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Wednesday, December 17, 2008

Japan's Contraction Is Evidently Far Worse Than Previously Estimated

by Edward Hugh: Barcelona

Yesterday's comments by Bank of Japan Governor Masaaki Shirakawa that conditions in Japan's economy are severe and that monetary conditions are rapidly tightening should not be taken lightly in my opinion. Viewed alongside last weeks data revision which showed that Japan’s gross domestic product contracted much more rapidly in the third quarter than initially thought, and the recent admission by Japan’s Finance Minister Shoichi Nakagawa that employment conditions are also nowbecoming “severe.” it is clear that we are in the process of settling-in for what promises to be quite a long and hard recession.

Revised data released last week showed that gross domestic product fell on quarter-by-quarter basis by 0.5 percent during the three months up to September, as compared with the preliminary estimate of only a 0.1 per cent decline. Year on year, the economy is now thought to have also contracted by 0.5 percent in the third quarter when compared with Q3 2007.

In another "red alert" treacherous-weather-ahead warning Japanese it is worth noting that Japanese industrial output was down again sharply in October and manufacturers forcecast further record falls in the months to come. This rather bleak news on Japanese factory output front may also be a pointer to a longer and deeper global recession than at first anticipated, as it also to some extent reflects the outlook for Japan's main customers - the euro zone and U.S. - and is undoubtedly associated with the very rapid growth slowdown currently taking place in the China.

Industrial output fell by 3.1 percent on the month in October, and by 7.1% year on year, and the outlook is now for a record 8.6 percent year on year contraction in the fourth quarter. Industrial output has already fallen in all three quarters so far this year and, with exports and household spending now also in decline, all the evidence points towards a long and deep recession, possibly the longest and deepedt since Japan's two decade low-growth/price-deflation agony started back in the early 1990s.

Machinery Orders Down

Further confirmation to back this bleak prognosis can be found in the fact that Japanese machinery orders also fell sharply in October. Machinery orders, which are normally thought to serve as a useful indicator of capital spending over the next three to six months, slid 4.4 percent from September, when they rose 5.5 percent, according to data from the Cabinet Office. Overseas orders - which tumbled 37 percent - took their biggest knock in five years. In addition November bookings for machine tools slid the most in at least 21 years, plunging 62 percent from a year earlier, according to the Japanese Machine Tool Builders Association last week.

Consumer Confidence Heading For the Floor

Further, Japan’s consumer confidence continued its long downward march in November as consumers became the most pessimistic in at least 26 years, giving a clear indication that we may expect even weaker spending which will surely only serve to further deepen the recession. The index dropped to 28.4 last month from 29.4 in October, according to data from the Cabinet Office. That is the lowest reading since the government began compiling the figures in 1982.

Economic and business conditions in Japan are evidently deteriorating and the Economy Watchers index posted its eighth consecutive monthly decline in November, with the current conditions index decreasing to 21.0 from 22.6. This index measures sentiment among Japan's so-called economy watchers, small businessmen and women of every type who are in day to day contact with the general public.

The forward looking diffusion index (DI) for the outlook two or three months from now also dipped - by 0.5 points to 24.7, hitting a record low for the second straight month. In fact all three components of the current conditions DI fell to a record low, with the index for household conditions dropping 0.7 points to 22.5, the index for business conditions falling 3.2 points to 19.2, and the index for the employment situation going down 3.9 points to 15.7.

Wages Continue To Fall

Japan's wages continued to fall in October, with the real wage index registering its seventh monthly decline and dropping at and annual rate of 2.2%. Even nominal earnings fell (by an annual 0.1%) as output reductions lead companies to cut overtime payments by the most in more than six years. Overtime working hours among manufacturers dropped 11.1 percent, a factor which was key in the overall earnings slide according to Japan's labour ministry.

Households also cut back spending for a eighth month in October, while the number of available jobs for each applicant slid to a four-year low.

The Tankan Drops The Most In 34 Years To Hit A Seven Year Low

Unsurprisingly given all this Japanese manufacturers’ confidence suffered a sharp decline in the last quarter, its sharpest in more than three decades, according to the latest edition of the Bank of Japan’s much-watched Tankan survey. The Tankan’s headline index which gives us an idea of the the mood of large manufacturers fell to minus 24, almost a seven-year low. And the 21point quarter-on-quarter fall in the index has only been previously surpassed by the massive 26 point plunge registered during the 1973-1974 oil shock.

Sentiment among large non-manufacturers fell to minus 9 from 1, entering negative territory for the first time in five years. Large companies said they plan to cut spending 0.2 percent in the year ending March. Sentiment among automakers plunged to minus 41 from 5, the steepest drop ever.

And Then There Is The Yen

The yen’s surge to a 13-year high last week has compounded woes for Japanese manufacturers who are already reeling from a collapse in export markets, since the yen’s 17 percent gain against the dollar since September has lowered the yen value of overseas sales and undermined the competitiveness of Japanese exports. The yen was trading at 90.95 per dollar yesterday and hit a recent high of 88.53 on 12 December, its strongest level since August 1995.

How Much Room Is There For Fiscal Stimulus?

The government has adopted a basic policy for the fiscal 2009 budget compilation. It will maintain budget caps introduced in 2006 by the Koizumi administration, which include a 3-percent annual cut in public-works spending and a ¥220 billion reduction each year in the natural growth of social security spending. But it also says that it will flexibly take drastic measures to cope with the worsening economic situation. This is reasonable and understandable since Japan's gross domestic product contracted for two consecutive quarters and the employment situation is deteriorating, especially for temporary workers.

But the message from the government is confusing because Prime Minister Taro Aso has failed to set down a convincing guiding principle for the budget. It seems to be saying that it will stick to the policy line in place since the Koizumi administration to restrain the budget growth, but will also pursue a big-spending policy.
Japan Times Editorial, December 9 2008

The recession is also taking its political toll, and the approval rating of Prime Minister Taro Aso has now dropped to below that "enjoyed" by his predecessor Yasuo Fukuda just before he was forced to step down three months ago - and is now at only 20.9 percent according to a Yomiuri newspaper poll published on 8 December. Thus the ruling coalition, which faces elections by September 2009 at the latest, is under some pressure to react, and is reportedly considering spending an extra 20 trillion yen ($215 billion) during the next three years.

“We need to implement policies to prevent the economy from falling apart,”
Economic and Fiscal Policy Minister Kaoru Yosano told reporters in Tokyo today.
“It’s going to be a tough year for the economy next year.”

Japan decided on Friday to allocate 10 trillion yen ($110 billion) to try to soften the blow from the recession, although this figure includes the 6 trillion yen already announced in October. However, there are doubts about how effective such measures can be, given that what Japan needs are export customers, and also given the large value of government debt already accumulated. This difficulty is presumeably part of the reason why Prime Minister Aso has not yet submitted a bill to the Japanese parliament to seek funding for the October measures.

The government has said it will spend 1 trillion yen in aid to unemployed workers, including housing assistance, and that the 10 trillion yen allocation includes about 3 trillion yen in fresh spending that needs to be financed in the budget for next fiscal year, according to the Ministry of Finance. Nikkei English news also reported on Tuesday that Japan’s fiscal 2009 general account budget may reach a record 89 trillion yen ($982 billion), up from the initial budget of 84.98 trillion yen, and while there is no doubt - given that Japan is a current account surplus country - that the necessary bonds can be sold, it is to the longer term debt dynamics that we need to look when we think about this.

Many observers simply point to the fact that the widely quoted OECD figure of 180% of GDP for government debt is a figure for gross debt, as if this simple point made the situation less worrying. But the problem is the underlying debt dynamic, whether we are talking in gross or net debt terms, since as we can see in the chart above (using IMF data which are slightly different from the OECD numbers) bot net and gross dent have been rising sharply since the early 1990s, and net debt now stands at 90.6% of GDP a worrying enough figure in its own right (and this is without taking account of the implied liabilities inherent in the social security system). Even more to the point, we have reputedly just been through Japan's longest running expansion in I don't know how many years, but if you look at the chart you will find that net debt didn't cease to rise at any single point, while of course, as life expectancy went up even more than anticipated, the implicit liabilities in the social security system also rose. Well basically, I claim this is unsustainable, since to show evidence of sustainability you need to be able to establish that Japan can (with a median population age of 43 and rising) still have expansions which generate enough sustained growth (after you turn the juice of zero interest rates and substantial fiscal injections off) to be able to bring the trend percentage of net debt (that is the one between the trough of one cycle and the trough of the next) down. We are a long long way from this at this point, and as such any claim that Japan will be able to bring the net debt dynamic under control should be treated as purely hypothetical and speculative. What we need is evidence, but Aso's recent policy initiatives suggest that things are now, rather, about to move in the opposite direction.

ZIRP or Quantitative Easing?

The Bank of Japan lowered its benchmark interest rate for the first time in seven years in October, and another cut “is an option,” at some point, according to former Deputy Governor Toshiro Muto in a recent interview. Interestingly he then added that “with the interest rate already so low, a further reduction would have only a limited impact.”

Adding to the specualtion that this interview produced, and speaking just two days before Japan's central bank meets to review rates, Bank Governor Shirakawa said that while the BOJ would certainly take appropriate action he was currently examining the potential effects of returning to a quantitative easing procedure.

"It's a near certainty the Bank of Japan will come up with something at its next
policy meeting, maybe not quantitative easing but perhaps outright purchasing of
commercial paper," said Chotaro Morita, chief strategist at Barclays Capital.

Of course, quatitative easing is precisely the policy Japan followed for five years between 2001 and 2006. Japanese media have also been reporting that the BOJ is examining new measures such as buying commercial paper outright, something they have so far resisted due to concerns about confusing liquidity and credit guarantee functions, although it is a practice the Federal Reserve has taken on board as part of its response to the financial crisis, as a way to help keep corporate business transactions moving. Commercial paper is a form of short-term unsecured lending often used to raise working capital and keep business moving.

Also among measures the BOJ could examine would be boosting the volume of long-term Japanese government bonds it purchases from the current 1.2 trillion yen ($13 billion) per month (the so called rinban operations) and expanding the type of collateral it accepts in fund raising operations. While the weak tankan reading has certainly fueled market speculation about a BOJ rate cut this week, quantitative easing, and unorthodox tools like expanding the balance seet to broaden the range of securities accepted and buying commercial paper seem to be more likely measures, since the effective benefits from dropping the benchmark rate to zero are not necessarily large in the context of quantitative easing, and focusing on QE helps the bank avoid the impression among the general public - as Bernanke once pointed out - that the Bank was running out of ammunition.

Indeed the BOJ has already take some less orthodox steps to ease credit strains, such as accepting a wider range of corporate debt as eligible collateral for its fund operations. Currently, the Bank of Japan buys commercial paper in its market operations to provide funds to banks, but only with a re-sale agreement rather than buying the debt outright, but again this policy could be "flexibilised", since the main objective at this point must surely be to get some much needed cash through to Japanese companies who are facing extreme difficulties raising funds through the capital markets (hence Shirakawa's reference to tightening monetary conditions), and such difficulties lead to the most rapid monthly rise in bank lending since records became available in 1992. A representative of the National Federation of Small Business Associations has also suggested that Japanese companies now appear to be rushing to secure funds out of concern latecomers would find it difficult to borrow.

What Now For The Growth Outlook?

Bank of Japan Governor Masaaki Shirakawa told the Financial Times in an interview this week that Japan’s economy may contract in the year ending March 2010. He also informed the newspaper that the central bank may next month revise downwards its current "mild recovery" forecast. From this starting point - that things are definitely getting worse rather than better, it is really take your pick in the forecasting world goes. Missubishi UFJ Securities, for example, now forecast a contraction of -1.1% for the fiscal year that end in March 2009, and a -1.0% contraction for the fiscal year ending in March 2010.

Morgan Stanley's base case call, on the other hand, sees negative GDP growth of 2.0% (previous forecast:-1.1%) in 2009, a pace which matches the contraction in 1998 at the time of Japan’s last financial crisis. Whatever the final outcome is, if we look at the chart above - where I have pencilled in the not implausible numbers of -2 for 2009 and -1 for 2010 (calendar years) - what can be clearly seen is that when all the shouting is over, and the talking is said and done, Japan's economy has still to exit the extremely fragile and weak growth dynamic it entered after the housing bubble ended in the early 1990s. Maybe there is a lesson here for someone or other.