Whither the USD-JPY?

Well it wasn't all that long ago that Claus was asking us when and whether the Japanese authorities would feel the need to intervene to stop the - at that point (9 Nov) - seemingly inexorable rise of the yen against the dollar. Obviously a few short weeks in currency markets are a very long time (which is why playing them has to be such a complicated business I feel), and as we can see from the chart below (kindly prepared by the people over at Daily Fx) since late November (ie just after Claus was having his think-out-loud) the market seems to have turned, and the yen has been in downward mode.





So what should we make of all this? Well first off I think I should make clear that when it comes to technical arguments, like the ones used by Daily Fx about A-B-C zigzag-wave evolution and all that, I am absolutely ignorant, this is not my area and all I can do is recommend you go over and read their take to decide for yourself. My view on this topic would be very much a case of the blind leading the half-sighted.

But... if I look at this chart as a macro-economist, then of course there are some things which seem to be blindingly obvious, and they fit in pretty well with the narrative we have been giving here at GEM as the year has progressed.

Basically we need to think about the relative interest rate policies over at the Fed and the BoJ. Essentially the yen's slide after February 2007 (following some initial upswing momentum in January) can be tied to the disappointment generated by the inability of the BoJ to carry out a vigorous "normalisation" process on interest rates. This inability, of course, was closely tied-in to the underlying Japanese macro-economic "fundamentals" ( a topic which Claus goes into in much more depth in his accompanying post).

Then as we reach July, growing bullishness from Fukui and the BoJ coupled with increasing stagnation in the US housing market produce a turnaround. The market seems to dither a bit around mid-October, as instability in the global scene has the effect that people really can't quite make up their minds whether the carry trade is going to unwind or not and whether Japan might not once more be turned into a safe haven in troubled times (hence all the coming and going, aka volatility), but the broad sweep of things continues until the market turns in late November, as people finally throw the towel in on the Japanese recovery, and talk moves away from when the BoJ will raise again towards how long it will be before we are back in ZIRP. In this sense I am inclined to back the conclusion that Daily FX draw from their technical analysis, but basing myself on the macro outlook.

The USDJPY has fallen nearly 200 pips since Thursday morning after testing a resisting trendline that dates to June. This price action has many believing that the downtrend that began at 124.13 is back underway. However, our interpretation of the price pattern suggests that a rally towards 115.00 is still very much a possibility.

As I say, I tend to agree, but my reasoning is other. Apart from the ongoing weakness that we are likely going to see in the yen, as the interest rate differential with some other Asian and Latin American economies make carry to somewhere or other still an interesting business, we have to think about the underlying fundamentals of the US economy and the evolution of future monetary policy in the US.

So Where Are We Going in 2008?

As I say, the future of the Yen in part depends on the future of interest rate policy in the United States, so what are we able to discern in the tealeaves here? Well as I argue in this post (and back up with some additional demographic data in this one here) it is hard to envisage a dramatic easing on the part of the Federal reserve at this stage. The problems that the sub-prime bust are creating for the US economy have probably been rather overrated (interestingly sales of existing homes rose ever so slightly in November, which is just a small reminder that in a key area like housing demographics - rates of new household formation - do matter).

Sometimes I feel that there may even be a political interest in stressing that the global tightening in lending conditions is a spin off from a US problem (and not, say a Spanish or a UK one), since in countries with inherently fragile economies like Japan and Germany politicians and bankers may find it easier to explain to their citizens that what is happening is a result of a sub-prime bust elsewhere, rather than confronting head on where the real problem lies. This may be perceived as being more palatable for voters. Be that as it may, it seems to me that the US is more likely to be in for a "soft" than a "hard" landing, and this may well be reflected in monetary policy over at the Fed. What I mean by this is that the US slowdown may prove to be more protracted than many currently envisage - driven by liquidity constraints being placed by the banks on US internal borrowing, and by the continuing pressure on the US consumer wallet coming from higher oil and food prices (which are a knock on effect of the global recoupling process, and the increased purchasing power of people in the emerging economies, who are, let it be noted in passing, very numerous).

One point that I think is worth making is that in the course of the great fertility debate many US contributers tend to emphasise two factors which they feel help account for the comparatively high levels of fertility seen in the US of late: the spacious family environment and the ubiquitousness of the private car. Now, these two areas are precisely where this slowdown is going to bite hardest and longest in an era of structural changes in energy costs, since the US urban landscape may now be out of line with the change in relative prices that a declining dollar and rising global energy demand is going to produce. What I am getting at here is that if we ever do get a rising yuan, and the rupee continues its rise, then energy will get steadily cheaper in these countries in relative terms. I think this is not going to be a marginal, incidental point.

So the US slowdown may well be more protracted, but softer, than the markets are currently pricing in, while the Japanese slowdown may be more protracted and harder. Both these points argue in favour of continuing yen weakness vis-a-vis the US dollar in my opinion.

Finally I would add just at two caveats, and these concern the question of safe-havens and China. At this point in time we do not know what the global correction that we will in all probability see in 2008 is going to look like. We do know that some emerging economies will quite likely be badly affected (Eastern Europe, possibly Russia) while it seems likely that others (Argentina, Chile, Brazil, Turkey, Thailand and India) may well continue to power ahead. But we don't really know the details of how recoupling is going to work out in practice, and we don't know precisely which "safe havens" all those savings that continue to pile up in the pension and hedge funds will have recourse to. If Bretton Woods II is in the process of unwinding, and Bretton Woods III is in the process of being born, the we should expect to see changes here. As a knee jerk reaction, any initial instability in Asia is likely to send money across to Japan, but this may not be back to the "usual business", and particularly not if some large Asian economies - India?? - continue to grow at a hefty rate.

The other big unknown in 2008 is China. Most analysts are assuming a very gradual slowdown in China. Here I have my doubts. The inflation problem they have is a real one, and at this point in time it is hard to see how they can adequately address it. Certainly unchaining the yuan could just as easily lead to an acceleration of inflows and an increase in the overheating problem as to any more benign outcome, and I would treat New Zealand (and India for that matter) as the "Canary in the Coalmine" (or if you prefer "smoking gun") here. So I would just like to put up a question mark on this count, and I would do this especially in the context of the underlying and strong structural break in the Chinese population pyramid which has been produced by many years of the one child per family policy. Looking at those other canaries - Latvia and Estonia (and then Russia) push-comes-to-shove time does seem to arrive a lot earlier than we had all been anticipating. As I say, 2008 could well be the year that inflation gets a hold on China. Certainly the strong uptick in the latter months of 2007 is evident, as can be seen in the chart below.

Curiously this uptick coincides exactly with the peaking of the 15 to 19 age group, as you can see in the chart, and the decline in this age group from here moving forward is really quite dramatic, as you would expect from the drastic policy measure which was applied.




I have selected the 2022 horizon looking forward based on the fact that this is now known data. We can predict with a reasonable degree of accuracy just how many 15 year olds there will be in China in 2022, since they have now already been born. So we have a pretty good idea of China's new labour supply going forward. Obviously China can still get considerable growth by relocating the existing workforce across sectors to more productive ones. But the end of the labour intensive low economic value growth must now surely be in sight, and the big question is can China sustain inflation-free growth of the order of magnitude we have been seeing in recent years, bearing in mind that much of the recent growth in many of the higher growth developed economies - the US, the UK, Ireland, Spain - has been very labour intensive. My feeling is that it can't, this is why all those exhausted canaries swooning in Latvia have been so useful, and that we will see a slowdown in China which will not simply be cyclical, but rather structural. Possibly the moment of inflection (or tipping point) here will come around the time of the Olympic Games.

So, as I say the 15 to 19 age group has now peaked in China, and from here on in it is essentially downhill all the way, as far ahead as anyone can see. The truth is that no-one at this point in time knows what the consequences of this are going to be. But don't worry, since at least one thing is for sure: we are all just about to find out.




Now as I argue in this post (and back up with more demographic data in this one here) it is hard to envisage a dramatic easing on the part of the Fed at this stage. The problems that the sub-prime bust are creating for the US economy have probably been rather overrated. Sometimes there may even be a political interest in doing this, since in countries with inherently fragile economies like Japan and Germany politicians and bankers may find it easier to explain to their citizens that what is happening is a result of a sub-prime bust elsewhere, rather than confronting head on where the real problem lies. This may be perceived as being more palatable for voters. Be that as it may, it seems to me that the US is more likely to be in for a "soft" than a "hard" landing, and this may well be reflected in monetary policy over at the Fed. What I mean by this is that the US slowdown may prove to be more protracted than many currently envisage - driven by liquidity constraints being placed by the banks on US internal borrowing, and by the continuing pressure on the US consumer wallet coming from higher oil and food prices (which are a knock on effect of the global recoupling process, and the increased purchasing power of people in the emerging economies, who are, let it be noted in passing, very numerous).

One point that I think is worth making is that in the course of the great fertility debate many US contributers tend to emphasise two factors which help account for the very high levels of US fertility seen of late: the spacious family environment and the ubiquitousness of the private car. Now, these two areas are precisely where this slowdown is going to bite hardest and longest in an era of structural changes in energy costs, since the US urban landscape may now be out of line with the change in relative prices that a declining dollar and rising global energy demand is going to produce. What I am getting at here is that if we ever do get a rising yuan, and the rupee continues its rise, then energy will get steadily cheaper in these countries in relative terms. I think this is not going to be a marginal, incidental point.

So the US slowdown may well be more protracted, but softer, than the markets are currently pricing in, while the Japanese slowdown may be more protracted and harder. Both these points argue in favour of continuing yen weakness vis-a-vis the dollar.

I would at this point add just at two caveats, and these concern the question of safe-havens and China. At this point in time we do not know what the global correction that we will in all probability see in 2008 is going to look like. We know that some emerging economies will quite likely be badly affected (Eastern Europe, possibly Russia) while others (Argentina, Chile, Brazil, Turkey, Thailand and India) may well continue to power ahead. But we don't really know the details of how recoupling is going to work out in practice, and we don't know where the actual "safe havens" will be. If Bretton Woods II is in the process of unwinding, and Bretton Woods III is in the process of being born, the we should expect to see changes here. As a knee jerk reaction, any initial instability in Asia is likely to send money across to Japan, but this may not be back to the "usual business", and particularly not if some large Asian economies - India?? - continue to grow at a hefty rate.

The other big unknown in 2008 is China. Most analysts are assuming a very gradual slowdown in China. Here I have my doubts. The inflation problem they have is a real one, and at this point in time it is hard to see how they can adequately address it. Certainly unchaining the yuan could just as easily lead to an acceleration of inflows and an increase in the overheating problem as to any more benign outcome, I would treat New Zealand (and India for that matter) as the "Canary in the Coalmine" here. So I would just like to put up a question mark on this count, and I would do this especially in the context of the underlying and strong structural break in the Chinese population pyramid which has been produced by many years of the one child per family policy. Looking at those other canaries - Latvia and Estonia (and then Russia) push comes to shove time seems to arrive a lot earlier on this count than we were all anticipating. As I say, 2008 could well be the year that inflation gets a hold on China. Certainly the strong uptick in the latter months of 2007 is evident, as can be seen in the chart below.



Curiously this coincides with the peaking of the 15 to 19 age group, as you can see in the chart, and the decline from here moving forward is really quite dramatic, as you would expect from the drastic policy measure which was applied.




I have selected the horizon looking forward with regard to the fact that this is now known data. We can predict with a reasonable degree of accuracy just how many 15 year olds there will be in China in 2022, since they have now just been born. So we have a pretty good idea of China's new labour supply going forward. Obviously China can still get considerable growth by relocating the existing workforce across sectors to more productive ones. But the end of the labour intensive low economic value growth must now surely be in sight, and the big question is can China sustain inflation-free growth of the order of magnitude we have been seeing in recent years. My feeling is that it can't, this is why all those exhausted canaries swooning in Latvia have been so useful, and that we will see a slowdown in China which will not simply be cyclical, but rather structural.

As I say the 15 to 19 age group has now peaked in China, and from here on in it is essentially downhill all the way, as far ahead as anyone can see. The truth is that no-one at this point in time knows what the consequences of this are going to be. But don't worry, one thing is for sure, we are all just about to find out.

Inflation, Employment and Various Interpretations of What is Happening In Japan

Well, promises are promises, but a birthday is a birthday, and since today it is my turn - and being a good Capricorn - what better way to spend it than in updating my excel files with all the new data coming out of Japan. And a veritable raft of data it has been, since there are releases about Consumer Prices, Family Income and Expenditure, the November Labour Force Survey, building starts, (covered separately here), and industrial output. But before we move on to the details, perhaps one "big-picture" detail is worth commenting on, and that is the very mixed reception which the perceived return of inflation to Japan is receiving (although please note I myself am not totally convinced that thing are as clear as some suggest, and that this months data may not be just another one of those "false calls", see below).

In this context I couldn't really help but be struck by the Bloomberg lead paragraph in their CPI coverage article:

Japan's inflation rose at the fastest pace in more than nine years in November and industrial production and household spending declined, signaling rising oil costs may derail the economy's longest postwar expansion.

So what is going on here. Isn't the return of inflation to Japan just what everyone was hoping for? I guess the response of Swedish blogger Setfan Karlsson in his "Wasn't Rising Prices Supposed to be Good For Japan?" post yesterday must be a reaction which is typical of what many are feeling. Namely, "huh"!

So where exactly are we right now? Is the momentary return of a positive reading on the core index to be welcomed or not? Is inflation a good thing or a bad thing? Obviously the answer is the ambiguous one of "it depends", and it depends especially on what you are looking for, but the problem of defining a consensus decision procedure in this case does give us a good illustration of what a hellishly complex business macroeconomics is. Not for the faint of heart this subject, I'm afraid.

Basically the problem is that economic systems are complex, and in them many variables are interconnnected in a way which may well produce important non-linearities. My feeling is that what you need in order to be a good macroeconomist is a feel for this complexity (and this is what sets the macro- off from the micro-economist, since the micro-economist is normally statisfied with some sort of partial analytic, you know, the good old ceteris paribus simulation, which may be very useful in terms of approaching certain very discrete and local phenomena, but turns out to be nearly useless when it come to real world, as it actually happens, macro). The macro-economist needs the ability to keep 3 or 4 (or more) variables in their head at the same time, and run sort of "what if" simulations mentally. Obviously it is hard to precisely assign an exact value to the number of parameters you need to keep spinning round simulataneously on any particular problem, or to give an explicit account of the system of virtual weights you implicitly assign to each of them, it is the scale of this that matters, and what counts if you want to do macro is the ability to carry out - on the fly - such large simultaneous mental simulations, since no computer model can possibly hope to handle the level of complexity involved, even if the parameters were well set up (ie included things like median age, fertility and life expectancy), which they aren't. This is basically analagous to the semantic interpretation argument in the Artificial Intelligence debate, and this kind of problem is one of the reasons why I feel machine translation is - at the very best - a long way off in the future, and the same really goes for "true to life" economic models. Try doing a machine translation from German into English, and reading through what you get. The print-out you get from running some version or other of MultiMod has just about the same degree of satisfactoryness.

So when we come to the inflation-in-Japan issue, the whole problem needs to be seen in the context of the undelying business cycle (and of course of why there is deflation there in the first place, which is a story for another day). What Japan needs to try to achieve is a positive reading on inflation as the economy expands (although this, please note, would not solve the economic difficulties which arise from Japan's oustanding demographically-related growth problems, but it would make them a damn sight easier to handle). Japan needs this kind of inflation for basically two reasons:

1) Firstly, simply because it is easier to maintain stability on a bicycle which is moving forward than it is on one which is stationary or moving backwards, so 1 to 2 percent inflation under normal conditions is possibly ideal for an economy in general terms. I think even modern monetarists like Jean Claude Trichet accept this, and this is why the ECB, for example, has its target on or around 2%, and not at zero.

2) This being said, the main reason you want some level of positive price movement in an economy is the technical one that without it you simply cannot run normal monetary policy. This is the argument - the technical liquidity trap one - that most people seem to have totally forgotten about recently (as I said, consensus discourse is normally only up to keeping one or two things in the head at a time). Back in February, when the BoJ finally decided to take the plunge and risk raising interest rates a further 0.25% to 0.5% I wrote a lengthy piece for Global Economy Matters - Japan in the Front View Mirror - where I basically argued that the whole "rate normalisation" policy being fomented by the G7 (a policy which had its origins in the central bankers and finance ministers meeting in Washinton in April 2006) and implemented by the BoJ was an error, and one which they might live to regret. Well, this is just where we are now, busy regretting all that "upswing exhuberance", and all the failure to really get down to the root of the problem. As I said at the time (and I think the whole article is still very much worth the read):

I cannot help having the unfortunate feeling that everyone is so busy eagerly looking forward (to the recovery, the end of the carry trade, or whatever) that they are making the glaring and rather irresponsible error of forgetting to check on what has been happening behind, and in the only all too recent past.......

The G7, as everyone by now probably knows, has just reasserted it's faith in the view that the Japanese economy is well on course to recovery. According to the official statement:

“Japan’s recovery is on track and is expected to continue. We are confident that the implications of these developments will be recognized by market participants”

Now this is a strange statement, since there are plenty of indications coming out of Japan that there are subtsantial doubts about this, and particular there are doubts about the resilience of domestic consumption in the current recovery, as Claus has already ably explained in two excellent posts (here and here). Since Claus will comment further on the details of the current decision, what I would like to do in this note is step back a bit, and reflect upon some aspects of the situation which should give us all cause for serious thought.

In particular there is the issue of deflation, and the danger that Japan may once
more fall back into the deflation trap. I say once more, since at the present
time I am already getting a strange feeling of deja vu, since few seem to
remember that the current approach was tried and found wanting once before, back
in 2000. Paul Krugman writing at the time had this to say:

So what if last Friday the Bank of Japan finally ended its "zero interest rate policy" (yes, ZIRP)? After all, it's only a quarter-point rise, in a faraway country that doesn't interest most Americans now that it no longer seems a dangerous competitor. And yet I would not be surprised if future economic historians look back at Friday's move as the beginning of the end for an era, and not just in Japan.

Really I strongly recommend reading Claus's No Signs of Inflation in Japan (1 Feb 2007), Japan's Economy Chasing Illusions? (19th January 2007) which give all the background on the whole debate, and will let you see had a glance who had been arguing sound-sense here, and who none-sense.

Now I did state that there are two potential grounds for feeling that a return of inflation in Japan - under the right business cycle conditions - would not be a bad thing, but I will rapidly correct myself, since I think there is a third argument, one which refers to global monetary policy. Basically Japan having interest rates so near the floor creates uncomfortable problems for the world monetary system (the presence of the carry trade being only the most visible and high profile of these) and it was as a result of some of this discomfort - a world being steadily flooded with liquidity - that the Central Bankers and G7 Finance Ministers took the decision to try to encourage the "normalisation" of rates. The decision was put into practice by the ECB in the first place, but the situation in Japan really was never far from the forefront of people's minds, and the BoJ soon followed suit.

The rub is that this "normalisation" process, far from being based on a decoupling phenomenon in some of the world's largest economies - obviously I am talking explicitly about Germany and Japan here - has only served to underline the ongoing weaknesses which exist in them. So I would argue that the G7 participants really do need do need to have some sort of a rethink at this point.

Basically the problem facing Japan is that the up-tick in inflation is taking place at precisely the same moment as there is a downtick in several other key economic indiactors. What this means basically is that Japan is getting squeezed on both fronts. As Bloomberg also note:

Core consumer prices rose faster than the 0.3 percent median estimate of 36 economists surveyed by Bloomberg News. Gasoline and kerosene contributed three-quarters of the gain, which was the quickest since March 1998, when an increase in the country's sales tax pushed the gauge to 1.8 percent.

The last time inflation showed signs of life in this way, Japan was pushed straight off into recession. History may well be about to repeat itself yet one more time here. But the real question is when will people actually start to learn some of the costly lessons experience is offering us?

Now for the data.

Consumer Price Inflation in November

The consumer price index for Japan in November 2007 was 100.7 (2005=100), down 0.2% from the previous month, and up 0.6% over the previous year. The consumer price index for Ku-area of Tokyo in December 2007 was 100.5(2005=100), up 0.2% from the previous month, and up 0.4% over the previous year.
Japan Statistics Bureau

So core consumer prices in Japan rose a faster-than-expected annual 0.4 per cent in November, with higher oil prices being the main driving force.

The change in core nationwide CPI, which includes energy costs, has now been positive for two straight months, after being at zero or in slightly negative territory for much of the year. The 0.4 per cent rise, excluding fresh food prices, came after a 0.1 per cent increase in October and was the fast rate of increase since March 1998, when a sales tax increase pushed the indicator up to 1.8 percent.

Nationwide, prices of oil-related products rose 9.2 per cent in November from the same period last year, against an increase of 2.2 per cent in October, showing the growing contribution of oil to the headline CPI reading.

Goldman Sachs - who described the phenomenon as “cost-push inflation” - cast doubt on the durability as well as its impact on consumer sentiment, which it said could be negative. As they say in their note, “The rise in CPI is largely a ripple effect from raw material prices rather than the result of domestic demand recovery.”

Even more to the point, so-called “core core” inflation - stripping out energy costs as well as fresh food in line with the general practice in many advanced economies - showed continued deflation of 0.1 per cent in November (see chart above). However, that was a slightly better performance than in October when prices, excluding energy and fresh food, fell 0.3 per cent. The question is, as Goldman Sachs argue, just how sustainable is this. Just how fast will oil prices continue to rise in 2008? Certainly the slowdown in demand inside Japan that we can now anticipate will tend to drag core prices downwards. So we are certainly not talking about any visible end to deflation in Japan at this point, and certainly not to a situation where a slight uptick inflation will lead the BoJ to consider a rate increase, which is really the reason - at the end of the day, and truth be told - that most people were hoping to see a return to inflation in Japan.


Employment and Unemployment

Next we have the monthly labour force survey. There is some evidence that the labour market is already becoming looser, raising the possibility that this economic cycle, which has already seen six years of growth, could run out of steam before deflation is in any way really over . Data out on Friday were positive on the surface, since they showed unemployment falling back to a seasonally adjusted 3.8 per cent after creeping up to 4.0 per cent during the two previous months, while the number of people in some form of employment or other was still up 230,000 year on year.

Summary of the November 2007 Survey Results
(1) Employment
The number of employed persons in November 2007 was 64.33 million, an increase of 230 thousand or 0.4% from the previous year.
(2) Unemployment
The number of unemployed persons in November 2007 was 2.46 million, a decrease of 130 thousand or 5.0% from the previous year.
The unemployment rate, seasonally adjusted, was 3.8%.
Japan Statistics Bureau



However, the jobs-to-job-seeker ratio, which many economists regard as a better guide to labour market conditions than the headline jobless number, weakened. In November, there were 99 jobs for every 100 jobseekers compared with 102 in October and 106 only a few months ago. This is the first time the ratio has dipped below 1 – at least 100 jobs for every 100 jobseekers – in the last two years.

Then we have the Family Income and Expenditure Survey. The deteriorating labour market, which has accompanied the economic slowdown since this summer, appears to be also damping consumer sentiment.

Expenditures for Two-or-more-person Households

The average amount of monthly consumption expenditures per household for November 2007 was 282,836 yen, same level in nominal terms but down 0.6% in real terms from the previous year.

Income and Expenditures for Workers' Households

The average amount of monthly income per household stood at 435,640 yen, down 1.5% in nominal terms and down 2.1% in real terms from the previous year. The amount of consumption expenditures was 302,879 yen, down 0.9% in nominal terms and down 1.5% in real terms from the previous year.
Japan Statistics Bureau

Real consumption down 0.6 per cent, which was more than expected, although the data are notoriously volatile and was affected to some extent by depressed car sales.






Industrial output

Industrial production, meanwhile, fell 1.6 percent in November from the previous month, the first drop in two months.Industrial output rose 1.7 percent in October after falling 1.4 percent in September, the Ministry of Economy, Trade and Industry said. The ministry also said manufacturers polled expect that their output will rise 4.0 percent on month in December, but will be unchanged in January.

Industrial Production in November decreased ▲1.6% from the previous month, showing a decrease for the first time in two months. It showed an increase of 2.9% from the previous year. The index in November was 110.4(seasonally adjusted).

Industries that mainly contributed to the decrease are as follows: 1. General machinery, 2. Electronic parts and devices, 3. Other industry, in that order.

Commodities that mainly contributed to the decrease are as follows: 1. Metal oxide semiconductor IC (Memory), 2. Semiconductor products machinery, 3. Printing machinery, in that order.

Japan METI

As we can see the recent performance of the Japanese industrial sector has been strong, November does represent a slowdown in the pace, but one month's data is clearly insufficient to be able to draw any substantial and robust conclusion from.

Japan Building Starts November 2007

Japan's housing starts fell for a fifth straight month in November, indicating that stricter rules for obtaining building permits, and the knock-on effects of the US sub-prime crisis may continue to act as a drag on economic growth in the first quarter of 2008. Ground broken on new homes and condominiums fell 27 percent from a year earlier after falling 35 percent in October and 44 percent in September, the Land Ministry said in Tokyo on Thursday.

According to Bloomberg:

Prime Minister Yasuo Fukuda said last week he regretted the slump in housing starts that resulted from building-code changes made in June after an architect fabricated earthquake-resistance data. The central bank lowered its evaluation of the economy for the first time in three years last week and the government slashed its growth forecast because of the building fiasco. Housing investment wiped more than 1 percentage point from Japan's 1.5 percent annual pace of economic expansion in the third quarter. The Cabinet Office last week cut its growth forecast for the year ending March to 1.3 percent from 2.1 percent. The Real Estate Economic Research Institute said last week that the condominium supply in Tokyo and the surrounding area will fall to the lowest since 1993 this year and may decline further in 2008.

The problem is affecting related industries. Demand for kitchenware, which represents about a quarter of the domestic stainless steel market, will decline from January, said Yoichi Saji, head of the Japan Stainless Steel Association. Nippon Steel & Sumikin Stainless Steel Corp., Japan's largest maker of the alloy, said yesterday it would cut output of nickel-based stainless steel by about 10 percent next month.

The 103-member Topix Construction Index has fallen 12 percent since having the biggest gain in more than eight years on Oct. 30 when the Land Ministry announced it would relax the building rules. Builders broke ground on 971,000 new homes and condominiums in November at an annual rate, the most since the regulations were introduced in June, today's report showed. The figure has risen from 720,000 in September, the lowest since the government began keeping records in 1965.

Merry Xmas and A Happy New Year

Well, a Merry Xmas and a Happy New Year to all our readers from me (Edward), Scott and Claus. Thank you for taking the time and trouble to pass-by. This blog will now - failing major and surprising new developments in the global economy - be offline till the end of the first week in January, or till after the festival of Los Reyes Magos in Spain (for those of you who know what this is all about). Come to think of it, maybe this is just what our ever hopeful central bankers are in need of even as I write - some surprise presents from the three wise men - but I fear that this year if these worthy gentlemen do somehow show at the next G7 meet, the star in the east which draws them will not be the one described in the traditional texts, but in all likelihood the rising star of India.



Credit crunch, did someone use the expression credit crunch?

Japan in 2008 ... ZIRP Coming Closer?

None of the writers here at Japan Economy Watch are professional forecasters and analysts per se. Yet, with what seems to be happening 'next' in Japan I can not help but think that you have been extraordinarily well served here at JEW during the past year. As such, let us have a look at what I said on Japan (and indeed the global economy) about a year ago as we stood on the brink of 2007.

(...) we have the Top 10 of economic predictions for 2007 by Global Insight where the chief economist Nariman Behavesh argues that the BOJ is likely to have raised to 1% by the end of 2007; this would then imply three 0.25% steps from the current level 0.25%. As you will see this is a part of a broad discourse concerning how global interest rates differentials will narrow as the Fed is going to cut while the BOJ and the ECB are going to raise; for the record I do not see this happening at all!

Now, the ever perceptive readers of this blog will immediately notice the apparent rather peculiar reason as to why I am feeling so smug in my introduction. In this way and apart, of course from the BOJ raising to 1%, isn't this thing of 'narrowing' of global interest rate differentials exactly what we have seen? It could indeed seem so as the Fed's aggressive easing have coincided with a fixed stance in Japan and increases moving over to holding operations at the ECB. However, this is also where I would like to start the whole 'what will happen in 2008' debate since how sustainable is this current state of affairs amongst the three G3 economies? Well, as for the US they have already bitten the bullit. The subprime mess is still pounding away with the recent victims being Morgan Stanley and Bear Sterns having to push the big delete button on a slew of internal balance sheets as it became clear that the subprime debacle had claimed yet another score of assets. But the US economy in general and while certainly still on the ropes is on its way to get to grips with its new situation and get on with the fight. I won't even begin to rant on the Eurozone here where I fear that 2008 will be a year of many a camel swallowing (or was that cold pouridge?) by those who have been pushing the Goldilocks narrative the hardest. Let me move swiftly over to Japan where as can readily be seen the BOJ has not managed to raise the short term interest rate to 1%, far from it actually. I should note in this context that I am not trying to pound excessively on Global Insight and its chief economist who I am sure is a very able and smart analyst. I am simply trying to hammer down that the consensus on Japan as it emerged from 2006 has not exactly materialised and what we now need to do is to understand why as well as we need to look forward as to what will happen next. I will begin with the latter question as Bloomberg today carries a piece on Japan where it is actually suggested that the BOJ will have to lower rates which effectively would take them back into ZIRP ...

Toshihiko Fukui's final act as governor of the Bank of Japan may be to cut borrowing costs for the first time in more than six years. Economists began predicting Fukui, 72, will have to lower rates after the Bank of Japan yesterday downgraded its assessment of the economy for the first time in three years. The bank has raised rates twice since July 2006, when it ended a policy of keeping borrowing costs near zero to beat a decade of deflation. ``They may have to cut,'' said Robert Feldman, head of economic research at Morgan Stanley in Tokyo. ``As Fukui said yesterday, the economy is getting worse.''

This is of course far from being a done deal but it is interesting to see how the discourse kicked off in 2006 with sustainable recovery stories flying all over the place to now where it seems as if we have come full circle. What I particularly want to emphasise here is that this Felman talking and when he says something on Japan people all over the place are bound to listen carefully. Whether the BOJ will actually go ahead with a return into ZIRP is difficult to say indeed. The point is that while economic factors will indeed be importants determinants so will political. The BOJ stands before a change in leadership in Spring 2008 and given the current spout of political uncertainty lingering in Japan combined with fierce debate over potential future 'un-popular' political measures (e.g. a consumption tax perhaps?) any decision and especially one downwards in the interest rate is bound to be surrounded by much commotion not least from the external environment where the G7 is sure to be jumping and dancing all over the place in the event of a cut. This brings me to the other question raised above and one which is far more fundamental and important. As such, why is it that Japan did not see that sustainable recovery? The first thing to bear in mind is clearly the fact that the financial turmoil which was brewing in the beginning of 2007 reared its head with much more force than most had anticipated. There is no doubt that this has not exactly been accomodative to the Japanese economy. However, what I really want to home in on is the narrative which has emerged here in the twilight of 2007 as it has become clear that Japan will probably be flirting with a recession. In this way, it seems that whatever happens next in Japan with respect to the inevitable slowdown of economic momentum is bound to shore up exclusively at the politicians' door. Now, this is an extremely dangerous path to go by I think as I also noted recently (for good measure, Takehiro Sato's 'Buckle Up' analysis can be found here). Edward also treats this point in one of the post which immediately preceedes this one where the following point is worth pondering ...

For anything to work for you in life you need a certain amount of good luck, and when your luck is down, and the level of adversity you face mounts, then the problems only seem to pile up. This perfectly describes Japan present problem set I think (I mean don't forget the famous pensions-records scandal, which seems to have been all but forgotten at the moment, except by the people who had their records lost, of course). If you really could live without a spanner showing up in the works, then it never fails to show up. That's what we mean by being "down on your luck". As Jefferson said, when I find myself being lucky I am normally sitting here, hard at work at my desk. That is, we make our own luck, using foresight and sound policy.

In this way and to paraphrase one of pre-modern history's most vexing questions on whose altar many a head has been severed from its body we need to ask whether the sun revolves around the earth or whether in fact it is not the other way around? Of course, no heads will be severed this time around which serves to indicate the strides human intelligence and community have made after all. So, leaving you with these arcane matters I might risk coming off as a scrooge here just before Christmas. This was not my attention but I do think that we need to think long and hard about what cause and effect are in terms of analysing the Japanese economy.

I will have more later on the actual market implications of all this and do have a Merry Christmas come next week.

Japan Exports November 2007

Japan's export growth slowed in November as the U.S. housing cut demand for automobiles and construction equipment, and the knock-on effect of the sub-prime turmoil started to be noted in other developed economies. Also worthy of note this month is that exports to China fell back slightly, from a revised 1.17 trillion yen in October to 1.14 trillion yen in November. Likewise exports to Europe, which fell from 1.14 trillion in October to 1.03 trillion in October.

Shipments to the U.S. declined on a year on year basis for a third consecutive month, the worst string of declines in more than three years. Since Japan's economy is now more dependent than ever on exports for growth this would seem to be the final nail in the coffin of the coming recession.



Exports rose 9.7 percent from a year earlier, the Finance Ministry reported in Tokyo today, following a 13.7% annual growth rate last month.




Imports rose 13.2 percent in November, the ministry said, after climbing 8.6 percent in the previous month, causing the trade surplus to fall 12.2 percent to 797.4 billion yen. Analysts expected an 11.8 percent increase.

Exports, we might like to remember, led by shipments to Europe and China, carried almost the entire weight of Japan's 1.5 percent annualized growth in the third quarter.

Oh yes, and almost as an afterthough, the Bank of Japan decided yesterday to maintain the 0.5% base rate on hold for yet another month. Did anyone in their right mind ever imagine otherwise!

Japan Economy 2007/2008, The Moment Of Truth?

Well the Japan Cabinet Office have just published their monthly economic report together with their their revised forecasts for fiscal year 2008. As could be expected, downward revisions are to be seen everywhere, except in the plans for government spending, which commentators expect may well be up (details of the 2008 budget are due to be released tomorrow), but even this last detail seems pretty ominous in the light of the fiscal problems which Japan faces, and the steadily rising cost of supporting Japan's growing elderly dependent population.

What is still the world's second-largest economy is now expected to grow by 1.3 percent in the fiscal year ending March 31, slower than a previous forecast of 2.1 percent. At this point in time it is very difficult to assess the viability or otherwise of this forceast, since it is obviously very sensitive to small changes of environment in key sectors as we move forward. However one or two observations are in order. The first of these is that we are likely to get a very strange reading on Q4 GDP. The reason for this is that GDP growth in Q4 2006 was very high indeed (1.3% quarter on quarter - see chart below - and indeed the strength of this growth threw Claus and I considerably when it happened - and the same was true of what happened in Germany - since we hadn't really forseen the spurt in the global growth rate - who had - and how this would influence the key export dependent economies. Everything is now, however, coming back into line, and I doubt we will see big surprises on the upside across 2008).





It is thus very probable that we will see negative year on year growth in Q4 2007 (the high base effect), even if the quarter on quarter Q4 2007 growth rate does not itself plunge into the red (a possibility which is not at all excluded at this point).

Looking more generally at the government revision other things stand out. First this:

”With the global economy recovering in fiscal 2008/09, the corporate sector will remain firm and households will show improvement gradually”

and then this:

”A private-demand-led economic recovery is expected through joint efforts by the government and the Bank of Japan.”

This strikes me as incredibly optimistic. On the global economy front things are really bound to get worse before they get better. Some economies - Thailand, India, Turkey, Chile, Brazil, India - may well be able to sustain momentum, but Eastern Europe is very likely to suffer a correction (in all probability quite a strong one), while both Russia and China will be struggling with their growing inflation problems. In particular in the Chinese case, some sort of slowdown or other is now almost bound to come - and it can be sharper or softer according to when it starts - since the inflation problem is really about to get out of hand if something is not done soon on this front.

The developed economies, on the other hand, will, if they are internal consumption dependent (Spain, the US, Australia, the UK etc) be wrestling for some time to come with the effects of the unwinding of the financial component of the construction boom, while those who are to some degree export dependent (Germany, Austria, Italy, Finland, Sweden - the rapid-ager group) will simply notice any slowdown in the rate of growth in world trade.

As for the above-mentioned support from the government and the Bank of Japan, this can only mean more fiscal support and the absence of any further rate increases from the BoJ (Fukui will have to retire without fulfilling his dream, and the big question now is rather when will the BoJ start to talk about coming down again).

On the fiscal front slower growth will probably place a squeeze on tax revenue, making it harder for the government to narrow the budget deficit and reduce its 777 trillion yen ($6.9 trillion) debt, which is the world's largest. The 2008 budget outline is due to be released tomorrow, and will probably incorporate an increase in government spending according to a leaked preview which appeared in Nikkei newspaper today. The primary deficit, the excess of spending over revenue excluding bond sales and interest payments, is projected to widen for the first time in five years, according to the article, suggesting that government spending may well rise to something in the order of 83 trillion yen as the continuous and relentless ageing of the population swellshealth and social welfare costs. Such an increase would constitute a 0.4 percent increase from this year's projected level.

Economic and Fiscal Policy Minister Hiroko Ota has already confirmed that the government anticipate that revenue from taxes will start falling, although Finance Minister Fukushiro Nukaga insisted when he spoke to reporters that the government still intends to try to balance the budget by year-ending March 2012. If they go down the road I think they are going to go down, and if this "slowdown" is a drawn out affair - as I think it is very possible that it will be - then it is hard to see this committment being fulfilled.

All of this reveals, and very clearly, just how fragile Japan's situation actually is at this point, despite all the bravado, and despite every attempt to put the best face possible on things that you can find in the government reports and the financial press at the moment. Structurally Japan is in a very tight fixt. The central bank has been unable, even during the longest expansion since the late 1980s, to raise interest rates above 0.5%, and the government has only been able to start thinking about reducing the massive outstanding debt precisely when it looks like we may be heading back to recession again, and thus they can't. You don't need to be a genius to see that there is a substantial underlying problem here, and that, in the mid term, none of this is sustainable.

Of course, the government fall back on the hope eternal argument of that anticipated rise in domestic consumption, but this failed to materialise during the boom, and I see little reason why we should anticipate its arrival at this point, indeed there are strong ageing-population-related structural reasons for assuming that we won't.

Policy Driven Or Structural?

Now one of the big debates which is bound to arise is the one which relates to the extent that (yet one more time around) Japan's problems are policy related, and the extent to which they are now "normal" problems associated with the impact of a steadily ageing population which has passed the median age 42/43 milestone. Claus has already drawn attention to Morgan Stanley analyst Takehiro Sato's views in this regard here.

Takehiro Sato presents the policy-driven case, which I will quote extensively:

Errant government policies have started to hurt domestic demand. First, the availability of consumer financing has dried up and micro businesses as well as small and midsize enterprises (SMEs) are having financing difficulties because Credit Guarantee Corporations (CGCs) started a ‘responsibility-sharing arrangement’ in October. Second, the revised Building Standards Law (BSL) has led to a sharp decline in construction starts. Third, consumption and investment sentiment has been further harmed by the prospect of higher taxes and a return to the 1990s-style fiscal policy. Implementation of the Specified Commercial Transactions Law and the Financial Instruments and Exchange Law (FIEL) can probably be added to the mix too. The FIEL has hampered foreign investors and accelerated yen appreciation. Just to be clear, we do not think that the objectives of these policies are misguided, but hasty moves by bureaucrats to implement such laws, without regard for the economy, have had a considerable impact.

We think that such errant policies will result in a policy-induced slump (‘kansei fukyo’). First, the contraction in consumer credit and financing backed by CGCs has already put a tight squeeze on micro businesses and SMEs. With sharp increases in material and energy costs worsening the terms of trade and labor’s share of income still high, SMEs do not have much leeway to increase wages or capex. The tightening of credit may lead to an increase in bankruptcies among SMEs in Jan-Mar 2008, when cash flow tends to be tight.

Second, housing investment has fallen off sharply because of the revised BSL and is unlikely to recover in F3/09. The condominium market took a heavy hit, particularly since demand had already been weak amid a decline in what households can afford to purchase. Condo starts have slumped in 2007 and are unlikely to fully recover in 2008 because the bottlenecks that have resulted from government inadequacies are likely to take time to clear up. GDP-based housing investment will probably take longer to recover. We estimate the housing weakness alone shaves 0.3ppt from our F3/08 GDP growth forecast, and do not expect a rebound of the same extent in F3/09. If the situation continues until mid-2008, small and midsize builders are likely to go bankrupt and housing spending would be affected, and hence the problems would be more than just bottlenecks.

Third, the government’s discussion of taxes has chilled consumer and investor sentiment. The Cabinet Office’s Council on Economic and Fiscal Policy released an estimate that the consumption tax needs to be increased to double figures, and the government’s Tax Commission is considering raising tax rates and limiting deductibles against income. The need for such a major consumption tax increase is understandable, but we think that the way the idea was floated was not a smart one. More SMEs may go bankrupt, housing investment looks unlikely to recover, and already-cautious consumer sentiment may worsen further as a result of all the talk of tax increases. The prospect of a return to 1990s-style fiscal policy could also harm personal consumption and investment due to Ricardian equivalence. The Specified Commercial Transactions Law and the FIEL, which are nominally designed to protect consumers and investors, actually appear to be dampening consumer spending and investments in financial products.

Well the list of policy "errors" is an impressive one, but let's think a little about some of them for a moment. Firstly the Specified Commercial Transactions Law and the FIEL. As Sato says, these are nominally designed to protect consumers and investors, so it is surprising that they are having such a negative effect. Since I am in no position to comment on the details of these measures, I will simply note that the danger of even well intended policy measures going wrong only increases as the fragility and vulnerability of an economy rises, and that is the phenomenon we seen to be observing in Japan right now. For anything to work for you in life you need a certain amount of good luck, and when your luck is down, and the level of adversity you face mounts, then the problems only seem to pile up. This perfectly describes Japan present problem set I think (I mean don't forget the famous pensions-records scandal, which seems to have been all but forgotten at the moment, except by the people who had their records lost, of course). If you really could live without a spanner showing up in the works, then it never fails to show up. That's what we mean by being "down on your luck". As Jefferson said, when I find myself being lucky I am normally sitting here, hard at work at my desk. That is, we make our own luck, using foresight and sound policy.

So then there is the housing permits paperwork issue(another of those spanners, I guess). I am sure this has been a factor, but I am sure it is not the whole story. The building permits question was merely the trigger which fired off an already primed gun. Let's look at quarterly annual growth in residential construction.

What we can see here is that the drop in Q3 is large and significant, but that the downward trend was already present even before the permits problem hit, and the situation is probably now being fed more by the knock-on effects of the credit crunch and the sub-prime concerns than by the paperwork issue itself. As such we should not anticipate any early resolution of the problem, although the rate of downturn is obviously going to ease up.

Lastly we have the fiscal issue. Now as Sato again notes, the reasons why people have been talking about such a consumption tax increase are understandable, since government debt problems are important, but as we can see from what has happened in Germany with the 3% VAT hike in January, in a society with a high median age population where domestic consumption is fragile, loading up the consumption tax is definitely not a good idea. Other solutions need to be found, and many of these will now involve cuts in provision I fear. This is the price to be paid for having left the ageing issue unattended for so long. There is now a certain inevitability about things.

Which is why it is also worrying that Sato says this: "the prospect of a return to 1990s-style fiscal policy could also harm personal consumption and investment due to Ricardian equivalence."

Leaving aside the knotty problem of whether or not there is such a thing as Ricardian equivalence, I take this to mean that he anticipates a return to fiscal deficit stimulus support. This is a very dangerous road to go down for an economy in Japan's situation. Each recesssion now is not simply a repeat of the earlier one, since each time now the screw will turn another notch, and one day something or other will break. Japan needs to look for long term solutions to its problems, which mean facilitating substantial immigration in the short term, and a radical change in fertility policy to try to address the longer term issues. Will we see that happen? I am not optimistic, but then the longer you keep saying that fertility doesn't matter, the longer people continue to think that there is no important and pressing reason why they should have children. That is, the situation becomes self-perpetuating. This is the damage that is doen by denial.


Update: 20/12/07

Well, as forecast yesterday by Nikkei, the Japanese Ministry of Finance has today announced that Japanese spending will rise by 0.2 percent to 83.1 trillion yen ($735 billion) in the year starting April 1 2008. The government will sell 25.3 trillion of new debt, almost the same as this year, to help fund the deficit. This spending increase may not seem that significant, but it will mark the first time Japan's budget deficit has increased in five years and will inevitably call into question Prime Minister Yasuo Fukuda's resolve to cut the world's largest public debt, following the recent electoral trouncing of the LDP.

According to the Japan MoF's own figures debt of central and local governments combined will now reach 776 trillion yen by March 2009, equal to 147.2 percent of gross domestic product. That compares with 149.6 percent as of March 2008. The significance of the present decision is that this trend may now reverse, and this of course raises the issue of just when the trend can revert back to debt reduction, given the presssure of population ageing, the rising median age of voters, and the fact that Japan is actually ageing more rapidly than anticipated in earlier forecasts. Ageing population related welfare costs and interest payments on bonds now account for approximately half of total spending in the budget.


General expenditure, covering items ranging from defence and public works to social welfare and education, is projected to rise 0.7 per cent from the current fiscal year to 47.28 trillion yen, largely due to an increase in social security payments. Social welfare, which accounts for 46 per cent of general expenditure, will rise 3.0 per cent as Japan’s ageing population requires more spending on pensions and medical services.

The new budget sets aside 7.44 trillion yen for pension payments, up 5.8 per cent from the current fiscal year. The government is also planning to increase tax grants to municipal governments by 4.6 per cent to 15.61 trillion yen to respond to pressure from rural voters to increase spending in an attempt to reinvigorate regional economies.

Interestingly enough the MOF has managed to reduce new debt issuance by 0.3 per cent to the above mentioned 25.34 trillion yen, in large part by increasing non-tax revenues such as transfer of surplus funds in the foreign exchange special account to the general budget account. Oh, that trade surplus!

What all this means is that the so-called primary deficit - the excess of spending over revenue excluding bond sales and interest payments - is now set to grow to 5.2 trillion yen from this year's 4.4 trillion yen.

And remember, despite the fact that the government yesterday redced its growth forecast for the current fiscal year, it is still anticipating 1.3 percent annual growth in this fiscal, and 2 percent next year. Any slippage on this will mean an even greater tax shortfall and hence a higher budget deficit.

Japan services Index October 2007

Japan's services sector rebounded slightly in October from the biggest drop in six months. Japan's tertiary index, which is a gauge of money households and businesses spend on phone calls, power and transport etc, climbed 1.1 percent in October after dropping a revised 1.8 percent in September, the Trade Ministry said today in Tokyo.



Consumer spending accounts for more than half of Japan's economy, and this continued softening poses problems, especially should growth in exports slacken off as we enter 2008. Household sentiment fell to the lowest level in almost four years in November and bonuses grew at less than half of last year's pace. As we can see in the chart below, the year on year rate of services expansion has been clearly slowing since August.



Wholesale sales climbed 2.8 percent month on month in August as raw materials drove prices of unfinished goods higher. Indeed Japanese producer prices rose at the fastest pace in 14 months in November as crude oil surged above $99 a barrel for the first time. We should however not get too excited about this surge in some retail prices, since deflation is still a much more important problem in Japan than inflation is. Indeed, as Bloomberg tells us this morning:

The difference in yield between Japanese and U.S. 10-year bonds climbed this week to the widest in a month on signs inflation is a bigger threat in the U.S. than in Japan.

On the other hand winter bonus payments, which consumers count on to buy big-ticket items such as flat-panel televisions, rose 0.9 percent this year, compared with 2.5 percent in 2006, according to Keidanren, Japan's largest business lobby last week.



Percentages in the last two charts are all for month on month changes.

Japan in a 'Mild Recession?' ... Sounds about Right to Me

During 2007, myself and especially Feldman and Takehiro Sato from Morgan Stanley have tended to move pretty much in unison when it comes to the economic analysis on Japan (non colluding!). Of course, this is very much due to the fact that I always make sure to read, at least, what the MS' Japan analysts have to say before saying anything myself on Japan. In this way, it is one thing to actually follow other analysts whereas an entirely different thing is to agree with them. However, it just so happens that I have largely agreed with the way Sato in particular covering the day-to-day analysis and Feldman have narrated the Japanese economy in 2007. This time around however it seems that Morgan Stanley might just be trailing me and my colleagues at JEW a little bit. At least, the following sounds very much as the tone which has been banging from the pages of Alpha.Sources' Japan pages as well as of course Japan.Economy.Watch' (JEW link above) day-to-day coverage and analysis for some time now.

Japan's economy is headed for a ``mild recession'' that could be worsened should a bigger-than- expected U.S. slowdown halt the nation's export-led expansion, Morgan Stanley said.

``It's time to buckle up,'' Takehiro Sato, chief Japan economist at the investment bank, said in a report yesterday. Sato cut next year's growth estimate for Japan in half, saying ``errant'' government policy has hurt consumers and the building industry at home, and credit problems stemming from the subprime- mortgage crisis will stifle demand from abroad. The world's second-largest economy is becoming more dependent on overseas markets just as world growth looks set to slow. Policies meant to protect homeowners from building fraud and borrowers from predatory lenders have hurt an economy that's already struggling with falling wages and record gas prices. ``The foreign-demand growth scenario for Japan's economy appears to be approaching a tipping point,'' Sato said. ``Coming on top of high energy prices, the fallout from the subprime crisis and errant policies will likely cause economic activity to stagnate.'' Sato slashed his 2008 growth estimate to 0.9 percent from 1.9 percent a month ago. He considers growth of less than 1 percent ``for an extended period,'' to constitute a ``mild recession.''

Of course, you would be well entitled at this point to ask just what this idea of a mild recession actually means. According to Sato it is defined by growth in the sub 1 % category for an extended period as you can confirm above. The question would then seem to be whether in fact not Japan might be heading for negative growth rates too? Difficult to say but the risk is definitely there I think. Also, I really want to warn against the discourse which is emerging about all this being the result of errant government policy. Institutions matter for sure but Japan's economy is faced with a far more potent driving force in its population structure and the last thing we need here is really that this is neglected while politicians are taking the heat even if those very same have not exactly put in a stellar performance. The thing is, people need to get their economic reasoning straight. Back in the beginning of 2006 and as we moved onwards from the ending of ZIRP in Japan myself and my colleague Edward Hugh were literally amazed to how the majority of the economic punditry came out exclaiming that now Japan was back amongst the leaders to paraphrase the FT's otherwise excellent Martin Wolf. And now suddenly it is the blame the politicians for the fact that it did not came to pass and not by a long-shot too. Something does not smell right here and I would be very discomforted to see if all this shored up yet again on the shoulders' of the 'institutions matter' paradigm since can these shoulders really take on more load as it is? You know, there is another side to this story too and far from being mutually exclusive we need both of them; institutions, policy and governance ... oh yes and demographics? Yes please!

Ok, sorry to be a rant here in the month of Christmas but I do feel rather strongly about this I am afraid.

Japan Consumer Confidence Index November 2007

Japanese households became the most pessimistic they've been in almost four years in November as fuel and food prices rose even while wage growth remained stationary, leaving consumers even less willing and able to spend. An index that measures confidence among households with two or more people slid to 39.8 last month from 42.8 in October, the Cabinet Office said in Tokyo today. A reading below 50 means pessimists outnumber optimists.




The drop prompted the government to cut its assessment of consumer confidence for a second straight month, the first back- to-back downgrade ever. Slower consumer spending at a time when demand in Japan's major export markets may be waning will almost certainly compel the central bank to keep borrowing costs oh hold in coming months.

Japan Economy Watchers Index November 2007

Well, even while machinery manufacturers ride on the back of strong export demand, the internal situation in Japan continues to deteriorate. The latest indication of this is the November edition of the Economy Watchers Index. This survey of barbers, shopkeepers and others who deal with consumers, fell for an eighth month to 38.8 from 41.5 in October, the Cabinet Office said today in Tokyo (Japanese only at present). A number less than 50 means pessimists outnumber optimists.



And we haven't seen the bottom of this yet, since merchants expect conditions to deteriorate in the next two to three months. The outlook index fell to 38.8, the lowest since March 2003, from 43.1 in October, and the Cabinet Office downgraded its assessment for the index for a second month, saying that sentiment is "very weak" having described it simply as "weak" in October.

And confidence at small businesses, which employ more than half of the Japan's workforce, is deteriorating according to an index of sentiment published by the Shoko Chukin Bank. This survey is carried out among small and midsized companies, and fell to 46.9 in November, the eighth straight month pessimists outnumbered optimists.

Japan Machinery Orders October 2007

Japan's October machinery orders rose at a rapid 18.7% year on year clip, signaling that companies have been increasing spending plans to meet Asian and European demand for chips, cars and electronics. Private sector orders climbed 12.7 percent to 1.08 trillion yen ($9.7 billion) from September, when they fell 7.6 percent, the Cabinet Office said in Tokyo today. But the biggest push came from government orders (up 21.6%) and overseas demand (up 16%). As can be seen in the chart below (click-over for better viewing), overseas demand has been much stronger than total domestic in recent months.





Orders for manufacturing equipment climbed 10.2 percent, the Cabinet Office said. Service companies increased orders 8.8 percent. Machinery orders indicate business investment in the next three to six months.



Exports to China and Europe, we should remember, surged to a record in October prompting companies to spend more on factories and equipment. And just to remind us of this I am again reproducing the key chart, which indicates just how the composition of Japanese exports is changing, with Europe and China more than making up for an absolute and relative decline in the importance of exports to the US (on all of which see this post here).




Sales overseas, we should remember, were responsible for almost all of Japan's economic growth in the third quarter. But we should also remember that the Economies of Japan's European customers are now slowing, while China is entering a "battle of the titans" type confrontation with an inflation process which is increasingly getting out of control, with an uncertain prognosis over the immediate and mid-term future.

Japan Q3 2007 GDP Revised Down

Japan revised down its third-quarter GDP growth estimate today, surprising both market participants and the great majority economic observers - although not, it should be noted, those of us who run the Japan Economy Watch Blog, or posters at Global Economy Matters (and remember Claus was writing this last piece back in January). Neither will the result exactly catch the ever readable MacroMan unawares. The consensus view had been expecting an upward revision, and this downside surprise will undoubtedly prompt many to revise their predictions on Bank of Japan rate rises since it is reasonably clear that there is now unlikely to be further talk of raising rates until either late next year, or early 2009, at the earliest, and the possibility that the next move may be once more downwards cannot be entirely excluded.

The OECD, for example, was back again yesterday warning the BOJ not to consider raising rates until the risk of deflation becomes negligible, and IMF First Deputy Managing Director John Lipsky took a similar view in his visit to Japan all the way back in May.





According to the revised data, the Japanese economy grew at a 1.5 percent annual rate in Q3, down from the preliminary reading of 2.6 percent and well below the median forecast among those surveyed by the press for a revision to 2.7 percent.



Soft capital spending saw gross domestic product rise just 0.4 percent in July-September, compared with an initial estimate of 0.6 percent growth and lagging the consensus forecast for a revision to 0.7 percent growth.



Of course all of this is furiously re-kindling the whole debate about global decoupling/recoupling. As MacroMan ironically and aptly notes:

At last, we have evidence of decoupling! Only it's been Japan, the great recovery favourite of recent years, that has decoupled from its major-market brethren. Ironic, isn't it, how the country perched on China's doorstep is the one with the lousy growth and asset returns.

Of course why it is that Japan has suddenly "decoupled" is giving a lot of room for debate. As I noted in this post here, the US economy is proving to be much more robust than many imagined it would be, and since Japan's problem is not with exports, which are giving what little growth she is getting at the moment (0.5% points in Q3, which out of 0.4% growth ain't bad - the 0.1% point needed to get the 0.4% overall growth is acheved when you "shave-off" for a rise in inventories). And, as we can see below, the composition of Japanese exports is changing, with Europe and China more than making up for an absolute and relative decline in the importance of exports to the US see this post here.



So I think we need to be careful with some of the generalisations that are flying around at the moment about "global-recoupling". There is global recoupling going on, with the BRIC-type powerhouses moving steadily to the front, but this is not a recoupling to the US sub-prime problem in a crude and primitive sense. In the Brazil context Marcelo Carvalho aptly summed things up in his Tuesday post on MS GEF:

As the US economy appears to slide towards recession, and global growth forecasts are cut back, the debate intensifies about whether emerging markets like Brazil would be able to ‘decouple’ from the developed world’s agony. The ‘decoupling’ debate is misplaced, in our view, at least in its binary version. If the US goes into recession, does Brazil necessarily have to contract sharply? We think the answer is no. But then is Brazil fully immune? Our answer is again no. Decoupling should not be seen as a yes or no proposition, but rather as a spectrum of possibilities, in a continuum of outcomes. As usual with these matters, in medio stat virtus: the truth lies somewhere in the middle.

What is clear is that the knock-on effects of the property market slide in the US, and the growing conservatism in the banking sector about investments in first-world economy property markets (aka the credit crunch) is steadily extending the US problem globally, but that is largely a result of the fact that the property boom was a global phenomenon and not simply a US one. So, on the one hand financial investors are getting to be more sensitive to risky assets in some markets, while they are pouring money like there was no tomorrow into others.

While it is absolutely right, then, to suggest that some form or other of decoupling is taking place among some (but not by any means all) newly emerging economies (and wouldn't it be nice to have a list of those which were and those which weren't) it is not the case that we have decoupling in the form many have suggested of other G7 countries moving up to the plate to take over from a beleagured US. Rather some of these are more than likely to be decoupling on the downside (and again, it would be nice to have a list of which was which was which - Japan certainly is, and Italy, and more than likely Germany, but what about the UK, now that it has taken its own "credit crunch" hit).


Essentially the downward revision in Japanese GDP is the result of slower than appreciated capital expenditure growth, which was marked down to a 1.1 percent increase from the initial estimate of a 1.7 percent rise. The revised data also showed domestic demand shrank 0.1 percent (due to the rise in inventories, compared with a preliminary reading of 0.2 percent growth). What we need to bear in mind at this point is that as we move forward household consumption is likely to weaken further as the economy slows (and especially on the back of the multiplier effect of the drought in construction starts), governemnt spending may need to move from neutral to negative as Japan starts to get to grips with its substantial public debt problems, and investment will fluctuate on the back of movements in exports. That is, Japan will be even more dependent on exports than usual, and at this moment in time will be very sensitive to any slowdown in Europe, and of course China.

Rate-hike expectations have, naturally, been falling steadily in recent months, and this process has only accelerated of late, with swap contracts on overnight call rates now pricing-in less than a 20 percent chance of a rate hike by March. This compares with a time, as recently as only two months ago, when a rate hike by March was fully priced in.

So what we need to think about really at this point is why it is that some countries are decoupling downwards in this way, even as current conditions in parts of the global economy are incredibly favourable. And in order to do that we need to think about domestic demand, and how this varies in strength from one OECD country to another, which is why some recoveries are more "sustainable" than others. Also we should be asking ourselves why recessions are relatively longer and deeper in some countries than they are in others, since where private domestic demand is weak, the entire economy has no second foot to fall back on as external conditions change from exceptional to unfavourable, and in the case of the usual suspects trio - Japan, Germany and Italy - there is less and less the possibility of falling back on domestic public demand (the traditional automatic stabiliser) since much of the ammunition has been already spent, and the looming arrival of large numbers of dependent elderly means that fiscal rigour is - or watch out for Moody's or S&P's - increasingly the "ordre du jour".

And why does the path of private domestic demand vary so much from one developed economy to the next? Well, you could try looking at comparative population median ages.

And just to remind ourselves what long and deep means in the present context, remember that Japan has had three recessions since the stock and property market bubbles burst in the early late 1980s early 1990s. The first of these lasted 32 months from March 1991 to October 1993, and the second dragged on for 20 months from June 1997 to January 1999. The most recent recession was in the 14 months from December 2000, when the bursting of an information-technology bubble damped exports and capital investment.