In all of this the export sector naturally demands special attention since it is, at the end of the day, what drives the Japanese economy forward at the present time. Indeed the data (see link above) reveals a continuation of the impressive Japanese export performance as epitomized by the February figures which show that the Japanese external surplus widened a whopping 7.7% y-o-y on the back of impressive exports which grew at a rate of 9.7% y-o-y in February. Of course the immediate outlook for export performance (and thus also for capital spending) in Japan is in part clouded by continuing questions about the future of the US economy and just how the current slowdown will play out in Q1 and Q2 of 2007. So what should we expect from Japan going forward?
Earlier this week the BOJ acted according to expectations and held rates at 0.5% on concerns that consumer prices might drop below zero, and this is a risk I also ascribe some weight to in my economic forecast on Japan. Also the recent announcement by the Fed in the US and the apparent move away from a tightening bias should provide an indication that global rates in the developed economies (save perhaps UK) might be getting close to their upper limit given economic fundamentals, and really I do think the ECB should take note here as well.
Another forthcoming data release from Japan may well point to changing sentiment in the Japanese economy as the Tankan business confidence survey is expected by many to fall back from a 2 year high, although it is worth noting here that there is far from a general consensus on this and, for example, Takehiro Sato from MS sees the Tankan survey in a somewhat different light. Once again the outlook of the US economy is bound to have a significant bearing on this.
The second important point to consider concerns consumer spending and more importantly the future course of inflation. Given the inflation data from January it is now almost certain that Japan will be flirting with deflation in February and March given the inbuilt downward trajectory in energy prices on a y-o-y basis. Whether this evolution in prices will be sustained is of course another story, but I am far from happy about potential developments in Q1 and Q2 and the possible feedback mechanisms with business and consumer sentiment that these may bring into play. On consumer spending, we have of course the recent drop in retail sales in January but on a m-o-m basis we should expect a pickup as the weather gets warmer and spring arrives. None of this will, however, change the underlying growth path of the Japanese economy which driven by capex which is in turn driven by foreign demand or, in other words, by exports. Lastly, and this perhaps is something which could modify the outlook I have sketched above, we have just learnt that land prices in Japan have risen for the first time in 16 years as appreciation in urban areas has finally outweighed depreciation in rural and provincial regions. Of course, this is once more prompting vigilance over at the BOJ where it is being interpreted as a potential forerunner of an asset bubble. Now, I think it is reasonable here to attach some qualifiers.
In the first place there seems to some be indication of speculation here, and especially in the big cities where the appreciation in property values is greatest and as such speculation needs to called what it is, namely speculation on further appreciation. Another interesting aspect is that a lot of the appreciation comes from overseas investors who are investing in Japanese property expecting to wheel-in a gain on future appreciation. Now, the overall property price level development is still substantially negative in Japan as shown here in the latest round up by the Economist on global house prices. I am not attempting here to deny the facts, but merely suggesting that the current speculation which is pushing prices up might be building on the back of expectations and a view of economic fundamentals which perhaps are not present in Japan.
Wood and Reading say that higher rates will help banks increase the margin between loans and deposits. Meanwhile, real estate companies should benefit as rising household incomes spur investment in land and deflation's end helps property prices.
``The Bank of Japan should raise short-term interest rates in one go to 1.5 percent now, not incrementally,'' said Wood. ``The normalization of rates in Japan would create a colossal buying opportunity for the stock market.''So where do I stand here then? Well, first of all I do see the predicament with current monetary policy in Japan since the interest rate pretty much represents a blunt weapon for the BOJ. However, I am not sure I buy the Wood and Reading's chain of arguments. What we need to consider is that any such abrupt move would almost certainly lead to the return of deflation - at least in the short term - and it is hard for me to see how this could push consumer spending higher even if equity markets saw a substantial appreciation. We need to remember Japanese demographics here too (strangely Wood and Reading do not include the marginal propensity to consume vs. saving anywhere in their analysis) and as such deflation coupled with substantially higher interest rates seem to represent a rather strengthened incentive to save relative to consume. Of course, goes the story, property prices would increase as well which together with equity market appreciation would represent enough savings for the domestic economy to put more money into consumption yet once again this is a strange prediction given the fundamentals of the Japanese with a median age of close to 43 and climbing. In the end however I am all for going against the conventional wisdom but even in a best case Wood and Reading's suggestion would represent some gamble not least with the BOJ's credibility and with Japan's ability to service a mounting public debt.