Double Dip Alert In Japan

Despite recent optimism about the apparent renaisance of growth in the Japanese economy, and the heightened sense of enthusiasm which surrounds the surge in economic activity right across the Asian continent there are considerable grounds for caution about the sustainability of the Japanese recovery itself.

The first of these is to be found in the fact that, as has become plain from the latest batch of data releases, Japanese manufacturers are continuing to curb both capital spending, salaries and workforces, making any recovery in domestic demand driven by “second round” effects extremely unlikely. A further reason for having second thoughts is the long term decline in the level of Japan’s trend growth, which has fallen substantially over the last two decades under the impact of its shrinking and ageing workforce. Thus whatever the initial rebound, without the aid of strong demand elsewhere it is completely unrealistic to anticipate strong sustained growth in the Japanese case. And lastly it is evident that whatever the recent optimism Japan's economy still faces major challenges, and in particular the risk of getting caught in yet another deflationary spiral, a danger which was recently highlighted by the announcement that prices fell at the fastet rate in half a century in October.

Indeed, fears that recent figures suggesting a robust recovery may have been a false dawn were only intensified last week when the Prime Minister himself sounded the official alarm that the country risked falling into a “double-dip” recession. With Japan’s export industry still reeling under the weight of the earlier sharp fall, and now bedeviled by both the plunge back into deflation and and soaring yen, Yukio Hatoyama made it plain that additional “measures are required so that the economy will not fall into a double-dip recession”. This warning, it seems to me, is not mere rhetoric, part of a political tussle between the government and the Bank of Japan, but refelects genuine concerns, concerns which have only been added to by the October industrial output data, and the November PMI readings. Clearly, any recovery from such a strong output fall as Japan has suffered was always going to incorporate some sort of initial momentum surge as final demand eventually adjusted to the sharp inventory run-down, but maintaining this momentum get harder and harder as we move forward, and the question we need to ask our selves is, "has all the low lying fruit now been picked".

Certainly the Japanese government fears it might have been, and has now made plain that it is going to introduce a further spending package to fight deflation and to ease the impact of the stronger yen. At the same time they have called on the Bank of Japan to take stronger measures to support growth and avoid deflation. “There’s a risk that excessive currency movements, along with deflation, will hurt Japan’s recovery,” the government statement said. “The government will compile stimulus measures this week and closely monitor currency markets,” it added, without elaborating on the size of the package, while Finance Minister Hirohisa Fujii has been adding to the pressure on the central bank by explicitly suggesting quantitative easing would “help” the economy.

The yen surged to a 14-year high against the dollar last week, only adding to the concern that a stronger currency will bring Japan’s recovery from its worst postwar recession to an early and untimely halt.

False Dawns?


At first sight Japan’s situation seems reassuring, since the economy seemed to have rebounded sharply in the third quarter as strong government stimulus measures sustained consumer spending and exports to rapidly growing Asian neighbours leapt upwards. The preliminary headline GDP reading even outpaced most economists' expectations, since the economy was estimated to have grown by 1.2% over the previous quarter (or at a 4.8% annualized pace).



This was the second consecutive quarter of expansion, following four successive quarters of contraction, and the apparent pace was a marked acceleration over the 2.7% annualized pace of the April to June period. But even before the champagne bottles were uncorked nagging doubts started to appear, in the shape of the domestic demand deflator – a measure of the changes in the price of goods and services - plunged by 2.6%, the fastest pace of price decline recorded since as far back as 1958. This was the third straight quarter of falling prices in Japan, and since there is no real likelihood that this situation is going to be reversed soon the government has now officially recognised that Japan is back in deflation.



In fact Japan's general index of consumer prices fell by 2.5% year on year in October, as compared with a 2.2% drop in the two preceding months. The headline figure was dragged down by a 6.8% drop in the cost of fresh food. Stripping out this component, deflation in core prices slowed slightly, to minus 2.2% compared with minus 2.3% in September. Although transport and communication costs continued to fall, the 4.6% contraction was the smallest fall in six months. The cost of housing fell by 0.3% and the cost of utilities fell by 9%, in both cases showing very little change from the previous month. When energy costs as well as fresh food are excluded, October prices were down by 1.1% after falling by 1.0% in September.

But looking beyond deflation more grounds for concern emerged as analysts realised that the contribution of private consumer spending to growth actual fell back in the third quarter (mirroring an effect I have already drawn attention to in Germany), offering yet more evidence of the limits measures to convert Japan from export to domestic-demand-led growth were up against. Private consumer spending, which accounts for more than half of Japan's GDP, rose 0.7% on quarter, compared with a revised 1% climb in April-June. Worse, almost everyone recognises that both these increases were largely the outcome of the previous Liberal Democratic Party-led government's economic stimulus programme, including as it did handing out cash to consumers and rebates for people buying energy-saving home electronics.

Finally, just last week we learn that revised estimates of capital expenditure by Japanese companies suggest that this fell at a faster-than-expected pace of 24.8% (from a year earlier) during the third quarter, as export pessimism in the face of a steadily rising yen and a struggle to show healthy profit numbers pushed managers towards holding off on new investment.



In fact the July to October data mark the 10th straight quarterly decline in capex spending, and follow a 21.7% year in year drop berween April and June. The latest estimate is being seen by analysts as rather a bad omen, and habinger of bad news about to arrive, since the data will be used to carry out the first revision of the gross domestic product figures, and it is clear Japan is now about to cut the preliminary GDP reading sharply. Estimates of how large the write down will be vary, with anything between 0.9% (3.6% annualised) and 0.3% (or 1.2% annualised), which would mean virtually no real growth at all in the third quarter if you take into account the fact that inventory build-up accounted for 0.4 percentage points of the healine number. In any event this part will be clear when we get the new estimate later this week. Whatever the final number the news will be bad enough, unfortunately however there is more to come.

Industrial Output Slows

It is now abundantly clear that the earlier surge in Japanese industrial output is now slowing, and the latest official data show it rose only 0.5% between September and October, far less than the 2.5% range in economist forecasts, and so despite everything compared to October 2008 industrial output was still down by 15.1%. So while Japanese industry is rebounding, it is hardly surging, and we are left asking ourselves, has all the low lying fruit now been picked?

The results of the November manufacturing PMI survey seem to suggest that they have, since despite remaining above the neutral 50.0 level for yet another month , the seasonally adjusted headline Nomura/JMMA Purchasing Managers’ Index fell from Octobers 54.3 reading to a four-month low of 52.3, suggesting that growth in the Japanese manufacturing sector continued to lose momentum, and that growth in the fourth quarter will be even weaker than the revised third quarter number, and may well be negative. The survey organisers reported slower growth of both output and new business, even if job shedding eased to its weakest rate for fifteen months, while output price deflation the hit the fastest rate since December 2001.

In addition pre-production inventories were reduced for the ninth month running.



Commenting on the Nomura/JMMA Japan Manufacturing PMI data, Minoru Nogimori, Economist of Financial & Economic Research Centre at Nomura, said:

“The Japan Manufacturing PMI fell 2.0 points to 52.3 in November. Although it remains above the key dividing line of 50.0, it fell for the second consecutive month, suggesting that the pace of improvement in operation conditions is slowing. The New Export Orders Index also fell by 1.1 points to 50.5, signalling that the rate of expansion in export orders has obviously slowed. We see growth of Japanese production activity decelerating, owing to the fading impact of economic rebounds overseas, yen appreciation and as government stimulus measures start to wane.”

And Services Wallow In The Mire

And Japanese services are hardly doing better, since the headline seasonally adjusted Nomura Business Activity Index fell for the third successive month to 42.3 in November, from 45.0 in October, indicating that sharp and ongoing contraction in Japanese service sector activity worsened, with conditions deteriorating at an accelerated rate, and indeed at the fastest pace since last May. Again survey respondents frequently mentioned further falls in new business, reflecting Japan’s increasingly uncertain economic prospects. This faster decline in services activity, combined with a slower expansion of manufacturing production, meant that Japanese private sector output fell at the most marked rate for five months during November with the Nomura Composite Output Index posted a reading of only 45.4. The composite index – which gives some orientation for GDP levels - has now remained below the 50.0 mark for three successive months. If this performance is repeated in December it is extremely likely we will see negative quarterly growth in the last quarter of the year.





Commenting on the overall PMI data, Alex Hamilton, Economist at Markit, said:

“PMI figures for November suggested that the recovery in the Japanese economy may be losing steam. Manufacturing output and new business rose at slower rates on the month, largely as a result of subdued external demand and the fading impact of fiscal stimulus measures. That said, it was the struggling services industry that continued to underperform, suggesting that demand from home markets remains fragile. Moreover, Japan appears set to resume its lengthy battle with deflation, suggesting that domestic consumption will remain lacklustre for the foreseeable future as real debt burdens begin to rise and clients delay their purchasing decisions. While GDP growth for Q3 was surprisingly upbeat, the outlook for the wider Japanese economy remains subdued.”

Housing Starts In Freefall

And as if all of this wasn't enough, Japan’s construction industry is unlikely to be a positive force, indeed housing starts may drop next year to a 48-year low as the sluggish economy and falling numbers of young married couples continues to eat into the housing market. The forecast was made byTakeo Higuchi chief executive officer of Daiwa House Industry (Japan’s largest homebuilder), who said starts for financial year 2010-2011 are likely to fall as low as 600,000, following this years 20 percent plus drop to 800,000.

“The property market will remain sluggish for another year or two because Japan’s economy is in bad shape,” Higuchi said in an interview last week. “High unemployment and falling wages are scaring away many potential buyers.” Japanese home sales are forecast to drop 7.2 percent to 1.57 trillion yen in the year ending March. Japan’s started building 1.04 million new housing units last year, a massive and long term fall from the peak of 1.9 million dwellings hit as far back as 1972. Starts of 600,000 would be the lowest rate since 1961.

Export Growth Not Sufficiently Strong

With most of Asia’s economies currently booming, it may seem surprising to many that Japan seems unable to rise up on the back of this wave of high growth, especially since Japan – unlike much of Europe and the United States – is not saddled with financial system problemsof the kind which could be expected to put a brake on economic activity. The problem basically is the pass through rate. Japan has now become so structurally dependent on exports, that there is nothing like sufficient momentum from consumer demand to take up the strain when these fail, while on the other hand the return rate on capital has dropped so low during the present crisis, and the yen has risen so strongly, that manufacturers find themselves with little choice but to systematically curb capital spending and aggressively cut costs, beginning with payrolls of regular employees.

For an autonomous recovery mechanism to go to work we would need to have a recovery in both corporate earnings and household income, but corporate earnings are only being sustained by cutting back capital spending, while employee income has steadily fallen, and is unlikely to revive again without a much stronger recovery in the other advanced economies. That is, Japan now needs to be pulled by the global train, and will certainly not itself be doing the pulling.

Basically during the good years Japan’s economy was being driven by robust global demand for its high-end manufactured goods (passenger cars, IT/digital products), which were made extremely cost competitive by the extremely cheap yen that was produced as a by-product of the carry trade. However all of that now belongs to the world which just fell apart. A man called Ben Bernanke is now running an interest rate and quantitative easing programme at the Federal Reserve which no longer makes the yen the preferred carry trade currency, while frugality has increasingly become the norm among European and US consumers who are desperately trying to deleverage.

One consequence of this is that there has been a shift away from Japan’s high-end goods and toward less expensive Asian products, especially given the loss of price competitiveness produced by the yen’s rapid appreciation. Japan’s factory sector consequently finds itself saddled with substantial excess productive capacity and excess employment and unless there is a significant return to a cheaper yen over a viable time horizon this situation is, quite simply, unsustainable. Rather than simply sitting back and waiting for normal cyclical corrective factors to do their work, what seems to be called for at this point is a thorough overhaul of the national industrial structure, as well as a significant long term structural rethink about how Japan got to this unfortunate situation and what to do about it, and boths of these are likely to take years rather than months. Indeed, even if global demand were to pick up in the short term, Japanese producers may well be more inclined to shift production overseas, rather than renewing and increasing domestic capacity given the uncertainty which now surrounds the future value of the yen. In these circumstances the recent sharp drop in capital spending is hardly surprising.

In is very striking how Japanese industrial activity is weakening just as the rest of Asia is surging. Even if Japan’s exports fell at the slowest pace in a year in October as government spending across the globe boosted demand, shipments abroad were still down 23.2 percent - a vast improvement, it should be noted, when compared with the 30.6 percent decline seen in September. Exports in recent months have been quite solid, with real exports (the seasonally adjusted nominal export value divided by the BoJ’s export price index) up 3.4% month-on-month in October after a 3.0% month on month gain in September, with the result that the October level was 5.1% higher than the July-September average..




Imports have been much weaker, reflecting the underlying dynamic of Japan’s domestic consumption, and fell 35.6 percent from a year earlier in October, which meant the trade surplus climbed to 807.1 billion yen ($9.1 billion), its highest level since March 2008 and well above the 465.5 billion yen median estimate of analysts.




When we come to look at the distribution of exports, shipments to Asia fell 15 percent year on year, easing back from a 22.2 percent drop in September. Exports to China, Japan’s biggest overseas customer, were down an annual 14.3 percent, a slight deterioration from 13.8 percent decline the previous month. Sales to the U.S. fell 27.6 percent, moderating from September’s 33.9 percent decrease while exports to Europe slid 29 percent after slumping 38.6 percent in September.


In fact real exports to all major regions increased on a month-on-month basis in both September and October, with exports to the US and Asia increasing for the eighth- and ninth-consecutive month, respectively. Real exports to the European Union and oil producing countries also rose in both months.

But there are differences, and these differences provide part of the key as to why we need to be cautious. In Asia solid final deman, led by China, lay behind the rise, but in the other two key regios renewed inventory building probably lay behind the rise.

Specifically, real exports to the U.S. increased 5.0% month on month in October following gains of 3.7% month on month in September and 3.0% month on month in August. It is hard to explain such a strong gain by final demand and there is a clear possibility that what we have been seeing is a powerful boost to sales from renewed inventory building by Japanese companies in the expectation of future demand. Real exports to the EU show a similar pattern ,with strong growth being registered (up 7.0% month on month in October after rising 8.2% month in September and decreasing 4.0% month on month in August.

In Asia the same picture of strongly increased real exports is evident, with a rise of 6.6% month on month in October following gains of 5.3% month on month in September and 0.3% month on month in August. However underlying GDP growth rates are much stronger in Asia, and it is likely that the increase is much more driven by final demand. Looking at more detailed data, exports to China gained 3.0% month on month in October after increasing 6.5% month on month in September and 2.0% month on month in August. This upward trend in China exports undoubtedly reflects the continuing positive impact of the various economic stimulus packages as well as some recovery in Chinese exports to industrialized countries. Meanwhile, exports to Asia excluding China surged 8.6% month on month in October after a 4.6% month on month gain in September and a 0.6% month on month drop in August.



What is evident, at this point, is that the global recovery is proving to be more evasive than anticpated, with strong variation between regions and countries, and in the light of this heavily export dependent countries like Germany and Japan, after an initial surge forward are now finding it hard work to maintain momentum.

Japan’s reduced trend growth

Apart from the factors mentioned above, one other reason not to expect some sudden and miraculous “bounce back” in Japan’s economic growth is the steady decline which can be seen in the country’s long term growth pattern (see chart below). This key fact here is surely the historic decline in Japan’s workforce (both ageing and now shrinking) the adverse effects of which are starting to be felt. To make matters worse, some long term consequences of repeated short term interventions (via the use of fiscal policy etc) in the private sector over the years of protracted stagnation we have seen since the 1990s. The impact of this cumulative neglect is to be seen not only in the mounting pile of public debt (gross debt will surely soon pass 200% of GDP, hitting limits never seen before in a developed economy), but also in the way overall labour productivity has been impaired due to substantial labour hoarding in non-efficient sectors. In addition to the short-sighted fiscal policies, expanded credit guarantees, intended to counter tight credit, have had similar adverse side-effects. While such macrostabilisation policies may have temporarily bolstered economic growth, and have certainly helped avoid large scale unemployment, at the end of the day they end up suppressing activity in more efficient and more profitable sectors, and in the long run exercise a downward drag on growth. Unfortunately policymakers seem not to fully realise the longer-term effects of loading on short-term policy package on top of another without adressing the underlying structural issues.

A Setback For Japan Will Be A Setback For The Global Recovery

Wages earned by Japanese workers fell for the 17th consecutive month in October, extending their longest losing streak in six years and adding further evidence that consumer spending is likely to remain subdued. Meanwhile on November 20th the government formally announced that Japan was back in deflation, effectively exerting pressure on the Bank of Japan to react, pressure which was only too evident in last weeks announcement by the bank of a new liquidity facility of roughly JPY10 trillion in three month loans to commercial banks. BOJ Governor Shirakawa, however, was at pains to make clear that even if he was willing to concede that the latest measure could be seen as a form quantitative easing, a term he has manifestly struggled to avoid using previously, there was no overall change in the BOJ’s economic assessment of the Japanese situation. Rather, the measure was designed to address what Shirakawa called the potential adverse effects on corporate sentiment caused by the rising yen and continuing weakness in share prices. Thus Japan's economy yet again slides steadily into deflation, but this time with no evident road-map or "script", or even credible short term hope of coming out again, a fact that is only adding to the general concern which is being expressed about where exactly it is that Japan is headed for. Certainly it would seem to be no good place.

Further, if Japan is indeed teetering back towards recession, the implications will extend well beyond Japan itself, and will more than likely involve significant consequences for the entire group of developed economies, and especially those unable to tap into China's continuing growth via commodity exports. Japan was the first large economy to fall into technical recession in the wake of the Lehman Brothers collapse, but was also the first to heave itself out. Being the first to fall back in again would not be a good omen, for anyone.

The IMF on Asia's Recovery and its Sustainability

By Claus Vistesen: Copenhagen

In case you had not noticed, the IMF is blogging and it is not "merely" the garden variety IMF staffers they are rolling out to fill the pages; nope here we are treated to the likes of Blanchard, Atkinson, Lipsky, Cottarelli and a host of other of the Fund's A-listers. Consequently, it would seem that in an already (over)crowded world of econblogging, the IMFdirect blog merits more than a little bit attention.

In the past week, the dual post coverage by Mr. Anoop Singh of the recent Regional Economic Outlook for the Asian and Pacific Region caught my attention in particular. In the first, Mr. Singh invokes among other things the puzzle of Asia's relatively sharp recovery given the notion that the region is largely dependent on exports to grow. Two reasons especially are important here. One is the simple fact that as these economies moved into the crisis with bulging coffers (especially on the reserves vis-a-vis the rest of the world), the room for fiscal manoeuvre was greater and it was used decisively. According to calculations by the IMF, the collective stimulus programs in the Asia-Pacific region added 1.75% to GDP growth in the first half of 2009 and it makes the programs even more generous than those observed in the OECD and other emerging markets. Secondly, Asian economies has benefited from the, so far, V-shaped comeback by part of the global economy and key regions who are likely to grow smartly in h02-2009.

In general, Mr. Singh's analysis appears cautiously tied to the great unknown of 2010 where it appears that we will see whether all those battered economies of the world will be able to hold their own in a world where quantitative easing from central banks and lax fiscal policies are withdrawn rather than enacted. Here, Singh's remarks echo the general discourse where the the underlying tone is one of skepticism. A long period of risky asset buoyancy coupled with upbeat economic data releases have proved before to be crying wolf of an impending recovery and policy makers are advised to take this into account.

It is hard for me to disagree with Mr. Singh that the green shoots observed in the Spring of 2009 seem way too shaky a foundation on which to build a narrative of recovery. Yet, this is exactly what has happened and the famous inflection point will be reached when we discover that the recovery observed thus has been because of and not despite monetary and fiscal stimulus which makes the enforcement of exit strategies going into 2010 a very interesting experiment in the making. Some will make it, some won't and some will inevitably fall back into recession (not just in Asia).

However, the most important part of Singh's argument and indeed the most important part of IMF's analysis in general is the question of whether Asia's economic trajectory, in a post stimulus/recovery context, will be driven by domestic demand or not? To put it in the most reductionist form. Will Asia be a provider of net capacity to the global or economy or not? If yes, it would mean that a post crisis Asia had truly emerged as something new in the form of a force of a real addition to total demand. If not, it would mean that Asia would revert to old tricks and habits of relying on exports and foreign asset income to propel growth in national income.

Now, leaving the question of the number of export dependent economies the world economy can muster neatly to the side, I am not so optimistic here on Asia's contribution to the rebalancing of global imbalances through a net expansion of domestic demand. Yet, let me also immediately qualify here that I am not very comfortable with talking about Asia/Pacific in one both because of the obvious heterogeneity amongst the economies, but more importantly; also because I am not really an expert here. I have done the analysis on Japan though and on this I can say with unequivocal certainty that we won't we seeing any provision of excess domestic demand from this side.

Ultimately of course, Japan is of little real importance here and so is the rest of Asia really. What really matters on this topic is China and all the hopes currently pinned on her shoulders in the form of the ability of the economy to pull the global economy out of the mire. Traditionally, this has boiled down to a rather technical discussion about the RMB and an almost perennial Becketian wait for the shackles to break and an appreciating RMB to solve all problems. While I concede that the RMB should rise, it won't solve any of the underlying problems inherent in China's investment driven economy. Basically, chalk it down to culture and institutional specificity in the origin, but the simple fact remains I believe that just as China may evolve to become the economy we all hope and believe her to become (say in a 2020 context) the one child policy will have done its work so to speak and China will be sporting an OECD like age structure and is likely to even surpass many of OECD's economies.

This is no recipe for an axis of rebalancing and although China will be the main story to follow for the immediate future I think we should look elsewhere to find the potential rebalancing candidates. This may indeed involve other parts of Asia (India for instance and Indonesia), but in the current discourse the likes of China, Japan (and Korea) hold little promise in terms of providing a decisive engine for rebalancing through sustainable growth in domestic demand which exceed the investment rate.

In this sense I remain cautious on the overall sustainability of the recovery in Asia mainly because of my skepticism towards the sustainability of overall global momentum where I acknowledge that I may be very wrong. Watch out for 2010 and all those exit strategies is what I say and particularly for the "post fiscal stimulus" world. This also means that I am more than a little bit skeptical on the prospects of a sustained recovery across Asia driven by domestic demand, especially in relation to Japan and China.

At least, this would be my humble argument here a murky Monday morning in Copenhagen. In any case, you might want to punch the IMFdirect blog into your RSS reader, just to make sure that you know what the IMF is up on a daily "research" basis.

A scenario for Japan’s public finances

A few days back there were rumblings of dissatisfaction from the market about Ministry of Finance projected issuance:

Japan’s Bonds Drop a 4th Day After 20-Year Auction Demand Cools – Bloomberg.com

It’s possible that the new government will have to limit its borrowing for “stimulus” spending, as the demand for additional JGB’s is limited.

It seems to me the scenario would work like this:

Ministry of Finance has to raise rates to sell enough debt

Yen spikes short term due to the interest rate differential, crushing exports more

Increased rates mean the increased interest cost can’t be covered by new issuance

BoJ prints yen to cover debt burden; yen collapses as the market flees rapidly devaluing currency

My theory about yen movement is based on the idea that a rise in rates would attract money to Japan short term, but that over time the size of the government debt burden and the higher interest payments would require yen printing.

I could be completely off base.

This just hit Bloomberg: Japan’s Bond Futures Fall as Fujii Signals Debt Supply to Rise – Bloomberg.com

“Japanese bonds fell after Finance Minister Hirohisa Fujii said the government will likely use debt sales to meet a tax revenue shortfall, raising concern increased supply will overwhelm demand.”

The Performance of Japanese Companies - A Growing Connection with External Demand

By Claus Vistesen: Copenhagen

(click on pictures for better viewing)

Last week, we learned that industrial production rose yet again in Japan clocking in at 1.4% month-on-month in September after having increased by 1.6% in August.

Companies said they planned to increase production in October and November as well, indicating the recovery from a record export collapse in the first quarter is holding up. Growth in China is generating sales for manufacturers including Hitachi Construction Machinery Co., which this week said it has worked off stockpiles that piled up during the recession.

“The pace of the recovery is faster than expected,” said Hiroshi Miyazaki, chief economist at Shinkin Asset Management Co. in Tokyo. Withdrawal of stimulus in the U.S. and Europe may cause output and exports to slow down this quarter, Miyazaki said, “but so far, today’s production report showed few signs of that.”

This is good news for Japan's economy even if it seems that Japan may simply be re-deploying old tricks in which companies are leveraging external demand but the domestic economy remains unable to pick up on the momentum. As ever, the disconnect between the level and flow of domestic activity (and price pressure) created by the domestic economy and the additional boost from external demand and asset income remains one the main perspective through which to look at the Japanese economy.

Within this context, the notion of Japan being dependent on exports to grow has emerged; initially as a strong market discourse and since in a more formal theoretical light in the form of the humble contribution of yours truly. It still represents a powerful market discourse and in fact, the idea of export dependency or reliance on external demand has been propelled to the main scene of the current economic turmoil as it has slowly but surely dawned on market participants and policy makers that the extent to which global imbalances need to be resolved, we have to find someone to run the deficits. And although this may seem a simple task, it has proved decidedly difficult to make the puzzles match in a world where deleveraging remains a key driving force on both the microeconomic and macroeconomic level.

In this entry I thought it would be interesting to look at a topic which combines the two perspectives above, that is; both the theoretical and the more market oriented narrative. On the former, this analysis would seek to move the analytical perspective down a notch from the pure macroeconomic level to a microeconomic level linking data on the company level (company accounts) with macroeconomic data (national accounts). On the latter, the analysis would provide some empirical foundation for the often cited relationship between a positive reading on industrial production/capex and a pick up in external demand, or more precisely the link between corporate activity and exports.

The analysis will be based on data from the Japanese trade ministry (METI) and OECD and will cover the period 1960Q1-2008Q4 (mail me for the excel sheet). On the company side, I will use data on sales (topline) and as well as profits (operating and ordinary). I will also distinguish between the manufacturing and non-manufacturing sector since one might expect, in Japan's case, the accounts of the former to be considerably more sensitive to external demand than in the case of the latter. With respect to national accounts I am using the OECD CARSA methodology which essentially signifies that we have current prices at annual levels with seasonal adjustment.

In line with the spin traditionally served here at Alpha.Sources, I will be looking at an increase in the connection between corporate sales and profits and external demand as an implicit function of age. This is to say, that this disconnect between domestic momentum and the ability of Japanese companies to generate revenues and thus growth based on external demand is a function of the increase in Japan's median age.

The main results of the analysis can be summarized in the following points.

• The positive relationship between the change in Japanese companies' profits/topline and the change in exports or the current account has increased markedly in a post 1990 and specifically post 1998-2000 context. This effect is predominantly a phenomenon observed amongst manufacturing companies.

• The empirical analysis suggest that Japanese manufacturing companies are now highly reliant on external demand to generate sales, profits and thus in some sense investment activity.

• The sensitivity of the sales of manufacturers to the volume of exports has increased by a factor of 60% from 0.25% to 0.4% around the period where Japan breaches a median age of 40 years.

• The sensitivity of the ordinary profits of manufacturers to the current account has equally increased markedly in the period where Japan has moved to a median age above 40. In the period after 1997 results indicates that a 1 unit (JPY) increase in the change of the current account has led to a 0.23 unit (JPY) increase in the ordinary profits of Japanese manufacturers which compares with a corresponding non-significant relationship in a pre 1998 context.

A Look at Company Performance, the Current Account and Correlation

Regardless of whether one squares the outlook on the Japanese economy, there is no doubt that the dent which the corporates have taken as a result of the economic turmoil is unprecedented.

Notice that I have indexed the charts with 1995 as a base year and then realize that current nominal value of company revenues has dropped to a level comparative to the one observed in 1993-1994 in relative terms. In absolute terms, the aggregate value of sales of Japanese manufacturers stood at some tn 84 and 82 JPY in Q1-09 and Q2-09 respectively which is value not observed since 1989 in nominal terms. This should give us a clear picture of drop in activity and then also the difficulty with which Japan will have in restoring productive activities back to normal whatever this might mean as we move forward.

With respect to Japan's external balance it is a bit more complicated, but there are some important points to remember as we move through the charts. Japan has been running an external surplus since the beginning of the 1980s, but as I have spent an entire academic paper explaining, it is only in the latter part of the 1990s and into the 2000s that this external surplus seems to be connected strongly with output growth. Moreover, it is important to distinguish between net exports and the income balance since the latter has been particularly important driving Japan's external balance in a from the 1990s and onwards

In light of the graph above, we can say that given the sharp decline in domestic growth in a post 1990 context external demand has take over, so to speak, both in terms of keeping national savings higher as well as contributing to headline growth. It is along the same axis that we would then expect the relationship between Japanese companies and external demand to have increased.

Moving on to some simple correlation analysis the following two charts which show the correlation between company sales and exports as well as the trade surplus/GDP will give us a nice initial overview of the data in question.

The representation is in changes (which is not unimportant) and smoothed by taking the correlation as a 4 year moving average (i.e. 16 quarters). The y-axis is ending period which means that a correlation for e.g. 1997 means correlation between 1993-1997.

Simply eye balling these charts does not seem to provide decisive evidence of the hypothesis of export dependency. Sure, we can easily see that the period 1997-2008 has seen a sharp increase in the relationship between company sales and the flow of exports as well as the share of external demand and GDP, but the key point to take away from these graphs is that they appear to be mean reverting (with a very weak positive time trend in the case of the second). This would mean then that the connection currently observed between exports and corporate sales is not unique. However, if we focus the attention on the second graph, it is also pretty clear that it is only in a post 1980 context that we have observed periods in which the correlation between sales and the trade surplus has been consistently and strongly positive. This would then seem to lend some evidence to the idea of export dependency and how this may be a distinct characteristic of contemporary Japan.

Moreover it would seem that it is not possible (except in the case of the correlation between sales and the trade surplus) to distinguish decisively between manufacturing and non-manufacturing. In later sections and using simple ordinary least squares analysis, it is however possible to differentiate this statement considerably.

Before we come to that though, it would be apt to use the initial conclusion above and have a closer look at the post 1980 period. Moreover, and courtesy of a more richer dataset on the macroeconomic level we can now augment the analysis with the income balance and thus the current account. This may seem trivial, but is very important in Japan's case since the income balance in particular has driven the external balance in recent years. From a company point of view and in order to be consistent, I will correct for the importance of the income balance by including company profits as the main gauge for company performance.

This chart (in level form and only for manufacturers) seems to be more supportive of the evidence of export dependency at least if we allow ourself the luxury to look only at the period from 1980s. The chart shows however that the strong positive relationship between the current account and the profits of companies is a relatively recent phenomenon which took off somewhere around 2000. Consequently, in the period from 1983 to 2000 the correlation between the current account and company profits in the manufacturing sector has been negative and in some cases strongly negative.

From this brief look at correlations, we should be satisfied that when it comes to the period post 1998 (more or less) the performance of Japanese companies have been strongly linked to external demand and income derived from external assets. Yet, this does not provides decisive evidence for export dependency measured as a strong and growing link between the performance of companies and external demand. In order to show this we must turn our attention to a bit more sophisticated statistical techniques although I can promise you that it won't be very fancy.

Some Models to Go With That?

The analysis which proceeds will center on the two following simple models which take the first difference or percentage change as a linear function of the change in either the value of exports or the current account.

The first regression will also be run with the sales of non-manufacturers as dependent variable in order to check the initial conclusion above that it is really not possible to distinguish between manufacturers and non-manufacturers[1].

Now, if you don't care about statistical analysis, you may stop here and move straight to the conclusion or go back to the summary in the beginning where the main results are reported. If you decide however to move on, rest assured that, following the models above, I never move beyond univariate OLS, so things should not get too complicated if you are a little bit familiar with statistical analysis.

Note that throughout, the full period will be Q1 1960 to Q4 2008, period 1 signifies the period where Japan had a median age below 40 and period 2 is consequently defined as the period in which Japan had a median age above 40.

If we begin with the first model that plots sales of manufacturers as a linear function of the volume in exports (both in % changes), the results for the full period, period 1, and period 2 regressions return the following results [2].

For those of you who are familiar with the results presented in my earlier work on Japan, these results should be well known. In this way, it appears that the relationship between the sales of manufacturers and the volume of exports has increased markedly, both in terms of the marginal effect as well as in the context of the overall fit of the model. Since this model is a log-log model, we can interpret the coefficient in percentages and in this way, the estimation indicate that the sensitivity of the sales of manufacturers to the volume of exports has increased by a factor of 60% from 0.25% to 0.4%. In words, it means that in the second period the estimation suggests that a 1% increase in exports will lead to a 0.4% increase in the sales of manufacturers whereas the corresponding number is 0.25% in period 1.

Looking at the overall fit of the relationship, the results clearly indicate that this representation leaves out a considerable source of the variation in the sales of manufacturers which is entirely to be expected. As always, it is essentially a qualitative and theoretical question whether the increase in the sensitivity as well as the goodness of fit (from 0.08 to 0.13) represents de-facto export dependency or simply indicates an increased reliance over and above other more important factors.

In relation to the second model which plots operating profits as a linear function of the change in the current account, it is important to note that this model is estimated in the first difference (and thus not log-log) because the current account in some cases has been negative. Moreover, the sample period is shorter than for the first model (1980-2008) since OECD does not have data for the income balance prior to 1980.

On an overall basis these results underpin those from the first estimation although they seem to confirm the hypothesis to a much higher degree. Abstracting from the full period result which serves as an anchor for the overall significance of the relationship, the difference between the model estimated for period 1 and period 2 is striking. Consequently, the first period estimation signifying the period where the median age of Japan is below 40 shows no significant relationship whatsoever, in this sense it appears that the apparent negative relationship implied above from the correlation charts do not pass the simple causality test which OLS represents. The second period regression on the other hand returns a strong and significant relationship which indicates that a 1 unit (JPY) increase in the change of the current account will lead to a 0.23 unit (JPY) increase in the ordinary profits of Japanese manufacturers. On the goodness of fit measure the only thing we can say is that it has increased considerably to signify the increase in relationship between the profits of manufacturers and the current account. However, whether a goodness of fit of 0.15 is high in an absolute sense here is difficult to say without a more thorough and comparative study. But since we have a univariate framework, I believe this result to be quite extraordinary.

Conclusion

I hope by now that I will have either convinced you or scared you off in terms of the importance of whether Japan is dependent on exports to grow or not. I would also hope that the connection to events closer to the market is not too difficult to see. For example, Bloomberg is running the story today that the BOJ, like most other central banks, is either willingly or, dragged kicking and screaming by market sentiment, moving towards the formulation and near execution of the famed exit strategy from extraordinary monetary policy measures. Clearly, interest rates are to remain low for as far as the eye can see, but it is interesting to ponder whether the decision by the BOJ scale back corporate debt purchases is related to optimism on the companies ability to leverage domestic growth or whether it is because they see export markets reving back up in which case it would be back to the same old growth strategy. Another example would be the latest inflation reading which suggests, more than anything, the extent to which the domestic economy in Japan is not able to provide an environment in which companies can operate profitably as well as it indicates how overall domestic momentum is essentially contractory.

It is within this general economic context that the notion of export dependency becomes important and specifically how this might relate to the ageing of Japan's population. In this entry I have tried to take this idea down a notch from the strict macroeconomic level in the form of an analysis of the relationship between external demand measured through national accounts and aggregate corporate accounts. The results, I believe, speak for themselves and strongly suggest I think that Japan indeed is becoming increasingly dependent on external demand to create the growth and income the economy needs to maintain economic growth. Following from this, a number of questions present themselves, not least the most crucial general question relating the issue of export dependency to ageing in a general sense and then on to the discourse on global macroeconomic imbalances. But for now, I will let you digest the data at described and analysed above.

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[1] - Results of this regression is not formally reported in the text; please mail me if you want my excel sheet and results.

[2] - In order to be really rigorous I would have to formally test for the difference between the two periods (e.g. through a Chow Test or related method), but here it will suffice to look at the change over the period without putting a label of statistical significance on it.

Japan - In the Eye off the Beholder

By Claus Vistesen: Copenhagen

(click on pictures for better viewing)

After a nice and entertaining week in Barcelona where I had the privilege not only to hold a seminar at the Universitat Autònoma de Barcelona, but also to meet a host of interesting people, I thought that it would be about time that I finished my piece on the latest data from Japan which admittedly will be a bit backward looking, but hopefully interesting nonetheless.

Beauty, as they say lies in the eye of the beholder and perhaps this axiom is worthwhile contemplating when thinking about the immediate condition of the Japanese economy or indeed the global economy and her asset markets, but for the sake for simplicity . Consider for example the news, out a week ago, that Japan's current account surplus widened 10% in August over the year. In an economy where external demand is the main driver of economic growth, this is a significant piece of news and should rightly be interpreted as a positive sign. Or should it?

Once we read beyond the immediate headlines it becomes clear that what we are really seeing in Japan is, in fact, a pendant (even if less severe) to the Spanish situation where the improvement in the external balance comes, not from a sustained and independent pick-up in external demand, but rather from the fact that domestic demand is contracting faster than external demand thus pushing up the current account. In Japan, exports slid 37.1% on the year but as imports shed a corresponding 41.2%, the current account improved as a result. Naturally, some would want to insert the point here that since Asia (and in particular China) seem to be the locus of small, but definitely noticeable, upbeat signs in the global economy, Japan should be at the forefront to snap up the gains. Surely this is true, and one wonders how far exports would have tumbled on the year if China had not been there to pick up the slack; yet, as we can see from the figures above; the downward momentum remains in spit. It seems, that beauty indeed is a subjective concept.

With respect to the most recent event as it were in the Japanese economy, the BOJ meeting held last week did not really bring much new to the table with respect to policy measures as rates were kept in QE mode. However, and as Societe Generale's Gleen Maquire points out in a recent publication (the weekly monitor) the point is moving closer with respect to whether the BOJ will extend its extraordinary credit measures or stop them. This would then be a discussion about the much debated exit strategies by part of especially the G3 central banks; how it will be conducted and equally as important when. The current message seems to be that while it is difficult to see the BOJ abandoning ZIRP any time soon, the BOJ is not going to extent the current measures of credit support in the form of the purchase of corporate bonds and commercial paper as well as a special funding program for corporate finance facilitation from the point of view of banks. As Maquire correctly points out and regardless of whether ZIRP is set to continue or not, a withdrawal of these measures would naturally represent a de-facto policy tightening and it is unclear just what the effect will be on the Japanese economy.

Moving on to a piece by piece look at the recent monthly data, August's numbers did bring with it a bit of light (September number will be out at the end of October) although the fundamentals have hardly changed.

Kicking off with domestic consumption, the headline figure reported by the statistical office clocked in a nice increase of 2.6% y-o-y which is of a magnitude not seen since January 2008. It is interesting to differentiate the headline figure of 2.6% (which is a real figure) is in somewhat stark contrast to the nominal decline in the consumption of workers' households of 1.4%. At this point, the average monthly change on an annual basis for the overall consumption index in Japan is -1.2% (up from -1.8% before the 2.6% figure reported from August); I will hold off any premature conclusions of a sustained pick-up in consumption before seeing what is in store in the coming months.

With respect to prices, Japan now looks thoroughly entrenched in deflation;

The general core index thus declined 2.2% over the year with the core-of-core index declining 2.6%. So far in 2009, the core-of-core index has declined 8.3% with an average monthly decline of 1%. This is a strong testament to the strong downward momentum in the domestic economy and underpins the following very reasonable assessment by Glenn Maquire;

Realistically, it will be very difficult for the Bank to forecast positive inflation over the next two to three years. The Consumer Price Index continues to fall sharply and the output gap remains extraordinarily large by any metric. With the yen now appreciating and political opposition to a stronger yen having passed with the Liberal Democratic Party losing power, Japan is likely to remain more at risk of deflation than inflation over the entire period including calendar 2012.

Especially the point on the output gap is important even if we don't observe this specific data point. I would add the qualifying comment that one thing is the size of the output which in some sense would signify the immediate damage incurred by the Japanese economy in the context of the financial crisis and another thing is the speed (and ability) with which Japan can close this output gap on the basis of domestic activities alone. A point that I would especially emphasise here is the simple fact that the potential growth rate of Japan is likely to be in an almost perpetual decline due to the demographic situation. In this sense, it may increasingly become a question of what in fact the potential growth rate is based on domestic activity (i.e whether it is positive at all) than a matter of closing the output gap.

On the labour market, things improved rather surprisingly in August with the unemployment rate declining from 5.7% in July to 5.8% in August.

In the context of the financial crisis, the unemployment rate has so far increased roughly 2% and although the number in no means is alarming in a relative sense, the prospect of a continuing increase is sure to make cautious consumers even more cautious.

Turning finally to the corporate sector, industrial production has recovered somewhat after the absolutely horrid decline observed in the first half of 2009. The question is the extent to which we should see this as a decisive positive sign or not.

Once again, this is a matter of interpretation but when for example the Swedish bank calls it a "new dawn" for industrial production after looking at the graph above I find it difficult to see exactly where this dawn is. Consequently and while it is certainly true that the index for industrial production has recovered some ground after bottoming out in February 2009, it is still situated 18.3% lower than its average value (measured from January 2003 to July 2009). This compares with an index for all industrial activity running some 7% below its historical average. These numbers are innocuous in themselves, but the important thing is the level of activity which can be supported by the Japanese economy and although we are certain to see some recovery in the data the underlying momentum may ultimately disappoint.

The chart above taken from JPMorgan's Global Datawatch is perhaps the clearest picture of what export dependency means in the case of Japan and how it drives the level of industrial activity.

With respect to the Tankan, the survey showed a pick up in sentiment which follows leads nicely the pick up in real economic activity. Pessimists still outweigh optimists by a rather large margin and it shall be interesting to see whether the apparent (and indeed lingering) positive sentiment among global market participants will spill over forcefully into expectations and investment plans moving forward.

Summary - A Beauty or a Beast?

Some of you may feel that I am spinning the story of Japan too much towards the negative sign. I don't believe this is the case however, and although I can see that some positive signs have emerged, I remain skeptical that it will be enduring. Call me a permabear, but 3-4 years of Japan watching has taught me to be careful when it comes to emphasizing positive news on the Japanese economy, and especially so when it comes to the momentum of the domestic economy.

This brings us to the global economy and the simple fact that the extent to which one would narrate the outlook on the Japanese economy in relative positive light would be tantamount to the extent that one also sees a relative benign outcome for the global economy. Here I am also skeptical which is ultimately also why I remain cautious on Japan and especially so in an environment where the JPY does not seem to benefit from low volatility and risk proneness to the same extent as before the Fed engaged in QE. But that is certainly a discussion for another day; for now, I will leave you my dear reader with the judgement on the immediate outlook for Japan's economy remembering full well that beauty indeed lies within the eye of the beholder.

Japan's US Treasury holdings through August

Note yet another increase in spite of continued yen strength.

Source

Japan's recent quantitative easing relative to other G-8 countries

Source: Danske Bank

Japan's US Treasury holdings through July

in billions of $...

A Cautious BOJ Stands Pat

By Claus Vistesen: Copenhagen

As the discourse is slowly but surely tilting towards exit strategies, by part of central banks, from ultra low interest rates and unconventional measures the BOJ opted to day to maintain a very cautious stance towards the incoming green shoots and whether they will prove enough to lift Japan out of the mire.

(quote: Bloomberg)

Officials kept the benchmark overnight lending rate at 0.1 percent, and maintained their emergency lending programs to banks and companies. While describing the economy as “showing signs of recovery,” an upgrade from the “stopped worsening” assessment last month, the Bank of Japan said in a statement in Tokyo today that it still sees “downside” risks to growth. Today’s statement reflected global doubts about the strength of a recovery from the deepest recession since the Great Depression. A Bloomberg News poll of U.S. households published today showed Americans plan to refrain from boosting spending even after the biggest drop in consumption in 29 years.

“Most countries are experiencing a recovery, but few can be confident about the sustainability of those recoveries,” said Yoshiki Shinke, a senior economist at Dai-Ichi Research Life Institute in Tokyo. “Japan will be the last country to raise its interest rate” because it has the added problem of deflation, he said. Bank of Japan Governor Masaaki Shirakawa told reporters in Tokyo today that while stimulus measures have helped the economy improve, “we’re not confident about the strength of private final demand after those effects fade.” He added that central bankers are monitoring the appreciating exchange rate, which is contributing to the drop in Japanese consumer prices.

Japan's problems are many fold but the most severe issues in the context of reading the tea-leaves of the recovery is the uncertainty attached to question of whether the current above par environment will linger beyond the last effects of the stimulus (which was front loaded due to the elections) as well as any inventory bounce which may come as Japanese companies rebuild their empty shelves in Q3.

It is difficult not to sympathize with the BOJ in its careful approach here since if you take a look at the underlying demand conditions they are, to put it mildly, sluggish! Only a week ago, I discussed the situation on the corporate level where companies were hit by falling top line sales on the domestic market and, as a result, only very carefully expanding capex. Moving on to other key economic indicators it is pretty poor reading if we look at the domestic economy in isolation.

By far, the most preoccupying problem has to be the fact that Japan's inflation rate is moving beyond sub-zero and essentially into the abyss which is a painful and almost, if you will allow me to be dramatic, tragic outcome after two decades of fight against this very malaise. Now, I know that we are observing one-off effects from high oil prices in the summer of 2008, but try to have a look a the actual numbers. Consequently the index that actually includes energy is currently running (inJuly ) at a rate of decline of 2.2% whereas the index which excludes energy and fresh food is running at an annual decline of 2.6% and thus more than the headline gauge. Clearly, the BOJ would like to see this figure correct or even stabilize over the summer before contemplating tweaking nominal interest rates.

With respect to consumption, the figure tracked as a headline gauge for domestic demand on the consumer side is quite volatile, but it should not escape our attention that despite its volatility, it has been consistent below the 0% growth mark throughout 2009. Thus the average annual growth rate on a monthly basis has been -1.8% so far in 2008 which suggests as a simple yardstick the negative drift we need to apply to the evolution of domestic demand in Japan.

Finally there is the labour market where the unemployment rate has increased rather harshly since the beginning of 2009 following a mean reverting pattern around 4% throughout 2008. 5.7% which was the reading in July certainly won't make any headlines comparing to the eye-popping figure we are seeing in e.g. Spain or elsewhere, but it is worthwhile contemplating this in a relative sense and thus the effect it is likely to have on the behaviour of already cautious households.

Where Goes the JPY?

If the round-up above suggest, in a real economic context, the current shaky condition of the Japanese economy it seems that Japan now has a new issue to deal with; the unduly appreciation of the JPY. Now, of course these days it may be of less use to look at the JPY measured against G7 currencies rather than for example against China, but the graph below should still capture much of the essence.

I think it is very interesting here to observe that in a post-crisis context the JPY has gained about 20% against the Euro and Buck where it has been ranging since the latter part of 2008. Clearly, this has an effect on the real economy in so far as it reduces the competitiveness of Japanese companies relative companies in the US and Eurozone (not to mention the UK); and remember, deflation here is becoming a zero sum game since at the moment the US, the Eurozone, and the UK is also suffering from a bout of deflation or very low inflation.

Of course, this presents Japan with a whole new problem in the sense that while Japan could hitherto expect to get a double boost from an increase in risk aversion as carry trade activity took hold lowering the Yen and allowing Japan to export away, this route is gettingincreasingly crowded. More specifically, Bernanke has entered the scene and as analysts and commentators start talking about the new "victims" of the global carry trade punt in the form of those brave souls among central bankers who dare raise interest rates before movement in the G3, Japan cannot be certain to be the exclusive funding currency. It has a rival in the form of the USD and notwithstanding the obvious consequences for the global economy that Bernanke is putting up a 0% interest rate on the world's most liquid fiat instrument, Japan might find itself pinched here.

Of course, there is a solution here even though it seems unlikely at the moment, I believe, that it will come to pass.

It was still telling that the branch of RBS in Japan (RBS Securities Japan Ltd) was quoted, by Bloomberg yesterday, personified by chief economist Junko Nishioka for noting, rather dryly I'd might add, that the most efficient way to spur growth in Japan would be through a devaluation. Hmm, that would be fun wouldn't ... a devaluation amongst the G3! Once again, we are left guessing as to just what value of the benchmark USD/JPY that will jolt the MOF and BOJ into joint action; 90, 85, 80, 75 ...? I will leave my readers to do the rest of the guesswork, especially since yours truly has burnt his prediction powers once too many trying to call JPY intervention. So far though, most bets seem off as the incoming Finance Minister Hirohisa Fujii made it quite clear that there will no such nonsense of intervention to weaken the Yen. Also, if Macro Man is right and this is predominantly a Dollar story rather than a Yen story, then what can they do as MM put it earlier this week.

In a general sense, it shall be most interesting to following both intra G3 currency movements and FX in general if and when some economies venture into a decisive tightening mode over the second half of 2009. And for Japan, well she will try to muddle through of course. I am watching the inflation picture closely as well as of course we must watch the extent to which Japan can really couple on to the Asian growth spurt we are currently observing. With respect to policy decisions, I feel confident that the BOJ is locked in at this point to, if not continue QE, then at least to keep nominal interest rates at or very close to the zero bound.

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[1]: Note, if you correct for stationarity the co-relationship dissipates so I may be over-stepping my bounds here.