Japan, Still Stuck

by Claus Vistesen

It did not come as a big surprise that the BOJ chose to hold rates steady once again on the outlook on inflation which seems to be deteriorating somewhat. More gravely for Japan the healthy growth clip of private consumption expenditures recorded in February of 1.3% seems to have ebbed out already in March where consumption expenditures rose a mere 0.1% and although this is an increase not unlike the secular decline throughout 2006 it still begs the question of what actually the outlook is on this reversion in Japan's growth path and the outlook that the BOJ is going to normalize any time soon? Digging deeper into the figures makes for troublesome reading indeed ...

Industrial output continued its decline in March albeit ever so sligthly at -0.6% and with the Japanese trade surplus expanding at a record pace (74% expansion y-o-y in March!) on brisk demand from China I would expect industrial output or that is to say Japanese capex in general to perk up in the coming months although I might still be underestimating the amount capex ramped up in Q4 2006 but I do think that de-stocking will soon come to an end if China continues to thunder along. In terms of consumption expenditures I have already noted that they rose 0.1% but worryingly retail sales posted the sixth consecutive decline in March which of course generally brings into question those heeding the call of the return of the Japanese consumer as a 'big spender'. Below, the figures plot consumption expenditures in % change each month since March 2006 as well as on a seasonally adjusted real index (2005 =100). As we can see it is trending up from 2006 but just how much can we expect to see here with lingering deflation?

And now that we are talking about deflation the following figures plots the CPI index since March 2006. Of course, CPI indices in Japan is a reasearch project in itself but take a look at the CPI index excluding food and energy and tell me on what grounds the BOJ could and should normalize?

In Summary

I am at a loss to understand the recent bullishness on Japan in terms of how we stand before an imminent correction in Japan's growth path. Japan is indeed growing but still driven largely by exports it seems and the return to deflation and specifically the immediate outlook which points to a somewhat lingering nature does not exactly bode well for the future. Clearly consumer spending is trending upwards but hardly anything conclusive can be said at this point on whether we stand before an imminent boom. I remain cautious especially given the outlook on prices which may feed into expectations at some point. Also, if this is a period in Japan where bonuses are rising and where consumers should be spending a lot of money is this really what we can expect? What happens then when things return to normal? I am of course happy that things are looking better but at this point we are just not out of the woods and on that note it is pretty irresponsible to hail the coming of a Japanese consumption boom and of course as always ... anyone got that textbook definition of a sustainable recovery?

Update on Sunday, April 29, 2007 at 09:12AM by CV

As ever, the weekly notes on Japan by Takehiro Sato over at Morgan Stanley follows mine quite nicely in terms of posting date (or more accurately perhaps my posts are following his?) and as such we also get the recent view on the outlook on Japan in the GEF edition this Friday.

As always, Sato's note is well worth a look as he sets out to discern the BOJ's recent report on the economic outlook.

Some of the risks regarding wages/prices and overseas economies cited in the previous October Outlook Report are emerging, but the April Outlook Report maintained the bullish scenario and forward-leaning stance on monetary policy. Overall, the Outlook Report is typically hawkish, but in the fine detail we also get a sense of some wavering on the part of the BoJ. Its statements on the management of monetary policy going forward, too, could be interpreted as a half-step retreat.

The median GDP growth forecast in the policy board’s F2008 outlook is almost unchanged at +2.1%, but the forecast for the core CPI inflation rate of +0.1% has been lowered more than expected from last October’s +0.5% following weak CPI results out the same day. Our impression is that this revision is too small (our forecast, after taking into account nationwide core data for March, is -0.1%), which means there is still some skepticism over the Bank’s outlook, but the downward revision itself was no surprise. The outlook for the economy and prices in F09, released for the first time, calls for steady economic growth of around 2% and relatively major improvement in prices of +0.5%. Under its forward-looking policy orientation adopted since the end of quantitative easing, the BoJ is keen to focus more on price rises to come than on weak price levels currently.

What Now in Japan

by Claus Vistesen

The BOJ is holding at 0.5%, exports are booming, and capex stays afloat. So what will happen in Japan as we venture forward into 2007. Well, this is what I am trying to answer in a recent note over at GEM. Here is an exerpt from my 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.

Interestingly I might have to revisit my view on Japan slipping into deflation on a y-o-y basis on the back of a dropping headline inflation rate. As such, the headline is ticking slowly back up at the moment and since Japan includes energy in their core inflation figures this is (at least for Japan) some sort of good news. Whether it is too late is of course another story and I maintain my view that Japan will be slipping into deflation in February and March on a y-o-y basis and in the end we really need to exclude energy from Japan's price index in order to get the right picture. Also, I think that it is not necessarily a great disaster if Japan slips into deflation in February and March (I mean the headline will probably be pushing up again in the rest of 2007 unless of course the US totally crashes) but more so the internal power struggle between the MoF and the BOJ will be exacerbated and I am sure that the MoF is poised to strike at the BOJ for raising prematurely should Japan touch base with deflation.

Japan Goes To AA

by Claus Vistesen

Indeed, Japan seems to be in a very vigorous economic mood at the moment with particularly consumption figures looking healthy in Q1. Perhaps the recent upbeat performance in Q4 2006 and Q1 2007 is in part why Standard Poor chose today to raise the credit rating on Japan (i.e. government debt) from AA- to AA.

Japan's debt ratings were raised one level to AA, the third-highest grade, by Standard & Poor's after the government cut borrowing and nursed a recovery in corporate earnings.

The increase in the long-term foreign and local currency debt ratings from AA- was the first by S&P since it assigned Japan the top AAA grade in 1975. Japan was downgraded three times between February 2001 and April 2002 as economic growth stalled amid deflation and banks struggled to dispose of bad loans.

S&P today said the banking system has been restored to ``good health'' and the world's second-largest economy will grow at about 2 percent, twice the pace of growth during the decade after an asset bubble burst 16 years ago. Prime Minister Shinzo Abe's government could improve the rating further if it finds the political will to raise taxes and cut spending, S&P said.

Clearly, this indicates that Japan is on the right way towards a sustainable recovery does it not? Well, there are two aspects of this of coures. First of all we have the actual credit upgrade by S&P. I have no doubt that the credit agencies' analysis on the Japanese banking sector is true in the sense that substantial reforms have been undertaking in order to bring back the sector to kind of efficiency on the back of the slumber in the 1990s. Yet, I am also a bit surprised on the short termism displayed in the outlook on government debt and public finances. Surely the recent efforts by Abe in terms of trimming the public budget and holding off sales of bonds are important but in the longer run should we not look at a rising old age depencancy ratio in order to gauge Japan's solvency and indeed ability to sustain debt at current levels? Ah well, I won't rain on the parade here and of course credit ratings can go south again soon enough and indeed we are perhaps looking at a short term improvement in the governmental debt position, but of course it is the longer term where I am worried. On another note, Bloomberg's surveyed economists point to a quickening in inflation which might prompt the BOJ to raise rates sooner rather than later in 2007 (if at all). This should clearly be seen in a more short term perspective than the credit rating decision above but still there is a pretty clear link since rising real interest rates also meant that yen denominated debt will be more expensive to service and then we do need to look at a rising old age dependancy ratio especially if your medium to long term macroeconomic outlook on Japan includes a reversion to a balanced growth path and thus also interest rate normalization.

In general, on Japan I also want to point towards some other sources before I leave. First of all we have Takehiro Sato's recent analysis on Japan. It is a very comprehensive account and analysis I have to say so be sure to give it a quick glance. Moreover, I also stumbled upon this article in the FT today about how Japanese asset holders (both retail and institutional) is now beginning to contemplate how to make all those assets earn a reasonable rate of return. Now, the interesting thing is of course to how big an extent this will prompt capital to flow abroad from Japan's borders in the search for yield. Lastly, we have Brad Setser's recent post which takes the pulse on another aspects of capital flows from Japan, namely the carry trade which is to say this is what the discussion converges on in the comments section. In reality, Brad sets off to note the recent reserve accumulation data in different central banks, well worth a look!

Japan and the Fertility Trap - A Worst Case Scenario?

by Scott Peterson

The way I understand how a negative scenario for population dynamics could play out in Japan is as follows:

Japan has a large segment of its population that is approaching retirement. When all of those people retire, they expected to be supported by the working population which is now far too small to support the large number of retired persons. Of course, theoretically those retirees should have some significant savings since we've been informed for years that the Japanese are great savers. So the burden of supporting a large retired population with a small labor force might be delayed for a few years. On the other hand, the use of savings by the retirees forms a wave of dis-investment that could torpedo efforts to offset the shrinkage of the workforce with robotic or mechanized production(of which much has been made in the press).

Political and social division ensue. Leaving aside the options the Japanese government has for handling that situation, pretty soon thereafter members of that retired group start dying. In 2006, according to PRB.org's World Population Datasheet, there were 9 births for every 8 deaths in Japan. When the retirees start dying off, that ratio reverses and could go fairly high in the other direction, say 12 people dying for every 8 born. So massive population shrinkage ensues.

Since the population is shrinking, domestic demand naturally is shrinking as well, and therefore Japan becomes even more dependent on exports for positive GDP growth. In reality, once the ratio of births to deaths goes much below 1.0, positive GDP growth is not possible. The shrinkage in domestic demand will be too much for any increase in exports to overcome. And when the yen's value versus other currencies eventually rises to a realistic value, exports will drop off as well.

Since the population is shrinking, real estate prices decline steadily as well. So there could be a negative home equity effect on consumer spending.

Another major problem will be the large national debt built up which now will need to be covered by the output of a much smaller labor force. A default by Japan on its sovereign debt could occur.

Did I leave anything out?

Standing Fast in Japan

by Claus Vistesen

eing a BOJ watcher can indeed be a tough job in terms of forecasting but sometimes it is also pretty easy. Consequently, the BOJ chose today, pretty much as expected, to hold rates steady on the back of a return of deflation in the recent months and also I guess on the back of the outlook that deflation will persist in Q1 07 and perhaps even well into Q2 07 as well. Also of course the slowdown in the US which after all is Japan's biggest export market.

The Bank of Japan kept interest rates unchanged for a second month after consumer prices fell and recent data signaled U.S. economic growth may slow.

Governor Toshihiko Fukui and his policy board colleagues voted unanimously to hold the key overnight lending rate at 0.5 percent, the lowest among major economies, the bank said in a statement today in Tokyo. The decision was expected by all 49 economists surveyed by Bloomberg News.

Fukui later told reporters that the U.S. economy will achieve a soft landing and Japan's consumer prices will rise in the long run after hovering around zero percent in coming months. Confidence among Japan's largest manufacturers slipped from a two-year high on concern a U.S. slowdown may hurt exports, the central bank's quarterly Tankan business survey showed last week.

``There's still a pretty big chance for a rate hike later this year if the central bank can confirm Japan's growth is supported by demand at home, even if the U.S. economy deteriorates,'' said Ryutaro Kono, chief economist at BNP Paribas Securities Japan Ltd. ``We expect the bank to act in the fourth quarter.''

For more on the outlook on the Japanese economy you can check out my recent notes which also dicusses in more detail the outlook in deflation based on recent analysis by Takehiro Sato from Morgan Stanley. More interestingly, we have consumer spending which indeed has shown positive signs as of late and most likely will show a healthy growth clip y-o-y in %. However, remember still that 2006 was a below trend year in terms of consumption expenditure and that consumption expenditure is still below 100 on a real Index 100 (2005) basis. In fact the trend since 2000 is one of secular decline as shown in the figure below.

This of course does not mean that this might not signify a significant pick-up but my main worry is that deflation will entrench itself in Q2 of 2007 which could feed into expectations and since Japanese consumers already are saving a lot the pick-up in consumption expenditure will perhaps be shortlived. For sure, the chance of a y-o-y improvement is there but I do not see a change in the overall trend. Finally and on deflation I leave you with a chart plotting real GDP growth and the evolution of the GDP deflation since 2001. As you can see real GDP has picked up as of late but of course so has a the Japanese trade surplus.

On a very last note I am not chaning my main position here and the outlook on deflation still worries me most although of course the recent pickup in consumption expenditure is most welcome. In terms of interest rate decisions we should expect the G7 ministers and other high lords to pounce on Japan again come next weekend although I expect that the criticism will be less pronounced than last time. I do expect however that European G7 members and officials in particular will spend time on the Yen. However, I do not see the BOJ raising on this side of Q3 with the current outlook in deflation.

Update on Wednesday, April 11, 2007 at 03:55PM by CV

The recent data on manufacturing orders in Japan actually seems to require a revision to the downside of my call on capex spending in Japan in Q1 2007. Consequently, machine orders fell 5.2% in February which clearly suggest that exports are losing steam going into 2007 and since the US after all is the biggest export market (22%) then this might be a sign of a transmission mechanism in the works (de-coupling anyone :)?). This also means that industrial production most likely will have continued its decline in March and April on two accounts Firstly, as a result of de-stocking on the back of high capex in Q4 2006 and secondly, as a result of a real decline in foreign capacity proxied by a US slowdown and perhaps also a cooling in Chinese investment.

A second data piece on Japan which caught my eye was the news that corporate credit growth supplied by Japanese banks fell in March. The decline was, it needs to be said, ever so slight and corporate credit is still growing albeit more slowly it seems. This is of course likely to be a derivative of the points above and an indication that capex in Japan is slowing on an overall basis in the beginning of 2007.

Kazumasa Iwata: the Current State of the Japanese Economy

by Claus Vistesen

have been pretty preoccupied as of late with Japan and as such I thought I would also share with you a recent speech by Deputy governor of the Bank of Japan Kazumasa Iwata on the immediate outlook of the Japanese economy and monetary policy. As you can see he is much more optimistic on the rebound of inflation and consumer spending than I am. Moreover the speech also gives a valuable insight into the policy setting process within the BOJ. Here is an excerpt from mr. Iwata's remarks on consumer prices ...

The year-on-year rate of change in the CPI (excluding fresh food) was flat in January, and depending on developments in crude oil prices and foreign exchange rates, it may turn slightly negative in the short term. From a longer-term perspective, however, consumer prices are expected, over time, to display trend increases given that the economy has expanded at an annual rate of around 2 percent over the last four years and that the expansion is expected to be long-lasting. With the continuing economic expansion, the utilization rates of production capacity and of labor have been rising steadily, and they are expected to increase further. As the recent Tankan (Short-Term Economic Survey of Enterprises in Japan) indicates, corporate managers are increasingly feeling shortages of production capacity and labor, while a positive output gap suggests that demand currently exceeds supply in the economy as a whole.

Note, especially the idea of a positive output gap and how demand exceeds supply in the economy. Methinks that someone is not taking into account the nature of Japanese growth and the relationship between domestic capex and foreign capacity. In short; how do we measure output gaps adequately in an ageing economy such as Japan's or more specifically ... how does ageing affects the operationalization of output gaps? In terms of output gaps Mark Thoma recently pointed to an article from the Dallas Fed by Mark A. Wynne and Genevieve R. Solomon. The article is an excellent intro to the economic operationalization and measurement of output gaps. Of course I have my mandatory adjustments in order to better take into account the fundamentals of ageing but all in all still a very readable article.

Following Up on Japan

by Claus Vistesen

A week ago I had a note on the economic outlook on Japan and now, with the recent data, I think it is time to do a whee round up. First of all, the chance (or risk) for an additional hike by the BOJ seems to have dissipated with the recent inflation data showing a -0.1% (overall consumer prices -0.2%) y-o-y drop in February on the back of a steady (0%) inflation rate in January. The decline was of course widely expected due to the y-o-y deflationary impact from falling energy prices but still it comes at a bad time for the BOJ after having pushed a rate on the basis of Q4 06 GDP figures and general international pressure to normalize interest rates and thus curb the carry trade. Moreover the preliminary data for March also suggest that prices declined -0.1% in. On a brighter spot industrial production 'only' declined 0.2% in February which suggests that Japanese companies won't sustain de-stocking from Q4 06 too much into March and perhaps capex will begin ticking up already in March which again depends on the fundamentals in Japan's major export markets.

On a much more positive note household spending increased 1.3% on a year earlier in February which indeed is good news as this figure is a key indicator for the sustainability and trajectory of the Japanese economy. Moreover, retail sales also showed slight positive signs although they were virtually flat y-o-y.

So, both good and bad news then but does it change anything from what I said in my last note? Firstly, let us look a bit closer on the outlook for inflation where the always excellent Takehiro Sato serves up the cold facts in a recent note over at MS GEF. The first thing to note is that deflation measured by the core index almost certainly will linger into March as I also noted above but more importantly Sato rolls out an argument and calculations which suggest that deflation will persist on a y-o-y basis much further into 2007 which effectively will stall the normalization process at 0.5%. As such, Sato notes the much pessimistic forecast of a 0.3% drop in the CPI index in Q1 2007 which may even be on the upside. In short, this smells rasther nastily of entrenched deflation in the first two quarters of 2007 save for a major hike in energy prices which are after all trending upwards at the moment. Secondly, we have private consumption and retail sales which show promising signs of a y-o-y improvement in Q1 but what about the fundamentals and the looming entrenchment of deflation? Most notably, the recent Tankan Survey (sorry, no link) also shows that consumer expectations of price increases have fallen back considerably which indicates that consumers probably will hold back spending. This is of course difficult to say and indeed the immediate outlook on demographics reveal that a lot retirees will be up for bonuses soon which means that consumer spending as a function of dissavings might be a trend to look out for but at the end of the if deflation sets in with its nasty grip the fundamentals will indeed be tested. Of course monetary policy is the last part of the equation and here I really do not think we should expect much of a hike although of course the G-7 ministers are still wandering around in wonderland poised to strike once again on the low Yen and the need for the BOJ to normalize.

In summary, I think that the recent signs from the internal demand side proxied by household spending are positive but I am truly worried and not at all happy about the outlook on in(de)flation which I fear will feed strongly into expectations and thus also consumer spending in Q2 2007.