Boston, MA -- (SBWIRE) -- 05/28/2014 -- There are few good options available to the Japanese government to address its ballooning debt load, but we believe that debt monetisation could prove to be the most costly in terms of its mediumterm economic impact. The government could find itself facing high inflation, stagnating economic activity, and rising pressure on bond yields if current policies persist. We maintain our bearish view on local assets given these growing risks.

Japan's Q413 GDP release does not make for optimistic reading. While real GDP came in at 1.0% q-o-q seasonally adjusted annualised, it marked the third consecutive quarter in which growth has slowed, showing the diminishing marginal returns of the ongoing monetary and fiscal stimulus measures. From a full-year 2013 growth rate of 1.6%, we expect to see a drop to 1.3% in 2014, which compares with consensus expectations of 1.5%. Even this relatively downbeat growth forecast faces serious downside risks.

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Japan's trade figures for January missed expectations by a wide margin, with imports surging and exports stagnating. We expect to see the country record a current account deficit in 2014 as the weaker yen is insufficient to counteract the structural forces at play. Beyond 2014, the deficit is likely to widen as policies aimed at creating inflation will seriously undermine the domestic savings rate.

Inflationary trends in Japan are picking up pace rapidly. This trend is one which is likely to remain in place over the medium term, and we could even see concerns arising that inflation is rising too rapidly before long. The decision by the Bank of Japan (BoJ) to explicitly target a 2.0% y-o-y inflation rate back in 2013, via increasing government bond monetisation market a major turning point for the economy's inflation outlook. While we have seen an increase in loan growth over the past 12 months, by far the largest increase in liquidity has been driven by the government spending via fiscal deficits.

Prime Minister Shinzo Abe will be forced to focus on economic issues rather than constitutional reform over the coming months, as the short-term benefits of 'Abenomics' wear off, and the public has shown little desire for amending the constitution. In addition, businesses and Abe's New Komeito coalition partner are likely to pressure him to deliver more economic reforms.

Major Forecast Changes

We have not made any significant changes to our forecasts for Japan's macroeconomic variables, other than to bump up our outlook for inflation in 2014, which we now see averaging 1.7% rather than 1.5%. From a qualitative perspective, however, we are noticing a number of inflationary trends (not least the bond market-implied inflation breakeven rates), which suggest to us that inflationary pressures are begging to mount under the surface.

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