As I wind up, post exam session, for some serious economic analysis it is to an economic landscape which is increasingly looking like a surreal mixture between Kafka and Dali. Having been paying only scant attention to the data stream the past 5 months, I have been adequately awake to note that the incoming barrage of data from the real economy has been absolutely horrendous. And this, incidentally, is not only the case for Japan. Clearly, we will get to the other side since such is our nature, but the amount of bodies we will leave in our wake may turn out to be quite substantial. In my opinion, this is exactly the main challenge which confronts at the present time; to identify the cases where the risk for a serious fallout is largest, and then to act.
One of those places may well be Japan and although she will still be one of the world's largest economies tomorrow and the day after tomorrow the data is still screaming, I think, that Japan is different and that understanding the why and how is crucially important to get the big global picture.
As per usual I shall be taking a bird's eye view of the Japanese economy homing in, when necessary, on the specifics. The topics covered should be well known to regular visitors in the form of output, prices, household demand, corporate capex, the external sector, and then finally what actions taken by policy makers to tackle the issue.
Leafing through my articles, the last time I had a look at Japan I simply noted that the recession was now, well and truly, here. This view was not completely rooted in the consensus although my favorite Japan watchers (MS' Sato and Ken Worsley) had already been delivering the same basic message through their writings. As it turned out, the official recession call came just in the knick of time before the house of cards finally collapsed. Thus, and although this is old news at this point, why don't we have a look at a simple chart of Japanese quarterly output since Q1 2006.
Within the alphabet soup of various definitions of recession Japan conforms to the conventional adage of two consecutive quarters of negative growth (a technical recession in the jargon). In Q2 and Q3 2008 Japan's economy contracted 1% and 0.5% respectively. Furthermore, if we scrutinize the smoother y-o-y figures of real GDP we observe the interesting fact that, on this measure, Japan's economy has been steadily slowing since the beginning of 2007. This is interesting in the context of just what effect the current travails of financial markets have had on Japan in the context of a cycle which so obviously were about to turn in any case. Turning to the immediate news in off the wire the situation in Japan apparently went from bad to worse and then onto horrendous in Q4 2008. The latest data points from December are thus quite staggering as will also be detailed below. Unemployment up from 3.9 to 4.4 %, consumption down 4.6% and most importantly (perhaps) factory output slipped a handsome 9.6% in December which confirms the worst fears in the context of the incoming manufacturing recession. Finally, we have the important leading indicator in the form of the PMI which is already released from January and as we can see, the downward trajectory is pervasive. As per usual in these indices everything below 50 marks a contraction.
Let this then be a subtle warning of what comes next.
Consumers are Still Holding Back
As a well known Achilles heal in the Japanese economy the consumer is still mired in a slump which has now, effectively, extended almost a year [1]. Consequently, 2008 looks set to become a year where headline household consumption fell in 3 out of 4 months. Breaking these figures down reveal that the retail sector in Japan is struggling. As per usual Ken Worsley provides the ammunition and although convenience store sales were up on the whole year in 2008, the more broad based purchases proxied by supermarket sales and department store sales are almost certain to reflect the general trend. In November 2008 department store sales slid 6.4% which marks, following Ken, the ninth consecutive decline. As for the overall retail sales gauge November marked the third consecutive monthly decline. On a broad measure retail sales registered a drop of 2.7% yoy in December which was the largest monthly drop in four years. Finally, the figure reported by the media in the form of overall household consumption expenditures solidifies the analysis showing a thoroughly negative trend on a monthly basis throughout 2008. As noted above, the latest -4.6% shocker for December solidifies the overall trend.
The fact that the Japanese consumer is not providing a cushion for the deterioration in corporate capex and exports is not surprising. However, it does represent an added issue since we could reasonably ask how long we should expect to observe these perpetually declining figures for domestic consumption? This is a non-trivial question since consumption still represents around 50-60% of the Japanese economy. Thus, one thing is if the consumer is not contributing to growth but quite another is if the domestic economy now spirals down into a black hole regardless of what happens on global markets. Forward looking indicators for consumer sentiment suggests that we are some time away from a pick-up in any sense of the word and while consumption can hardly be a bigger drag on growth than is currently the case, it still constitutes a tough starting basis upon which to stage a "recovery".
Prices, the return of an (un)welcome friend?
One obvious topic bound to come back with a vengeance in the context of the present slowdown is the prospect of a solidification of the deflation which, despite many an odd economist's predictions, Japan has never escaped. Well, if you want to nit pick Japan could still have made it in 2008. Thus, the mean value of the y-o-y monthly increases in the core of core up until November was 0.0% and with today's 0.0% reading for December Japan still has not created one year of domestically induced inflation for a long time.
One thing is sure then, whatever some will have you believe, deflation is still a major preoccupation for Japan and in light of the fact that we are now entering the worst year for the global economy in several decades, I would humbly submit that comments about an escape from deflation best be kept under raps.
Apart from the US style core index' linear walk above and below the 0% mark the graphs above also show how the big inflation panic observed 6 months ago exclusively came from headline pressures and did not, in any sense of the word, produce second round effects in Japan. This is to say that even though the core index spiked significantly in the year from august 07 to august 08 it did not pull up the core-of-core to any significant degree. My initial statistical analyses (more to follow) suggest that the relationship between the US core and General core index has steadily deteriorated since 1971 and is almost non-existing at this point. Or to put it briefly; we have indeed had cost push inflation but not demand pull.[2]It is interesting in this regard to watch how, as headline inflation abates, the inflation indices are nicely coming together. In connection with the heated debate of second round effects and the scare from energy push inflation I feel vindicated from the current message told by the data in both Europe and Japan.
This does not mean that inflation may not come back in the form of a pressure on commodities and the barbarous relic(s) as the global central banks flood the system with fiat money. This would then be a scenario of stagflation which it looked as if we would tussle with half a year ago. Yet, at this point in time I think risks are still more heavily tilted towards deflation as the main global macro concern. Many of the smartest people around seem to think the same; a couple of days ago John Hempton suggested that the Fed actually bring the helicopter metaphor to life (and here) and before you discard it as a bad joke, you would be wise to look at the underlying argument since it is all about the key aspects of monetary policy in the context of the liquidity trap. And finally of course, we have Cassandra's well thought note on inflation v. deflation [3] which as ever is a must read.
In this environment then, it seems all but a question of time before Japan once again slips into deflation with respect to core prices. Of course, asset prices in Japan have been in fast decline for quite some time , but with unemployment coming onto the scene it appears that another nudge down into the basement for domestic demand will strengthen the path towards deflation.
The question of deflation v. inflation in core prices may seem rather trivial in a Japanese context. Yet, with interest rates already running at 0.1% and with a strong downward momentum both in terms of external and internal demand the BOJ could soon find itself in a situation, alongside its peers, where it cannot really fight off the threat. And in Japan's case, the situation may still be more interesting than elsewhere since there are reasons to believe (demographics for one) that Japan may fall deeper and further into deflation with subsequent severe effect on an already large and increasing domestic debt burden. [4]
When a Growth Engine Falters
One thing which is often forgotten in the context of this almost omnipresent pessimism that has grapped economists and commentators (which would include myself) is that Japan did actually manage to churn out growth during the past three to four years. What I, and others, have simply been pointing out in the face of those heralding the return of Japan among the leaders was the nature of this growth, where it came from, where it did not come from and consequently the very nature of Japan's way of creating wealth to pay for its rising liabilities.
Thus, it should be a well known narrative by now that Japan is dependent on export and foreign asset income to grow. It is important to understand the fine print here. What I am not saying is that domestic demand is trivial; it isn't. What I am saying however is that on the margin and in terms of ensuring a "respectable" growth rate Japan simply needs the boost from exporting its surplus goods and capital abroad. Absent this surplus the domestically induced capacity and subsequent trend growth would simply not be "adequate" (i.e. nothing to fall back on) and in fact, it is not at all theoretically impossible to envision a negative trend growth rate in countries such as Germany, Italy, and Japan in the absence of external demand to buy a given surplus of production and capital.
In Japan's case, the important connection to understand is the one between growth, exports and foreign asset income as well as the former's relation with corporate capex. Taking together, high global growth giving rise to healthy demand for Japanese goods in turn pushing up corporate investment and capex as well as a strongly positive net foreign asset position (with the subsequent positive income flows) have been the main drivers of Japanese growth. As it turns out, it is exactly these main drivers which are now collectively faltering and since domestic demand is still a perpetual drag, the Japanese economy simply has no shield against the incoming slowdown. Only recently, the Japanese ministry of Finance cut its assessment of the regional economy specifically citing that companies are cutting heavily back on investment due to the collapse in exports. One of the ingredients is the sharp drop in global demand as well as the strength of the Yen is also pushing companies to cut back sharply. And cutting back they are indeed ...
It is quite obvious from the graphs that the slump in corporate capex decidedly set in q4 2008 which is also evident from the most recent industrial production print. Thus, by scrutinizing the graphs of quarterly moves it only shows a timid decrease due to the fact that it only includes data up until Q3. However, by looking at the monthly graph which includes the first two months of Q4 as well as the graphy plotting monthly and annual changes, the picture changes strikingly. Predictably, and following a pattern from other Japanese recessions, core industrial production which is most sensitive to global trade volume has tanked completely. The only thing which is preventing the composite index from following the same trend is that the decrease in the services industries (which comprise some 60% of the total activity) has seen a more modest decrease.
The reason why industrial production has now finally fallen off of that famous plateau analysts have been talking about is a slump in export growth and thus the trade balance.
Of course, the graph to the right is not really indicative in the current form. The way to read it however, given that it is monthly, is to realize that as long as the graphs stay in positive it means a steady accumulation of surplus versus the rest of world. In this way, the consecutive sign of the monthly number is more important than the actual level of the number. And then again ... it is quite clear that exports have steadily trickled down and if the trend continues (especially with the strong Yen) Japan may find itself with a trade deficit in the first quarters of 2009. On the other hand however, an often overlooked part of Japan's external balance is also revealed in the graph.
Consequently, the current account is still firmly in black due to the stable revenue from a large portion of foreign asset. It is quite certain that in the current environment, foreign asset income will go down but since most of Japan's foreign assets are held in the form of bonds the income is more stable than if it had been equities or other kinds of investments. There is of course always the risk of default and we saw how more than a few eyebrows were raised in relation to the break up of Lehmann Brothers and their large amount of samurai bonds held by Japanese asset managers and investors. Ultimately though, the income balance and its positive contribution is about the only positive thing to remark about the Japanese economy at the moment.
The JPY, adding insult to injury?
As a final nail in the coffin of Japan's outward looking companies the global environment of deleveraing and rising risk has, as per reference to well known empirical regularities, brought the JPY to levels not seen in a long, long time.
It is evident that while the initial stages of the financial turmoil did indeed push up the JPY against the three big OECD currencies the last six months have seen an absolute surge in the JPY. Especially the move against the GDP is staggering although it must be seen in light of the fact that Sterling has been completely buggered on a wide scale during the past months.
Obviously, this level of the JPY is wholly inconsistent with fundamentals and as we have seen before movements motivated by carry trade dynamics are subject to quick and abrupt reversals. In any case, with global central banks collectively heading for a global ZIRP regime it seems that old theories on carry trade dynamics and currencies may need to be calibrated; I suggest you to read one of Stefan Karlsson's latest posts for more on this. However, for the time being old habits linger and the the relative safety of a healthy external position is supporting the Yen.
Having played the waiting for godot punt during the better part of 2008 (0-1 AS v Macro Man)[5] I am weary about calling MOF/BOJ intervention in the JPY. Yet, currency wonks are still beginning to timidly voice the proposition that authorities may finally get enough at some point. According to GFTFx' director for currency research Kathy Lien 87.00 may well be magic level for the USD/JPY. Ms Lien points to the fact the BOJ is certain to be under considerable pressure from domestic companies to cushion the JPY's ascend as well as the simple fact that the JPY is now overshooting considerably. Darrel Whitten compares a USD/JPY at 80 with crude at 147 $ p/bl; over bought, which further suggest that investors are ready to reverse. And finally, Jonathan O'Shaughnessy also moves in to argue that the Yen is poised to drop lower. Three factors could motivate a reversal in my opinion; a sudden a sustained return of risk appetite, intervention by policy makers, as profit taking on a large scale in the context of current positions. Of the three the second is most likely at the current juncture (here I go again) with the last one being driven by this exact event.
Traditional disclaimers apply in the sense that I am not a currency strategist, but it would seem plausible that within the arsenal deployed by Japanese policy makers a move to nudge the JPY back towards an acceptable level might become reality in the near future.
What do to then?
Faced with this set of dire fundamentals the obvious question becomes what Japanese policy makers are doing about it. Without languishing too much in the realm of basic macroeconomics Japan, as other non-EMU nations, have two tools at their disposal; monetary and fiscal policy. In the context of the former, it was always a bit difficult to see what the BOJ could do in terms of tweaking the nominal rate since it was already running at 0.5% when the bad news decidedly hit the shores of Japan. The current stance of 0.1% must, in this case, be seen as symbolical to the fact that we have effectively re-entered QE and ZIRP. In this way, the BOJ is following closely, albeit with a lag, in the steps of Bernanke and the Fed who have not only slashed nominal interest rates to virtually zero, but also enacted a number of measures under the current QE scheme.
One key path followed by the BOJ here is the focus on financing conditions for companies. According to the minutes of the last meeting in December the BOJ is heavily focused on alleviating the liquidity crunch for companies and announced the provision to buy 33 trillion Yen worth of corporate paper (A1 rating) through the first quarter of 2009. This focus seem warranted. According to Bloomberg, the spread between government and corporate A1 paper has widened 72.5 basis points since Lehman Brothers collapsed last year. This again is forcing bigger companies to ditch the debt market and apply for loans in banks which again is squeezing the ability of small companies to get to the emptying trough.
If monetary policy makers are readily expanding the central bank's balance sheet to attack the problem of funding what is happening on the fiscal front?
Any talk of fiscal policy, and thus in the current situation stimulus packages, has to be cast in relation to Japan's debt burden. As Edward explains here, the numbers do not make happy reading. Japan's big budgetary problem is essentially a structural one which can be seen from the fact that even before a single Yen has been spent on extraordinary stimulus packages Japan will need to issue some 33 trillion worth of government paper to cover the primary budget deficit alone [6]. In 2009 the primary deficit is expected to increase from 5.2 trillion to 13.3 trillion. Add to this that the debt to GDP ratio is already running at alarmingly high levels, Japan finds itself in a situation where, despite policy makers' best intentions, the room to manoeuvre is very small. Or as Edward succinctly puts it;
This is the real core of the problem that Japan faces in 2009, that previous fiscal policy did not attack the growing fiscal deficit in the good times, so there is little room to manoeuvre in the bad ones. Which is why the Japan economic outlook in 2009 is grim, grim and nothing but grim.
Having said that, desperate times calls for desperate measures and only a few days ago Japan's PM Taro Aso managed, with difficulty, to pass a 4.7 trillion Yen stimulus package through parliament. However, Aso and the government should not rest on the laurels because of this. It is consequently widely held by domestic economists and observers that the package is too small to really have a lasting effect on its own thus suggesting that more packages are needed down the road. Given that we are in an election year, Aso may be inclined to deliver on populist grounds alone although of course it is difficult to see how any kind of fiscal measure could decidedly break the gridlock.
Much more important then may be the plan by the government (see also Ken Worsley) to allow the Development Bank of Japan to enter the equity market and buy common as well as preferred shares. According to the plan, or at least as I get it, the Development Bank will not draw upon public funds directly in this initiative, but rather public funds will indirectly be supplied to cover the investments (i.e. the losses). Worsley informs us that 80% will potentially be covered.
In summary, Japanese policy makers are in many ways offering the standard response to this crisis in the form of ultra loose monetary policy as well as fiscal stimulus. However, this is also where the comparison stops. Consider consequently the fact that monetary policy was loose long before the advent of the current crisis. If it did not help boost domestic demand at the time, it is difficult to see it having a meaningful effect now apart from the fact that it is needed in order for Japan to avoid a deflationary spiral. On the fiscal side, Japan is naturally constrained for reasons elaborated above. It remains to be seen whether the plans to invest directly in companies as well as their debt will help ward off big bankruptcies and thus mass layoffs.
All Doom and Gloom Then?
What a way to begin the posting again eh? Well, you should know my stance on Japan by now and if it was structurally bearish before it is bound to be considerably gloomier now. In many ways, Japan is pulling all the right strings in my opinion since I do feel that following the Fed's lead here in terms of concrete policy tools may not be the worst thing to do. The problem however is that Japan is constrained in a number of key areas. First, the whole idea of the liquidity trap and the inability for the central bank to reignite inflation expectations sprung from exactly Japan's experience in the 1990s and into the 21st century. Thus and while the Fed may clinch it, in terms of acting as the irresponsible policy maker suggested by the literature the BOJ has been trying this for the better part of two decades; with no luck. On the fiscal front the steps are also fundamentally sound I think, but once again Japan is constrained on the debt side and especially of the fact that before a single penny can be spent on the crisis at hand the fiscal authorities need to issue a handsome portion of paper just to cover the primary budget deficit.
In terms of the immediate outlook for Japan it is consequently dire. As detailed above all gauges are pointing downwards and now that the push from external demand is decidedly faltering the last small shield of defence is down. At this point, Japan is left to hoping that foreign demand will pick up again during 2009 and that she will be able to latch on to any pieces there will be left. This looks unlikely but it is not impossible that we will see some emerging markets staging a recovery after the first two quarters. However, to believe in this hypothesis you need to be almost as optimistic as this note has been the opposite.
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[1] Although the underlying trend is much more structural.
[2] There may of course be a myriad of reasons to this in the context of pass-through mechanisms and transmission mechanisms from energy and food inflation to core of core inflation. The main message here would be one of changes in inflation and thus how Japan steadily has moved towards a situation where inflation is primarily cost push rather than demand pull.
[3] I see that a follow-up has just been produced, and it is absolutely splendid.
[4] And don't give me that hoola-balloo about Japan being a surplus country and thus owing the money to itself. While certainly a mitigating factor in terms of sustainability these bonds are still assets with a value,and I would humbly submit that the shift of value from the government's future discounted revenues (which are declining, remember) over to domestic bond holders only works until it does not; this is to say, only until those very same revenues cannot cover the term payments. This is really a question of how many times you can sell the same bicycle, or in this case, the same and declining future stream of revenues.
[5] Actually, Morgan Stanley's Stephen Jen also stood on the other side of the fence, and was right as a result.
[6] The primary budget surplus (or deficit) of a government is the surplus excluding interest payments on its outstanding debt.
