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Tuesday, January 1, 2008

Japan in 2007 and Looking Forward to 2008

By Claus Vistesen Copenhagen

It is the 1st of January and people are probably still recovering from a night of bubbles, bombs and broken records in alcohol intake. However and although I guess that most of our readers are enjoying a day away from the computer stocking up with plenty of fast food, coffee and pain killers we are going to break radio silence here at GEM and have a look at Japan in 2007 and forward into 2008. Over at the Japan Economy Watch a whole slew of notes are already up which substantiate and elaborate on the points below so if you are into details on all of this JEW is the place to go. What follows is a note from my personal blog Alpha.Sources but it ties in excellently with the general coverage of Japan and the global economy here at GEM


The general coverage of Japan here at Alpha.Sources in 2007 has mainly been centered on two issues; BOJ watching and tracking a series of monthly data on prices and domestic consumption. This line of analysis has then entered the much wider and encompassing general analysis as it has been presented over at the Japan Economy Watch blog. As for the series of monthly data tracking I don't have the entire 2007 represented with specific analyses but most of it as can be seen from the list below.

Japan, Still Stuck (April 28th)

Playing the Waiting Game in Japan (June 29th)

Is Japan Heading for a Recession? (September 3rd)

Finally Some Good News from Japan? (September 28th)

Where is Japan Heading? (November 4th)

In the new year, I would like to present the fruits, as it were, of my labours on these notes as I have tried to knit together a methodology which can track the evolution of domestic household demand in Japan. Of course, this is nothing more than a mixture of data from various sources but the overall and underlying argument is pretty important. Quite simply, I am hypothesising that domestic demand won't be a future driver of Japanese growth as many has proclaimed and in order to do that I obviously need to tie my argument to some tangible data which is basically what this whole 'consumption expenditure watching' exercise has been all about. Let me consequently round up 2007 such as it is with Japan moving closer to what increasingly looks like a recession. As per usual Edward has already beaten me to it over at JEW with a note covering the majority of the recent data releases.

For now, let me present my traditional graph of the evolution of the three key price indices in Japan which shows us one of the big stories coming out of Japan in here in the twilight of 2007, the return of inflation.

As can readily be seen, inflation in the two main core indices took a leap towards the sky in October and November and I would expect the same in December. Immediately we should note that the stripped core index which excludes fresh food and energy is still in negative territory but is closing in on the 0% mark. However, the distinction between these three inflation measurements is not without importance since they tell a cautionary tale of the current inflation dynamics in Japan. You see, and as Stefan Karlsson ponders accordingly, it has widely been recognized that the day Japan returned to inflation would be the day we could finally call an end to a decade long slump in the Japanese economy. As I have argued before this essentially represents a fallacy. At the current juncture it is of course almost painfully obvious and almost a bit tragicomic really not least because history it seems has been well and truly forgotten or as Edward puts it ...

Basically the problem facing Japan is that the up-tick in inflation is taking place at precisely the same moment as there is a downtick in several other key economic indiactors. What this means basically is that Japan is getting squeezed on both fronts. (...) The last time inflation showed signs of life in this way, Japan was pushed straight off into recession. History may well be about to repeat itself yet one more time here. But the real question is when will people actually start to learn some of the costly lessons experience is offering us?

In other words, what we are seeing are not demand-pull inflation which would have been the hallmark sign of a recovery driven by domestic demand but rather cost-push inflation which is being imported through high energy and base commodity prices; remember all that flurry of the rising price on mayonnaise, Starbucks lattés as well as recently wholesale prices which would rear their head in the PPI indice(s). On the general situation and as per usual, Morgan Stanley's Takehiro Sato also remains calmly on top of the situation in his recent note Inflation Irony where the bottom line is the following and I cannot but agree.

Indeed, it is ironic if the BoJ has to consider the monetary accommodation in the midst of the long-awaited recovery of the CPI rate.

So, as always in Japan the headline message which in this case tells us about a return to inflation is masked by a considerable underlying story and one which is not merely about a technical discussion of different kinds of inflation. Much more pertinent however it raises a fundamental question as the kind of price dynamics we can expect in a country with Japan's demographic profile. To that end the recent Christmas bumper edition Bizcast on Japan hosted by, among others, Ken Worsley for the Japan Economy and News blog has an interesting discussion. Lastly, we should return to the graph fielded above and note that Japan is still formally in deflation measured by internal price dynamics proxied by the general index stripped of fresh food and energy. Of course, this measure might soon enough shoot in to positive territory as well if the current trends continue but if and when it does it won't signify the coming of a sustainable recovery in Japan.

Moving onwards to the second part of my analysis as I have been presenting it throughout 2007 we have three graphs of domestic consumption.

As I noted above, I am still pondering the general methodology here but the graphs above still manage to convey some important general messages. The first graph plots y-o-y changes in consumption expenditures and above all it is important because this is the measure which is traditionally reported by the business press. As such, I have been attaching a forecast to this series throughout my analysis as I predicted that the rolling y-o-y average would not exceed 1%. The actual numerical forecast is not that important here but more so is the overall message in the sense that whatever underlying trend we expect of domestic consumption it will not be enough to pull forward the Japanese economy towards the much hailed sustainable recovery as well as it won't be enough to decisively pull Japan out of deflation. Currently as of November the rolling average stands at an increase of .75% and knowing that December might still succeed to shatter my forecast I am smug enough to call this one in the box. The two other graphs are important because they can be used to differentiate the traditional headline measure. As for the month-on-month series it clearly shows what we know now, namely that the trend measured by intra-year dynamics clearly is one of a down trending path. As for the real index (100=2005) it is there to give the big picture and to show the current trend relative to a fixed historic benchmark. At this point in time the graph really does not add anything as it seems to have been pretty much shadowing the other series. However, what will be interesting in the new year and especially if Japan falls into sub-zero growth rates will be to see the relative slump in domestic consumption and more importantly the relative 'recovery' which may come in the future. My guess is that the ups and downs will be there but that the spikes and troughs will be situated lower and lower on the index as we move forward.

Conclusively, the trend in domestic demand in Japan is very clear. Compared to 2006 which was clearly a pretty abysmal year with respect to monthly consumption expenditures 2007 will see an overall increase in monthly consumption expenditures. However, and in the light of the analysis above it is clear that although the trend is positive it is not near enough to confirm the claims of how Japan is heading for a sustainable recovery driven by internal demand. For a detailed look at the recent monthly GDP figures for October (the last one out) published by the Japan Center of Economic Research is worthwhile and confirms the rather gloomy outlook.

Finally in this note I am going to field a series of predictions for Japan in 2008 or perhaps as Macro Man put it recently we should rather be talking about 'non-predictions' ... In any case and now that I am talking about him why don't we have a look at those of MM's predictions where Japan is involved, just to get us started that is ...

  • My first prediction moves in alongside Macro Man's fifth prediction in noting that the BOJ will not raise rates in 2008. This may not seem to be a particularly outlandish call but remember that all through the first half of 2007 expectations had it that the BOJ would end the year at 1% or thereabouts. This was clearly a long-shot and here on the brink on 2008 it paves the way for another one across the bov, namely that 2008 will see the return to ZIRP. Yep, now I have said and I will as always be ready to eat my words just as I will have to eat them for not calling it right when I said that 2007 would end on a ZIRPy note. So, before you pull the plug on your Alpha.Sources RSS feed here are two reasons as to why Japan might yet again return to ZIRP in 2008. Firstly, I believe that the current slowdown will be tougher than most people anticipate and secondly; there is the political situation. You see, the BOJ is set for a change of leadership in the Spring and with Fukui leaving the seat without being able to normalise rates in any given sense of the word the future course of the BOJ seems to be situated in somewhat of a limbo in terms of strategy. This needs to be tied together with the general political situation in Japan. This is of course a pretty messy topic but it essentially shores up at the point about how the new leadership at the BOJ needs to be ratified by both houses of the Japanese parliament and how the Democratic Party of Japan (DPJ) might use their majority in the upper house to stall the installation of a new BOJ leadership. This will mean that political interests proxied by the Ministry of Finance (MOF) will be brought temporarily closer to the decision making on monetary policy if this happens in the midst of a tougher than expected slowdown it might just be what pushes the needle in favor of ZIRP. Conclusively, I see the return to ZIRP as a plausible outcome mainly on the basis of a larger than expected deterioation of economic fundamentals with the likely political situation as a potential trigger.
  • Takehiro Sato recently told us to Buckle Up and sit tight as we were moving for what he called a 'mild recession.' All this very quickly turns into a battle royal of definitions since what exactly is a recession not to speak of a mild one? Well, according to Sato a mild recession would be a series of quarters (minimum two in a row) with sub 1% growth in output. I really wouldn't want to rob Roubini of his alter ego Dr. Doom but when I look at Japan from all angles available I see a recession coming which would be defined as at least two consecutive quarters of below 0% growth. I concede that this is a very uncertain call and in essence we would perhaps be better off by just calling it a tough slowdown and forget neatly about the numbers. However, we don't quite have that luxury I feel since if Japan really falls into a recession it is going to bring out all kinds of ghosts from the past. As I noted above I think ZIRP will be one of them but also the ever looming government debt will race to the forefront of the agenda I think especially if some of those rating agencies find it in them to actually lower the sovereign debt rating of Japan. The concrete ammunition for the recession call is pretty clear I think. The housing start debacle which saw a sharp reduction in housing starts and thus residential investment is likely to cast considerable shadow into 2008 as well. Domestic consumption is not likely to provide any kind of shield especially not with a decline in real income and a near decade low reading on the consumer confidence indices. The real key as always in Japan will the evolution of external demand and as a derivative of this corporate capex and industrial production. On the latter front November saw a decrease of 1.6 % but the overall trend in IP is still very much positive. External demand is likely to recede overall due to a global slowdown but remember that this is more about re-coupling than de-coupling and even if the US will stop buying those Toyotas as fiercely as in 2007 other markets may help offset this. All I can say is that it remains to be seen.
  • Another big story for 2008 is the potential for the Yen to rise to such uncomfortable levels against the USD that Japanese authorities will find it necessary to intervene. Well, perhaps I should reiterate slightly here in the sense that this was suppose to be one of the big stories. As such and back in early November where the trouncing of the Dollar was at almost epic proportions (hell, the Danish kronor even saw 4.98 USD for a minute there) market participants were positioning themselves for a potential intervention on the Yen as the USD/YEN drifted ever so closely to the 100 mark. I asked the question the 9th of November. Of course, and as Edward succinctly puts it his most recent post this has turned into something of a mute point. Consequently, the USD/YEN has moved into much more comfortable territories from the point of view of Japan at least trading at around 114-115. In terms of actual calls this is approximately where I saw the USD/YEN for the end of 2007 (a bit too low actually, I was looking for more like 118-120) and clearly a USD/YEN at levels consistently below 110 and perhaps even 105 are not likely to go down well at all with Japanese authorities for an extended period. I will refrain from a y-o-y call on the USD/YEN since such calls are absolutely pointless (although I do respect Stephen Jen's ongoing stalwart efforts of satisfying Morgan Stanley's clients), especially in these day and age where technical analysis much more than fundamentals analysis seem to be in vogue amongst currency traders . Rather I am moving in behind Macro Man in proclaiming that we won't see any intervention on the USD/YEN in 2008. In short, I would like to have the real option to adjust as I move along. I do want to emphasise though that Yen weakness and carry trade are set to be topics well up the 2008 agenda, at least from where I am sitting.
So, these are the predictions and analysis on Japan such as it is for 2008 (for the record, here are my 2007 predictions and analysis). As always I encourage people to let me eat my words with gravy and extras if it turns out that I am wrong. In the new year I will continue to move forward with my general domestic demand and inflation analysis, BOJ watching as well as general observations on the great land of the rising sun. What is left is then to wish you all a happy new year and a prosperous one too.