Reforms Not Guaranteed Despite Greater Policy Execution Potential

BMI View: The Liberal Democratic Party's recent success in the Upper House elections has increased the potential for policy formation and execution in Japan, prompting us to revise up our near-term forecasts for the country's construction sector. However, it still remains to be seen if the Japanese government will be able to take advantage of its political strength 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 activity continues to improve since 2011. Latest data from the Ministry of Land, Infrastructure, Transport and Tourism (MLIT) showed that monthly construction works executed by the country's 50 largest construction companies grew at an average rate of 6.1% year-on-year (y-o-y) in H113, significantly higher than the same periods in 2012 (3.9% y-o-y in H112) and 2011 (-2.2 y-o-y in H111). We believe this indicates that the economic stimulus package approved by the Liberal Democratic Party (LDP) on January 11 2013 is providing some impetus in spurring reconstruction and infrastructure activity in the country.

Despite this pick-up, we believe that a large portion of the project pipeline in the construction sector has yet to be completed. Since the March 2011 earthquake and tsunami, monthly construction orders in Japan have grown at an average rate of 8.6% y-o-y, while monthly construction works has only grown at an average rate of 4. 1% y-o-y over the same period.

Orders Slowly Translating To Activity
Japan - Monthly Value of Construction Orders Received And Work Executed, Big 50 Construction Companies, % chg y-o-y

BMI View: The Liberal Democratic Party's recent success in the Upper House elections has increased the potential for policy formation and execution in Japan, prompting us to revise up our near-term forecasts for the country's construction sector. However, it still remains to be seen if the Japanese government will be able to take advantage of its political strength 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 activity continues to improve since 2011. Latest data from the Ministry of Land, Infrastructure, Transport and Tourism (MLIT) showed that monthly construction works executed by the country's 50 largest construction companies grew at an average rate of 6.1% year-on-year (y-o-y) in H113, significantly higher than the same periods in 2012 (3.9% y-o-y in H112) and 2011 (-2.2 y-o-y in H111). We believe this indicates that the economic stimulus package approved by the Liberal Democratic Party (LDP) on January 11 2013 is providing some impetus in spurring reconstruction and infrastructure activity in the country.

Orders Slowly Translating To Activity
Japan - Monthly Value of Construction Orders Received And Work Executed, Big 50 Construction Companies, % chg y-o-y

Despite this pick-up, we believe that a large portion of the project pipeline in the construction sector has yet to be completed. Since the March 2011 earthquake and tsunami, monthly construction orders in Japan have grown at an average rate of 8.6% y-o-y, while monthly construction works has only grown at an average rate of 4. 1% 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) also contributed to delays.

Greater Potential For Policy Execution

This quarter, we have revised up our near-term growth forecasts for Japan's construction sector. Construction real growth is forecast to reach 3.4% in 2013 (previously 3.2%), 3.9% in 2014 (previously 3.4%) and 2.3% in 2015 (previously 1.9%). This revision is primarily due to the greater potential for policy formation and execution. On July 21 2013, the LDP, led by Prime Minister Shinzo Abe, and its partner, the New Komeito party, secured a 55% majority in the Japan's House of Councillors (Upper House). This means that Prime Minister Abe has a majority in the lower and upper houses of the Diet (parliament), ending the period of a divided Diet that has lasted since 2009. In fact, since 2006, Japan has endured a revolving door of prime ministers, which has meant that a succession of governments have lacked the mandate to carry out their policy agendas.

LDP Win A Potential Game Changer
Japan - Distribution Of Seats In The Upper House, %

We are already started to see some positive developments take place following the change in Japan's political landscape. In September 2013, the Japanese government announced that it would be taking a more direct role in resolving the Fukushima nuclear crisis and would spend JPY47bn (US$470mn) to contain the rising amount of radioactive water being released from the damaged Fukushima nuclear power plant. Resolving the nuclear crisis is crucial for the country's long-term economic and construction revival. This is because it could allow Japan to win the bid to host the 2020 Olympic Games (which will increase demand for tourist-related facilities), gain greater public support for restarting some of the country's nuclear power facilities (the use of thermal fuels for electricity to offset the loss of nuclear generation has been a major drain on the country's fiscal position) as well as return more than 100,000 nuclear evacuees to the affect areas (which could reduce welfare spending and revive the economies of these areas).

Short-Term Boost Comes At Long-Term Expense

Despite this greater potential for policy formation and execution, 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 0.8% per annum between 2016 and 2022. This is primarily because it remains to be seen if the Japanese government will be able to take advantage of its political strength and 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 balance and increased domestic borrowing costs. 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 230% of GDP ( see 'All In On Abenomics', July 22 2013 ).

Meanwhile, the 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.

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

Reforms Is The Key

In our opinion, the sustainability of the first two phases depends heavily on the implementation of the third and final phase of Prime Minister Abe's revitalisation strategy - 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 it increases the competitiveness of the construction market and reduces 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. To be sure, 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.

These economic reforms however, are difficult to implement as it they 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 militar y, 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 August 2013, Japanese utility Chubu Electric Power announced that it would be acquiring an 80% stake in Tokyo-based electricity supplier Diamond Power (owned by Mitsubishi ) by the end of 2013. Chubu is the main utility operating in the Chubu region (which is located on Japan's largest island Honshu), and the move marks an incursion into Tokyo Electric Power 's turf, a sign of increased competition ( see 'Chubu Electric: Tokyo Expansion Indicative Of Increasing Competition', August 16 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 3.4% 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 2.1% in 2016 and average a negative 0.3% per annum between 2017 and 2022.

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Sector: Infrastructure
Geography: Japan, Japan, Japan, Japan
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