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Tuesday, September 16, 2008

Japan - The Recession is Here

By Claus Vistesen: Lausanne

It has been a while since I last had Japan under the spotlight where and where I noted that Japan almost certainly would be tumbling into or very close to recession. Since then, data have been pointing only one way really and with the recent downward revision of an already quite awful Q2 GDP reading Japan now seems certain to be flirting with a recession.

As per usual, I will peruse the most recent pile of data but now that Japan stands on the brink of yet another recession in the 21st century, I also think that it also finds itself confronted with a crucial question. What will happen to spending and the political situation in the wake of Fukuda’s resignation? I am no political specialists, but I will try to highlight the issue from an economic view point all the same.

All the Features of a Recession

As if the initial Q2 GDP reading was not tough enough clocking in at -2.4% y-o-y the revised figure released by the cabinet office of -3.0% suggests that Japan’s economy took a significant beating in Q2. On a quarterly basis Japan’s economy thus pulled the rather dubious trick of completely erasing Q1 0.7% growth rate meaning that growth in H01 2008 stands at 0% q-o-q. The corresponding figure for annual values is -0.2%. Given the sharpness of the contraction it should not surprise many that almost all components of GDP were down. Most important perhaps were net exports which failed to make a positive contribution for the first time in three years.

Especially domestic demand and investment weighed heavily on the head line figure and without neither government spending nor, more importantly, exports with net exports contributing -0.1% this is the figure you get. In general, Japan seems to be caught in somewhat of a vicious circle at the moment. With domestic demand congenitally weak and foreign demand now faltering corporate capex seems certain to fall back. Add to this, a decline in terms of trade due to the increase in imported goods prices as well as a fiscally strained government and you end up with a busted ship as they say in the sci-fi shows.

If we turn our attention to prices it seems that Japan got that last spurt of headline inflation pressure in July with all three indices posting positive rates.

The general inflation index rose 2.3% from a year earlier, but more importantly the US style core-of-core index managed to eek out a full 0.2% print. This brings the average, for this index in 2008, to 0% y-o-y. It is the first time since August 1997 that the core-of-core index posts such a gain. Clearly, and since the increase in inflation comes at a time when the economy is actually shrinking to the tune noted above, this is all about cost push inflation. The deterioration in Japan’s terms of trade represents an important underlying current here since Japan, for the most part, imports energy and food related produces. In so far as goes the domestic value chain inflation has only scarcely found its way to the market in terms of the core-of-core index, a point I have emphasized in my analysis before.

Given the rather violent setback of global headline inflation so far in H02 2008 and the imminent outlook of oil dropping to negative growth rates y-o-y towards Q4 Japanese consumers should once again find some solace, if only a little bit, at the pumps and in the supermarket as we move towards the end of the year. Of course, this will probably mean that Japan slips back into deflation in the core of core index, but it is important to understand that this seems to be the rule rather than the exception.

A further breakdown of domestic demand shows us that household consumption expenditures have contracted in every month so far in 2008. Even if the rate of contraction seems to be edging in the right direction, it still indicates that Japan has been hit extraordinarily hard by the recent bout of global stagflation.

Japanese consumers once again cut back on fuel and food expenditures while spikes in expenditures on furniture and clothing kept the index from plummeting completely. A worrying trend in the context of domestic consumer demand is furthermore that household income and wages have almost fallen off a cliff in recent months. Total cash earnings fell back 2.5% in July and household income was down 3.5% on the year. In light of this, it is difficult to expect the Japanese consumer to be able to muster that much debated second bulwark against recession once foreign demand trends down.

As for corporate sector the overall headline news was actually a rare bright spot as industrial production climbed 0.9% in July from June where it fell 2.2%. While certainly down on an annual basis, industrial production still seems to be increasing at levels higher than those seen throughout 2006 and H01 2007. The news from the small services on the ground, in the form of Japanese small merchants, consequently point towards a further deterioration. This is no doubt strongly related to the slump in consumer confidence and spending and shows the extent to which the slowdown in demand is affecting businesses that are dependent on the home market alone.

It is also difficult to see much upside in the July number given the slew of other incoming data. As such, the overall gauges for fixed capital formation in Q2 points towards a sharp de-acceleration of activity and one really finds it difficult to conclude much else than the fact that Japan is now in a recession.

According to Morgan Stanley’s Takehiro Sato one mitigating factor here may be the relative tight management of inventories by Japanese companies in recent years. The point here would be that since Japanese companies do not have a large backload of inventories to scale down, headline production may not have to slump completely. Sato remains skeptical of this analysis and I agree. Clearly, the inventory related argument ultimately depends on the actual rate and severity of the incoming slowdown not least in Japan’s main export markets. It is clear to me that any sharp slowdown signals from China would mean for Japanese corporate capex to see a significant period of downscaling. In fact, with all external deficit economies slowing down sharply, it is difficult to have much faith in the inventory argument. The point here is simply that the level of industrial activity that the domestic sector can support in light of falling external demand may be much lower than many expect.

In this context and while exports continued to de-couple from the US in July imports also rose at record pace. The resulting narrowing of the trade surplus to an almost even balance is exactly what is robbing Japan from part of its growth engine. Clearly, and if the terms of trade are set to improve it could be all back to normal for Japan in H02 2009. However, it seems anything but certain that a correction is also coming in terms of emerging markets even if it will be relatively short lived. On that note, net exports and foreign asset income will be less of a driving force for growth in the latter part of 2008.

What is more, Japan also seems to be sporting its very own miniature residential investment crisis as bankruptcies amongst construction and real estate companies continued to climb to alarmingly high levels in August. Sato digs deeper into this issue and directs attention to the point that one of the main risks facing Japan is that credit dries up leaving even more companies without the possibility to carry on their operations. This tune is well known and has credit crunch written all over it. According to Sato, one of the main risks at the moment is consequently that the sharp contraction of credit and activity in the real estate sector could spread to other sectors. One key development to gauge here would be the trend in overall corporate bankruptcies, especially over the course of H02 2008.

Fiscal Stimulus to the Rescue?

The probability and discussion of fiscal stimulus to revive Japan’s economy got significantly more clouded with the recent decision of Prime Minister Fukuda to step down. The decision itself was not entirely unexpected as the PM, and his cabinet, has had a distinctly hard time getting their will through parliament, as the opposition controlled the lower house. According to Ken Worsley, Fukuda’s resignation is thus a part of a more fundamental strategy to install a special session in the Diet which allows the ruling party (the LDP) to pass a number of bills.

In the middle of all this there is a 2 trillion yen ($18 billion) expansive fiscal deal on the table. If the economy continues to deteriorate one would think that such a deal could be relatively swiftly passed by both chambers of the parliament. With mounting rumors of a general election in November, the current situation looks pretty unpredictable. . As with the impending and much debated consumption tax to widen the budget’s revenue base it seems that priorities in the political system are not yet straight when it comes to moving forwards, or backwards, on the fiscal front.

As could have been expected the candidates to replace Fukuda are rounding up and while I know way too little about Japanese politics to say anything about the individual contenders, it is clear that one issue high on the agenda will be what they intend to do with respect to the fiscal lever and by derivative the much debated reform ghost in Japanese politics. In this connection recent comments from various candidates reveal somewhat of a disagreement. Obviously, the difficulty with which Japan can actually use fiscal policy, saddled with a debt/GDP ratio of +180%, is not new. The outgoing PM consequently stated the following rather incredible claim a few months ago (quoted by Bloomberg).

There is nothing to be done but wait for export markets to recover.

I do find this rather interesting not least because it comes from, at the time, a leader of a country and an economy. Essentially, I agree with Fukuda though. It is very unlikely that Japan will be able to ignite domestic demand to a degree which will make the incoming slowdown milder. This is the nature of export dependency as a result of an ageing economy. However, the sentiment expressed also highlights, I think, a more profound perspective with respect to Japan’s policy makers’ relentless strides to rebalance the economy. Basically, Japan is now set on a growth path which no immediate policy can change. Anything short of a very local Japanese version of the IT induced positive productivity shock [1] would not do the trick, so there is, in fact, not much to be done. Of course, the sentiment turns almost delusional with comments quoted from Hiroaki Muto senior economist at Sumitomo Mitsui Asset Management Co. in Tokyo.

Japan's economy is weak because foreign demand is slumping and the terms of trade have been worsening, not because there are any big domestic structural problems.

I would grant Mr. Muto some of his argument in the sense that the specific deterioration in the terms of trade, this time around, has made matters worse. However, it is precisely because Japan has domestic structural problems that she is export dependent, and therefore it also because of domestic structural issues that Japan’s economy finds itself in a weak position when foreign demand falters.

This display of sentiment also seems to cut across the fistful of potential candidates on offer to replace Fukuda. Some seem to share the outgoing PM’s sentiment while some again seem to believe that a stimulus package, of some kind, would be appropriate. It is also important to note here that an 11.7 trillion yen stimulus deal is on the table. The deal is mainly targeted to alleviate funding conditions for small and medium sized companies. One of the main aspects must clearly be the extra provisions set up in the context of the shared credit responsibility implemented a year ago. Takehiro Sato and Morgan Stanley’s Japan team have been warning before of the adverse effects of letting banks assume part of the responsibility here in the sense that it would lead to a sharp retrenchment of credit to small and medium sized companies. I will let Sato himself provide the details

So alongside this new system created to ease funding problems, the new economic package also brings a wider range of safety net guarantees of different types.
Safety net guarantees lie outside the shared responsibility system, and have been used, as the name says, to provide a safety net for the SMEs that cannot access CGC-backed loans. Originally, about 70 sectors were designated as eligible for credit support based on criteria such as sales performance, but the number has almost doubled in the wake of the errant policy-induced housing shock that followed last year’s revision of the Building Standards Law. The eligibility of a debtor is decided by the external criterion of whether it is included in the specified industries and whether sales are down more than 5%Y for the latest three months, but the number of industries covered could rise as the recession deepens.

If the economy continues to deteriorate one would think that such a deal could be relatively swiftly passed by both chambers of the parliament. However, this seems far from certain with in light of the political limbo in which Japan now finds itself. As with the impending and much debated consumption tax to widen the budget’s revenue base it seems that priorities in the political system are not yet straight when it comes to moving forwards, or backwards, on the fiscal front.

More importantly, Sato also muses on the potential for the Japanese government to pull of the extra emergency provisions without having to issue more paper. I can see the argument in the sense that the government would only have to fork over its part of the cash if the debtor went belly up. In a general perspective however, any kind of slack in terms of loosening fiscal policy, which really only could be financed through the issue of government bonds, would certainly bring forth the rating agencies. Especially, any de-facto abandonment of the objective to balance the budget by 2011 would not be taken lightly [2] .

In any case, and as Sato also explains in some detail, it is not at all certain that fiscal stimulus would help boost the economy but merely shift liabilities from companies and the consumer over to the government. The key argument here is one of Ricardian Equivalence where by economic agents adjust their expectations so as to negate the initial effect from the fiscal windfall. Obviously, the shift in liabilities themselves would not be without advantage since the increased savings by households and companies would likely bring the overall discounted value of Japan’s liabilities down. [3] In essence though, this remains a very theoretical argument and should not distract us from the point that Japan is slowly but sure trending towards an end point when it comes to its public balances. At some point she simply won’t be able to pay and the international institutional set-up (rating agencies) and policy makers (G8 anyone) would be wise to think in alternative solutions here. The alternative in terms of some ageing countries’ abilities to fund their ongoing liabilities will not be pretty at all.

Moreover, if we take Sato’s argument to the extreme the theoretical future discounted value of Japan’s government debt could be made equal to the equivalent future discounted value of the entire stock of company and household savings. However, this is not the way it is likely to materialize.

As such and while I agree with Sato’s initial point that increased savings through deposits are likely to be channeled into cheap government funding, we also know that Japan’s savings are increasingly flowing out towards higher returns. Furthermore, this is a story with both a short term and a long term perspective, where the former is epitomized in Ms. Watanabe and her carry trading efforts and the latter by portfolio and investment outflows. As such, and given the current levels of Japan’s public debt ratio the theoretical process of funneling domestic savings into government bonds may not correspond to practice. I would hold this to be particularly doubtful in light of the fact that the income earned on foreign holdings of stocks and bonds are precisely what drive top line growth in Japan together with goods and services exports.

What Kind of Recession?

Now that everybody seems to agree that Japan is in a recession the focus has naturally turned towards the question of just how it will look. V(W)-shaped, U-shaped or perhaps even L-shaped are all potential scenarios at this point. Official authorities in Japan in the form of the BOJ and the Cabinet Office maintain that this will be a quick recession. The analytical landscape is less convinced though. Takehiro Sato seems to be leaning towards a somewhat nastier scenario. As I have highlighted above, a sharp emerging market correction in China would definitely be catastrophic for Japan. Also Mary Stokes from RGE sees considerable downside risk to Japan’s situation.

I tend to go for the more pessimistic of the narratives noted above. I also concur though that if headline inflation is set to decline as briskly as seems the case, it could just bring the relief Japan needs if she is not to falter completely. In the end however, external demand and asset income will, as ever, be crucial parameters to watch. This ultimately also means that Japan will suffer at the whims of the global economy.

On that note, I see considerable upside in places such as Turkey, Brazil, and India. Japan’s savers would be wise to expose themselves towards these regions in the future in their attempt to hold the most efficient global portfolio. Many great unknowns present themselves though. China’s development is crucial for the global economy, but also the potentially incoming train wreck in Eastern Europe and the instability in Russia could be one of those famous trigger points.

Conclusively, I see Japan limping ahead for the remainder of 2008 where foreign demand, all things equal, will be less of a driving force than hitherto.

[1] Given the rate of technology adoption and diffusion across economies today, it is very difficult to see how Japan would be able to sustain a relative competitive advantage in any sense of the word.

[2] Personally, I think that this is very unlikely to materialize in the first place, but as in other, more fundamental parts of life, commitments matter.

[3] I am assuming here that the government can finance its budget deficit more cheaply than individual consumers and companies.