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Tuesday, July 31, 2007

Japan - The Fundamentals Linger

By Claus Vistesen Copenhagen

As the result of Sunday's upper election is ticking in it is now clear that the ruling party LPD and its Prime Minister Shinzo Ape have suffered an expected trouncing by Japanese voters. However, the defeat apparently has not prompted Abe to resign his post which was also expected but the defeat does signal that the whim of the electorate does not support the current government's reform process which has also been riddled with scandals and mishaps. In this entry I shall not dwell with the political aspects of the very recent Japanese election, although I expect it to be difficult to disregard it entirely, but rather turn to Japan's economy in the remainder of 2007 and beyond. The most important economic issue at the moment and in the immediate horizon is whether the BOJ will raise to 0.75% come August's meeting? Until recently markets were basically certain that the BOJ would take it up a notch in August but now suddenly the sentiment seems to have changed somewhat.

In the following I will argue that it is not very likely that the BOJ raises in August but more importantly I will paint a picture of a Japanese economy which has not experienced a change in the fundamentals as many commentators have proclaimed. Japan is still stuck in a deflationary environment, domestic demand is still sluggish and a surplus on the external balance is still what drives the Japanese economy through its indirect effect of industrial production/corporate capex and through positive growth contribution from net-exports. Moreover, the recent election result indicate that the Japan is entering a period of reform fatigue right at a crucial time where bold reforms and changes are needed. Lastly, it seems as if markets are entering a fresh spout of risk aversion and fear over a credit crunch in the US on the back of the lingering subprime woes which recently stretched its fangs as far as to Germany.

All these factors will affect the Japanese economy and almost uniformly cloud the outlook on any expectation of a sustained process of interest tightening and essentially normalization in Japan and more generally the picture remains of an economy whose structural anatomy has very close ties to its demographic profile with a rapidly ageing population.

Firstly we might want to take a look at quarterly real GDP figures for Japan the past 1 1/2 year to see what we are in fact looking at. As such it seems evident that much of the flurry about Japan's coming sustainable recovery is vested in the rather dubious spike of growth observed in Q4 2006. In fact as can be readily seen growth already slowed somewhat in Q1 2007 and given the downward path of industrial production in the first half of 2007 as well as domestic which seems to be trending downwards (at least as we move into Q3) it remains unclear how 'sustainable' this end-of-2006 recovery really was.

Regarding the overall reasons for why the BOJ might run into difficulties raising in August and beyond there are many but in essence we know them very well. As such, it appears that while domestic demand has indeed been holding reasonably well in the first part of 2007 this may now change. The recent 0.4% decline in June's retail sales represent a valid indicator on this. And in general as we can see from the graph below, growth figures for domestic demand do not look perky by any means of the word. Especially we need to think about the big picture here and whether indeed domestic demand can pull Japan upwards towards meeting the challenge of a secular and severe decline in its working age population?

Another indicator which weighs heavily on the shoulders of the BOJ is the lingering trend of deflation as we move further into 2007. As such the general CPI index which excludes fresh food continued to stay in negative territory on a y-o-y basis and in fact as you can see in the graph below all measures of inflation in Japan are now stuck firmly in negative territory. Moreover, prices in Tokyo also fell 0.1% in July which points to how prices are not set to rise over the summer and into the Autumn.

This convergence of price measures may well be for cyclical as well as for structural reasons and regarding the former we should not get our hopes up on July and August either since, as mentioned by Takehiro Sato from Morgan Stanley, energy prices were very high in the summer of 2006. Turning to structural causes of deflation there are too many to deal with here but suffice to say that the lingering trend of wage decline (see appendix at the end) as well as the relative wobbles in domestic demand do not provide much hope as regards to a pick-up in inflation. On the other hand it seems as if food prices as well as indeed energy/commodity prices are now set to drift steadily upwards to a degree which have even prompted many economic commentators to hail the end of the great moderation which would again mean higher interest rates. This raises two crucial questions for the BOJ. First of all is the question of the general inflation index and what kind of inflation to actually target. And secondly is of course the whole Gordian knot of just how to reconcile the need to keep the costs of domestic sovereign debt low at the same as heeding the calls of financial markets and actors to normalize interest rates in order to help policing the excess global liquidity. Of course, at this point such a dilemma facing an ageing population is not mentioned in many textbooks but at this point it is very real in Japan.

In connection to the rather meager contribution of domestic demand to growth (except perhaps Q1 2007) which can be inferred from the graphs above other measures such as industrial capex suddenly becomes very important. On this account it seems as if the capex bonanza of Q4 2006 is drawing a longer shadow than could have been expected especially given the fact that the Japanese external surplus continues to thunder along (more about that below). As can be observed from the graph below industrial production is still situated on somewhat of a plateau given the impressive upward spurt over the course of 2006. Whether industrial production will stabilize at this level is difficult to say. The trend in the first of half of 2007 has been one of a modest but steady decline from the high levels of 2006 but then today we see that industrial production nudged back up significantly in June somewhat pairing the slide from the first part of 2007.

As long as the trade surplus continues to expand I would not expect any major correction in industrial production. For some general figures on the external balance I have some graphs in the appendix at the end which show how the trade and current account surplus is on a sustained positive path. Another important derivative aspect of the external balance is of course the perpetually low Yen which is causing much commotion in amongst financial market practitioners, institutional actors, and other central banks. The most important and often overlooked aspect here is the in-built propensity for BOJ to refrain from raising too much too fast as a result of Japan's dependence on exports to grow. I am sad to say that I have no hard data on the actual contribution of net exports to growth but at this point I would argue without much uncertainty that it is substantial on a yearly basis. This also means that Japan needs a low Yen in order to boost its exports which again means that any signal of normalization from the BOJ would have to be hinged on a pretty certain expectation that domestic demand would be able to take up the slack. Hence we are back into the same old dilemma.

At this point, you could perhaps be tempted to point out that while this might be true the Yen and thus the current interest rate level held by the BOJ were far too low to justify such 'traditional' arguments. I somewhat agree with this line of reasoning but it comes with an important question. What is a 'normal' interest rate in Japan given its underlying economic and demographic fundamentals? And, would this level of interest rate suffice to stem the tide of the carry trade and global liquidity flow? I have my doubts here and even at this point we also need to factor in Japan debt-to-GDP ratio at about 160-170% and what kind of interest rate level Japan can hold to anchor a long term value of the Yen in order to simultaneously be able to service its debt? These are not trivial questions I think and before we demand that the BOJ normalizes we need to understand the fundamentals of the Japanese economy which revolve around these very questions.

As we can see above the economic fundamentals in Japan remain the same. This does not mean that the BOJ cannot and will not raise come August but it suggests that the it will have a hard time justifying its course based on economic data. Of course we need to remember here the in-built change in the BOJ discourse where governor Fukui has made it well clear that the BOJ indeed could raise in a context of lingering deflation based on future expectations of inflation pressures. In the immediate horizon of 2007 this statement seems to come under considerable stress as prices are set to decline even further in July and August on the back of a negative adjustment from very high energy prices during the same period in 2006. Yet, beyond this short term perspective it is of course very likely that structural headline inflation will give the BOJ some justification to raise but this comes at an expense since it demands that the BOJ take a somewhat myopic view on price gauges relative to what seems to be a certain relative deterioration of economic fundamentals in the latter part of 2007 and perhaps beyond. This is also excellent noted by Takehiro Sato in a recent note over at MS GEF. Note in particular one of Sato's 'inconvenient truths' in the form of the observation that capital demand is receding, even at current interest rate levels.

Recently, bank lending figures have been fairly weak, despite 18 straight months of YoY positive growth. In the July ‘Senior Loan Officer Opinion Survey on Bank Lending Practices at Large Japanese Banks’, results indicated that capital demand is receding further, mainly at SMEs and for home mortgages. Results like this call into question the effectiveness of monetary policies in boosting the economy.

Whether or not the recent tightening of monetary policy has hit harder on corporate spending and private capital demand is indeed a worthy question to ask. However, more pertinent is perhaps to look at the recent legislative initiative which links up to this issue. As such we learned from the FT a month back how legislation to lower the maximum of potential loans to private as well as lowering the maximum interest rate on consumer loans. As the article quotes reveal this kind of legislation will especially make its presence felt in the context of small start-ups and SMEs.

Another ever recurring topic is of course the future course of the fiscal balance in Japan. In short, Japan badly needs to get the public books in order especially given the demographic profile which is set to worsen in the years and decades to come. In this way, the fall is set to be centered around a debate on whether to instigate a consumption tax hike. It will be most interesting to follow the further course of this consumption tax hike in the light of the recent trouncing of the LPD where you might expect Shinzo Abe to be rather weary of pushing forward such fiscal measures faced with a grumpy electorate. Of course, Abe left all options open just before yesterday's election but cabinet secretary Yasuhisa Shiozaki's corresponding qualifier puts the future course of the consumption hike in perspective, particularly given the rather strong message sent by the electorate this weekend.

(...) Shiozaki, who serves as the top government spokesman, said the issue should be brought up during the next House of Representatives election. "If we decide to raise the consumption tax as part of the drastic reform of the tax system, we must ask the public whether they will support it. If the next House of Representatives election is held after that, then we'll of course ask voters.

Finally, there is of course the recent credit and risk flurry in global financial markets which were felt the past week as Treasury yield plummeted to reflect a flight to safety among investors. This recent spree of market turmoil was interesting in so far as it was not driven by economic data from the US. In fact, the recent data releases on real economic indicators in the US point to somewhat of a recovery already in Q2 2007 although it does indeed seems as if consumer spending is finally coming down which raises the question of whether business investment can take up the slack entirely. For a complete overview of the recent wobbles in the US credit markets and economy Ted Wieseman over at Morgan Stanley has the necessary calm and cool oversight to provide a nice round-up. As a very final note on global financial markets I would also keep a weary eye on Eastern Europe and the CEE economies where the latter part of 2007 also will see the test of many countries' economic resilience as well as their credit/asset markets' liking amongst investors.

In Summary

The most important immediate point regarding the Japanese economy is whether the BOJ is going to raise to 0.75% come the much expected August meeting. Just a week a ago the implied probability of a hike which could be derived from various market derivatives and indices stood firmly above 70% towards predicting a 0.75% refi rate in Japan by the end of August. However, with the recent disappointing data on wages and consumption expenditures in June out today the overall sentiment towards a hike has cooled significantly in line with expectations as they have been laid out recently on Japan Economy Watch. This does not of course mean that the BOJ could not press on regardless but as I have also argued above the coming August decision will be a test on the acclaimed willingness by the BOJ to raise in the midst of deflation and down trending consumption spending on the back of solidified expectations of future sunshine. I maintain my view that it will be a hold but there is considerable risk attached to this call in the form of how the BOJ could act on future inflation expectations as well as to maintain its image in financial markets of a central bank devoted to the normalization of interest rates.

In a more long term and structural perspective I have also emphasised above how little has changed in the Japanese economy despite many an economic commentator's claim to the contrary. In this way I argue, through my data presentation above, that Japan is not set on the path of a sustainable recovery driven by domestic demand but rather still 'stuck' with the reliance on export and export driven capex to grow. This growth path which in my opinion is a fundamental result of Japan's demographic profile raises important questions and essentially puts Japan in a dilemma which is not, as far as I know, treated in any economic textbook. This dilemma centers around three inter-connected challenges of how to deal with lingering deflation, how to keep the public finances on a sustainable path as well as how to maintain external credibility as regards to monetary governance. In this note this dilemma was conceptualized on the venue of monetary policy where the BOJ needs to factor in much more than external pressure to unwind the carry trade in an orderly fashion. This is not to say that the current global liquidity situation is not creating distortions which might abruptly unwind but it is to say that it is more complex than just laying the blame at Japan's door.


In the appendix I present some further data on Japan which serves to substantiate the general general argument I am fielding above. First off, I have two graphs which attempts to capture the trend of wage decline. However as I finalized them and put them into this post I realize that they are perhaps not well suited. At least we need to remember that the y-axis is denominated in nominal Yen which of course tend to muddy the waters in a context of deflation. Moreover, we need to remember that the income data fielded below is for household heads as well as bonus and one-time payments are factored out. In this way I feel that the general picture of wage decline in Japan which is also due to the labour force's changing age composition and the growing prevalence of part time jobs is not well captured but still, as it were, hinted in the graphs below.

The second topic here in the appendix relates to the external balance and also here I have been struggling to find suitable data. As such the monthly figures fielded below are not very representative I think in the sense that I would have preferred data expressed in percentages. However, note in particular that I have included the income balance which is set to become important as Japanese retail and institutional investors alike look outside the borders of Japan in their search for yield.

The final graph in this appendix makes up, I think, for the shortfalls of its peers noted above. The graph plots monthly domestic consumption expenditures as Index 100 = 2005 since January 2000. As we can see and whatever we might want to claim about a sustainable recovery in Japan the trend in domestic demand seems to be one of secular decline. Furthermore, we should note that each cycle peak seems to be lower relative to the previous which lends evidence to the hypothesis of a secular decline in domestic consumption, all things equal, as a country enters the demographic state of Japan.