Japan Economics Viewpoint Bankof America Ready for ignition Merrill Lynch 18 November 2016 Consensus underestimating GDP and inflation poral We are upbeat on Japan’s outlook and think consensus is underestimating the strength of medium-term GDP and inflation. We expect growth of 1.4% in CY2017 and 1.2% in CY2018, well above consensus of just 0.8% growth next year. For the first time in four years both monetary and fiscal policy are supporting growth. The combination of modestly higher commodity prices, a weaker yen, and a tightening output gap should drive Japan-style core inflation to 1.0% in CY2017, and 1.4% in CY2018. We expect the Bo) to keep its rate targets unchanged for the foreseeable future as inflation moves in the right direction. > Izumi Devalier Fiscal and monetary policy realigning For years Japan has oscillated between loose and tight fiscal policy. Japanese policymakers now seem to be on the same page and we see little risk of another policy error. If anything, we see upside risks from greater fiscal stimulus via a third Izumi Devalier supplementary budget or a relatively aggressive FY17 ordinary budget. Meanwhile, the eaten oy Bo)’s new interest-pegging regime ensures that financial conditions will become +81 3 6225 6257 . . . . . . [email protected] increasingly stimulatory as inflation rises. 2017 - a year of recovering domestic demand We think the economy is heading towards a cyclical sweet spot and see a broad-based recovery in domestic demand. Specifically, 1) consumption is poised to rebound as the saving rate peaks; 2) capex should accelerate in response to the improving demand outlook, deepening supply-side constraints, and “low-for-longer” real rates; and 3} increased efforts by policymakers to accelerate income redistribution could push up the velocity of money at the margin, helping to reflate the economy. Biggest risk factor: US policy uncertainty External developments pose the greatest risk to our forecasts, chief among them US policy uncertainty. The downside scenario for Japan is a combination of rising US protectionism, sliding global trade, and a stronger yen, which could reduce 2017 growth to zero. The Trump presidency may increase pressure on Japan to achieve greater military self-reliance, boosting defense spending. There will also be greater incentives to deepen economic and trade linkages with key regional players, such as China and Russia. Chart 1: We think consensus is underestimating the strength of medium-term GDP and inflation 2.0 1.5 1.0 0.5 0.0 -0.5 Real GDP %YoY 14 CPI ex fresh food %YoY 14 1.0 CY16 CY17 cY18 CY16 CY17 cY18 m@BofAML m= Consensus (Bloomberg, as of 15 Nov 2016) Source: BofA Merrill Lynch forecasts, Bloomberg BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 13 to 14. 11686430 Timestamp: 17 November 2016 03:00PM EST Unauthorized redistribution of this report is prohibited. This report is intended for [email protected] HOUSE_OVERSIGHT_014410

Escape from zero The Q3 CY16 GDP print confirms our view that Japan has at last emerged from the de facto zero-growth trap of the past few years. Growth accelerated to an above- consensus 2.2% q-o-q Saar, after a 0.7% rise in Q2 CY16 and 2.1% rise in Q1 CY16. We expect a moderation in Q4 CY16, but underlying growth will remain firmly in the 1.0- 1.5% range. We are currently tracking CY2016 growth of 0.7%, a modest improvement from 0.6% in CY2015, though the switch to a new GDP standard’ next month raises uncertainty around our forecasts. Upturn in exports to be sustained through Q3 CY17 The recent recovery has been driven by a fading consumption tax shock and stronger exports. The downturn in the global industrial cycle in 2014-16 hurt Japan, but manufacturing activity bottomed out early this year and is now modestly expanding (Chart 2). The OECD leading indicator continues to signal a synchronized pick-up in global growth (Chart 3). The domestic inventory cycle also points to production gains ahead (Chart 4). For Japanese exporters, the improvement in demand has been most visible for Europe (Chart 5). US and Chinese demand will likely follow, though the mainland’s structural shift to services implies only a modest acceleration. We expect the current up-cycle in global exports to be sustained through Q3 CY17 — possibly longer depending on developments in the US (more on this later). The combination of stronger external demand and a weaker currency should shore up business confidence, especially among manufacturers, and lay the foundations of Japan’s recovery. Chart 2: Industrial activity has bottomed out Chart 3: OECD leading indicator points to modest global expansion Index 2010=100 3mma sa a 110 6 105 “ 2 100 0 95 By, 90 4 85 6 2010 2011 «2012-S«2013-S«« 2014-2015 = 2016 «2047 2000 2002 2004 2006 2008 2010 2012 2014 2016 == OECD global leading indicator, %YoY (LHS) == Japan real exports, %YoY (RHS) Source: BofA Merrill Lynch Global Research, OECD, Bo} ——|P -———Real exports Source: BofA Merrill Lynch Global Research, METI, Bo} Chart 4: The shipment-inventory cycle points to production gains ahead Chart 5: Japan's real exports by destination, 3mma %YoY 10 50 40 5 > 30 oO > 20 <0 # 10 ® 5 Bee Mar 2013 419 220 -20 -10 5 0 5 10 2010 2011 2012-2013, 2014. 2015 = 2016 Inventories %YoY aN. America ===EU —— China Source: BofA Merrill Lynch Global Research, METI Source: BofA Merrill Lynch Global Research, Bo} | Japan will switch to SNA2008 methodology, starting with the release of revised Q3 CY16 GDP due 8 December 2016. Bankof America 2 Japan Economics Viewpoint | 18 November 2016 Merrill Lynch HOUSE_OVERSIGHT_014411

Automatic easing Policy headwinds are also abating: for the first time since 2013, both fiscal and monetary policy are poised to turn stimulatory in 2017. Monetary policy: Bo) pegs to zero The Bo)’s transition to yield-curve targeting ensures that real yields will drop as inflation picks up, implying that financial conditions will turn increasingly loose as the recovery progresses. There are good reasons to be cautiously optimistic: after all, despite a triple whammy of weak domestic demand, weak commodity prices, and a stronger yen, Japanese inflation measures are showing early signs of bottoming out (Chart 6). We expect Japan-style core inflation (CPI ex fresh food) to trough in Q4 CY16, after which it should accelerate relatively quickly in the first two quarters of 2017 in response to 1) a recovery in crude oil prices, 2) a weaker yen (we assume USDJPY rebounds to 120 by the end of the year), and 3} stronger wage growth. This also implies stronger core-core inflation (CPI ex food & energy). We are bullish on all three factors and see CY17 core inflation running at an above-consensus 1.0% and 1.4% in CY18. This is still short of the central bank’s 2% target (Chart 7). But we believe there will be little pressure to lower rates further, especially against the backdrop of a weakening yen and rising global yields. More broadly, things are moving in the right direction for the Bo). The private sector has been steadily re-leveraging, albeit gradually. Meanwhile, labor markets continue to tighten and wage growth is slowly improving: the 4-quarter moving average for hourly wages is now up to 1.2% y-o-y (Chart 8). With the labor market for lower-cost part-time workers nearing saturation, growth in higher-quality, full-time jobs is picking up (Chart 9). We expect a moderation in employment gains and faster wage growth ahead. Chart 6: Produce and consumer price inflation (ex-tax effect) 4 1.0 2 0.5 0 0.0 -2 0.5 4 -1.0 -6 -1.5 2011 2012 2013 2014 2015 2016 —— Corporate goods prices %YoY (LHS) ——Headline CPI %YoY (LHS) == Corporate service prices %YoY (RHS) Source: BofA Merrill Lynch Global Research, MIA Chart 8: Wage growth is picking up on the back of tight labor markets Chart 7: Japan-style core inflation (CPI ex fresh food) forecasts (FY basis) 2.0 1.0 0.0 -1.0 -2.0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 BoJ BofAML Consensus —= —= Target Source: BofA Merrill Lynch Global Research, Bo), JCER *Consensus is JCER ESP survey Chart 9: Full-time job growth is accelerating 2 1 0 ' NR 2000 2002 2004 2006 2008 2010 2012 2014 2016 ——Hourly wages, %YoY 4qtr ma == US-style core inflation (ex-tax), %YoY 4qtr ma Source: BofA Merrill Lynch Global Research, MHLW, MIA 3.0 Abenomics 2.0 1.0 0.0 -1.0 -2.0 -3.0 2000 2002 2004 2006 2008 2010 20121 2014 2016 mae Part-time, ppt contribution moe Full-time, ppt contribution —— Total employment, %YoY Source: BofA Merrill Lynch Global Research, MIA Bankof America Merrill Lynch Japan Economics Viewpoint | 18 November 2016 3 HOUSE_OVERSIGHT_014412

Fiscal policy: turning looser In FY17 Fiscal policy is undergoing an equally important shift. In August, the Cabinet approved an economic stimulus package totaling JPY28trn (roughly 5.5% of GDP). Though “real water” government spending is a comparatively modest JPY7.5trn (1.5% of GDP}, this is enough to put the fiscal impulse back in expansionary territory, after three years of tightening (Chart 10). The stimulus measures, which are centered on public investment and cash transfers to households, should boost CY2017 GDP by O.5ppt. Public construction orders are already rebounding as the government front-loaded public infrastructure spending (Chart 11). Meanwhile, the next stage of the consumption tax increase has been postponed until October 2019. Chart 10: After 3 years of tightening, fiscal policy to turn loose in FY17 2.5 2.0 1.5 1.0 0.5 0.0 0.5 -1.0 Contractionary Forecasts 5 Expansionary FY10 FY11 FY12 FY13 FY14 FY1Sf FY16f FYI7f m Fiscal impulse (change in cyclically-adjusted primary balance), % GDP Source: BofA Merrill Lynch Global Research, IMF, CAO To be clear, we are not talking about massive shifts in the fiscal stance here—the Ministry of Finance remains very much opposed to expanding the deficit and Prime Minister Abe has yet to abandon the government’s long-standing goal of balancing the primary balance by FY2020. However, there is a growing consensus among Japanese policymakers that premature fiscal tightening is counter-productive for reflation efforts, especially when monetary policy is stretched. Even Bo) Governor Kuroda, who initially underplayed the risks from 2014 fiscal tightening, has recently acknowledged that loose monetary and fiscal policies will have a “synergistic effect.” The upshot is that the risk of another policy error is low, in our view. If anything, we see upside risks from greater fiscal stimulus in the form of a third supplementary budget or relatively aggressive FY17 ordinary budget. We would not rule out further delays to the October 2019 consumption tax hike, either. Chart 11: Public investment is poised to pick up in the months ahead 30 20 10 0 -10 -20 2010 2011 2012 2013 2014 2015 2016 = Public construction orders received %YoY 3mma =—=Public construction orders completed %YoY 3mma Source: BofA Merrill Lynch Global Research, MITI Bankof America > 4 Japan Economics Viewpoint | 18 November 2016 Merrill Lynch HOUSE_OVERSIGHT_014413

2017: a good year for domestic demand Policy tailwinds are only one pillar of our call for Japan’s outperformance in 2017. We also believe the stars are aligning for an organic improvement in domestic demand, which would support the current recovery: the economy is firing on all cylinders for the first time since 2013, and growth should accelerate to 1.4% in CY2017, followed by 1.2% expansion in CY2018 (Chart 12). We see three catalysts: a consumer comeback, stronger capex, and a shift in income away from high-saving corporations in favour of higher-spending households and stockholders. Chart 12: Steady improvement in growth, led by domestic demand 3.0 BofAMLForecasts 2.0 1.0 0.0 -1.0 -2.0 2011 2012 2013 2014 2015 2016 2017 2018 mama Private demand meee Public demand mmm Net exports ===Real GDP growth %YoY Source: BofA Merrill Lynch forecasts, CAO 1. Consumer comeback Households have been the noticeable laggard in the current recovery and the main reason why Japan’s economy has barely grown since the 2014 consumption tax hike. This is not for a lack of income growth: real employee compensation (wages + employment) has staged an impressive recovery of late, rising 1.2% in CY15, and an estimated 1.9% in CY16 (Chart 13). One explanation is that private consumption is simply being underestimated in demand- side GDP statistics: researchers at the Bank of Japan recently produced experimental supply-side estimates of GDP that were significantly higher than existing expenditure- side statistics. We find the Bo) research interesting and agree that Japanese consumption statistics are beset by data quality issues. But this alone cannot account for the consumption slump. We think two factors are equally to blame for depressed household spending: 1) a squeeze on disposable income from higher taxes and social security contributions; and 2) a surge in the saving rate (Chart 14). Calling Japan right in 2017 is largely about correctly forecasting whether these two trends will reverse. We see several reasons for optimism. First, we expect real employee compensation to accelerate further, driven by a continued pick-up in per capita wages. The call on the saving rate is admittedly trickier. But having surpassed the 2006 highs, we think it is unlikely to surge further, given that consumer confidence is improving and income growth is firming. FY17 tax reforms are also likely to support household sentiment at the margin: for example, discussions are underway about enlarging tax cuts for second-earners who work part-time. Overall, we expect private consumption to rise 1.0% in CY17, adding O.6ppt to growth. Should the saving rate stabilize, as we expect, consumption should again start rising in tandem with compensation. Investors should not have to wait long to get some visibility around these trends. We expect the saving rate to peak in Q4 CY16 and consumption to rise strongly from this quarter. ? Link to the research paper (in Japanese only): https://Awww.boj.or.jp/research/wps_rev/wps_201 6/data/wp1 6j09.pdf Bankof America <2 Merrill Lynch Japan Economics Viewpoint | 18 November 2016 5 HOUSE_OVERSIGHT_014414

Chart 13: Real labor income and private consumption Chart 14: Workers’ saving rate at all-time high 270 330 22 265 - 320 20 260 310 18 255 - 300 16 250 290 14 245 280 12 wo ico} led foe} Lo2} Q x N oO s+ wo ico} Ss 8s 8S SSESSESESESES 10 NSN SH NN YN AS NSN NS NON 2oM ODO OAM Or AHR A MH ANA YN MS Eee MHEe womnnonoeoelmlUtlhlhlmUhchSDhUcOUCOCUCUOULUCUCUNUCULDLSLDLUMD onooonnonnmWmrdrDd on DOD DP ODO 0D GD G2 GS NN NNN NN ———Real employee compensation, JPY trn saar (LHS) ; ; ‘ Private consumption, JPY trn saar (RHS) —— Saving rate of workers’ households, % 4qtr ma Source: BofA Merrill Lynch Global Research, CAO Source: BofA Merrill Lynch Global Research, MIA 2. Capex revival We also see a fundamental case for higher capital spending. Borrowing rates are very low and will fall further in real terms as inflation rises. Stronger growth and improved confidence should also encourage higher capex. And deepening supply-side constraints offer a strong incentive for Japan Inc. to accelerate productivity-enhancing capex, ensuring that this expansion is durable. For these reasons, we think that the impulse of capital expenditures will likely be higher in the non-manufacturing sector, where capacity utilization rates are higher, and labor shortages (and hence wage pressures) are more acute (Chart 15 and Chart 16). Chart 15: Capacity utilization rates by sector Chart 16: Labor shortages by sector 40 Insufficient AO Insufficient 0 -20 10 0 20 20 30 40 40 Excess 60 Excess 2003 2005 2006 2007 2008 2010 2011 2012 2013 2015 2016 2003 2005 2006 2007 2008 2010 2011 2012 2013 2015 2016 ———BoJ Tankan production capacity - manufacturing, Dl ———BoJ Tankan employment conditions - manufacturing, Dl BoJ Tankan production capacity - non-manufacturing, Dl BoJ Tankan employment conditions - non-manufacturing, DI Source: BofA Merrill Lynch Global Research, Bo} Source: BofA Merrill Lynch Global Research, Bo} Chart 17 shows the ratio of personnel costs to sales, using MoF corporate survey data. The ratio is particularly high for lodging & accommodations (23%), eating & drinking services (27%), medical, healthcare & welfare (37%) and education & learning support (37%). Somewhat surprisingly, personnel expenses are fairly restrained in retail. But this is partly due to the relatively heavy reliance on lower-cost part-time workers. Given the rapid growth in part-timers’ wages, such cost savings is likely to become increasingly difficult to maintain. Bankof America 6 Japan Economics Viewpoint | 18 November 2016 Merrill Lynch HOUSE_OVERSIGHT_014415

Chart 17: Personnel costs to sales, % ratio 4qtr ma (as of Apr-Jun 2016) 40 35 30 29 20 15 10 Source: BofA Merrill Lynch Global Research, MoF Analysis by METI suggests that many of these non-manufacturing industries have the scope to raise productivity. Wholesale/retail, utilities, and eating & accommodation have particularly low levels of productivity relative to the US (Chart 18). We think the solution is to boost capex, especially in ICT and automation. More broadly, an acceleration in capex is needed if we are to see a pick-up in productivity and sustained profits. Though we are by no means in the late stages of the profit cycle, the trend clearly points to higher wage costs going forward, requiring proactive efficiency-enhancing investment by corporates. Bottom-up data capex data for MSCI Japan also suggest that the investment cycle has troughed and will pick up next year as earnings momentum improves (Chart 19). Chart 18: Japan's labor productivity relative to the US: services is low Chart 19: Capex — YoY change in Japan vs Global Earnings Revisions (2003-07) 18 140 16 120 3 100 > 14 80 B12 60 Bre 40 g 10 20 © 08 0 S g 0.6 Ks B oA r 02 me Global Earnings Revision Ratio (LHS) Source: BofA Merrill Lynch Global Research, METI 3. Policy priorities and redistribution We think an increase in government pressure on corporations could speed up income redistribution at the margin, ensuring that money circulates to those sectors and agents with a higher propensity to consume. Elevated corporate savings remain a focal point for the government. Cabinet Office officials have used the concept of the “cash-out ratio” to highlight the creaky transmission from corporate profits to spending. Chart 20 3 The idea of the “cash-out” ratio was first raised by private sector representatives of the Council on Fiscal and Economic Policy. The measure is defined as cash out / cash and deposits. The numerator includes capex, personnel expenses, R&D, dividends, and changes in equity investments in related companies, The denominator includes cash and deposits, and securities, short-term lending, and investment securities classified under liquid assets. Since we are restricted to Ministry of Finance Corporate survey data, our version of the “cash-out ratio” is defined as capex + personnel costs + dividends / cash and liquid assets. 90 92 94 96 98 00 02 04 06 08 10 12 14 16 30% 20% 10% 0% -10% Japan CAPEX (YoY Chg) -20% -30% ee SCI Japan capex %YoY (RHS} Source: BofA Merrill Lynch Global Quantitative Strategy Bankof America Merrill Lynch Japan Economics Viewpoint | 18 November 2016 7 HOUSE_OVERSIGHT_014416

shows that this measure has been on a steady downtrend, with the numbers particularly low for large corporates. So far, the government’s approach has relied more on carrots than sticks, with Prime Minister Abe using a combination of moral suasion and sweeteners to encourage firms to disgorge profits. The pattern has continued as we approach FY2017. For example, local media have reported that the government is considering offering corporate tax breaks to SMEs that raise wages, in light of more modest wage growth at SMEs. Discussions are also underway in the Prime Minister's office about reforming working practices with the immediate focus on “Equal Pay for Equal work (EPEW)”—i.e. reducing the wage gap between regular and non-regular employees. But the issue is contentious from both a capital and labour perspective. And considering the time it will likely take for related legislation to pass in the Diet, we think the lack of compliance mechanisms may mean that the immediate impact of EPEW will be limited. Instead, the debate seems to have shifted towards limiting excessive and unproductive overtime work. This is low-hanging fruit that does not address the issue of Japan’s labour market rigidities, which are at the heart of the problem of suppressed wages and weak household spending power. That said, there are signs that the government’s patience is wearing thin and that the Prime Minister is increasingly leaning towards direct intervention. For example, the government has already delivered a minimum wage hike in FY2016 and plans to take the national average up to JPY1,000 by 2020 via yearly hikes of 3%. These policy changes should offer small tailwinds for the recovery in private consumption. We also think the debate over a possible retained earnings tax is unlikely to go away. We are sceptical it will be introduced in this year’s tax reforms. However, the government’s escalating war on corporates hoarding cash is likely to lead to a continued rise in dividend payouts and share buybacks (Chart 21). Chart 20: Firms’ cash-out ratio*, % 4qtr ma Chart 21: Dividends and share buybacks by Japanese firms (TSE 1st section listed) 40% a thY trn) 30% 15 r i | 20% 10 wl I 10% -) I 0% "PTF PPP a wh oP ahh wl 1980 1985 1990 1995 2000 2005 2010 2015 SSeS SS cd Od cB oY BY © -_ | | PEEP EE EEE ES All firm sizes = ==Large firms Small firms m Share buyback Source: BofA Merrill Lynch Global Research, MoF *The cash-out ratio is defined as personnel Source: Nikkei Astra, BofA Merrill Lynch Global Research expenses, capex, and dividend payouts as a share of cash and liquid asset balances Note: FY2016 dividend is companies’ guidance. FY2016 share buyback is estimated by annualizing the YTD numbers as of November 2016 Risk factors: largely from overseas A key risk to our 2017 outlook on the domestic side may be weaker-than-expected growth in real labor income, or a continued surge in the household saving rate, which would constrain consumption. However, we think the biggest risks in either direction stem from abroad. Specifically, we see higher uncertainty over global trade, risk sentiment, and FX as a result of political transitions in the US and Eurozone. We consider multiple policy scenarios under a Trump presidency. Trump’s campaign promises have mixed implications for Japan. On a positive note deregulation, tax cuts, and aggressive infrastructure spending could boost US aggregate Bankof America 8 Japan Economics Viewpoint | 18 November 2016 Merrill Lynch HOUSE_OVERSIGHT_014417

demand. Our US economics team expects the stimulus to boost growth in H2 CY17 and likely CY18. Japan should be a big winner from stronger US growth, given its high exposure to the US economy in terms of exports and corporate profits (Chart 22 and Chart 23). On the negative side, aggressive protectionist trade measures, if implemented, would depress US growth and global trade further. If combined with a stronger yen, Japan’s economy would be hit hard. Chart 22: Japan's export exposure (% of total gross and value-added Chart 23: Breakdown of Japan exports to US by commodity, 2015 exports*) 30 25 20 15 10 5 0 USA CHN KOR TWN GER = Chemicals = Manufactured goods m Machinery . m Electrical Machinery m Transport equipment Others mGross exports m Value-added basis Source: BofA Merrill Lynch Global Research, MoF Source: OECD Base case: “benign Trump” scenario For the moment, we are assuming limited positive and negative policy changes. Our US team expects uncertainty to cause a modest slowing of growth in the first half of next year, but this will be more than offset by fiscal stimulus in the second half and into 2018. But the size of the fiscal expansion will likely be smaller than promised, and the introduction of modest protectionist measures means that the boost to global trade will essentially be zero. Table 1 shows the impact on growth under two scenarios, based on different assumptions for global trade and FX. Under the upside case, Japan’s GDP could rebound towards 2%, as the economy benefits from a combination of stronger global trade and a weak currency. Under a downside “protectionist” scenario, 2017 growth would slow to around zero and would most likely tip Japan back into deflation. Table 1: Sensitivity of Japan's growth to global trade and foreign exchange rate (Assumptions) Baseline Case 1 - Upside Case 2 - Downside Global trade 0.0% 3.0% -10.0% % JPY appreciation (*) 1.0% -10.0% 10.0% (Simulation results) Change (Contribution) Change (Contribution) Change (Contribution) {") {") {") Real GDP impact 0.2ppt — 0.9ppt — -1 Appt — Consumption 0.0% (0.02ppt) 0.3% (0.15ppt) -0.8% (-0.44ppt) Capex 1.9% (0.26ppt) 2.9% (0.40ppt) 3.2% (-0.44ppt) Net Exports = (0.00ppt) = (0.30ppt) = (-0.23ppt) Source: BofA Merrill Lynch Global Research, CAO, MoF, IMF (*) Rate of appreciation of Japanese yen in terms of effective exchange rate (**) Contributions to the change in real GDP Political impact of a Trump administration For Japan, the impact of Trump’s election goes beyond economic issues. It also impacts defense spending and regional trade arrangements. Military self-reliance and budget choices Trump has made it clear that he wants allies of the US to shoulder a greater share of the defense burden. There is a lot of uncertainty as to how far Trump will go to re- define the US-Japan alliance. Despite his criticism, Japan already pays about 75% of US military hosting costs. However, it seems fair to assume that Japan will be expected to Bankof America <2 Merrill Lynch Japan Economics Viewpoint | 18 November 2016 9 HOUSE_OVERSIGHT_014418

increase its defense spending. Under Prime Minister Abe, the defense budget has expanded by 7% but has been kept at roughly 1% of GDP, in keeping with historical guidelines. This is small by international standards and more likely than not will rise in the coming years (Chart 24}. The composition of spending is also likely to shift from operating costs towards procurement, which is currently a very small part of the budget (Chart 25). Chart 24: Military spending % of GDP as of 2015—Japan's is low by int'l Chart 25: Breakdown of Japan's defense-related expenditures standards 6 100% 5 4 50% 2 0% 2000 2003 2004 oOo ore © ooo 02 NN NN 2009 2012 2013 2014 2015 2016 owt QoQ NN 2001 2002 mJP R&D, facility development, maintenance etc. 0 m JP procurement of equipment JP UK AU CH FR KR US RU m= JP personnel and food provisions mwU.S Forces Japan-related cost Source: BofA Merrill Lynch Global Research, World Bank Source: BofA Merrill Lynch Global Research, Ministry of Defense TPP and trade policy: potential for linkages with other regional players Trump and his aides have made it clear that they consider the Trans Pacific Partnership (TPP) to be a “bad deal.” Media have reported that President Obama is not considering pushing the deal through a lame duck Congress. This means the deal is likely dead in its current form. While negative for Japan, the expected withdrawal of the US from TPP could spur new arrangements with regional partners. One potential positive is the prospect of improved economic and trade linkages with other key players in the region, including Russia and even China. Three upcoming events are worth monitoring closely (Table 2): first, the 19- 20 November APEC Summit in Lima, Peru, where we are likely to see vigorous discussions on the future of the TPP as well as further progress on the Regional Comprehensive Economic Partnership (RCEP); second, the 15 December Abe-Putin Summit, in Yamaguchi prefecture; and third a potential trilateral summit between Japan, China, and Korea, which onshore media now say is being scheduled for 19-20 December, though it may not happen given the unfolding leadership upheaval in Korea. Bullish bottom line - don’t underestimate the recovery We are optimistic on Japan and think the acceleration in GDP and inflation in 2017 will be much stronger than consensus expects. For the first time since 2013, fiscal and monetary policy will be lined up in the same expansionary direction. The global export cycle has turned and is now tracking modest expansion. Meanwhile, the headwinds to domestic demand are finally turning into tailwinds. Unlike in the past, we think the risks of a policy error are low. Assuming that external risks are kept at bay, we think Japan will surprise with the strength of its recovery. Bankof America 10 Japan Economics Viewpoint | 18 November 2016 Merrill Lynch HOUSE_OVERSIGHT_014419

Table 2: Calendar of political events Date Event 2016 Sep 26 - Nov 30 (to be extended) Extraordinary Diet session (supplementary budget, TPP, tax-hike delay, casino bill) Nov 15 Japan-Russia trade officials meet (Tokyo) Nov 17 Abe, Trump meet in New York Nov 19-20 Abe, Putin meet at APEC (progress on territorial issue a key public concern) Dec 8 Jul-Sep GDP 2nd preliminary (change to 2008SNA) Outline of FY2017 Tax Reform to be released Dec 15-16 Russia's Putin to visit Abe in Yamaguchi prefecture Dec 24 Cabinet to compile FY17 budget Ordinary Diet session (Jan) 2017 LDP annual convention (Mar 5) Tokyo parliamentary election (summer) 2018 and later Governor Kuroda's term ends (Apr) 2018 Abe's second term as LDP President ends (Sep) Lower House election if no snap election before (Dec) Nationwide local elections (spring) 2019 Upper house election (summer) Consumption tax hike (Oct) 2020 Tokyo Olympics 2021 LDP Presidential term ends Source: BofA Merrill Lynch Global Research Bankof America <2 Merrill Lynch Japan Economics Viewpoint | 18 November 2016-11 HOUSE_OVERSIGHT_014420

Table 3: Economic forecast summary Calendar Year Fiscal Year Quarterly 2015 2016 2017 2018} 2015 2016 2017 2018) 3016 4Q16 1017 2017 3Q17 4Q17 1018 (A) (F) (F) F) (A)___(F) F F) (A) (Ff) s+) i) a Real GDP %,qoq ann. 0.6 07 14 2 09 14 4 2 2.2 03 2.1 5 1.0 24 0.1 Private Consumption %,qoq ann. -1.2 0.4 1.0 2 0.1 0.6 ; 3 0.2 1.0 12 0 14 14 08 Private Capex %,qoq ann. 1.6 06 7 3.2 2.1 07 24 29 0.1 5.0 0.8 4A 25 10 3.1 Private Resid. Investment — (%,qoq ann. 25 5.3 03 Al 24 64 -13 rf 96 -20 20 -39 5.9 6.1 1.6 Government Consumption (%,qoq ann. 1.2 1.6 08 0 16 14 0.9 Al 17 08 06 2 08 08 08 Public Investment %,qoq ann. 25 15 3.1 -2.1 2¢ 0.9 A Of 27 16 82 148 -115 -78 3.9 Exports of Goods & Services (%,goqg ann. 28 -0.3 53 3.1 04 09 58 23 8.1 45 45 59 11.0 46 =-3.0 Imports of Goods & Services (%,qoq ann. 04 13 3.9 18 00 04 43 1.4 24 90 2.0 46 118 19 -16 Contribution points Domestic Demand %,yoy 0.2 0.5 12 09 08 08 ll 1.0 0.2 14 17 2 11 3 0.2 Net Exports %,yoy 0.4 0.2 03 0.2 0.1 0.2 0.3 0.2 20 08 0.4 02 01 1 03 Industrial Production %,qoq 1.4 07 06 6 25 A 09 %,yoy -1.2 -08 35 3.6 -14 04 42 3.0 0.4 12 17 3.1 42 49 46 Nationwide BOJ-style Core CPI (%,yoy 0.5 -0.3 1.0 14 00 860. ie 14 05 -01 07 07 13 4A 1.4 Nationwide US-style Core CPI %,yoy 1.0 04 04 11 06 03 0.6 13 0.2 0.1 02 02 05 07 09 Unemployment Rate %) 3.4 3.1 29 27 33 3. 28 26 3.1 3.0 3.0 29 29 28 28 Bou ST interest rate target End of period) -0.1 -0.1 -0.1 -0.1 01 0. O01 01 O01 01 O01 O11 O01 O01 -01 BoJ LT interest rate target End of period) nla 0.0 0.0 0.0 nla 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Yeni$ End of period) 120.2 1080 120.0 115.0} 1126 1120 115.0 115.0} 1014 1080 1120 1150 117.0 120.0 115.0 Yen/Euro End of period) 1306 1166 1260 121.0) 1281 1176 1240 1210) 1139 1166 1176 1173 1193 1260 1240 Note: We may revise our forecasts once additional data become available. Sources: Bo}, MoF, ESRI of Cabinet Office(EPA), MPMHAPT(MCA), METI(MITI), Ministry of Land, Infrastructure and Transport and BofA Merrill Lynch Global Research estimates. Bankof America 12 Japan Economics Viewpoint | 18 November 2016 Merrill Lynch HOUSE_OVERSIGHT_014421

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