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Tuesday, June 2, 2009

More Than "A Whiff" Of Deflation In Japan

By Edward Hugh: Barcelona

Well, as Claus pointed out in his last post, Japanese data is pretty much a mixed bag at the moment. Industrial output shot up in April, and the May PMI data suggested that the easing of manufacturing contraction continued in May. However household spending and retail sales fell, unemployment rose, and the CPI reading suggested the Japanese economy is once more getting itself firmly wedged in deflation territory. So while the industrial data offers some much needed short term relief, the mid term outlook is still pretty bleak.

Industrial Output Surges

Well, as Bloomberg kindly pointed out, industrial output surged the most in 56 years in April. Production rose 5.2% from March, marking the second monthly gain, according to data from the Trade Ministry. The increase was faster than the 3.3 percent consensus forecast, and companies said they planned to boost output in May and June as well. The headline reading, which registered the sharpest hike since March 1953, when it rose 7.9 percent, was well above the average market forecast of a 3.2 percent increase in a Kyodo News survey.

The seasonally adjusted production index was thus up for the second straight month, and stood at 74.3. To put this in perspective we are now more or less back where we were in January, and still well below the 100 base level of 2005.

At the same time as making the announcement the ministry upgraded its basic assessment of industrial production for the first time in 20 months, saying, "Developments for a recovery are to be seen", although it needs to be emphasised that what can be seen are still only the developments which could - ultimately - lead to a receovery, not recovery itself. And at this point, with world trade flat, investment and consumption falling, and unemployment rising, it is not really clear where the recovery could come from. The ministry official who gave the press briefing pointed towards the upturn in Japanese exports to China, and this is certainly a valid reference, but exports to China alone cannot pull Japan out of deep recession (see chart below), indeed the actual level of exports is still only a third up on December's low, and still only two thirds of the high hit last summer.

Shipments to China, which is now Japan’s biggest trade partner, fell 25.8 percent in April from a year earlier. The rate of decline thus fell for a third straight month, suggesting Beijing’s $585 billion stimulus package is having an effect, at least as far as Japan exports go. Month on month exports to China we more or less stationary, but they are up around 60% from January's low point. In fact shipments to China are now about a third larger than those to the US, and 40% larger than those to the EU.

Output of electronic parts and devices, which was up 15.7 percent from March, lead the overall advance together with increased production of semiconductor integrated circuits for mobile phones and portable music players. The output of chemical products also increased, up 13.8 percent, on rubber products for automobile tires. Transport equipment makers saw a 7.0 percent rise in their production as exports of passenger vehicles to Europe and North America grew.

Meanwhile, general machinery products continued to fall, and were down 14.5 percent month on month, a sign that managers remain wary of upgrading factories and equipment before they are convinced an economic recovery has taken hold. If you look at the chart below (click on image for better viewing) you will see that the year on year drops (indicated by black triangle) in machine output continued to be massive in April, with production of general machinery down almost 50 percent on the year.

Data last week also showed Japan's core private-sector machinery orders fell 1.3 percent in March, wiping out a 0.6 percent rise in February but it was a much smaller decline than the median market forecast for a 4.5 percent slide. From a year earlier, orders fell 22.2 percent in March compared with 30.1 percent in February. The Cabinet Office said the “pace of declines has eased,” changing the wording of its assessment from “the orders trend continues to decline.”

The position of Japan's manufacturing in May appears to be following a similar trend according to what we can see from the latest Purchasing Managers Index (PMI) survey, since while the survey found that activity in the Japanese manufacturing sector fell for the fifteenth successive month, the drop in output was the smallest seen in just over a year. I wouldn't attach too much importance to the discrepancy between the PMI survey and the actual output outcome at this point, since the survey methodology (which is normally pretty reliable) is probably struggling a little at this point to handle the severity of the shock in the manufacturing sector and calibrate results. The general direction of an easing in the annual rate of contraction is in harmony on both readouts.

In fact, the seasonally adjusted headline Purchasing Managers’ Index (PMI) rose sharply in May to 46.6, from 41.4 in April, pointing to the slowest deterioration in operating conditions for nine months.

May’s survey also showed that incoming new orders received by Japanese manufacturers fell for the fifteenth month running. But again the rate of decline continued to ease from December’s record drop to the smallest contraction in the weakest in the current sequence. While foreign order levels continued to fall, they did so at a much slower rate as improved orders from China continuing demand weakness in other regions (such as the US and Europe). May’s survey pointed to a sixth successive monthly decline in the prices charged by Japanese manufacturers for finished goods.

Although still sharp, the latest drop in output charges was the weakest since last December. Strong competitive pressures and falling raw material prices were cited as key factors undermining manufacturers’ pricing power in May. Average cost burdens faced by Japanese manufacturers fell for the sixth month running in May. Despite remaining steep, the rate of decline eased to its weakest for four months. Lower raw material prices were reported to have depressed costs during the month, with steel frequently mentioned by panellists. Levels of business outstanding fell again in May, extending the current period of decline to sixteen consecutive months. Despite slowing to its weakest since last August, the rate of backlog clearance was still steep in the May survey period. Evidence provided by the survey panel linked the latest decline in work-in-hand to spare capacity resulting from falling workloads.

The PMI report also showed that Japanese manufacturers reduced their workforces for the tenth straight month in May. The rate of job shedding remained sharp, despite easing to its weakest for six months. Of those firms that reported a decline in employment, the majority attributed this to the non-renewal of temporary contracts and lower output requirements.

Unemployment On The Rise

Japan's unemployment climbed again in April and the current 5 percent (seasonally adjusted) jobless rate is the highest since November 2003. Job seekers found it harder to secure work and the ratio of positions available to applicants slumped to 0.46 (from 0.52 in March), matching the lowest ever recorded - in June 1999. The jobless rate rose to 5 percent from 4.8 percent in March, according to the government statistics bureau.

Not surprisingly, with unemployment rising and output down Japanese wage earners' total cash earnings fell in the year to April for the 11th decline in a row, as companies cut costs amidst growing uncertainty as to whether or not the pick-up in overseas demand will last. Total cash earnings fell 2.5 percent in April from a year earlier to 272,453 yen ($2,85). In March, wages fell a revised 3.9 percent from the previous year, the largest decline in nearly seven years.
Overtime pay, a barometer of strength in corporate activity, fell 18.8 percent in April from a year earlier, compared with the previous month's 20.8 percent decline, which was the biggest fall on record. Overtime pay has now fallen for nine successive months.

Consumer Prices Show More Than A Whiff Of Deflation

Japan’s general (headline) index of consumer prices fell for thrird month in April, adding to signs that the recession will initiate a resurgence of Japan's long run deflation dynamic. Consumer prices on both the general and the core (excluding fresh food) indexes declined 0.1 percent from a year earlier, according to the latest data from the statistics bureau. The "core-core" index (excluding both fresh food and energy) was down 0.4% year on year, the fourth successive month of decline.

Bank of Japan Governor Masaaki Shirakawa said last week that price declines will accelerate through the middle of the year ending March 2010 as demand slackens and crude oil continues to trade lower than last year’s record. It is hard to escape the conclusion that the Japanese economy is now, once more, entrenched in deflation, and given the continuing weakness in the economy, it’s hard to see consumer prices reversing course and opening up an exit strategy for the Bank of Japan from the present highly accommodative monetary policy.

Indeed, in what is probably a harbinger of things to come core prices in Tokyo fell 0.7% in May from a year earlier, the biggest drop in six years, according to the report, and the first such decline registered in Tokyo since September 2007. Core prices - ie those excluding fresh food will are expected to fall by 1.5 percent in this fiscal year and 1 percent in the next, according to the central bank policy board forecast last month, and obviously there is lots of potential downside risk here.

Wholesale inflation - the cost companies pay for goods and fuel - dropped at the fastest pace in 22 years in April, and prices paid for services declined for a seventh month. And the drop in prices may be worse than the numbers show. Core prices would have declined by an additional 0.2 percentage points had the government not temporarily waived the gasoline tax in April last year. Furniture retailer Nitori announced last week that it will cut prices by as much as 40 percent on May 30. The company has launched five price-cutting campaigns in the past year. Supermarket operator Daiei have also just lowered prices on 1,000 items of clothing, food and household goods, expanding discounts to 6,000 items.

But despite falling prices and abundant offers household spending was down again in April (by 1.3% on a year earlier) for the 14th consecutive month. The impression one has is that even if Japan’s economy return to some slight positive growth in the second quarter, if we start looking beyond, there will are very strong downside risks. The deterioration in employment and falling income will likely exert a growing influence in the months ahead, taking a toll on consumers and the economy. We’ll start to see the impact of massive output cuts become clearer in the job market which will leave households with little ability to support the economy.

Unsurprisingly Japan’s retail sales fell for an eighth month in April as worsening job prospects and declining wages deterred shoppers. Sales slid 2.9 percent from a year earlier after decreasing a revised 3.8 percent in March, the Trade Ministry said

So it is evident that Japan's worst postwar recession is now spreading to households. Consumer spending is too weak to support a recovery, given the deterioration in the job market and Japan’s economy will remain fragile in the absence of stronger growth in external demand.

The Bank of Japan and the government continue to put a brave face on things, and both have now raised their assessments of the economy for the first time since 2006 on signs that exports and production are starting to stabilize. Both, however, continued to point to weakness in consumer spending and rising unemployment as risks to a recovery.

Bank of Japan Governor Masaaki Shirakawa seems reasonably convinced that the economy will resume growth this quarter after a record 15.2 percent contraction in the previous three months. The central bank cut the key interest rate to 0.1 percent in December, and has since bought corporate debt and expanded government bond purchases to revive the economy.

The government, on the other hand, have begun distributing 12,000 yen ($125) to each resident in March to encourage spending. Prime Minister Taro Aso’s administration has also cut highway tolls and introduced a programme of incentives to purchase environment- friendly televisions, refrigerators and air-conditioners.

But all of this amounts to paddling up river with a strong wind in your face. Japan's output gap widened to a record in the first quarter as supply grossly exceeded demand, which could push Japan further into its second bout of deflation just under two years after the BoJ officially announced the country had broken lose from its stranglehold. The output gap, which measures the estimated balance between demand and supply in the economy, fell to 8.5 percent in the three months ended March 31, according to the Cabinet Office, a significant increase in the 4.5 percent registered in the last three months of 2008. Thus despite the recent resurgence in the monthly output number we should not forget that output is still around a third lower than it was a year ago, and if things don't change soon deflation could easily become a very big problem, especially for the government, whose gross debt is fast approaching 200% of GDP.