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Wednesday, November 29, 2006

Japan is Getting Interesting

(Cross post from Alpha.Sources)

As regular readers of Alpha.Sources will know I have become quite fond of 'Japan-watching' as a discipline and as the pundits' commentaries and general economic data keep coming in I must say that it is getting exceedingly more interesting. Clearly, I have an impetus here and in essence I feel that I am on to something and I will keep poking and scratching accordingly; so should look at the next round then? Let us by all means begin with some recent data ...

First of all the picture of consumer spending is shining bright as ever, this time as a derivative of dropping retail sales figures in November. (From Bloomberg)

Japan's retail sales unexpectedly fell for a second month, reducing the likelihood that consumer spending will accelerate and lead to an increase in the lowest interest rates among the world's seven biggest economies.

Receipts at retailers fell a seasonally adjusted 0.2 percent in October from a month earlier amid warmer-than-usual weather, the trade ministry said today. Sales of winter clothes and electronics led the decline.

The retail ``report does make it somewhat more difficult for the bank to move because things aren't exactly adding up,'' said Jan Lambregts, head of Asian research at Rabobank International in Hong Kong. ``The Bank of Japan is taking an optimistic view on the economy.''

In terms of coherency of arguments we might want to hold on to the one made by Jan Lambregts as he points out that things, in terms of the BOJ's ability to raise, not exactly are adding up. Meanwhile, we also have the recent numbers on industrial output and wouldn't you know it; here Japan shows a quite impressive progress, (from Bloomberg).

Japan's industrial production unexpectedly rose to a record, backing the central bank's assessment that the world's second-largest economy is strong enough to withstand higher interest rates. The yen rose.

Factory output in October climbed a seasonally adjusted 1.6 percent from a month earlier, the Ministry of Economy, Trade and Industry said in Tokyo today. Gains were led by autos and semiconductors as production rose 7.4 percent from a year earlier, the biggest jump in more than two years.

Toyota Motor Corp., Japan's biggest company, said this week it increased output in October by 16 percent because it expects overseas demand to climb. Central bank Governor Toshihiko Fukui said yesterday the lowest interest rates among major economies will have to rise to ensure the economy keeps expanding.

Notice especially the central bank governor Fukui's discourse about how the economy surely is on its way to become resilient enough to sustain an increase in the interest rates which for the record is still running at a staggering 0.25%. Now dear reader I can certainly understand if something in your mind is not adding up but I can assure you that by applying the right tools we can break this nut. Let me first get one point across the board here which has to do with the nature of economic growth in Japan. In short, how would we explain growth in an economy where total output is going up while domestic output is down driven by declining domestic consumption? Yep, you got it; export driven. This is of course not very complex but we need to ask ourselves why Japan's growth is export driven and more importantly why/whether it will continue to be so as we move along. As such there are two rivalving analyses here ...

1. The first explanation is roughly based on the ideas of business cycles in the economy and seems to be the mainstream way to see this. Following this it is by defintion only a matter of time before the upbeat trend in the corporate sector spills over into the private sector and thus pulls up private consumption in order to achieve a balanced growth path. As such a recent commentary from Morgan Stanley's Global Economics Forum argued the following;

As shown in preliminary Jul-Sep GDP numbers, the contrast between the corporate sector and the household sector has intensified, and this gap is not likely to close for some time. We assume that it will take a year or more for a positive growth cycle to develop, as momentum on the corporate front gradually spreads to the consumer and household level.

Notice particularly the idea of the 'gap' closing here as it is precisely this kind of dynamic I for one do not see in Japan as we move along. This is also from where we get all the mixed messages from monetary policy watchers since it is presumed that monetary policy should act counter cyclically as the economy gains momentum in order to keep the economy not to spiral out of control and thus make the bust on the other side even more severe. However, it is of course increasingly getting difficult to defend a raise since domestic consumption stays persistently low. In essence this kind of analysis ends up as one big waiting game in which the prediction of the transition towards a 'sustainable/balanced' growth path (i.e. one based on domestic consumption too) amounts to circular reasoning based on arguments about how domestic consumption is bound to go up at some point.

2 . The second explanation is the one I have been forwarded in my observations on Japan and essentially I argue that the current environment in Japan is a result of the structure of the Japanese society with the world's oldest population. This is in fact all I am arguing at first hand which crucially means that we should not expect any hikes by the BOJ anytime soon and also that private consumption will continue to drift gradually downwards. So am I trying to re-write the economics textbooks here? Well not yet at least ... I am sure that at some point as the effects of the global demographic trends become clear there will be a theoretical showdown between growth and business cycle theory on the one side and another pardigme which is way more sensitive to the demographic changes which display a very real transmission mechanism with the macroeconomic environment.

On that note let us also take a look at a recent piece from, yep you guessed it, Morgan Stanley Economics Forum (Robert Alan Feldman) about the peculiar nature of private consumption in Japan. Now let me say initially here that Feldman's piece comes really close to an explanation of what we are seeing here and he is really getting a lot of things right in my opinion. The first important thing is that Feldman seems to want to address head-on the conundrum of why corporate investment (CAPEX) is increasing while private consumption remains low. Notice also in particular Feldman's recognition that business cycles are of little use here ...

What is “funny” at the moment? Consumption is decelerating while capex is accelerating and profits are still rising ― all this after what has already been the longest expansion in post-war history. There is a problem of consistency here. Corporations are predicting an outright decline of profits in the second half of the year. But if firms are so worried about profits, why are they investing so much?

(...)

Cycles are cycles, goes the mantra, and if things are good today, they have to turn bad tomorrow. If we have not seen the downturn yet, it must be coming soon. So, consumption swings wildly, and firms continuously undershoot profit estimates. So far, the number of people saying “That’s funny” is small. However, the longer the anomaly of strong capex and weak consumption continues, the more likely will emerge others (like myself) who will claim that high capex and low consumption is the correct structure for the economy.

Wow, that is certainly interesting is it not? Hands down, Feldman is the first semi-influential commentator I have seen who have argued this to be a structural phenomenon and consequently I feel we have already taken a huge step forward here. Now, for the sake of argument I will skip through to Feldman's conclusion in which he reveals his fundamental case for optimism;

The key reason for my optimism is simple: The combination of aging demographics and structural reform has created a new dynamic in Japan. This new dynamic will keep capex and productivity rising, and obviate the need for as much consumption growth as would have been necessary at an earlier stage of Japan’s economic history.

This is of course where I disagree a bit with Feldman but let us still scrutinize this a bit. A new economic dynamic in Japan driven by changing demographics which influence the use of input variables to production (i.e. high CAPEX) thus maintaining high productivity growth and indeed economic growth detatched from the need to rely on domestic consumption. Or as I put it above in fewer words above; export driven ... and this time it should seem pretty clear that the export nature of growth is a structural and indeed inevitable result primarily caused by the ageing of the domestic population.

So why do I disagree with Feldman? Well, in order for Japan to run on exports others need to run deficits, this should be fairly clear for even non-economists. This is of course all migthy fine but the problem is that Japan is not the only country in the world with a rapidly ageing population and the need to run a surplus in order to grow. In fact, this is beginning to look alarmingly much like an explanation of what we like to call global marcroeconomic imbalances; or as Edward Hugh neatly puts it;

In other words Feldman has, inadvertently walked right into the current global imbalances minefield by suggesting that Japan, as an aged economy (and the first of many more to come) will have to be high capex, low consumption, and logically, to sell the product, dependent on exports. What happens if this ever sinks in somewhere?

Food for thought I should say?

Tuesday, November 28, 2006

What's Funny About Consumption in Japan?

This question was being asked yesterday by Morgan Stanley GEF analyst Robert Alan Feldman (the post can be found towards the bottom of the page).

Now as Claus Vistesen will undoubtedly hammer home at some stage Feldman does get some important parts of the picture which I have referred to in my last posts (and here):

The data on consumption have certainly been a disappointment this year. Although the nearly 4%Y/Y rate reached at the end of 2005 was clearly not sustainable, the sharpness of the slowdown this year has been a surprise. In addition, the deceleration in compensation (whether measured by compensation per worker from the national accounts or by hourly earnings from labor data) has also been a surprise ― especially with record-high corporate profits. The weak growth of wages is all the more puzzling in light of tightening of labor markets shown by a number of indicators. Yes, the weather has been weird this year, but that cannot be the whole story. What is going on?

So far, the number of people saying "That's funny" is small. However, the longer the anomaly of strong capex and weak consumption continues, the more likely will emerge others (like myself) who will claim that high capex and low consumption is the correct structure for the economy.



Why? The idea is simple: As Japan ages, there will be a much faster shrinkage of the labor force than of the population. Hence, each remaining worker will need a lot more capital in order to keep productivity growth fast enough to maintain living standards. Economic growth theory ― in contrast to standard macroeconomic theory ― tells us that high capex and low consumption is just what an economy needs when aging. The implication for investors is equally simple: Stop worrying and love the high-capex economy.


Well really he is getting very near. But then note this:

"As a practical matter, however, consumers and investors will need more time before they accept that consumption need not become the engine of growth."

Well I would put a lot more names on this list other than consumers and investors, people like Brad Setser, Nouriel Roubini, the IMF, the BIS, US Treasury Secretary Paulson, Trichet and the gang at the ECB etc etc. In other words Feldman has, inadvertently walked right into the current global imbalances minefield by suggesting that Japan, as an aged economy (and the first of many more to come) will have to be high capex, low consumption, and logically, to sell the product, dependent on exports. What happens if this ever sinks in somewhere?

Basically he is not quite right about the contrast between macro theory and growth theory, since even though the Solow model is supply side oriented, it is normally situated in a general equilibrium model which includes demand side components and hence generates relative prices.

So you really do need a general equilibrium model running in your head somewhere to get to grips with the implications of what he is arguing. One of the factors he doesn't seem to think about - and why should he, he isn't a theoretical macroeconomist - is how the changed relative balance of consumption and saving affects interest rates, and thus the cost of all that capex, which with low interest rates is much less, and then of course you need to get onto relative prices, and especially if deflation persists.

Curiously he mentions Asimov, and Asimov was interested in robots (he could also have mentioned Zamyatin who wrote a novel called "I Robot"). Now the interesting thing is to think about VERY HIGH capex, at the levels we might see when robots get to build the machines, and then start thinking about whether this would be expensive (which is the story Feldman is trying to sell the investors, hence the possibility of good returns) or whether this would in fact be very cheap, being funded by virtually give-away money with very little of the really scarce and relatively expensive input (labour) being required and with the other constraint being the cost of the raw materials and power that the robots need in order to go to work. Of course, whoever develops the robots can make an initial short term 'rent' ( a la Schumpeter) while they still have a monopoly on the technology, but again there are winners and losers, since some will try and build the technology and fail.

Anyway, this point aside, Feldman is clearly in the right ballpark, and all people now need to do is take the relatively simple step (a small one for them, but a giant one for humanity, perhaps) of thinking this through to a much more general level, and contextualizing all this in what has come to be known as the demographic transition. Now just who the hell was that who ever said that demography isn't important to economists?

Consumption Decline in Japan

My friend Eddie Lee mailed me this morning about this news:


Japan's retail sales unexpectedly fell for a second month, reducing the likelihood that consumer spending will accelerate and lead to an increase in the lowest interest rates among the world's seven biggest economies.

Receipts at retailers fell a seasonally adjusted 0.2 percent in October from a month earlier amid warmer-than-usual weather, the trade ministry said today. Sales of winter clothes and electronics led the decline.

The retail ``report does make it somewhat more difficult for the bank to move because things aren't exactly adding up,'' said Jan Lambregts, head of Asian research at Rabobank International in Hong Kong. ``The Bank of Japan is taking an optimistic view on the economy.''


Now as Eddie says "i just found it a little amusing ..."

".. Bank of Japan Governor Toshihiko Fukui ``doesn't have the ammunition to back up'' a December interest-rate increase, said Kirby Daley, a currency strategist at Societe Generale Group's Fimat unit in Hong Kong. ``We are continuing to make excuse after excuse after excuse for why the consumer isn't coming to the table and it constantly is the weather in Japan.''

... ``The newspapers are saying that the economy is recovering, but that hasn't filtered down to households yet,'' said chain store association spokesman Masahiro Watanabe. Declining receipts at the nation's supermarkets are due more to restraint on the part of consumers than price competition, he said."


Exactly, something other than the weather is at work here, and the Japanese Stock Market seems to sense this:

Asian stocks fell, led by Honda Motor Co., on concern sales are slowing in the U.S and Japan. Li & Fung Ltd., a clothing supplier to American retailers, contributed to the Hang Seng Index's biggest points decline since the Sept. 11 terrorist attacks.


And following the line of thought expressed in Eddie's sense of humour, I couldn't help chuckling to myself at this point:

"``It's unavoidable to adjust interest rates in order to sustain economic growth for a long time,'' the BOJ's Fukui said today at a meeting of business executives in Nagoya, central Japan."

I was chuckling since what he was presumably trying to tell the poor guys who had assembled to listen to him was that afahic it is unavoidable to *raise* rates, whilst what they may well have been wanting to hear is that given weak consumption it is, in their view, unavoidable to go back to ZIRP.

Really Japan is becoming the big test for all the various imbalance theories. Once people finally accept what is actually happening in Japan vis-a-vis rising median age and consumption then the whole global picture will have to adjust, since these ages are set to go up even further and don't look set to come down again anytime this side of 2050, if ever. Meantime you can almost hear the pain as the neurones grind away while people try to figure this amazingly simple detail out.

The Fiscal Position In Japan

Glancing through the OECD Japan Economic Survey 2006 section on the Japan's current fiscal position, I couldn't help having some inconvenient thoughts.

Now as explained here, societies with high median ages and large fiscal deficits (like Japan, Germany and Italy) really face a very special problem: they need to generate sufficient economic growth on a sustainable basis (and since with high median ages they have comparatively low propensity to consume from additional income, and a comparatively high propensity to save, this means export-driven growth) to create sufficient revenue for the exchequer to be able to balance income and expenses. None of the three usual suspects have been able to achieve this balance in recent years - and they have therefore seen their net financial position deteriorating - so it is clear that if they are going to be able to convince the financial markets that long term their position is sustainable, then they need to be able to change course, and demonstrate an ability to maintain the change. This, I take it, is what all the fuss about the 'sustainable recovery' is all about.

The curious thing is that despite all the fuss about the fact that this has been the longest boom since the Izanagi cycle of the late 1960s you tend to read comparatively little about this problem, or about the macro implications of addressing it.

The OECD estimate the current level of the debt/GDP ratio at around 170% of GDP. Now this number is highly contested, since they do have assets in a social security fund, but, otoh, if you count these, so the argument runs, then you also need to take into account implied liabilities, and from here on in there is a large accounting and political wrangle.

I am inclined to take the same view as the Standard and Poor's guy who was very un-impressed by recent attempts by the Greek and Italian governments to reclassify upwards their GDP values by incorporating estimates for the informal economy (an attempt we should note which did to some extent cut ice with Almunia at the EU Commission, I guess those who inherently want to be convinced are grateful to anyone who can offer them a reason why they should be). Basically the S&P's guy said that all this makes little difference since what matters with sustainability is revenue and expenditure, and how they balance. This is what determines the dynamic of the debt, and informal activity by definition doesn't pay tax.

So the same goes for Japan. What matters isn't really the exact number to be attached to the debt/GDP ratio (which in any event is large) but whether the relation of expenditure to revenue is moving towards a balanced path or whether they are spiraling out of control. In the context of population ageing this issue is huge, since obviously stagnant GDP opens the possibility that such debts may NEVER be payable, something which no-one yet seems to want to contemplate, but this doesn't mean that at some point or another markets won't wake up, and maybe with a jolt.

(Incidentally, just a little side dish at this point. We have had a series of red-herrings in the great ageing debate, and one of these is the issue of stock market meltdown. In fact this confusion comes from applying a time horizon which is far too long - so many studies focus mechanically on the 'magic number' of 2050 - and a rigid idea of the life cycle theory, whereby people dis-save as they get to the oldest-old ages. What we can see is that you need to look at a much shorter time horizon - I would say 2010 to 2020, wasn't Keynes's big 'discovery' the ability to distinguish between short, medium and long terms, something which despite the frequent use of the 'in the long run we are all dead' quip, few seem to think about. Sometimes I think that, in economic terms, we live in something of a fools age. The other point would be that before we reach the dis-saving age - if we ever reach it, in fact the oldest old seem to be very spendthrift, so somehow I have my doubts here - we go to an age of increased saving, this is what we are seeing in the older countries across the globe. People are being very mislead here by the savings decline in the US. So I think that rather than stock market melt down what we may see is a very low rate of return environment - remember I am talking 2010-2020 - and the real issue is about what the pension funds can realistically offer their clients if this environment holds).

So I think that at some point the markets will wake up, and this is one of the reasons that I have become so interested in Hungary, since this may well become the first case in history of a country which finds itself stuck on just such an unsustainable (or rather self-evidently unsustainable, since Japan and Italy, IMHO, are already on unsustainable courses, but no-one wants to recognize this) path. Hungary may become the case where this conclusion becomes hard to avoid. I say may, and I mean may, but since the *possibility* exists this certainly makes it worth following for this reason alone, apart from everything else that can be learnt there, and the pure technical fascination of the situation for anyone interested in macroeconomics, it is just such a classic case in some senses, but a classic case with a new, and potentially deadly, ageing twist.

The thing is that if people do start to wake up over Hungary, then eyes will turn to Italy, and if there is a crisis in Italy, then this will obviously lead to a reconsideration of what exactly is going on in Japan. I think I am tentatively outlining a scenario (or possible scenario) here.

So to close, just one or two details on Japan:

Limiting the growth of government spending is the priority in addressing the serious fiscal problem. The FY 2001 Structural Reform and Medium-Term Economic and Fiscal Perspectives set an objective of freezing public expenditure at 38% of GDP through FY 2006, and this target is likely to be achieved. Such spending restraint, which was achieved in part through cuts in public investment, aimed at the goal of a primary budget surplus for the combined central and local governments in the early 2010s. On a general government basis, the primary budget deficit has fallen from 6.7% of GDP in 2002 to an estimated 4% in 2006, with about half of the decline due to structural factors, and the rest accounted for by the economic expansion.


What we should note here are really two things. Firstly that despite everything Japan is still running a substantial fiscal deficit, and that really this deficit hasn't reduced hardly at all if you take into account the fact that half of the saving has come from increased revenue during the boom, and that the other half, which has been a real reduction, may well reverse if 'automatic stabilizers' are applied during the downturn.

Then there is this:

The Reference Projection for the FY 2005 Reform and Perspectives shows a primary budget balance for the combined central and local governments in 2011. However, a balance would not be adequate to stabilise the level of public debt relative to GDP in the long run if the nominal interest rate on government debt exceeds the growth rate of nominal output. While the economic expansion and an end to deflation may push the nominal growth rate above the interest rate in 2006, assuming that growth remains higher would not be prudent for setting a medium-term fiscal objective. Indeed, population ageing will tend to slow output growth while possibly increasing the interest rate. In sum, stabilising the public debt to GDP ratio is likely to require a primary budget surplus for the general government of between ½ and 1½ per cent of GDP.

The point about interest payments is important since of course if rates were to rise in Japan this would put even more pressure on the budget deficit, since the costs of the debt would rise for the Japanese government, which is another reason why some at the finance ministry may be urging the BoJ to exercise caution in raising rates. Indeed Japan may already be in some kind of trap here, given the continuing weakness of domestic consumption. Fortunately (from this point of view) rates are not likely to rise (IMHO) and I fully expect Japan to be back in Zirp either sometime in 2007 or in early 2008.

Friday, November 24, 2006

Checking up on Japan

(A crosspost from Alpha.Sources.)

Time is indeed a scare ressource and as such I have not been on the spot with some reporting on Japan as the third quarter came out a week ago. This is consequently to make amends on that but also to react on some interesting comments on Japan I have found in the week gone by. Let us begin with the economic data then and to that end Edward Hugh really has the all arguments ready at hand. At first hand we have good news here as Japan managed to expand for the seventh consecutive quarter. Yet the story has not changed much as Edward also points out;

So the picture remains pretty much the same, strong export lead growth sustained by capital investment, with shrinking domestic consumer demand. A big part of the burden was carried by growing investment demand.

Furthermore, the crucial point is that the lack of consumer spending does not seem to want to push up even in the light of increasing corporate bonuses. This obviously links up with the monetary situation in Japan where the central bank just cannot find the justification to raise rates. This, subsequently, is also keeping a lid on the Yen despite talks in high international circles about how the Yen should be a bit more willing to adjust to the fundamentals. More accurately in my book though, some are beginning to speak of being too much in a rush to normalize monetary policy. Another very interesting aspect of the Japanese economy deals with the tightening of the labour market. Many commentators have claimed this to be a result of a recovery in the making but I believe that we should rather look at it as a structural evidence of a shrinkening labour force. Following this is the discussion about why the tightening labour market is not pushing up inflation/wage growth; as Edward explains ...

One thing which is striking here is the way in which, despite the inevitable labour market tightening as the population shrinks, wage drift and inflation remain incredibly tame. This is an indicator of just how far the reform process has actually gone in Japan, since there seems to be absolutely no room whatever for wage-push inflation. This is also something of a warning for those who simply argue that more structural reforms will cure the problem, since in the case of Japan at least they seem to have been tried and found partially wanting.

What is most interesting here is that if we don't look at demographics in Japan's case we end up with a very thin line of argumentation in which we are down to musings about when the positive growth cycle begins in Japan and consumer spending picks up again ... take for example one of the latest pieces on Japan from Morgan Stanley's Global Economics Forum.

As shown in preliminary Jul-Sep GDP numbers, the contrast between the corporate sector and the household sector has intensified, and this gap is not likely to close for some time. We assume that it will take a year or more for a positive growth cycle to develop, as momentum on the corporate front gradually spreads to the consumer and household level.

On what is this assumption above vested, that is the only thing I ask. When, for example, will people recognize that the life-cycle component of the consumer spending behaviour story is important? It seems wholly unreasonable to me to claim that the situation is any better a year from now based on business cycle analysis. Morgan Stanley claims to be bullish on the economy and cautious on prices (wage growth) the latter position mainly driven by high productivity. On this we are approaching the issue from two sides ... we both agree that prices and wages are not going to pick up anytime soon. However, where I, and also to some extent Edward above, are arguing that consumer spending will remain low and thus keep the core index and wages down as a function of the structural and lasting changes in the labour market structure, Morgan Stanley argues that;

Trying to predict when wages will rise and what the catalyst will be is a difficult task, but if the Japanese economy has been running about a year behind the US economic cycle since the bursting of the IT bubble, it should take about the same amount of time as it did in the US. The US economy bottomed out in early 2002 and wages began to rise just this year. This suggests that the labor distribution rate in Japan is not likely to rise until F3/08 at the earliest, and only then if a knock-on effect from increased hiring does in fact finally translate into higher wages. In such a case, we would expect nominal wages to run more or less flat during the forecast period and for real wages to continue to decline during this time. Accordingly, we maintain our cautious stance regarding consumer spending.

The most decisive answer I can provide here is that Japan is not USA; actually far from it and precisely because Japan is such a special case in terms of population dynamics we cannot expect the economy to behave according to the textbook explanation of business cycles. Once again I am ending this with a point about where to begin our analysis. I am not for example dismissing the recent articles from Morgan Stanley; people are definitely scratching some of the right places but if we want to get this right we need to begin with the beginning and in Japan's case that is quite simply demographics.

Thursday, November 23, 2006

The Japan Government Reduces Its Economic Forecast

In many ways this is significant. The Japanese government has just reduced its economic forecast for the first time since December 2004. So it seems that now all the signs are there that the longest economic expansion since the great recession began is now begining to come to an end. Foremost among the weak points is, of cousre, domestic consumption. Rather than repeating myself for the umpteemth time here, I would simply direct you to yesterday's post by Claus Vistesen, where the issues involved are made extremely clear.


Japan's government lowered its evaluation of the economy for the first time in almost two years, after sluggish wage growth prompted a slump in consumer spending.

``The economy is recovering, despite some weakness in consumption,'' the Cabinet Office said in its report for November in Tokyo today. ``Private consumption is almost flat,'' it added, cutting the assessment for the first time since December 2004.

The last time the government lowered its assessment was in December 2004, as stalling global demand prompted a glut in corporate inventories and a slump in production. The world's second-largest economy almost slipped into a recession when slower export growth caused it to contract in the fourth quarter.

Household spending, which has declined every month this year, plunged 6 percent in September, the biggest drop since 2001. Wages were unchanged in the same month, after rising only about 8,000 yen ($68) since January.


Although it lowered the assessment, the government maintained its view that the economy is ``recovering,'' unofficially putting the current expansion in its 58th month, the longest since 1945.

``As far as the monthly economic report is concerned, the economy of Izanagi has been surpassed,'' Ota said, referring to the so-called Izanagi boom that ended in 1970.

During the Izanagi boom, a 57-month period named after a Japanese god, gross domestic product almost doubled, helping Japan emerge as a major economic power. The expansion, sandwiched between the 1964 Tokyo Olympics and the 1970 Osaka world expo, was so named because the economic miracle was compared in significance with Izanagi's creation of the Japanese islands.

Japan's economy has grown at an average 2.5 percent in the current recovery, about a fifth of the average 11.5 percent seen during the Izanagi period, according to Dai-Ichi Life Research Institute, a Japanese think tank.


The biggest difference between Izanagi and the current recovery is that deflation plagued most of the latter, meaning growth relied on exporters as consumers, discouraged by job and wage cuts, spent less. Unemployment surged to a record 5.5 percent during the current recovery, more than four times the average rate between 1965 and 1970, government data show.

``Deflation crippled non-manufacturers, who employ about 80 percent of the workforce, which has made it hard for most citizens to feel the recovery,'' said Hideo Kumano, a senior economist at Dai-Ichi Life Research Institute and a former central bank official. ``The recovery may be the longest since the war, but it certainly isn't the largest.''

Wednesday, November 22, 2006

Japan Trade Surplus Narrows

This is hard to interpret, but it does seem that we have here more evidence of an investment slowdown in China (as well of course of a decrease of the rate of growth in US consumption), and Japan is one of the first to feel all of this. Now we have to watch for Germany. Note that many commentators are asking for domestic consumption to take the strain, and that doesn't sound at all realistic to me.

Japan's trade surplus narrowed more than expected as U.S. demand cooled, signaling the impetus that exports gave to economic growth last quarter is fading.

The trade surplus fell 24.8 percent to 614.7 billion yen ($5.2 billion) in October from a year earlier, the Ministry of Finance said today in Tokyo. The median forecast of 33 economists surveyed by Bloomberg News was for a surplus of 770 billion yen.

Demand for Japanese exports is cooling after the country's largest export market grew at the slowest pace in more than three years. Waning overseas demand leaves the world's second-largest economy more reliant on its consumers, who reined in spending last quarter, to sustain the longest expansion since 1945. Exports rose 11.6 percent, the slowest growth in six months.

Growth in exports to the U.S. slowed to 13.5 percent in October, after climbing 20.5 percent a month earlier, as demand for automobiles cooled. Shipments to the European Union grew 8.7 percent, slower than the 14.2 percent growth in September. Exports to China expanded 18.4 percent after climbing 19.7 percent the previous month.

Exports measured by volume, which don't take into account price fluctuations, grew 2.2 percent, the slowest since August 2005.

Demand for transportation equipment and electronics, which together make up almost half of Japan's exports, waned last month. Exports of transportation equipment, which include cars, trucks and automobile parts, rose 17 percent from 21 percent in September, the report said. Electronics shipments grew 7.3 percent, down from 11.8 percent.

Wednesday, November 15, 2006

The Japanese Yen

One of the important features of the current Japanese export driven 'recovery' is the relatively low (indeed vis-a-vis the euro historically low) value of the yen. Surprisingly few commentators have seen fit to comment on this, or on the significance it might have for the debate about whether or not Japan is finally escaping the deflation problem. In the days when people still used to talk about this issue, there was one proposal on the table (principally advocated by Swedish economist Lars Svensson) known as the 'foolproof path' (Professor Svensson's homepage is here, and it contains a whole slew of papers related to this topic).

The foolproof way is to announce (1) an upward-sloping price-level target path to be achieved, (2) a depreciation and a temporary peg of the yen, and (3) the future abandonment of the peg in favor of inflation targeting when the price-level target path has been reached. Then, the BOJ and the MOF just have to behave accordingly.

Now it can easily be seen that a key component of this 'foolproof way' is a substantial depreciation in the value of the yen, and this is what we have seen across 2006. Surprisingly however, and despite the low yen values and extremely high energy costs, Japanese inflation has yet to poke its head above the 1% mark, and with falling energy prices and a slowing global economy is now more than likely (IMHO) headed back into negative - and hence deflationary - territory.

Now one of the important details about the current low values of the yen is that it is in part driven by an outflow of funds from the Japanese themselves:

The yen weakened against the dollar and euro on speculation Japanese investors are seeking the extra yield of U.S. and European assets.

Japan's currency was near a record low against the euro as a government report today showed demand for services in the world's second largest economy fell twice as much as expected in September. The Bank of Japan started a two-day policy meeting today, with economists saying interest rates will stay at 0.25 percent, the lowest among the world's major economies.

``People are looking to the BOJ meeting for more clues on the rate hike outlook,'' said Niels From, a currency strategist in Frankfurt at Dresdner Kleinwort, ``You're still getting big returns from investing in higher-yielding currencies, and the yen should continue to suffer against the euro.''


Now Morgan Stanley's Stephen Yen (who Brad Setser apparently doesn't like at all) had an interesting post about this situation on the MS GEF last week (what Jen calls retail flows are in fact movements of funds by individual investors):


"The accelerated decline in the 'home bias' for mutual funds and retail investors is worth a closer examination. While there is still no definitive explanation of this trend, there is a possibility that it may not be the case that the individual investors' 'home bias' is genuinely lower, but rather that there is just more capital controlled by individuals and therefore more to invest overseas."

"Something that happened 60 years ago may be one contributing factor behind the general weakness in the JPY. During 1946-1949, Japan experienced a mini baby boom. Though it was milder and shorter-lived than the US baby boom (from 1947 to 1964), it nevertheless created a big enough demographic bulge to have consequences now. Relative to a long-term average of around 1.2 million a year in the 'natural' rate of population (birth rate minus death rate), during these four years, the bulge in the demographic profile was close to 2 million, i.e., there was a net 2 million increase in population during this period — an average of 500,000 a year."

"Sixty years later, in 2006, the first wave of these baby boomers reached retirement age. When they received their cash retirement payments, they may have allocated a greater portion of their assets overseas than in previous generations. This may have helped propel an accelerated decline in the collective 'home bias' of mutual funds and retail investment."


Now this is fairly interesting since Jen attempts to link this behavioural change away from home bias to some features of Japan's changing demographics, and in particular to the need (in the uncertain climate of Japan's ongoing problem in funding its pensions liabilities) of finding added yield to cushion any future problems.

Now takes on a lot more interest when you start to think about the fact that a lot of the recent rise in the Japanese stock market was driven by capital inflows - from people with oil surpluses, things like that - on the expectation that the 'recovery' was finally coming. OTOH Jen seems to be indicating that the individual Japanese (institutionally the Japanese will of course always have home bias, which is why you shouldn't expect 'melt down' any time soon, this is one of the big differences between Japan and Italy, IMHO) are sending their money to where they can get higher returns, and in particular the US.

My guess is that people like Brad Setser and Nouriel (and even the likes of Martin Wolfe) with all their dollar-melt-down orientation are completely missing this. So what happens when it becomes obvious that the recovery in Japan isn't sustainable and the BoJ has to back down and re-introduce ZIRP. Well a lot of the foreign money goes out, that's what happens. And the 'retail' flows (as Jen calls individual investors) will keep heading for New York etc. So we are really talking about the Yen potentially holding to very low values (and of course never forget that the renminbi is to some extent weighted to this).

Tuesday, November 14, 2006

Japanese Third Quarter GDP

Well Japanese GDP maintained its momentum in the third quarter according to the initial data released today:

Japan grew more strongly than expected in the third quarter with strong exports more than offsetting weak domestic consumption to produce annualized growth of 2 per cent......The economy, which grew a revised 1.5 per cent in the second-quarter on an annualized basis, has been expanding for seven straight quarters. Next week, the recovery will enter the record books as the longest - though far from the fastest - period of sustained growth since the war."

"Third-quarter numbers showed that consumption shrank 0.7 per cent from the previous quarter. But exports climbed 2.7 per cent and capital investment, in spite of weak recent numbers, jumped 2.9 per cent, marking the 10th quarterly rise in a row."


and Bloomberg:

Consumer spending, which accounts for more than half of the economy, fell 0.7 percent, twice as much as the 0.3 percent drop expected, amid a spell of bad weather that kept shoppers at home and as wages growth stalled.

So the picture remains pretty much the same, strong export lead growth sustained by capital investment, with shrinking domestic consumer demand. A big part of the burden was carried by growing investment demand:

"Capital spending in the quarter surged 2.9 percent, more than three times the 0.9 percent gain expected. Mizuho Financial Group Inc., Japan's second-largest bank by market value, and Tokyo Electric Power Co., the nation's biggest power company, announced plans this month to invest as the economy grows."

But the big question mark still remains as to whether this is anticipating internal demand which may not arrive, and whether or not this investment is justified if export demand weakens. In other words we may have excess capacity building up again, which obviously would be deflationary in its impact. This is presumably not being lost on the BoJ who are using the growth in such investment spending as an argument for raising rates, but here, as I have been arguing, they are trapped between a rock and a hard place, and indeed it is hard to assess how many of these investment projects are being financed now precisely to avoid having to pay the higher interest rates which the BoJ is threatening to introduce later.

One thing which is striking here is the way in which, despite the inevitable labour market tightening as the population shrinks, wage drift and inflation remain incredibly tame. This is an indicator of just how far the reform process has actually gone in Japan, since there seems to be absolutely no room whatever for wage-push inflation. This is also something of a warning for those who simply argue that more structural reforms will cure the problem, since in the case of Japan at least they seem to have been tried and found partially wanting. Still, there are those who live in hope:

Koji Omi, finance minister, told the Financial Times last week that the recovery remained solid in spite of signs of slowing US demand. It was true, he said, that higher profits had not fed quickly into better wages and stronger consumer demand. However, he said that, with the labour market tighter than at any time in 15 years, he expected wages and consumption to pick up soon.

Sunday, November 12, 2006

Right and Wrong on Japan?

This is a cross-post from my own blog Alpha.Sources in which I argue that any economic analysis of Japan must begin with the demographics. I am no fundamentalist but it seems very clear to me that any economic analyses on Japan which do not take the time to look at the structural effect of the demographics on the economy are not worth much I am sad to say.

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We are now ready to another trip around the economic commentaries dealing with the Japanese economy and its sustainable/ongoing recovery. For a list of my recent post on Japan go here.

Let us begin with the those who are getting it right. First off, the FT's Lex column seems to be on the right track concerning Japan. Back in September Lex ran a column asking about what in fact was happening to the Japanese recovery based on disappointing data coming out from June. This week Lex also takes on Japan in one of her columns pointing once again to weak data especially on lending and subsequent consumer spending.

(bold parts are my emphasis in terms of all excerpts presented below)

What recovery? Japanese economic data continue to disappoint. The latest, published on Thursday, show bank lending growth decelerated on an annualised basis in October, for the third month in a row. City banks actually lent less than a year ago.

Borrowers are clearly in short supply. Companies are less willing to invest. Even if they were willing, most have plenty of cash on their balance sheets. Nor is it just borrowers who are thin on the ground. Shoppers too are holding back, as the government knows to its cost: consumption tax revenues fell 3 per cent year-on-year in the six months to September. Private sector economists are slashing estimates for third-quarter growth, due out on Tuesday. Since consumption alone fell 0.9 per cent, it is possible the economy contracted.

Also the FT's David Pilling is scratching the right places in an article discussing how the BOJ might act pre-emptively against inflation and raise rates come next meeting (that is, some time before the end of the year). Yet as Pilling so rightly points to (at least implicitly); what inflation? If we discount the headline Japan is still running deflation and even including energy Japan is flirting with a potential backlash into a vicious deflationary circle.

Speaking to a seminar in Tokyo, Mr Fukui said: “Waiting for inflation to build up in raising interest rates would cause a sharp swing in the economy. Our task is … to take careful action before these conditions appear in order to achieve price stability and keep future economic swings gradual.”

The governor’s comments come against a background of weak headline inflation and concern among some analysts that the economy, which is going through a weak patch, could actually slip back into deflation.

His remarks reinforce the bank’s insistence that it will not tie its policy to the headline rate of inflation, which has been sliding, partly due to technical factors.

Instead, the BoJ, which raised rates in July for the first time in six years to 0.25 per cent, wants room to be able to act against inflationary pressures before they are apparent. It has what some economists consider to be an overly conservative understanding that price stability equates to an inflation rate of between zero and 2 per cent.

This allows no buffer against slipping back into deflation, and the bank has resisted hitching its policy to a specific inflation target.

Jonathan Allum, Japan strategist at KBC Financial Products, said: “The nightmare scenario is that A: you begin to see evidence of economic contraction, B: you get a return to deflation, and C: the Bank of Japan ignores all this and tightens anyway.”

Mr Allum said the economy had been slowing for nearly a year and that it could even contract in the third quarter because of sluggish consumer spending. “Clearly there is a danger that the BoJ is too gung-ho in its view of the economy,” he said. “If energy prices are excluded, as they are in most economies, Japan is still in deflation.”

So these were the ones getting it right. Moving on I should say that I do not have an FT subscription but instead I have chosen some three years ago to go with The Economist. I stand by that decision but in no way because of the magazine's continuing la-la position on Japan. Consequently, The Economist runs a story this week about the 'vigorous' state of the Japanese economy.

The school of Japan-watchers that keeps an eye on the country's economy chiefly out of a morbid interest in terminal decline (ouch :)) has stopped dwindling . It has even taken on new adherents of late. For signs are mounting that the recovery that began in 2002 has slowed—or even, some say, gone into reverse.

The chief worry is that what started as a recovery driven by exports (chiefly to China), and then expanded to one led by business investment, has failed to spread to households, whose spending remains sluggish. Prices still flirt with deflation (see chart). And some economists predict that figures published on November 14th will show that the economy actually shrank in the third quarter.

Is this growing uneasiness justified? Mostly not. Take the economy first. Certainly, its anaemic performance marks this recovery as out of the ordinary, but then it follows long years of extraordinary distress. Habits are hard to change. So even though households now have more income—because companies are hiring more, and raising overtime and bonuses—this has not shown up in consumer spending. Alarm mounted last week when the main survey of household spending recorded a plunge in September of more than 6% compared with a year earlier. Yet this fall is too big to be credible; the survey (like early GDP numbers and other Japanese statistics) is notoriously unreliable.

Meanwhile, expectations are rising, even if habits have not yet caught up. Households' estimates of future inflation and property prices have climbed since the spring. People are not spending gaily, but they are starting to remove money from risk-free havens and invest it again. Deflation had killed the appetite for risk. There are other signs that the recovery is still broadly on track, even if it has, as in 2004, hit a soft patch. The latest bank lending figures seem to confirm this: though growth slowed in October, the year-old recovery in bank lending is still intact.

(...)

Moving forward in Japan? Well, certainly and good all the same! Addressing the Japanese 'dual-economy.'

A priority is to address Japan's so-called “dual” economy. The competitive exporting industries are not matched in agriculture and services, which are shielded from competition, lack economies of scale and are backward in their use of information technology. To boost investment, the government is mulling a cut in corporate income tax and other tax changes. Deep reforms to pensions and health care are also expected.

oh yes, and to use a classic proverb - it's the demographics stupid!

Japan's demography, says Genichiro Sata, the minister for regulatory reform, demands higher growth, and it is the Abe government's intention to impart deep structural change—including even a wholesale restructuring of government, by crunching Japan's 47 prefectures into a handful of American-style states. These are early days. Mr Abe has given little sense yet of his priorities, and many of the proposals are hardly vote-winners. Reformist achievements are yet to be seen. But the charge that Mr Abe has no reformist intentions is getting harder to make.

Ok, am I being too much of a dooms-speaker here on Japan? Perhaps I am but only time will tell really. What I would like to do though is to make a point across the table here. Japan as a society and in this case as an economy is deeply affected by its demographics, subsequent low fertility and more importantly high median age. Demographics are not destiny but if we begin here I feel that much of Japan's current economic plight can be explained in its core. As such, I believe that the continuing lack of consumer spending is not subject to an automatic reversal as The Economist rather naively, I am sad to say, suggests. In fact, low consumer spending is a structural indicator of Japan’s population structure which is also why Japan is running a trade surplus and also why in the end Japanese economic growth is by and large export driven. I hardly think it is a problem of ‘habits which merely take time to adjust.’ This argument has wide consequences for the way we look at Japan and its problem with deflation which after all must also be considered a structural phenomenon in the economy. Even more obvious is the labour supply where many a commentator (although not any linked here!) have argued that the tightening labour market was a cyclical phenomenon pointing to supply having problem keeping up with demand as the recovery really got underway. I am sympathetic to this point since it is theoretically a good point, just not in Japan where the age composition of society is a proxy for tightening of the labour supply and as such is a structural effect of the changing pyramid more than a cyclical fluctuation.

So let us begin with a strong basis of analysis and move our way up from there, that is really all I am pointing to.

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And the Update 11 November based on the latest data on machine orders.

Sadly the data keeps on going the wrong way for Japan.

(From Bloomberg - bold parts are my emphasis)

Japanese machinery orders unexpectedly slumped, signaling economic growth may stall and prevent the central bank from raising interest rates, already the lowest among major economies. Stocks fell.

Non-government machinery orders, excluding shipping and utilities, dropped a seasonally adjusted 7.4 percent to 997.5 billion yen ($8.5 billion) in September from a month earlier, the Cabinet Office said in Tokyo today. Third-quarter orders sank 11.1 percent, the biggest decline ever.

Bonds rose on expectations that the report, an indicator of capital spending plans, will ease the Bank of Japan's concern its key overnight lending rate of 0.25 percent could fuel excessive investment. Next week's gross domestic product report is expected to show corporate spending growth slowed in the third quarter.

`The drop in machinery orders was a surprise,'' said Soichiro Kimura, an analyst at Mizuho Securities Co. in Tokyo. ``It's adding to speculation the report will weaken the central bank's case for raising rates.'' `

(...)

``The gap between the actual economy and the Bank of Japan's view might be widening,'' said Hiromichi Shirakawa, chief economist at Credit Suisse Group in Tokyo.

Sustained growth in exports, the only standout in the quarter, will be key in ensuring business investment keeps rising, Dai-Ichi's Iizuka said.