Japan Industrial Output January 2008

Japan's factory output fell in January at a much faster rate than most economists were expecting. Output was down 2 percent from December, when it rose 1.4 percent, the Trade Ministry said today in Tokyo.





The report also showed that companies plan to cut production further in February, with manufacturers antipitaing that output will slide 2.9 percent from January, before rebounding by 2.8% in March. It should be noted though, that despite the monthly drop, the year on year level was still up in January. However as far as Q1 2008 growth goes this number is far from being encouraging, and does not bode well at all for the coming months.




Two weeks ago, in a general Japan analysis, Claus had this to say:

In Morgan Stanley's GEF (edition 8th of February) Takehiro Sato points towards industrial production trends as well as US GDP readings and tantamount to the forecast that Japan is heading more meager times ...

"The risk of dual recession is mounting. Our US economics team is already calling for capex-induced negative GDP growth in successive quarters (Jan-Mar, Apr-Jun), for a technical minor recession in the first half of the year by definition. We are forecasting that Japan will cling on to a modicum of growth in the Oct-Dec 2007 quarter, boosted by external demand, but there is a possibility that, like the US, that quarter will mark the peak and the economy will retreat in Jan-Mar. Future data for industrial production will tell us if this is the case."

Well, if Takehiro Sato is right, then the industrial production data are now telling us just this.

Japan Trade Statistics January 2008

Bloomberg have a pretty misleading article today on the latest set of trade figures published by the Japanese finance ministry (let's say even more misleading than I have unfortunately become rather accustomed to in the Japanese context). Basically the Bloomberg story is:

Japan's export growth unexpectedly quickened in January, as rising demand for cars and steel from China and Russia made up for falling U.S. sales. Exports, the engine that drove almost half of the economy's expansion last quarter, rose 7.7 percent, from December's 6.9 percent gain, the Finance Ministry said today in Tokyo.

And all of this is, let it be said, absolutely true. The annual rate of growth in exports in January did accelerate when compared with December (slightly), but the rate of annual increase is way down from the double digit growth figures (see chart below) achieved in the May to August period, and this seems to be the significant detail. Also since November last imports have been increasing at a faster annual rate than exports, which means that the trade balance is not increasing as rapidly as it was (indeed there was a deficit of 3.5 billion yen in January, although January is an unusual month, since ports are closed for the New Year holiday, so I wouldn't make a great deal of this at this stage), and since it is the trade balance that matters for headline GDP growth, it would seem that the net contribution from external trade is SLOWING at this point, and not as the Bloomberg slant on the story would have it, holding up well.



All the data Bloomber present, apart from this rather unhelpful slant is, of course, very much to the point. Shipments to Asia and Europe were at a record level for the month of January - up by 4.6% y-o-y to China (which the astute reader will note is below the average rate of increase in exports, so this is not a China story by any means at this point, and indeed Japan's trade deficit with China deteriorated by 5.8% y-o-y). Exports to Europe, OTOH, were up by 10% (and with Russia and Central and Estern Europe by about 40%) on a January to January basis, while shipments to the US were down 3.2%. Latin America is also starting to figure - although from a very low base, with Chile up 61% and Brazil 33%. Vietnam was up 67%, and India 44%. Indonesia was up by 26%, but Philippines is definitely not a Japanese export story, with January shipments being down nearly 10% y-o-y.

Shipments to the U.S. accounted for only about 20 percent of total exports in 2007, compared with about 30 percent in 2000. Over the same time period, China's share jumped from 7 percent to 15 percent. Sales to Russia have doubled in the last two years.

Really this sort of country-level data breakdown is going to be very interesting to follow going forward now, since it will give us some concrete reference points in that great "de-coupling re-coupling" debate. As Bloomberg point out the International Monetary Fund last month forecast emerging economies will expand 6.9 percent in 2008, compared with 1.5 percent growth in the U.S. while they anticipate that China will expand 10 percent. I would say the points to watch here are the slowdown in Europe, and the inflation problem which is steadily extending its grip from the Baltic States - where the fire first broke out - across Central and Eastern Europe (via Ukraine and Russia) and now onto China. This whole issue raises real downside doubts on that 10% China number, and also raises the spectre of a major correction in Russia and Eastern Europe at some point.

Toshihiko Fukui's Term At The BoJ

Toshihiko Fukui will retire as governor, after five years at the helm of the Bank of Japan, on the 19th March. His successor may well be announced this week. This morning in the Financial Times David Pilling has a long, and very "fair and balanced" asseessment of Fukui's time at the BoJ, which is more than worthwhile reading for those of you who would like to understand the workings of this venerable institution just a little better. As Pilling's concluding paragraphs make clear, what would seem to matter most in this case isn't so much what just happened, as what gets to happen next:

“Fukui has often been portrayed as chomping at the bit to raise rates,” says Ben Eldred of Daiwa Securities “The truth is that Fukui’s BoJ has been fairly pragmatic – waiting until relatively late in the economic cycle before raising rates, doing so only very gradually and pausing as soon as it became clear that the global economic outlook had worsened in 2007.”

The pause to which Mr Eldred refers has lasted a year. As well as a response to international circumstances, the delay also reflects the failure of the domestic economy to click into gear as Mr Fukui has long predicted. The governor has continually stressed his belief that record corporate profits will feed through into higher wages and consumer demand – a “virtuous circle” that might have been a good justification for the bank’s forward-looking policy.

Unfortunately, it has not panned out. Wages have stalled or even fallen as global competition, coupled with labour market and demographic changes, has short-circuited the normal mechanism by which profits flow into remuneration.

This has left Japan’s economy running on only one, export-led engine and flying too close to the deflationary ground for comfort. What headline inflation there has been is due almost entirely to higher oil and commodity prices. If commodity-led inflation fades – as many predict if the global economy slows – Japan could yet crash-land back into deflation.

Markets are factoring in the possibility that the BoJ’s next rate move will be down – not up as the governor has long intimated. It would be a severe blow indeed for the bank to put hard-won interest rate rises into reverse. But if the day for such a decision arrives, at least it will not be Mr Fukui’s to make.

Basically I think Fukui's big bet was that domestic consumption would prove strong enough to provide a second leg (in tandem with exports) for the Japanese economy. As Claus details at great length here (and here) - and as Pilling also seems to accept -this view seems to be inadequate, and fails to get to grips with the malaise which is affecting the Japanese economy. And as if to give just one last kick to this now thoroughly wobbly perspective, todays index for December services has just been published by the Japanese Trade Ministry. The tertiary index, which is a measure of the money households and businesses spend on things like phone calls, power and transportation, declined 0.6 percent from November. The Ministry listed the following sectors as having declined:

1. Finance and Insurance, 2. Services, 3. Compound Services, 4. Wholesale and Retail Trade. Industries that contributed to the increase are as follows:1. Eating and Drinking Places, Accommodations, 2. Real Estate, 3. Learning Support, 4. Electricity, Gas, Heat Supply and Water, 5. Medical, Health Care and Welfare.

Although the index actually rose some 0.2 percent over the fourth quarter, this latest sign of weakening will certainly not come as good news for Fukui as he prepares to clear up his desk.

Q&A on Japan

In the context of Francois Guillaume's pertinent comments and questions to my review and preview note and in the light of today's much surprising Q4 GDP release I have chosen to present my comments and answers to Francois' questions/comments above the fold à la Q&A.

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1) GDP much higher than expected...how do you explain that ??

I want to focus on two issues here. First of all, the current figures are preliminary and in this light I expect to see a downward revision in March. In this light, we need to realize I think that given the incoming stream of data we have seen from the three months of Q4 2007 this figure of 3.7% (Q4 YoY) is pretty hard to justify. For a reasonable take on the whole situation Graham Davis from the Economist Intelligence Unit had a good overview I think in his interview with Bloomberg (can’t hyperlink to the clip I am afraid). Also, we should note I think a comment made recently by Takehiro Sato over at Morgan Stanley’s GEF …

Incidentally, in Japan’s case, quarterly GDP data are too volatile to be a suitable criterion for calling the economic cycle. This is clear from the GDP trend in past recessions. Yet while GDP has at times been positive when the economy is in retreat, industrial production has consistently mirrored the downward path of the economy. It seems reasonable to say that the critical factor for assessing the economic cycle is simply the direction of industrial production.

However, if we accept the figure as it is I still don’t think that the underlying path of the Japanese economy has changed even if the level seems somewhat too high. Let me consequently highlight some of the snippets from Bloomberg’s report on the break-up of the GDP components as well as the much more detailed break-up provided by Edward vis-à-vis the official estimate provided by the Cabinet office. What thus seems clear to me is that although consumption rose in the last half of 2007 net exports and by derivative capex continues to drive forward Japan on the margin. Remember that we need to talk about levels here too since private consumption commands a much larger share in the Japanese economy than does both investment and net exports. Let us try to annualize the quarterly growth rates in both real and nominal terms which yields a quite different picture. In real terms Japan thus grew 1.8% through 2007 and in nominal terms we are down to a rather un-impressing 0.6%. Particularly for Q4 the figures are 0.9% and 0.3% for real and nominal growth rates respectively. In this way, the GDP deflator is a welcome alternative to the CPI index in that it accounts for the change in prices relative to what consumers actually buy in the measurement period. Thus note in passing the following from Bloomberg …

Rising oil prices may have boosted growth in real terms. The GDP deflator, a broad measure of prices used to calculate real growth from nominal, fell 1.3 percent from a year earlier, the biggest drop since the first quarter of 2006. The deflator is adjusted downwards when oil prices rise. In nominal terms the economy grew an annual 1.2 percent in the fourth quarter.

I am going to discuss this more below since inflation measurement is clearly one of those areas where data mining and basket building can be used to construct just about any kind of number you would like. In this way, all these kinds of inflation adjusted growth rates etc need to be taken with a pinch of salt. In conclusion on the GDP figures I think the following is important to note. First of all, this is good news since it indicates, all things equal, that Japan has defied at least some of the claims that a recession/slowdown is imminent. However, I am not sure how much valuable information we can reasonably derive from the figures at this point. First of all, I think these figures are in for a haircut once they are subject to revision. Yet, even if we rely on them such as they are I think that it is reasonably clear how for example the value component of energy prices might have pushed up the real GDP to unrealistically high levels if we consider the underlying trend.

2) Inflation: see my previous posts: CPI is just a price index. Its definition is very different from a country to another. Change in the index & methodology would give a total different picture. Most important is the trend of the index itself, and the recent trend is up. It’s ridiculous to speak of deflation any more. CPI has been ranging from -2% to 1% in last years. It doesnt make a lot of difference. Asset-prices are more important: Nikkei is still nearly more than 80% off 2003 lows, real estate in central Tokyo as well despite being off its highs probably by 20% at least.

Unfortunately I am not sure about which posts Francois is referring to here but nevertheless he fires off a lot of reasonable questions here. First of all, I completely agree with the point on methodology. Since the CPI is based on a basket which can be changed and re-weighted and since the CPI may or may not include headline inflation what we end up with is a veritable mind field of potential ‘best practices’. This also means that whatever the picture you want you can rig the data so that your specific view of the world emerges. I don’t think however that this is what I have falling victim to in my analysis of Japan. In my opinion, the price movements in Japan both in the most recent period as well as in 4-5 year perspective show two things. First of all, there is the overall level of inflation which has been very low and essentially negative. This, coupled with the very aggressive monetary regime put in place to normalize conditions indicates I think that there is indeed ‘something funny’ about consumption and domestic demand in Japan and this is what has led me to conclude that the whole price edifice in Japan has something to do with the population structure of the country. Secondly and in the more immediate context the recent divergence between input and output prices further support my claim that price dynamics in Japan do not follow the theories we can discern from macroeconomic textbooks and traditional empirical studies. Moreover, it obviously suggests that the equality often exclaimed in the financial press between the return to inflation and economic recovery is wrong.

Now, all this leads me to disagree with Francoise when he says It doesnt make a lot of difference. I think it does although I do agree that asset price deflation/inflation is extremely important too. In this respect the Nikkei is mentioned being considerably off its low levels of 2003 as well as those much debated Tokyo real estates have seen hefty increases in price. Both these points are very important to take aboard I think and merits, at least a bit, that Japan has moved on. Of course, the most recent developments in the Japanese housing sector suggest that the construction/residential sector in Japan might very well be in for a more difficult future but let us leave this point here. However, what about another kind of asset in the form of human capital? How does the value of this asset stand? Well, as we have observed one of the recent trademarks of the Japanese labour market has been a consistent decline in wages and the transition from a labour market of full time workers to part time workers (on the margin of course). Since aggregate national wages essentially can be seen as a measure/reflection of the national labour productivity (either absolute or per/hour) what does this imply for the general price level in Japan? As can be seen, this readily becomes rather complicated. Another reason as to why inflation matters has to do with the workings of a modern economy is monetary policy. Quite simply, deflation or next to no inflation has implications for the workings of monetary policy as well as it has implications for the consumption dynamics of the society. More importantly, we have seen the condition of deflation in Japan and subsequent low interest rates have had notable externalities on the global economy. So, I would say that it does indeed matter.

3) Monetary policy. I fear there could be a big misconception on USD buying interventions. MOF as you know is running a hell lot of debt. It is short Yen cash. But it seems to me that most of the FX intervention is executed by BOJ, but on behalf of the MOF. So when MOF buys USD, it needs to borrow even more JPY. But with the end of Quantitative easing, they can’t issue as many Financial Bills to back them as they would like to (because BOJ would basically buy an unlimited amount of them @ 0% before.) I think that with the deterioration of public finances, it becomes harder to do such intervention. So I see just a lot of talk, not much more.

Here I stand corrected. Consequently, I had not, in my analysis of the JPY and subsequent potential for intervention, thought about the perspective Francois presents here. It is very interesting I think. Now, for some of our readers this may seem a bit complicated but what Francois is saying is simply that absent quantitative easing/ZIRP it becomes more ‘expensive’ for the MOF to intervene since they cannot be sure that they are able to offload the subsequent debt. Of course, this also paves the way for a rather perverse scenario. Consider thus that the JPY is driven largely by risk sentiment at the moment. If the BOJ sees it fit to lower rates during the course of 2008 and perhaps even returns to ZIRP we could expect the JPY to shoot up given we accept the current market dynamics. Note in passing here that this morning’s GDP release has been followed by a depreciation of the JPY which shows the disconnect between the fundamentals and the JPY. In this way, a return to ZIRP or just a drop to 0.25% could in this context be followed by an increased in the pressure to intervene. Of course, this is not a plausible scenario at this point but still goes to show the potential dynamics as we move forward.

4) JPY everybody I talk to is bullish on the JPY... maybe that is why it is so sticky now...but its way off its lows against many crosses.

As I have said above and also in my recent review and preview the JPY remains wholly disconnected from the fundamentals of the Japanese economy. I concur with Francois that the sentiment on the JPY at the moment seems to be bullish given the general risk sentiment in the markets. At time of writing it is sniffing at 108+ which is outside the recent weeks’ range of 106-107. It is difficult to see where it goes from here. I am expecting this ‘stickiness’ theme to dominate since it is unclear I think whether market conditions would favor a move below 105 or upwards to 110.

5) Long term interest rates... the credit markets have imploded in less than a year. My prediction is for a failure of a big govt bond market in 5 to 10y time. Japan would be an obvious candidate. In that scenario, long term interest rates are heading HIGHER. Just people will be tired to be stuck with low interest rates when there is inflation everywhere. But in the short term, as the asset-bubble is deflating, and this process is not over, global govt bonds will remain for some time the asset of choice, by default.

Now, this is very interesting in my opinion. Whether or not we will see a failure in a government bond market is an open question subject to one of those rather long term falsification clauses. I have argued before that in the context of countries such as Japan and Italy it will, at some point, cease to make sense in ‘rating’ the sovereign debt market based on the same criteria as you treat e.g. India, the US etc. Quite simply, this will become unfeasible as we move forward since this would push these countries into a technical default. As Francois alludes this may of course come to pass some way or another not because of the rating agencies themselves but rather because with inflation the nominal yield may become too unattractive. Note also that once we enter this discussion we also enter a whole gamut of issues in the context of Japan in the sense that the BOJ and the MOF is in a double bind. On the one hand the BOJ faces external pressure (those externalities again) to raise or more aptly to normalize rates but it finds this difficult because deflation still dominates the general price level. Moreover, a transition towards whatever the interest level we assert to be normal would most likely drive up the value of the JPY and thus further lead to deflationary pressures. We should also consider the simple points that as interest go up the debt becomes more expensive to service and in this way the MOF has a distinct interest in keeping interest rates down. Within this framework headline inflation pressures are of course simply a further pinch it seems not least because of the reasons mentioned by Francois.

This topic on sovereign debt and long term interest rates is very important I think but for now I think that I will lower my guns. Thanks for Francois for the comments. Needless to say, here at JEW (and at Alpha.Sources) we always appreciate to be challenged on our views and opinions.

Japan Q4 2007 GDP Preliminary Estimate

Well the preliminary Q4 GDP numbers are now out and they are definitely better than expected. Japan's economy grew at an annualised rate of 3.7 percent in the last quarter of 2007, and this was at least double the pace most economists were expecting, as strong business investment and exports to Asia and Europe helped the Japanese economy weather the U.S. slowdown. Gross domestic product in the three months which ended Dec. 31 accelerated from a 1.3 percent annualised rate expansion in the third quarter, according to data released by the Japanese Cabinet Office in Tokyo today. We need to be a little carfeul in using these annualised rates, since they are derived by simply multiplying quarterly rates by 4, but still whole year growth for 2007, according to the first preliminary estimate, was 2.1%, which compares with 2.4% in 2006 and 1.9% in 2005, so the final result is not at all - by current Japanese standards - a bad one.



On a quarter-on-quarter basis, growth in Q4 was at 0.9%, up from 0.3% in Q3, and the -0.4% contraction in the second quarter.So it is clear that, despite all the negative sentiment we have been faithfully recording here, the Japanese economy actually accelerated in the second half of 2007 and this despite the dramatic slowdown in residential housing. The big question - as Francois reasonably asks in comments to Claus's last post - why?

I freely admit these results have surprised me, as I was expecting something significantly worse. But I suppose we should to some extent have seen this coming. Growth in Q2 was very bad, and the rebound in Q3 was relatively weak, yet all those export numbers we have also been recording over the months - and the surprise upside in consumption in December - should have been some sort of indication. Plus government spending in the last quarter seems to have been pretty strong. Lets take a look at some of the details.

I have made the following charts on a simple cut-and-paste basis from the PDF summary file provided by the cabinet office, but I think they may help people to see what is happening at a glance, since they show either the percentage contributions of the more important components to growth or the quarterly percentage growth rates (depending), and hence may make what are otherwise pretty dry numbers a bit more real. Firstly the evolution in real quarterly GDP growth (all the charts are based on real, not nominal, data).



If we now come to look at the comparative role of exports and domestic demand, we can see that while the role of exports continues to be strong (and is much better in both Q3 and Q4 when compared with Q2) the share was actually down slightly on Q3, so exports aren't the whole story here by any means, since domestic demand moved from being a negative 0.4% drag in Q3 to a positive 0.5% boost in Q4.



Household consumption was up slightly, contributing 0.2 percentage points to growth:



The decline in residential construction continued and even accelerated across Q4 (residential construction declined by 9.1% over the previous quarter when it declined by 8.3% from Q2, although the rate of decline may well have been slowing off in November and December).



Private non-residential investment (or fixed capital formation) grew strongly in Q4. Could we interpret this as a response to the stronger than expected performance in exports in the face of the US slowdown?



But perhaps the biggest surprise of all comes from government consumption, which grew 0.8% over the previous quarter, contributing 0.1 percentage points to quarterly growth.




So to go back to Francois original question, about how to account for the Q4 performance, could we say some small improvement in household consumption, sustained export growth, an increase in government consumption (perhaps undertaken to offset the impact of the housing contraction), and a large rise in investment, as I say possibly the outcome of the strong performance in exports and the reasonable domestic consumption outcome leading people to be a wee bit more optimistic about the immediate future.

And here's a bit of news I just saw in Bloomberg that may help explain some of what is happening on the exports front:

Japan's shipments of construction machinery may rise 9 percent to a third straight annual record next fiscal year as building and mining booms in Asia drive demand for earthmovers built by Komatsu Ltd. and its rivals.

Shipments of excavators, tractors, cranes and other construction machinery may climb to 2.6 trillion yen ($24 billion) in the year starting April 1, according to estimates released by the Tokyo-based Japan Construction Equipment Manufacturers Association today. Shipments in the year ending March 31 may reach 2.4 trillion yen, 15 percent more than the previous year.

China's effort to develop its hinterland, oil-funded construction booms in Russia and the Gulf nations, and mining projects in Southeast Asia have countered the housing recession in the U.S., the world's biggest market for earthmoving equipment. The demand has prompted Komatsu and Hitachi Construction Machinery Co., Japan's biggest makers of earthmoving machinery, to expand factories and boost production.

Review and Preview on Japan

(Cross-post from Alpha.Sources)

I realize that I am moving in a bit late with this but the data I use to input in my analysis only recently came out for December 2007. More generally, this post is going to be quite big since I have a lot of things I want to get off my chest this time around. I have two main areas of focus I want to cover.

• Firstly I want to finalise my analysis of Japan in 2007 with the December data for consumption expenditures and prices.

• Secondly, I want to continue with a general assessment of two of the main market points in Japan at the moment. The Yen and the BOJ rate policy faced with an incoming slowdown and potential recession.

As for the general situation in Japan I am sure it has not escaped your attention that Japan now seems set to enter a recession. The only question will be the extent and more importantly the length of the slump. In Morgan Stanley's GEF (edition 8th of February) Takehiro Sato points towards industrial production trends as well as US GDP readings and tantamount to the forecast that Japan is heading more meager times ...

The risk of dual recession is mounting. Our US economics team is already calling for capex-induced negative GDP growth in successive quarters (Jan-Mar, Apr-Jun), for a technical minor recession in the first half of the year by definition. We are forecasting that Japan will cling on to a modicum of growth in the Oct-Dec 2007 quarter, boosted by external demand, but there is a possibility that, like the US, that quarter will mark the peak and the economy will retreat in Jan-Mar. Future data for industrial production will tell us if this is the case.

This note will not focus on figures for industrial production or US GDP stats but rather I will initially move in with my traditional focus on the internal demand dynamics in Japan. As ever, the Japan Economy Watch contains the latest cyclical indicators fresh in off the wire in order to bring you up to speed. Here at Alpha.Sources I made a note recently which also sums up the most recent trends and pieces of data. For now, let us turn to the updated charts which usually form the main edifice of my analysis of Japan ...

If we begin with prices we see that inflation, at a first glance, seems to have returned to the shores of Japan even to such an extent that I will soon need to adjust the y-axis of my graph (and yes, this is an apology for a sloppy excel graph). Yet, the most important point to take away from this is, as I have been at pains to hammer home before, the disconnect between the inflation indices. Core inflation as measured by inflation ex food and energy prices is still in negative territory whereas the general index is shooting up thanks to headline inflation. This disconnect suggests that the inflation we are seeing in Japan is not driven by demand factors (demand pull) but rather by supply factors (cost push) and thus this does not signal an impending Japanese recovery. Quite the contrary in fact as the spurt of inflation at this particular point in time will only further pinch an already troubled Japanese consumer. Edward also moves in with a much worth while analysis of the inflation issues in Japan. A key point here will be the extent to which future inflation readings will have a bearing on the BOJ's decision to actually move in with a cut in the already low interest rate of 0.5% in order to accommodate a slumping economy. I don't think Fukui will cut rates before his term ends this spring and given the debacle which may arise in the context of finding a new governor it seems that economic fundamentals should not be the only thing to watch in order to make a call. What seems obvious however is that if inflation pressures suddenly show signs on abating the door will be open for a cut.

If we turn to the indicators for domestic demand proxied by various measures of consumption expenditures we can also close the book on my forecasts for 2007. As such, I dared to venture that growth in consumption expenditures would not increase by more than 1% on a y-o-y basis. Let us look at what we have.

Let us start by the forecast first. As can be observed the Japanese consumers put in a strong showing in December on a y-o-y basis with a 2.2% increase. I have to say that this figure represents something of a fluke for me since if you look at the underlying indicators such as income, retail sales and department store sales they all clocked in with declines. Ken Worsley also ponders the 2.2% increase and provides a detailed break-down which shows how spending on culture and recreation as well as furniture and household utensils accounted for a substantial part of the increase. I have to agree with Worsley though when it comes to January and beyond where the rise in energy prices, declining income, and a general slumping confidence will be sure to slow spending considerably. As for the forecast, the December reading almost had my forecast shattered or, if you will, assured that I was very close to the mark. Consequently, the mean value of the increase in consumption expenditures was a 0.95% monthly y-o-y growth rate. The two remaining charts are merely there for differentiation. The average value for the m-o-m chart was 0.217% in 2007 and together with the y-o-y figure it shows the momentum and level of growth rates we can expect from Japanese internal demand in a given economic environment. The long term index anchors my analysis in the sense that it supports the general hypothesis that domestic demand is on a structural decline in Japan and that this might very well be due to the demographic profile of Japan, this last point of course being a hypothesis of mine. In terms of forecasts for 2008 I have no trouble extending my forecast of an increase of <1% in domestic demand proxied by consumption expenditures (i.e. a strict consumption definition of internal demand dynamics). This may even seem too easy as 2008 is set to become a somewhat tough year for Japan economically speaking. This was thus it for Japan in 2007 and as is readily clear 2008 promises to bring with it a rather choppy ride for Japan. I will of course continue with my analysis as we move forward. Before I finish I want to make a leap up towards current events and assess a couple of mounting issues in the context of Japan.

Firstly, I think that the Yen demands some attention. Recently, I noted how the Yen was driven by anything but macroeconomic fundamentals. This clearly still seems to be the case. However, the main question is when this will end? At the moment and if you look at the FX price action in the beginning of 2008 almost all Yen crosses have been correlated with the stock market and thus by derivative the general sentiment of risk aversion in the market. This is nothing new in the sense that since the subprime market hit the global economy in the middle of August 2007 the Yen has been the main canary in the coalmine when it comes to the risk sentiment in the market. Yet, the Yen is not only driven by cyclical factors. As such, the decline in home bias of Japanese investors as well as the general yield disadvantage of Japan suggests that all those talks about an undervalued Yen aren't clued in to what is really going on in the sense that what is really the fair Yen value at this point? We need to think about the fact that the whole global economy seems to be undergoing the initial phases of a much more structural correction (recoupling) and in this context it is difficult to see how the Yen can stand its ground. It might not happen today or tomorrow but I have difficulties seeing how the risk aversion dynamic can hold the ground for the more wider and structural trend. Turning to more immediate drivers of the Yen the potential that Japan would intervene in currency markets to cushion the Yen's depreciation has reared its head with regular intervals. Back in early November I asked the question putting the limit at 105 for the USD/YEN which. Various other estimates have been around. Morgan Stanley's Stephen Jen puts it at 100 which is just the same as Macro Man. Recently, currency strategist at Dailyfx Boris Schlossberg kept the speculations alive suggesting, as me, that 105 just might be the threshold for Japan. Currently the Yen is hovering in the region of 106-107 and in this light Boris' conclusion seems to be a sound one, if a bit noncommittal, to take with you in the trenches of FX trading.

While there is certainly no guarantee that the BOJ will intervene at the 105-100 area, economic factors and positioning data suggest that Governor Fukui and company may indeed opt for that solution. Given that possibility the above mentioned strategies should hopefully minimize risk and optimize return for both momentum and carry traders. At the very least traders should pay particular attention to the price action if USDJPY slides down to the 105 level in the near future.

From a macroeconomic point of view this makes sense. Japan is largely dependant on exports to fuel growth as well as need to remember that an appreciating currency is deflationary and Japan has not escaped those fangs just yet. As for the Yen all evidence seems to point towards a continuation of current trends for the immediate future with the Yen acting as a global parameter of risk and investors' risk aversion. In this light, the risk of intervention needs to be weighed in as a potential market mover as we move forward.

The second topic I want to cover has already been mentioned above and essentially also cuts across the whole discussion on the Yen. In short, what will we see from the BOJ? Perhaps the most important thing to note here is that before we get to the discussion of what exactly the policy rate will be as we move forward into 2008 the BOJ will need a new governor. As I noted in my long end-of-2007 note this may well turn out to be quite a messy affair. Whether the shift of guards at the BOJ will turn into the political gridlock many observers have indicated is difficult to see from my desk here in Europe. However, there are some clear risks. As I have argued before a situation of political stalemate in which the Democratic Party of Japan (DPJ) will use their majority in the upper house to stall the nomination of a new governor will, all things equal, bring the MOF closer to monetary policy making. Basic logic would, in such a situation, call for a freeze of the nominal interest rate until the new BOJ leadership is set to assume their seats. However, if this current slowdown turns for the worse it may provoke measures which at this point in time might seem unrealistic. One risk is thus that Japan re-enters ZIRP over the course of 2008 and that this happens sooner rather than later. Before this materializes however, I am quite happy moving in behind the Morgan Stanley team in forecasting a cut in the main refi rate for Q2 2008.

In Conclusion

A lot of ground has already been covered in this piece and as such I think it is time to move in with some summarising remarks. I had two main objectives in this note. Firstly, I finalised my monthly analysis of consumption expenditures (domestic demand) and prices for 2007. Even though 2007 most likely will go down as a rather strong year in relative terms the failure of the overall consumption expenditure gauge to break the 1% threshold YoY tentatively suggests that domestic demand cannot become a driver of growth in Japan in any given sense. This point was underpinned by the monthly and long terms indicators of consumption. In connection to prices, we observed how inflation seems to be coming back to Japan. Yet, if we strip out energy and food Japan is still stuck in deflation and even though the core-of-core index might also nudge up towards positive territory the transmission mechanism from headline inflation to core inflation does not suggest that the inflation pressures we are seeing are driven by buoyant domestic demand. This does not warrant complacency against inflation but tells a story which needs to be told I feel if you really want to understand what is going on in Japan.

I also had a brief look at the Yen and more specifically the driver of the currency. I concluded that while risk sentiment seems to be the main trend explaining the current movements more general structural forces should not be neglected. The key issue here is timing and thus the dynamic relationship between the immediate environment and the more long term structural trends. Moreover, I also reviewed the latest speculation that we will observe intervention in the FX market by MOF and the BOJ. At this point, we have no clear indication that this will occur but I think the possbility should be entertained that the MOF will dip its toe at some point. In terms of the the BOJ and a subsequent call on the rate policy in Japan I moved in behind Morgan Stanley noting that Q2 2008 will see a cut to 0.25%. Another factor which I discussed was the extent to which the departure of governor Fukui will result in a policy gridlock. The risk is definitely there I would argue and it is a possibility which should be taken into account. I think that such a gridlock would (and should) result in a an effective standstill of rate movements but if the slump turns for the worse new dynamics may come into play where the MOF moves in to 'politically' steer down interest rates. Whether 2008 will see ZIRP is still an open question I think. I believe the probability is fairly high not least because I think that the recession we are now seeing on the horizon may very well be more severe than many expect. The main question however is not centered on the slowdown in Japan per se. This is the nature of economic cycles in the sense that they go up and down; yet, what remains the most compelling question in Japan's case is just how far and how long it will be this time.

Japan Consumer Confidence January 2008

Since Claus has just written a substantial analysis, this is just a brief note to keep the data up to date. The news, hardly unexpectedly, isn't good, since Japan's consumer confidence dropped in January to its lowest level in more than four years as rising prices and falling wages continued to squeeze households. The Consumer Confidence Index fell to 37.5 last month from 38 in December, according to the Cabinet Office in Tokyo today. Confidence among consumers hasn't been this low since June 2003.



Inflation expectations have certainly arrived although, if we look at what Claus has to say about core-core prices, they may yet turn out to be disappointed as the year advances, and a record 84.9 percent of those questioned said they thought prices would be higher in a year.

The Cabinet Office left its assessment of sentiment unchanged for a second month, describing it as ``deteriorating.''

In terms of the sub-indexes, both the employment component and the willingness to buy one continued to deteriorate, with employment falling to 38.6 from 40.6 in December and willingness to buy falling to 36.7 from 37. As can be seen in the chart below these have both been on a downward trend for some months now.

Japan Economy Watchers Index January 2008

Japanese merchant sentiment fell to a six-year low in January as stagnant wages and rising oil and food prices forced consumers to cut back on spending. The Economy Watchers index, a survey of barbers, shopkeepers and others who deal directly with consumers, fell to 31.8 in January from 36.6 in December. This is the biggest monthly drop ever the Cabinet Office said today in Tokyo.





The index is now at the same level as it was when Japan was when Japan last entered recession in 2001. The Cabinet Office downgraded its assessment for the index for the first time in three months, saying that sentiment is "worse than very weak." The classification in December was "very weak".

In the face of the evidence people are now begining to adjust their positions. Bank of Japan Governor Toshihiko Fukui said today the cycle of profits feeding into wages and consumption that he had consistently argued had supported what has been on some measures Japan's longest postwar expansion is now "temporarily weakening", of course we are about to see how long "temporarily" actually means, since on many measures earnings and consumption have never been strong during the expanision phase, so what they will look like during the contraction one is anyone's guess. Consumers are currently being squeezed by falling wages, a tighter job market and a 14 percent plunge in the Nikkei 225 Stock Average.

There is a lot of speculation around about the precise meaning of the fact that household spending actuall rose 2.2 percent year on year in December even as consumer confidence dropped to a four-year low. "Consumer spending is solid, even though consumer confidence has deteriorated considerably" central bank Deputy Governor Kazumasa Iwata said yesterday. My own personal feeling if we now look at all the other indicators, is that this must have been a blip (and also December 2006 was a reasonably low level), but still we will soon start to find out when we get the January data.

Consumer confidence remains at a four-year low and companies keep a tight lid on wages even as they pare-back hiring as demand slows. Indeed wages had their biggest drop in three years in December, making it unlikely in my view that the consumer will step up to help the world's second-largest economy overcome slower export demand.

Japan Machinery Orders December 2007

Japan's machinery orders fell for the second consecutive month in December as manufacturers scaled back investment in anticipation of slowing global economic growth. Machinery orders which provide us with a useful indicator of business spending for the coming three to six months, dropped by 6.8% in December from November (on a seasonally adjusted basis) the Cabinet Office said today in Tokyo. In November total orders fell from October by 5.9%. Export orders fell 4.9% from November, when they fell 18.4% from October. So there is strong prima facie evidence that export growth may be week in Q1 2008.



Over the October-December quarter orders rose by 2.5% compared with July-Sept on a seasonally adjusted basis. Private sector orders fell 4 percent in 2007 compared with 2006, the first decline since 2002 when the economy emerged from recession.

The data on machinery orders only confirms the impression given in other reports earlier this week which all tend to show that the Japanese economy is hovering around the recession mark. The leading indicator of the economic outlook this week signaled for a fifth straight month that growth is losing steam. Manufacturers are also signalling they plan to cut production in January and February, the first time they anticipate back-to-back declines since 2005, a Trade Ministry report showed last month. Each of Japan's three previous recessions since 1991 have been initiated by output slumps.

Japan Index of Leading Indicators December 2007

Japan's leading index, which is the government's broadest indicator of the economic outlook today signaled slowing economic growth for a fifth consecutive month. The leading index was at 40 percent in December, below the threshold of 50 that signals growth will slow in the next three to six months, the Cabinet Office said today.




Nonetheless the reading is up on November's 10, and if you look at the chart there has been a steady rebound since September's "horrible" zero. Since the index is claimed to reflect growth three months forward it does not seem to have been performing too badly last year, contracting somewhat in the February to April period before the Q2 GDP contraction, and then was well up in June and July, anticipating the growth recovery in Q3. So if September's reading is anything to go by, Q4 may well surprise on the downside. The rebound suggests that Japan GDP will continue to be weak in Q1 2008, but that the brake won't be being slammed on so hard as it was towards the end of 2007.

The Q4 GDP report is expected to show that net exports accounted for most of Japan's growth for the second consecutive quarter, with housing and deomestic consumption remaining weak. We will all know soon enough since the Cabinet Office will release the preliminary GDP report on Feb. 14 at 8:50 a.m. in Tokyo.