDP's recent success in the Upper House elections, and Tokyo's successful bid to host the 2020 summer Olympics. However, it still remains to be seen whether the Japanese government will be able to overcome its fiscal problems and carry out the necessary reforms that could lift long-term construction demand. At present, we have seen some progress in implementing reforms specific to the infrastructure sector.

Japan's construction sector is performing well. Latest estimates from the Ministry of Economy Trade and Industry showed that monthly value-added construction activity grew by 13.3% year-on-year (y-o-y) in September 2013, the highest monthly growth rate in a decade. We believe this indicates that the economic stimulus package approved by the Liberal Democratic Party (LDP) on January 11 2013 is providing strong impetus in spurring reconstruction and infrastructure activity in the country.

Indeed, construction activity looks set to grow from strength to strength as several factors are generating a huge number of construction orders for Japan's largest construction companies. These factors are the stimulus package, renewed demand for Japanese real estate, the growing use of thermal generation for electricity, the potential for policy formation and execution in Japan following LDP's success in the Upper House elections, and the announcement of Tokyo's successful bid to host the 2020 summer Olympics in September 2013 ( see 'Reforms Not Guaranteed Despite Greater Policy Execution', September 1 2013, '2020 Olympics: Initial Euphoria Will Not Overcome Structural Risks', September 26 2013, and 'New Thermal Plants Indicate Gravity Of Nuclear Woes', October 30 2013).

On The Ascent
Japan - Monthly Estimate Of Value-Added Construction Activity, Seasonally Adjusted, (Base Year 2005 = 100)

Construction Sector Growing In Strength Over The Near-Term

BMI View: Japan's construction sector continues to grow from strength to strength and we believe this could continue over the near term due to several factors - namely the stimulus package announced in January 2013, renewed demand for Japanese real estate, the growing use of thermal generation for electricity, the LDP's recent success in the Upper House elections, and Tokyo's successful bid to host the 2020 summer Olympics. However, it still remains to be seen whether the Japanese government will be able to overcome its fiscal problems and carry out the necessary reforms that could lift long-term construction demand. At present, we have seen some progress in implementing reforms specific to the infrastructure sector.

Japan's construction sector is performing well. Latest estimates from the Ministry of Economy Trade and Industry showed that monthly value-added construction activity grew by 13.3% year-on-year (y-o-y) in September 2013, the highest monthly growth rate in a decade. We believe this indicates that the economic stimulus package approved by the Liberal Democratic Party (LDP) on January 11 2013 is providing strong impetus in spurring reconstruction and infrastructure activity in the country.

On The Ascent
Japan - Monthly Estimate Of Value-Added Construction Activity, Seasonally Adjusted, (Base Year 2005 = 100)

Indeed, construction activity looks set to grow from strength to strength as several factors are generating a huge number of construction orders for Japan's largest construction companies. These factors are the stimulus package, renewed demand for Japanese real estate, the growing use of thermal generation for electricity, the potential for policy formation and execution in Japan following LDP's success in the Upper House elections, and the announcement of Tokyo's successful bid to host the 2020 summer Olympics in September 2013 ( see 'Reforms Not Guaranteed Despite Greater Policy Execution', September 1 2013, '2020 Olympics: Initial Euphoria Will Not Overcome Structural Risks', September 26 2013, and 'New Thermal Plants Indicate Gravity Of Nuclear Woes', October 30 2013).

To be sure, latest data from the Ministry of Land, Infrastructure, Transport and Tourism (MLIT) showed that monthly construction orders received by the country's 50 largest construction companies grew by a record 89.8% y-o-y in September 2013.

Orders Aggressively Boosted
Japan - Monthly Value of Construction Orders Received And Work Executed, Big 50 Construction Companies, % chg y-o-y

These new orders will further boost the project pipeline in Japan's construction sector, which is already bloated due to sluggish progress. Since the March 2011 earthquake and tsunami, monthly construction orders received by Japan's 50 largest construction companies have grown at an average rate of 11.7% y-o-y, while monthly construction works have only grown at an average rate of 4.8% y-o-y over the same period.

We attribute this sluggish progress in clearing the project backlog to a lack of building materials and manpower to carry out reconstruction, the inefficient allocation of the government's reconstruction budget (brought on by poor coordination between the different levels of government), as well as the slow progress by the government in removing debris created from the 2011 natural disaster. The designation of safe zones for reconstruction in the areas impacted by the nuclear reactor in Fukushima prefecture (brought on by the lack of resolution with the Fukushima nuclear crisis) has also contributed to delays.

Short-Term Boost Comes At Long-Term Expense

Short-Term Boost Comes At Long-Term Expense

Overall, given this strong potential for growth, we have further revised up our short-term forecasts for Japan's construction sector, with real growth forecast to reach 4.4% in 2013 (previously 3.4%) and 4.9% in 2014 (previously 3.9%).

However, it remains our opinion that this near-term boost in construction activity will come at the expense of the sector's long-term growth potential. We remain bearish towards the Japanese construction sector over the long term, with the sector forecast to contract at an average rate of 0.5% per annum between 2016 and 2023. This is primarily because it remains to be seen whether the Japanese government will be able to carry out the necessary policies for sustainable economic and construction growth.

Growth Still Not Expected To Last
Japan - Construction Industry (and its Components) Forecasts

In our June 2013 analysis of Japan's construction sector, we highlighted that the current boost in the country's construction and economy activity was attributable to the first two phases of Prime Minister Abe's strategy to revitalise the Japanese economy - liberal fiscal spending and aggressive monetary easing ( see 'Abenomics A Short-Term Fix Only For Construction Sector', June 12 2013).

However, we caution that these two phases do not appear sustainable over the long term as they place further pressure on Japan's precarious debt burden. Indeed, Japan's public finances are already strained by the Fukushima clean-up. In November 2013, Reuters reported that the Japanese government is finalising plans to increase borrowings for the Fukushima clean-up from US$50bn to US$80bn (this excludes the decommissioning of the Fukushima reactors). Coupled with the increased use of fuel imports to generate electricity as Japan's nuclear reactors remain largely offline ( see 'Growing Thermal Capacity Suggests Upside Risks To Import Growth', 21 October 2013), Japan's public finances are getting worse.

The additional public spending requires the issuance of new government bonds, increasing the potential for a debt crisis (a major threat to public fixed spending) as the government's sovereign debt already exceeds 240% of GDP ( see 'Coalition Partner's Demands Could Aggravate Debt Burden', October 7 2013).

Capping Public Spending
Japan - Total Government Domestic Debt, % Of GDP (LHS); % chg, y-o-y (RHS)

Meanwhile, the potential for a rise in Japanese government bond yields is likely to lead to higher financing costs for the public and private sectors, which could eventually pose a risk to their capital expenditure plans. This could negatively impact construction activity as early as 2016 and this view is reflected in our forecasts, with Japan's construction sector expected to contract by 1.5% in 2016.

Reforms Is The Key

In our opinion, the sustainability of the first two 'arrows' of Prime Minister Abe's revitalisation strategy depends heavily on the implementation of the third and final 'arrow' - namely economic reforms that materially improve Japan's business environment and make the country more competitive.

For the construction sector, this means the launch of strategic special zones to attract foreign investment, the full liberalisation of the electricity market and the increased use of public-private partnerships (PPP) and private finance initiatives (PFI) to implement infrastructure projects - the government had previously stated that it aims to triple the number of PFI and PPP projects over the next ten years, from JPY4.1trn to around JPY12trn. These measures are crucial in boosting construction activity as they would increase the competitiveness of the construction market and reduce excessive fixed spending by the government. Unlike the public sector, the private sector (foreign and domestic) usually has the expertise and incentive to complete and operate construction projects in the most time- and cost-effective manner.

Without these reforms to increase private sector participation, Japan's construction sector is unlikely to experience growth. As highlighted above, there is limited upside for the Japanese government to increase fixed spending and we are already signs of this trend. In June 2013, the country's Finance Ministry stated that it plans to keep fiscal spending for FY2014/15 (April-March) and FY2015/16 at around JPY70trn, the same amount of funds budgeted for FY2013/14. In October 2013, the Japanese government stated that it is thinking of downsizing the projected facilities surrounding the primary stadium for the 2020 Summer Olympics (cited from the Japan Times). This announcement comes just a month after the country was awarded the rights to host the games and is aimed at reducing the cost of the venue, which is currently estimated to be around JPY300bn.

These economic reforms however, are difficult to implement as they would involve challenging the country's vested interest groups (including major supporters of the LDP) and risk stoking popular disapproval. At present, there are signs that these plans, which are still lacking in detail, are unlikely to produce the impact that the government has touted, as politicians remain keen to stick within social expectations ( see 'Third Arrow Shaping Up To Be More Bad News Than Good', August 27 2013).

There are also concerns that Prime Minister Abe could use his recently-gained political capital to shy away from the third phase and focus on constitutional reforms. For many years, the prime minister has favoured revising Japan's constitution to ease restrictions on the use of Japan's military, the Self-Defence Forces. This is because Japan's security situation has become more challenging in recent years, due to the re-emergence of the Senkaku/Diaoyu islands territorial dispute with China, and North Korea's increasingly provocative behaviour.

Lastly, the third phase does not liberalise all aspects of the Japanese economy (such as the agriculture sector and the labour market) or tackle key structural problems that are dampening construction demand such as the use of immigration to offset the country's declining population and worsening demographics picture. Such structural dynamics will continue to adversely affect construction growth over the long term. A decline in population growth is likely to eventually lead to a decline in demand for housing, electricity and intra-city transport services (such as urban rails), while a worsening demographic picture could impose greater fiscal constraints on the government (i.e. a decline in tax revenues due to shrinking working population and an increase in public welfare expenditure), making it difficult to finance new construction projects.

Poor Demographics
Japan - Key Population Ratios

Infrastructure Potential Available

These macroeconomic developments would have varying ramifications in the sub-sectors that make up the Japanese construction sector, particularly in the infrastructure sector, which is reliant on public spending. At present, we have seen some signs of progress with implementing reforms specific to the infrastructure sector - namely the liberalisation of the electricity market and the increase use of schemes to increase private sector participation in infrastructure development.

In November 2013, the Upper House of Japan's parliament approved the establishment of an independent body by 2015 to coordinate demand and supply across the nation's electricity grids. The legislation had passed through the lower house on November 1, and more reforms are expected to be legislated in future parliamentary sessions. Some of the reforms proposed by upcoming bills include liberalisation of the retail electricity market by 2016 and requiring the country's 10 regional utilities to break their generation, transmission and retail operations into separate legal entities from 2018 to 2020 ( see 'Sector Deregulation Making Headway And Likely To Proceed', November 19 2013).

In June 19 2013, the Diet passed a bill to allow the government to sell the rights to operate facilities at state-owned airports, with five airports (the Sendai, Kansai and Osaka airports were specifically named) expected to take up PFI schemes, according to the Yomiuri Shimbun, citing unnamed banking sources. At the same time, Japanese banks are also being spurred by the government to accelerate their preparations to invest and provide loans for PFI infrastructure projects. For example, the Yomiuri Shimbun reported that the state-owned Development Bank of Japan had opened its PPP/PFI promotion center in mid-June, while the Mizuho Corporate Bank had formed a public infrastructure PPP task force.

Roads And Utilities Lead Growth
Japan - Infrastructure Industry Value Forecasts, By Industry, JPYbn (LHS); & Real Growth, % chg y-o-y (RHS)

Overall, we continue to expect roads and the utilities sectors to be the primary drivers for infrastructure activity between 2013 and 2015, with infrastructure real growth averaging 4.1% per annum between 2013 and 2015. However, the potential decline in construction investment from the public and private sectors as well as the structural weakness in Japan's macroeconomic environment could reverse this bullish growth performance, with infrastructure real growth forecast to reach a negative 2.2% in 2016 and average a negative 0.4% per annum between 2017 and 2022.

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