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Friday, December 7, 2007

Interpreting the Downward Revision to Japan Q3 2007 GDP

by Edward Hugh, Barcelona

Japan revised down its third-quarter GDP growth estimate today, surprising both market participants and the great majority economic observers - although not, it should be noted, those of us who run the Japan Economy Watch Blog, or posters here at Global Economy Matters (and remember Claus was writing this last piece back in January). Neither will the result exactly catch the ever readable MacroMan unawares. The consensus view had been expecting an upward revision, and this downside surprise will undoubtedly prompt many to revise their predictions on Bank of Japan rate rises since it is reasonably clear that there is now unlikely to be further talk of raising rates until either late next year, or early 2009, at the earliest, and the possibility that the next move may be once more downwards cannot be entirely excluded.

The OECD, for example, was back again yesterday warning the BOJ not to consider raising rates until the risk of deflation becomes negligible, and IMF First Deputy Managing Director John Lipsky took a similar view in his visit to Japan all the way back in May.

According to the revised data, the Japanese economy grew at a 1.5 percent annual rate in Q3, down from the preliminary reading of 2.6 percent and well below the median forecast among those surveyed by the press for a revision to 2.7 percent.

Soft capital spending saw gross domestic product rise just 0.4 percent in July-September, compared with an initial estimate of 0.6 percent growth and lagging the consensus forecast for a revision to 0.7 percent growth.

Of course all of this is furiously re-kindling the whole debate about global decoupling/recoupling. As MacroMan ironically and aptly notes:

At last, we have evidence of decoupling! Only it's been Japan, the great recovery favourite of recent years, that has decoupled from its major-market brethren. Ironic, isn't it, how the country perched on China's doorstep is the one with the lousy growth and asset returns.

Of course why it is that Japan has suddenly "decoupled" is giving a lot of room for debate. As I noted in this post here, the US economy is proving to be much more robust than many imagined it would be, and since Japan's problem is not with exports, which are giving what little growth she is getting at the moment (0.5% points in Q3, which out of 0.4% growth ain't bad - the 0.1% point needed to get the 0.4% overall growth is acheved when you "shave-off" for a rise in inventories). And, as we can see below, the composition of Japanese exports is changing, with Europe and China more than making up for an absolute and relative decline in the importance of exports to the US see this post here.

So I think we need to be careful with some of the generalisations that are flying around at the moment about "global-recoupling". There is global recoupling going on, with the BRIC-type powerhouses moving steadily to the front, but this is not a recoupling to the US sub-prime problem in a crude and primitive sense. In the Brazil context Marcelo Carvalho aptly summed things up in his Tuesday post on MS GEF:

As the US economy appears to slide towards recession, and global growth forecasts are cut back, the debate intensifies about whether emerging markets like Brazil would be able to ‘decouple’ from the developed world’s agony. The ‘decoupling’ debate is misplaced, in our view, at least in its binary version. If the US goes into recession, does Brazil necessarily have to contract sharply? We think the answer is no. But then is Brazil fully immune? Our answer is again no. Decoupling should not be seen as a yes or no proposition, but rather as a spectrum of possibilities, in a continuum of outcomes. As usual with these matters, in medio stat virtus: the truth lies somewhere in the middle.

What is clear is that the knock-on effects of the property market slide in the US, and the growing conservatism in the banking sector about investments in first-world economy property markets (aka the credit crunch) is steadily extending the US problem globally, but that is largely a result of the fact that the property boom was a global phenomenon and not simply a US one. So, on the one hand financial investors are getting to be more sensitive to risky assets in some markets, while they are pouring money like there was no tomorrow into others.

While it is absolutely right, then, to suggest that some form or other of decoupling is taking place among some (but not by any means all) newly emerging economies (and wouldn't it be nice to have a list of those which were and those which weren't) it is not the case that we have decoupling in the form many have suggested of other G7 countries moving up to the plate to take over from a beleagured US. Rather some of these are more than likely to be decoupling on the downside (and again, it would be nice to have a list of which was which was which - Japan certainly is, and Italy, and more than likely Germany, but what about the UK, now that it has taken its own "credit crunch" hit).

Essentially the downward revision in Japanese GDP is the result of slower than appreciated capital expenditure growth, which was marked down to a 1.1 percent increase from the initial estimate of a 1.7 percent rise. The revised data also showed domestic demand shrank 0.1 percent (due to the rise in inventories, compared with a preliminary reading of 0.2 percent growth). What we need to bear in mind at this point is that as we move forward household consumption is likely to weaken further as the economy slows (and especially on the back of the multiplier effect of the drought in construction starts), governemnt spending may need to move from neutral to negative as Japan starts to get to grips with its substantial public debt problems, and investment will fluctuate on the back of movements in exports. That is, Japan will be even more dependent on exports than usual, and at this moment in time will be very sensitive to any slowdown in Europe, and of course China.

Rate-hike expectations have, naturally, been falling steadily in recent months, and this process has only accelerated of late, with swap contracts on overnight call rates now pricing-in less than a 20 percent chance of a rate hike by March. This compares with a time, as recently as only two months ago, when a rate hike by March was fully priced in.

So what we need to think about really at this point is why it is that some countries are decoupling downwards in this way, even as current conditions in parts of the global economy are incredibly favourable. And in order to do that we need to think about domestic demand, and how this varies in strength from one OECD country to another, which is why some recoveries are more "sustainable" than others. Also we should be asking ourselves why recessions are relatively longer and deeper in some countries than they are in others, since where private domestic demand is weak, the entire economy has no second foot to fall back on as external conditions change from exceptional to unfavourable, and in the case of the usual suspects trio - Japan, Germany and Italy - there is less and less the possibility of falling back on domestic public demand (the traditional automatic stabiliser) since much of the ammunition has been already spent, and the looming arrival of large numbers of dependent elderly means that fiscal rigour is - or watch out for Moody's or S&P's - increasingly the "ordre du jour".

And why does the path of private domestic demand vary so much from one developed economy to the next? Well, you could try looking at comparative population median ages.

And just to remind ourselves what long and deep means in the present context, remember that Japan has had three recessions since the stock and property market bubbles burst in the early late 1980s early 1990s. The first of these lasted 32 months from March 1991 to October 1993, and the second dragged on for 20 months from June 1997 to January 1999. The most recent recession was in the 14 months from December 2000, when the bursting of an information-technology bubble damped exports and capital investment.