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Tuesday, May 3, 2011

Japan's Economy Struggles For Air

With the arrival of the first real Japanese data since the Tsunami struck the immensity of the tragedy which Japan is passing through is only now gradually becoming apparent. Exports were down by a seasonally adjusted 7.7% in March over February, while imports were only fell by a much more modest 1.4%, with the inevitable consequence that the trade surplus which forms the lifeline for Japan's fragile economy shrank sharply. In particular car production was badly hit, with output at Toyota plunging 62.7% during the month, while Nissan reported a drop of 52.4% and Honda put the shrinkage in its Japanese domestic production at 62.9% adding that output would be at 50 percent of its former projections until at least the end of June.

In fact March output across the whole of Japanese industry fell at a record monthly pace of 15.3%, while household spending declined at the record annual rate of 8.5%.

Large as they are, however, these numbers were to some extent expected. More worrisome from the Japanese point of view is the fact that production may be many months getting back to earlier levels given supply chain problems and the fact that electricity generating capacity will remain problematic, leading to reductions in the level of power available. These delays in restoring production in Japan’s auto industry at a time of substantial economic growth in potential new markets raise the prospect that some of the damage may be permanent, as some part of the Japanese market share goes to the country’s main competitors. Indeed just this point was raised by S&Ps recently when they cut their outlook to negative for all three manufacturers along with suppliers Aisin Seiki, Denso, and Toyota Industries. In their report justifying the move S&P’s stated "The outlook revisions also reflect our opinion that extended production cuts may erode Japanese automakers market shares and competitive positions in the longer term."

Among companies who may well inadvertently benefit from Japan's ill fortune is the US company General Motors, who less than two years after declaring themselves bankrupt now seem poised to reclaim the global auto sales number one spot from their struggling rival Toyota. Japan's car manufacturers have also been hurt by the sharp rise in the value of the yen. After years of a weak yen boosting sales and corporate profits, the Japanese currency has steadily strengthened to 81 yen to the dollar from 112 at the end of 2007. What might have been seen as a temporary development now looks much more permanent, and strategic planning by Japanese corporates will undoubtedly be influenced by this when it comes to decisions on where to locate new plant and capacity. And in the meanwhile, they stand to loose market share in both the US and in the key growth market, China.

German manufacturing is also an indirect beneficiary of Japan's ills, and the German April manufacturing PMI once more revealed a very strong performance, underpinned by ex-European demand for capital and intermediate goods.

Obviously the substantial under-performance will continue, as was confirmed by the April manufacturing PMI which showed a second month of sharp contraction, with the indicator registering 45.7 reflecting a deterioration on the already sharp contraction (46.4) registered in March (50 marks the neutral, or no change mark on these indexes). And while after years of deflation and slow growth Japan’s economy may not be what it used to be, it is still the world’s third largest economy, so it should not surprise us if JPMorgan attributed a large part of the fall in their March Global Composite PMI (to a six monthly low of 54.7) to the Japan impact. Without the contraction in Japan, they suggest, the Global Output Index reading would have been in the region of 57.3.

On the other hand, since Japan is an export surplus country, and it is highly likely that the slack left by Japan’s export losses will be taken up by its main competitors, beyond a short-lived supply chain blip there is unlikely to be any major impact on Global economic growth in 2011 following from the disaster. The problem here is very much a Japanese one.

We also now have details of the first instalment of money allocated by the government for the reconstruction programme. As expected the initial spending is modest in relation to the extent of the damage, with an emergency budget of 4 trillion yen ($48.5 billion) while total costs have been estimated as lying more in the region of $300 billion. Further, the government have been at pains to stress that no new debt will be issued to cover this spending, and that the resources will be found from cuts in social programmes and from pension fund resources. In fact the package has been financed using 2.5 trillion yen from the country's pension funds plus money originally intended to increase payments to families with children. Ironically this money had been promised as part of a campaign to try to address the country's long term demographic shortfall, which is now playing a key role in generating the country's evident economic imbalances. In any event, these are hardly "stimulus" measures, although paying for the next round of reconstruction will be much harder without recourse to a new debt issue.

Significantly, no decision seems yet to have been taken on whether to increase consumption tax, since given the ongoing weakness in Japan domestic consumption the application of such a remedy in the current environment may create as many issues as it resolves. The reticence of the Japanese authorities to raise new debt is comprehensible given the fact that the IMF estimates that gross government debt will hit 229% of GDP in 2011 (and net government debt 128%) while the rating agencies are waiting in the wings waving imminent downgrade warnings. Subsequent packages are likely to prove far more challenging in terms of financing, and markets are liable to remain nervous.

It is now more or less universally acknowledged that Japan is in recession, and Bank of Japan governor Masaaki Shirakawa has confirmed this impression by asserting the Bank’s view that the economy will continue to contract throughout the first half of the year. In fact only last Saturday he described the country's economic outlook as "very severe" and asserted that the central bank was resolute in its determination to take appropriate action to support the economy. Most observers interpret this as meaning that the bank will ease further by increasing its asset purchase programme. The BOJ eased policy in the days following the tsunami by doubling to 10 trillion yen the funds it sets aside for purchases of a range of financial assets, such as government bonds and corporate debt, and despite the fact that a proposal from Deputy Governor Kiyohiko Nishimura to expand the programme by 5 trillion yen ($62 billion) was outvoted by the board, the mere fact it was discussed could mean that bank could loosen policy further as early as next month.

It is important to bear in mind that Japan’s recovery from the global crisis was always fragile, and that while post-Lehman growth resumed in Q2 2009, the economy contracted again in Q3 2009, and suffered a further relapse in Q4 2010. At the end of last year economic activity in Japan was still at the same level as in Q1 2006, and the short term impact of the Tsunami will only have served to blow it further back in time.

Thus while it seems pretty clear that growth in Japan will resume in the second half of the year, and that the rebound in manufacturing industry will be pronounced once a normal power supply is restored, the thesis that natural disaster shocks are invariably good for economies with a lethargic track record of pronounced under-performance seems rather questionable. It is entirely possible that Japan will turn into a reference-case-example of a country where this does not happen (particularly given the major differences in the demographic profile between Post WWII Japan and the country today). In addition, while additional government indebtedness and burden sharing from the private sector may well be short term growth positive, the stimulus will be short lived, since what Japan needs is not a “one off” push start, but major structural changes and in particular a new openness to immigration. Further down the road only lie major tax increases (which will surely slow the domestic economy even further) or (ultimately)debt restructuring, since surely, even in the Japan case, the sky is not the limit for sovereign debt, and while any Japan sovereign restructuring would have little external impact given that the Japanese are the main holders of their own debt, Japan's banks (who hold the lion's share) would hardly escape unscathed. But beyond immediate government debt-woe issues, the big question is the extent to which lasting damage is being done to demand for Japanese home-grown products, and whether or not this will make it more rather than less difficult to sustain in the longer term the external surplus the country so badly needs to underpin its fiscal survival.

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