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Wednesday, December 19, 2007

Japan Economy 2007/2008, The Moment Of Truth?

by Edward Hugh: Barcelona

Well the Japan Cabinet Office have just published their monthly economic report together with their their revised forecasts for fiscal year 2008. As could be expected, downward revisions are to be seen everywhere, except in the plans for government spending, which commentators expect may well be up (details of the 2008 budget are due to be released tomorrow), but even this last detail seems pretty ominous in the light of the fiscal problems which Japan faces, and the steadily rising cost of supporting Japan's growing elderly dependent population.

What is still the world's second-largest economy is now expected to grow by 1.3 percent in the fiscal year ending March 31, slower than a previous forecast of 2.1 percent. At this point in time it is very difficult to assess the viability or otherwise of this forceast, since it is obviously very sensitive to small changes of environment in key sectors as we move forward. However one or two observations are in order. The first of these is that we are likely to get a very strange reading on Q4 GDP. The reason for this is that GDP growth in Q4 2006 was very high indeed (1.3% quarter on quarter - see chart below - and indeed the strength of this growth threw Claus and I considerably when it happened - and the same was true of what happened in Germany - since we hadn't really forseen the spurt in the global growth rate - who had - and how this would influence the key export dependent economies. Everything is now, however, coming back into line, and I doubt we will see big surprises on the upside across 2008).

It is thus very probable that we will see negative year on year growth in Q4 2007 (the high base effect), even if the quarter on quarter Q4 2007 growth rate does not itself plunge into the red (a possibility which is not at all excluded at this point).

Looking more generally at the government revision other things stand out. First this:

”With the global economy recovering in fiscal 2008/09, the corporate sector will remain firm and households will show improvement gradually”

and then this:
”A private-demand-led economic recovery is expected through joint efforts by the government and the Bank of Japan.”

This strikes me as incredibly optimistic. On the global economy front things are really bound to get worse before they get better. Some economies - Thailand, India, Turkey, Chile, Brazil, India - may well be able to sustain momentum, but Eastern Europe is very likely to suffer a correction (in all probability quite a strong one), while both Russia and China will be struggling with their growing inflation problems. In particular in the Chinese case, some sort of slowdown or other is now almost bound to come - and it can be sharper or softer according to when it starts - since the inflation problem is really about to get out of hand if something is not done soon on this front.

The developed economies, on the other hand, will, if they are internal consumption dependent (Spain, the US, Australia, the UK etc) be wrestling for some time to come with the effects of the unwinding of the financial component of the construction boom, while those who are to some degree export dependent (Germany, Austria, Italy, Finland, Sweden - the rapid-ager group) will simply notice any slowdown in the rate of growth in world trade.

As for the above-mentioned support from the government and the Bank of Japan, this can only mean more fiscal support and the absence of any further rate increases from the BoJ (Fukui will have to retire without fulfilling his dream, and the big question now is rather when will the BoJ start to talk about coming down again).

On the fiscal front slower growth will probably place a squeeze on tax revenue, making it harder for the government to narrow the budget deficit and reduce its 777 trillion yen ($6.9 trillion) debt, which is the world's largest. The 2008 budget outline is due to be released tomorrow, and will probably incorporate an increase in government spending according to a leaked preview which appeared in Nikkei newspaper today. The primary deficit, the excess of spending over revenue excluding bond sales and interest payments, is projected to widen for the first time in five years, according to the article, suggesting that government spending may well rise to something in the order opf 83 trillion yen as the continuous and relentless ageing of the population swellshealth and social welfare costs. Such an increase would constitute a 0.4 percent increase from this year's projected level.

Economic and Fiscal Policy Minister Hiroko Ota has already confirmed that the government anticipate that revenue from taxes will start falling, although Finance Minister Fukushiro Nukaga insisted when he spoke to reporters that the government still intends to try to balance the budget by year-ending March 2012. If they go down the road I think they are going to go down, and if this "slowdown" is a drawn out affair - as I think it is very possible that it will be - then it is hard to see this committment being fulfilled.

All of this reveals, and very clearly, just how fragile Japan's situation actually is at this point, despite all the bravado, and despite every attempt to put the best face possible on things that you can find in the government reports and the financial press at the moment. Structurally Japan is in a very tight fixt. The central bank has been unable, even during the longest expansion since the late 1980s, to raise interest rates above 0.5%, and the government has only been able to start thinking about reducing the massive outstanding debt precisely when it looks like we may be heading back to recession again, and thus they can't. You don't need to be a genius to see that there is a substantial underlying problem here, and that, in the mid term, none of this is sustainable.

Of course, the government fall back on the hope eternal argument of that anticipated rise in domestic consumption, but this failed to materialise during the boom, and I see little reason why we should anticipate its arrival at this point, indeed there are strong ageing-population-related structural reasons for assuming that we won't.

Policy Driven Or Structural?

Now one of the big debates which is bound to arise is the one which relates to the extent that (yet one more time around) Japan's problems are policy related, and the extent to which they are now "normal" problems associated with the impact of a steadily ageing population which has passed the median age 42/43 milestone. Claus has already drawn attention to Morgan Stanley analyst Takehiro Sato's views in this regard here.

Takehiro Sato presents the policy-driven case, which I will quote extensively:

Errant government policies have started to hurt domestic demand. First, the availability of consumer financing has dried up and micro businesses as well as small and midsize enterprises (SMEs) are having financing difficulties because Credit Guarantee Corporations (CGCs) started a ‘responsibility-sharing arrangement’ in October. Second, the revised Building Standards Law (BSL) has led to a sharp decline in construction starts. Third, consumption and investment sentiment has been further harmed by the prospect of higher taxes and a return to the 1990s-style fiscal policy. Implementation of the Specified Commercial Transactions Law and the Financial Instruments and Exchange Law (FIEL) can probably be added to the mix too. The FIEL has hampered foreign investors and accelerated yen appreciation. Just to be clear, we do not think that the objectives of these policies are misguided, but hasty moves by bureaucrats to implement such laws, without regard for the economy, have had a considerable impact.

We think that such errant policies will result in a policy-induced slump (‘kansei fukyo’). First, the contraction in consumer credit and financing backed by CGCs has already put a tight squeeze on micro businesses and SMEs. With sharp increases in material and energy costs worsening the terms of trade and labor’s share of income still high, SMEs do not have much leeway to increase wages or capex. The tightening of credit may lead to an increase in bankruptcies among SMEs in Jan-Mar 2008, when cash flow tends to be tight.

Second, housing investment has fallen off sharply because of the revised BSL and is unlikely to recover in F3/09. The condominium market took a heavy hit, particularly since demand had already been weak amid a decline in what households can afford to purchase. Condo starts have slumped in 2007 and are unlikely to fully recover in 2008 because the bottlenecks that have resulted from government inadequacies are likely to take time to clear up. GDP-based housing investment will probably take longer to recover. We estimate the housing weakness alone shaves 0.3ppt from our F3/08 GDP growth forecast, and do not expect a rebound of the same extent in F3/09. If the situation continues until mid-2008, small and midsize builders are likely to go bankrupt and housing spending would be affected, and hence the problems would be more than just bottlenecks.

Third, the government’s discussion of taxes has chilled consumer and investor sentiment. The Cabinet Office’s Council on Economic and Fiscal Policy released an estimate that the consumption tax needs to be increased to double figures, and the government’s Tax Commission is considering raising tax rates and limiting deductibles against income. The need for such a major consumption tax increase is understandable, but we think that the way the idea was floated was not a smart one. More SMEs may go bankrupt, housing investment looks unlikely to recover, and already-cautious consumer sentiment may worsen further as a result of all the talk of tax increases. The prospect of a return to 1990s-style fiscal policy could also harm personal consumption and investment due to Ricardian equivalence. The Specified Commercial Transactions Law and the FIEL, which are nominally designed to protect consumers and investors, actually appear to be dampening consumer spending and investments in financial products.

Well the list of policy "errors" is an impressive one, but let's think a little about some of them for a moment. Firstly the Specified Commercial Transactions Law and the FIEL. As Sato says, these are nominally designed to protect consumers and investors, so it is surprising that they are having such a negative effect. Since I am in no position to comment on the details of these measures, I will simply note that the danger of even well intended policy measures going wrong only increases as the fragility and vulnerability of an economy rises, and that is the phenomenon we seen to be observing in Japan right now. For anything to work for you in life you need a certain amount of good luck, and when your luck is down, and the level of adversity you face mounts, then the problems only seem to pile up. This perfectly describes Japan present problem set I think (I mean don't forget the famous pensions-records scandal, which seems to have been all but forgotten at the moment, except by the people who had their records lost, of course). If you really could live without a spanner showing up in the works, then it never fails to show up. That's what we mean by being "down on your luck". As Jefferson said, when I find myself being lucky I am normally sitting here, hard at work at my desk. That is, we make our own luck, using foresight and sound policy.

So then there is the housing permits paperwork issue(another of those spanners, I guess). I am sure this has been a factor, but I am sure it is not the whole story. The building permits question was merely the trigger which fired off an already primed gun. Let's look at quarterly annual growth in residential construction.

What we can see here is that the drop in Q3 is large and significant, but that the downward trend was already present even before the permits problem hit, and the situation is probably now being fed more by the knock-on effects of the credit crunch and the sub-prime concerns than by the paperwork issue itself. As such we should not anticipate any early resolution of the problem, although the rate of downturn is obviously going to ease up.

Lastly we have the fiscal issue. Now as Sato again notes, the reasons why people have been talking about such a consumption tax increase are understandable, since government debt problems are important, but as we can see from what has happened in Germany with the 3% VAT hike in January, in a society with a high median age population where domestic consumption is fragile, loading up the consumption tax is definitely not a good idea. Other solutions need to be found, and many of these will now involve cuts in provision I fear. This is the price to be paid for having left the ageing issue unattended for so long. There is now a certain inevitability about things.

Which is why it is also worrying that Sato says this: "the prospect of a return to 1990s-style fiscal policy could also harm personal consumption and investment due to Ricardian equivalence."

Leaving aside the knotty problem of whether or not there is such a thing as Ricardian equivalence, I take this to mean that he anticipates a return to fiscal deficit stimulus support. This is a very dangerous road to go down for an economy in Japan's situation. Each recesssion now is not simply a repeat of the earlier one, since each time now the screw will turn another notch, and one day something or other will break. Japan needs to look for long term solutions to its problems, which mean facilitating substantial immigration in the short term, and a radical change in fertility policy to try to address the longer term issues. Will we see that happen? I am not optimistic, but then the longer you keep saying that fertility doesn't matter, the longer people continue to think that there is no important and pressing reason why they should have children. That is, the situation becomes self-perpetuating. This is the damage that is doen by denial.

Update: 20/12/07

Well, as forecast yesterday by Nikkei, the Japanese Ministry of Finance has today announced that Japanese spending will rise by 0.2 percent to 83.1 trillion yen ($735 billion) in the year starting April 1 2008. The government will sell 25.3 trillion of new debt, almost the same as this year, to help fund the deficit. This spending increase may not seem that significant, but it will mark the first time Japan's budget deficit has increased in five years and will inevitably call into question Prime Minister Yasuo Fukuda's resolve to cut the world's largest public debt, following the recent electoral trouncing of the LDP.

According to the Japan MoF's own figures debt of central and local governments combined will now reach 776 trillion yen by March 2009, equal to 147.2 percent of gross domestic product. That compares with 149.6 percent as of March 2008. The significance of the present decision is that this trend may now reverse, and this of course raises the issue of just when the trend can revert back to debt reduction, given the presssure of population ageing, the rising median age of voters, and the fact that Japan is actually ageing more rapidly than anticipated in earlier forecasts. Ageing population related welfare costs and interest payments on bonds now account for approximately half of total spending in the budget.

General expenditure, covering items ranging from defence and public works to social welfare and education, is projected to rise 0.7 per cent from the current fiscal year to 47.28 trillion yen, largely due to an increase in social security payments. Social welfare, which accounts for 46 per cent of general expenditure, will rise 3.0 per cent as Japan’s ageing population requires more spending on pensions and medical services.

The new budget sets aside 7.44 trillion yen for pension payments, up 5.8 per cent from the current fiscal year. The government is also planning to increase tax grants to municipal governments by 4.6 per cent to 15.61 trillion yen to respond to pressure from rural voters to increase spending in an attempt to reinvigorate regional economies.

Interestingly enough the MOF has managed to reduce new debt issuance by 0.3 per cent to the above mentioned 25.34 trillion yen, in large part by increasing non-tax revenues such as transfer of surplus funds in the foreign exchange special account to the general budget account. Oh, that trade surplus!

What all this means is that the so-called primary deficit - the excess of spending over revenue excluding bond sales and interest payments - is now set to grow to 5.2 trillion yen from this year's 4.4 trillion yen.

And remember, despite the fact that the government yesterday redced its growth forecast for the current fiscal year, it is still anticipating 1.3 percent annual growth in this fiscal, and 2 percent next year. Any slippage on this will mean an even greater tax shortfall and hence a higher budget deficit.