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Friday, March 23, 2007

Japan - What Now?

The first months of 2007 have certainly seen some wobbling in the Japanese economy, or perhaps it would be more accurate to say in the monetary policy of the Bank of Japan; the economy actually has been muddling along quite nicely as per usual in recent months, driven largely by export growth and of course playing the much allured Japanese specialty of a tightrope game with deflation. So we recently saw the BOJ raise the overnight lending rate to 0.5% in a move which was both odd given the shaky character of some of the economic fundamentals and at the same time perfectly in line with the general perception that global interest rates need to move towards 'normalization' in order to scoop up excess liquidity. However, clearly 0.5% does not constitute normal in any meaningful sense of the word, at least not when it comes to the fundamentals for the carry trade it doesn't. So, what now for Japan? Well, If we look at the economic data we have seen so far for 2007 it is tempting to go for a 'steady as she goes' take and although I do believe that this view would not be too far from the truth I still think it is worth taking a bit closer look at the data we have in front of us.

An Economic Outlook on Japan - Watch that In(de)flation!

The first thing to note I think is that Japan entered 2007 with 0% inflation being registered in January, and this it should be noted was before the hike to 0.5% which was itself justified on the back of comparatively strong Q4 06 GDP figures. However it should be noted that the domestic component in the economy shows continuing signs of weakness and both retail sales and industrial production dipped in January. Retail sales in fact fell by 0.8% on a y-o-y basis, and this of course should not be seen as grave drop yet it does as always bring to the forefront the question of whether or not consumer spending in Japan really does stand before an imminent surge. Industrial production also dropped by 1.5% from December, with this fall being mainly due to de-stocking from the pre-January build-up. Expectations point to further de-stocking in February and perhaps even March although of course the widening export surplus may well provide some much needed relief here. Yet, once again there seems little correction in Japan's overall growth path and this of course raises questions about what actually can be done concerning Japan's growth imbalance, and about just how long we can carry on believing in the likelihood of a spillover effect from buyoant capital spending to the household economy.

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?

First of all we have the monetary policy question which is pretty sure to be at a standstill for the immediate and forseeable future (which in the present case means over the course of the coming summer).

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.

The Yen and Carry Trades - Still Exciting

I cannot of course write any note on Japan without also doing a stop-off in FX-ville and take the latest pulse on the Yen and associated carry trade. The first observation to take away from the carry trade debate of recent months is that it is the volatility displayed by the Yen which has been prompting commentators on an on/off basis to hail the end of the carry trade. Yet, they have of course not been reading or not fully understood what Artim noted recently in his brief on carry trade. Of course I am not trying to say that that we should not be keeping a wary eye on the Yen and on the potential for unwind of the carry trade, but we should also do this whilst remembering that the recent day-to-day volatility has basically been driven by stock market and economic data from the US and elsewhere, and that the fundamentals have not really changed and neither have the expectations, at least not decisively. Of course, the minute expectations begin to solidify towards an appreciation of the Yen Japan will be in hell of a bind since an appreciating currency is associated with deflation which is also why I don't see the BOJ moving much further north on rates in a climate where the Fed is likely to be on hold and perhaps even move down on the back of downside risk of a recession in the US. However, none of this has happened yet which leaves Artim's analysis noted above pretty much right on cue. Now, there is more to a yen carry trade than going short on the Yen and as such what is the most likely long position which we can expect from, for example, your average hedge fund? Well, of course the USD is always an option but as Brad Setser notes in his very recent entry there is much more to this than meets the eye in terms of the choice of high carrying currencies which make the flip side of a carry trade.

In Summary

So, on the economic outlook for Japan going forward I would especially like to stress one thing to watch, and that is the substantial risk of Japan falling back into deflation in March (and perhaps February) on a y-o-y basis. If this happens it will undoubtedly cause some ripples between the MoF and the BOJ where the latter will be accused of acting prematurely on the basis of a backward looking hike in February. The other thing is industrial production which almost inevitably fell in February on a m-o-m basis due to de-stocking on the back of the unsustainably high capex seen in Q4 2006. The evolution of the export surplus from March onwards will determine just how much capex can be ramped up in the months to come, and this again depends on how key economic data coming out of the US (and to some extent also China) evolves. On consumer spending, we should expect to see a small pick-up over the next few months on a m-o-m basis but I am not bullish about the evolution of consumer spending on a y-o-y basis. On the carry trade I see no change in the fundamentals and indeed if the US economy edges further towards a recession and the Fed begins to ease I am not sure that this would cancel out the carry trade in any substantial way. The point is that Japan, at this point, cannot muster an expectations driven appreciation of the Yen as this would feedback into price levels with a deflationary impact. As such, I see a distinct risk for the BOJ heading back into ZIRP if expectations begin to drive the Yen up relative to the USD and the Euro.

Finally, I want to end on an open note in terms of Japanese interest rates and whether the BOJ should normalize or not. My impetus is a recent article in Bloomberg which cites forecasters Christopher Wood and Brian Reading, who are both ardent Japan watchers, as saying that Japanese should interest rates and do so rather sooner than later. Wood for example notes that the BOJ should raise immediately from the current 0.5% to 1.5% in one go. But, we could ask, where might the sanity in such move be located?

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.