No News from Japan

By Claus Vistesen: Copenhagen

Sometimes no news is more telling than one might initially think and although it was hardly earth shattering for the market that the BOJ chose yesterday to keep its main benchmark rate sitting at 0.1% it does highlight the extraordinary difficulties Japan currently face in terms of sparking its economy back into some kind of forward momentum.

(quote Bloomberg)

The Bank of Japan held interest rates near zero and said it remains committed to fighting deflation as gains in the yen risk stunting the recovery from the country’s worst postwar recession. “I hope that price declines will be overcome as soon as possible,” Governor Masaaki Shirakawa told reporters in Tokyo after his board kept the overnight lending rate at 0.1 percent. “It will take time before we can see prices rising to favorable levels,” he said, adding that the central bank will maintain an “extremely accommodative financial environment.”

Japan’s credit rating outlook was lowered by Standard and Poor’s today, highlighting concern that the world’s biggest public debt will lead to higher borrowing costs in a country already facing falling prices and a strengthening yen. Finance Minister Naoto Kan said today that the BOJ can do more to battle deflation, and people with knowledge of the matter have said it may consider expanding an emergency loan program or increasing purchases of government bonds. “It’s highly probable the central bank will come under pressure to ease policy further as the economy loses steam,” said Teizo Taya, a former central bank board member and now adviser to the Daiwa Institute of Research in Tokyo. “The bank will likely consider expanding the lending facility, while it will try to avoid increasing bond buying as much as possible.”

The statement by the governor Shirakawa really tells it all and one can only second his hope that price declines will soon hit the shores of Japan. Yet, this seems more and more unlikely which is also why the BOJ seems to be moving straight back into full out QE mode at the same time as its peers are set to try, albeit with great difficulty, to restore some kind of normal monetary conditions over the course of 2010.

The BOJ consequently seems to be silently conceding that it will have to cooperate tightly with the MOF in trying to bring some kind of momentum back to Japanese soil. In this concrete case it will mean keeping open the taps to create a bid for the steady flow of Japanese government bonds.

(click on graphs for better viewing)

The core-of-core index has now fallen since January 2008 with the total accumulated decline in the core nominal price level of 6.8%. Now, I don't need, I think, to spell out what this implies for debt and growth dynamics in Japan which just seem to perennially stuck at the moment.

The problem for Japan is really that it is fighting a losing battle on two fronts. Firstly, and quite as most observers would expect Japan is having great difficulty in terms of building up domestic demand (see graph here). Secondly however and much worse; conventional wisdom would have that as the risky assets began to fly back in March 2009 and as the global economy showed the first tepid signs of emerging from the death bed so should the JPY weaken and Japan ride, through the carry trade effect, the global upturn on exports. Yet, this has not been the story so far and while Japan indeed is exporting a lot to service the runaway train China, the new found reluctance of the JPY to react to global risk sentiment is preoccupying.

Measured against the Euro and using the period 2004 to 2009 (more or less) as the base average value the JPY is now 10% and 17% stronger against the Euro and the Buck respectively.

Finally, to add injury to insult S&P moved in Monday with a nudge as it threathened to downgrade Japan's sovereign debt rating less it gets its fiscal book on the mend. As a mitigating factor S&P mentions Japan's strong net external position which acts as an important dam towards the rising flood of public sector debt. Yet, unless Japan succedes in pushing the JPY down on a sustainble basis against its main competitors this dam will break sooner rather than later. Needless to say that if the BOJ decides to abide completely from the implied domestic pressure to continue funding deficit spending, S&Ps hands will be effectively forced. One thing is for sure as Societe Generale's chief Japan economist Takuji Okubo is quoted by Bloomberg;

"The market should be braced for the BOJ keeping its current rate unchanged for a very, very long time".

Indeed, and thus as the big talking point in the rest of the world remain fixed on exit strategies and the need (and peril) of fiscal consolidation Japan continues to be stuck in the mire. My own personal feeling is that it might very well be the BOJ leading the pack of global central banks rather than the other way around, but for now the fact that there is no news from Japan is exactly what makes it news.

A Detailed Look at Savings in Japan

By Claus Vistesen: Copenhagen

In short, if the world economy is to get through this crisis in reasonable shape, credit worthy surplus countries must expand domestic demand relative to potential output. How they achieve this outcome is up to them. But only in this way can the deficit countries realistically hope to avoid spending themselves into bankruptcy.

Martin Wolf (2008)

It is not the first time that I am using this quote by the FT's chief economics commentator and I don't suspect that it will be the last. Of all the attempts by pundits and analysts to pinpoint the crux of the current crisis the observation above is the most important aspect in my opinion and I have argued as such several times (see also Rogoff and Obstfeld (2009) and Baldwin and Daria (2009)). However, I disagree with Mr. Wolf in one critical aspect. Specifically, I don't think that this is simply a question of it being up to them, as it were, in terms of how export dependent/oriented economies may succeed in pushing their growth path onto one increasingly driven by domestic demand. In this way, I believe that the export dependency of Germany and Japan (and a whole batch of economies which will now join them) are ultimately rooted in their demographic profiles where decades of below replacement fertility and rising life expectancy have now condemned them to an economic structure where the growth generated by domestic demand is virtually zero leaving external demand as the only meaningful way to create growth.

This does not mean that the combined external surpluses of these economies do not represent an important and potentially negative externality to the global economic system, but it does crucially mean that we cannot expect Japan, Germany et al to simply revert, through e.g. structural reforms, to a growth path driven by domestic demand that would allow them to suck up excess global capacity through an external deficit.

In order to focus the attention in this ongoing debate I will home in on Japan and concretely, a recent piece in which Martin Wolf actually fleshes out a specific way in which Japan would potentially be able to raise domestic demand to benefit of herself and the global economy. Martin Wolf's piece is worth pondering in its entirety, but in this context I am going to focus on the notion of high corporate savings and whether its release from corporate balance sheets holds the potential for spurring domestic demand in Japan.

My own view is that the underlying structural problem has been the combination of excessive corporate savings (retained earnings) and diminished investment opportunities, once catch-up growth was over. As Andrew Smithers of London-based Smithers & Co notes, Japan’s private non-residential fixed investment was 20 per cent of GDP in 1990, close to double the US share. This has fallen to 13 per cent after a modest resurgence in the 2000s. But no comparable decline has occurred in corporate retained earnings. In the 1980s, the challenge of absorbing these savings was met by monetary policy, which drove the cost of borrowing to zero and sustained wasteful investment. In the 2000s, the challenge was met by an export and investment boom, driven largely by trade with China (see chart).

(...)

Japan’s aim now must be to achieve domestically driven growth. The most important requirement is a big reduction in corporate saving. Mr Smithers argues that this will happen naturally, since savings are largely capital consumption, itself the product of the history of excessive investment. I would add that if ever an economy needed a market in corporate control, to shift cash out of the hands of sleepy managements, Japan is it. Not being beholden to Japan’s corporate establishment, the new government should adopt policies that would change corporate behaviour, at last.

What follows is my take on this argument seen through the lens of a detailed look at the savings behavior of households and corporates in Japan.

Household Savings - (Dis)saving in Japan?

Standard life cycle theory states that consumers run down their assets into old age (dissave) and thus that a rapidly ageing society at some point should move into a state of perpetual dissaving with the consequence in an open economy context being an external deficit (eventually). However, both in theory and in practice this is not so simple and Japan is a good example here. In this way and while the household savings rate (out of labour income) has indeed plummeted in Japan, the economy still has a large and persistent external surplus. Since we know that the government is mired in both current and future debt this has, by definition, to reflect a high level of corporate savings. Thus and with a low savings rate in the household sector the reduction in corporate savings holds perhaps the biggest potential for releasing domestic demand in Japan or so at least is the crux of Martin Wolf' argument as I see it [1].

Most analyses on household saving rates in Japan do not move beyond the representation above which plots net savings as a share of net income. And indeed, this paints an unequivocal picture. The quarterly figure is highly volatile and subject to notable seasonality, but smoothed through a 12 quarter moving average shows us that since 2000 the savings rate of Japanese households have not exceeded 5%. More interestingly is of course is relentless downward trend which shows, more than anything, that the real economic conditions for Japanese households have changed significantly. This perspective which looks at the flow of savings is strongly underpinned by many empirical studies on the savings behavior of Japanese households. The most recent study is Horioka (2009) who presents a timely overview of the literature on the dissaving of the eldery in Japan. The evidence strongly suggests that Japanese consumers dissave into old age and as Mr Horioka ends his article, this is likely to have important ramifications on global imbalances assuming, I guess, that as Japanese consumers steadily move into a state of negative saving the economy will move into a current account deficit. I assume further that this is what Martin Wolf expect would happen if corporate savings were released to the benefit of Japanese households since otherwise Japan would not do much to correct global imbalances.

Now, I cannot refute the amount of evidence presented by Horioka and thus the conclusion in the main. What I can do however is to respectfully take Mr. Horioka to task on the definition of savings and thus what is defined here as dissavings. In this way, Horioka notes that the main source of dissaving by elderly take the form of declining social security benefits, increase in taxes and social insurance premiums, and increasing consumption expenditures. Let us quickly dispense with the last one and agree that Japan has not experienced any meaningful consumption boom in a long time which suggest that dissaving is not likely to take the form of a surge in consumption in any meaningful way (I don't suspect this is what Horioka wants to argue, but it is important for me to point this out).

Since 1997 the growth rate in GDP and private consumption expenditures have languished at a depressing mean reverting trend around the zero percentage annual growth mark. This indicates quite clearly that whatever the extent to which ageing households in Japan have dissaved through increasing consumption expenditures it has not been any meaningful driving force of consumption.

But what about the other two (increase in taxes and social insurance premiums). Are these really dissaving? I don't think so. Rather, these represent a transfer of saving from households to the government and thus an attempt by part of the government to reduce the future cost of age related liabilities and thus to compensate for a strongly negative net asset position by part of the government both in a current but more importantly, in a future perspective. In an ageing economy this is exactly why we would expect the dissaving hypothesis to be in need of significant adjustment since there will be forced savings through the inevitable attempt by the government to stabilize the deteriorating fiscal situation.

As such, the representation above does not paint an adequate picture of household savings in Japan and while this initially may be explained in light of the fact that we should look at the savings of the entire Japananese consumer base and not only the elderly (retired) consumers the rapid and ongoing process of ageing in Japan means that these two argument will inevitably converge over time, a point Horioka (2009) also makes.

Specifically, the account of dissaving above fail to take into account, at least, two important missing links. The first is the simple fact that the rate of savings out of total income is closely related to the annual growth in income which, in Japan's case, has exactly declined significantly in the same period in part because of the deflationary environment but also, I would argue, to reflect the changing productivity structure of the Japanese labour market with an ageing work force.

Between 1998 and 2005 the change in the annual income flow to Japanese households was persistently negative and suddenly; a consistent savings rate in the same period of about 3-5% does not exactly come off as rapid dissaving. In fact, at no point in the graph above has the savings rate been below the annual growth in income which provides a very important qualifying perspective to the idea that the release of corporate savings either as a lump sum transfer or through a steady trickle of dividends would immediately be channeled into discretionary spending. I find this very difficult to believe, but in effect this will be subject to easy falsification if and when corporate savings in Japan became an important policy variable in terms of stimulating domestic demand.

The second missing link relates to the idea that savings may be defined in two overall ways, the first which is a flow perspective is described above and the second is a stock perspective. The best example of the latter is the asset meltdown hypothesis that envisions a sharp decline in asset prices as aged households grind down their stock of assets by selling them to a smaller and shrinking base of working age households who will not be numerous or wealthy enough to support asset prices at the given level.

In the context of Japan, I have argued before how there is no meaningful destocking of assets even if the growth of households' total assets have stalled significantly.

Despite the obvious drawback of only having data from 1997 and onwards the picture is quite clear. Between 1997 and 2009 the overall household balance sheet in Japan has remained pretty "stable" rising from trn 1285 JPY in 1997 to about trn 1440 in 2009 JPY (current prices). I choose to put stable in quotations mark here since the real thing to notice is the lack of expansion (i.e. debt driven asset expansions) by part of Japanese households to reflect the fact that there was no housing bubble let alone any other kind of bubble in Japan in the period in question. The main point is of course that despite a continuing decline in the rate of savings from a flow perspective, Japanese households are not (yet!) engaged in any meaningful de-stocking towards what ever end point the economy would reach if ageing households and indeed the society as a whole began to run down its stock of savings.

In terms of composition, we find evidence of the often cited fact that Japanse households are quite risk averse Nakagawa and Shimizu (2000) holding between 50% and 55% of their total assets in either deposits or currency. In comparison, and while direct holdings of shares and investment trusts have indeed risen over the period, this entry still makes up only about 11% of the total balance sheet in 2009. Naturally, there is some cyclical effect here as the total share (value) of risky assets held directly in portfolio of Japanse households peaked in the years 2005 to 2007 at about 16-17%. Moreover, it is safe to conclude that if we include indirect holdings of risky assets through pension and insurance holdings, the picture becomes more balanced.

Looking at direct evidence of dissaving, we find none in the aggregate. Over the period in question the stock value of time, savings, and transferable deposits have gone up by 11% (i.e. a net addition of savings by the Japanese household) from some bn 665 JPY in 1997 to bn 742 JPY in 2009. Moreover, it is remarkable to see that the amount of currency held by Japanese households have increased by 40% in the same period. This suggests, more than anything, the risk aversion of Japanese households. Finally, I think it is worth to mention that although the amount of bonds held directly by Japanese households is next to none, Japanese households are naturally doing a substantial part of the heavy lifting in terms of financing the ongoing and almost perpetual deficit spending by part of Japan's governments. In this way, the large bulk of deposits as well as insurance and pension funds are very likely to be substantially invested (de-facto) in Japanese government bonds.

As an interim conclusion ans while a first glance suggests that Japan indeed is dissaving through its household sector it is an argument which does not hold entirely up to scrutiny. It is important for me to emphasize two things. Firstly, I don't dispute the analysis in Horioka (2009) and thus the wide range of previous studies that have shown how the life cycle model of savings is well calibrated to a Japanese context. However, I do think it is important to differentiate it with the points above and particularly the notion that Japanese households, as a whole, do not seem to be rapidly dissaving to the extent that many claim. Secondly, I want to reiterate the point that I am not arguing that dissaving will never occur in the aggregate. What I am saying however is that looking at the dissaving of the elderly and concluding that this will lead Japan towards an external current account deficit misses the current and real effect from ageing in Japan. Consequently, the picture of Japan at the present time running an almost perpetual external surplus is one of an economy fighting like hell to avoid obvious end point that would occur in the event of rapid de-stocking/dissaving.

Corporate Savings - Restraining Consumption through Retained Earnings?

Traditionally, economic models such as e.g. an OLG model set in an open economy context does not discriminate between the savings of corporates and households Rogoff and Obstfeld (1996) and Mason (1988) which is often because our economic models are set-up in a representative agent framework where the representative consumer is the sole shareholder of the representative firm and thus must be the sole beneficiary of whatever earnings (retained or otherwise) the company has. In a widely cited study Friend (1985) concludes that there is a moderate degree of substitutability between household and corporate savings which sounds about right to me.

In practice though and although principal agent problems and a thick corporate veil may make the direct link very sluggish, once foreign ownership of the domestic market cap is accounted for (about 20% in Japan's case I would say) there should no problem substituting corporate for private savings. In any case and to the extent that there is indeed a very long way from the dividends of Japanese corporates to the pockets of households it is, I assume, exactly here that Martin Wolf inserts his main argument.

As should be immediately clear here, it is not as if Martin Wolf is shooting blanks here although I don't suspect anyone really suspected that. Consequently, both the nominal value of retained earnings (manufacturers and non-manufacturers excl finance and insurance) as well as its share of total company assets have increased markedly since the mid 1970s. Since the second quarter of 1975 the nominal value of the stock of retained earnings has increased by a little over 270% while the corresponding figure for total assets is 163%. In terms of the share of total assets, the graph above does not tell the whole story as retained earnings as a share of total assets actually reached its low in the mid 1970s at around 5% declining from the mid 20s% in the 1950s. The average quarterly share of retained earnings relative to total assets in a post 1990 context is 14.14% with a steady upward trend throughout the 1990s and 2000s.

So far so good then.

However, as with the case of household saving above, once we dig a bit deeper in the analysis it is not certain that retained earnings constitute the magic bullet. First of all, the representation above is one of stocks and not flows and thus if we express it as flows we get the same picture as above with household savings; namely, that while the stock of savings (in the aggregate) is not being drawn down the flow of savings is steadily declining even if the flow of corporate savings is quite volatile.

Still, the flow of corporate savings have been impressive even in a post 1990 context where the average quarterly growth rate (yoy) has been 4.5% (with a correspondingly high SD of 6.7%). Moreovern, the relationship between the total amount of gross fixed invesment on a quarterly basis and the stock of retained earnings is further indicative here. Between 2000 and 2008, Japanese corporates consequently kept an average of 183% worth of retained earnings on their balance sheet relative to the average value of quarterly gross fixed capital formation. As Martin Wolf evidently points out, this is ultimately a question of a secular decline in investment demand to which Japanese corporations only can do two things; dissave to match the decline in investment demand or let those savings flow out in the form of an external surplus. In the context of Japan and in strict sense of national accounting it is the latter route which has been chosen.

The more interesting question in terms of what those retained earnings are financing (i.e. on the asset side) is almost implicitly answered above although it is not as simple as it looks.

Consequently, conventional wisdom has it that the retained earnings of Japanese corporates are merely sitting on the asset side in the form cash and deposits and thus would be readily and easily available for distribution to shareholders. The more I look at the data however, the more this seems to me to be a myth.

The total amount of cash and deposits as a share of total assets held by Japanese corporates peaked in the first quarter of 1990 at 15.5% and has since declined to about 10% in the 2000s. Now, I might be missing an important liquid asset entry here, but it should serve to differentiate the picture somewhat of Japanese companies as cash hoarders.

Yet, the main picture remains in the sense that even if retained earnings have then gone to finance land acquisitions or the build-up of fixed assets the GDP entry of GFC shows with all certainty that investment activities in Japan have been in secular decline for the past 20 years as the nominal value of GFC peaked in the first quarter of 1991.

It is worthwhile to note however that of the main balance sheet entries on the asset side, "investment securities" is the one that has exhibited the strongest growth rate in a post 1990 perspective. This suggests that a large part of the incremental change in retained earnings in this period has been parked in yield bearing instruments be it government bonds or more importantly foreign securities which have helped Japan gain a substantial boost (far bigger than from goods and services exports) from a positive income balance. Since 2005, the stock of investment securities held by Japanese corporates has been approximately equal to 68% of the stock of retained earnings.

More generally, the flow of investment securities onto corporate balance sheets rose steadily until about 1999-2000 after which we observe a discrete bounce and a much more rapid (and volatile) increase hereafter. From Q1-00 to Q1-01 the stock of investment securities rose 25% and has since increased steadily to about trn 181 in 2008.

This last point in particular serves to differentiate the argument by Martin Wolf even if it is unquestionably true that the share of retained earnings used to finance the asset side appears extraordinarily large in the context of Japanese corporates. Moreover, I cannot of course say for certain what would happen in the event that those retained earnings became the subject of political attention as a tool to muster domestic demand.

Is it Optimal to Dissave?

The standard life cycle model tells us that it clearly is, and especially so when set in the context of a representative agent model aggregated to the macroeconomic level. Sure, we may incorporate bequest motives or uncertainty, but in the limit; dissaving on a microeconomic level will transfer itself to the macroeconomic level. Implicitly, this is the argument advanced when it is held that the retained earnings of Japanese companies can meaningfully be deployed to boost domestic demand in Japan and, most importantly, lead Japan towards an external deficit which would go some way to rebalance the global economy.

Let me be clear. I don't dispute the dissaving argument in itself; especially in a context where fertility "never" recovers (which may well be the practical case in Japan). However, and while dissaving certainly would be the fate for a closed economy, it need not be for an open one. In fact, it should take us very little time to agree that dissaving as a function of old age perhaps even to the extent that the economy moves into an external deficit is utterly undesirable from the point of view of the economy as a whole. Thus, it is my contention that ageing societies are not, in the main, characterised by aggregate dissaving but rather by the fight against it. In Japan's case the high level of private savings reflected primarily in the level of corporate savings becomes a vital shield towards spinning further into negative trend growth and deflation.

Apart from this which is really my main observation on a theoretical level I have two additional points.

Even if we assumed that the retained earnings of Japanese corporates could be effectively channeled to the purses of households, would these same households increase spending? Put differently, what is the underlying demand here? Needless to say, I am quite sceptical here and moreover, it is important to remember that the rate of savings closely follow the growth rate in income. Thus, if suddenly income rose either through a lump sum payment or a steady trickle would the savings rate follow?

Finally, the extent to which Japan may become a global provider of spare capacity not only hinges on the trend of dissaving but also, by definition, on investment demand. This makes the whole issue much more complicated since what we are really looking for is a net effect and since both savings and domestic investment demand can be expected to decline with the transition into old age and it is the mutual pace between the two that determines the external balance. Consequently, empirical as well as theoretical studies have spent considerable time to pin down what this net effect is supposed to be. I will not go into the conclusions from this literature (my upcoming thesis will have much more on this), but merely note that we can observe how countries such as Germany, Japan, Finland etc are running external surpluses, why this surplus is critical for their growth prospects and thus why the salient features of an ageing economy is not dissaving but rather the fight against it.

Once you get this point and extrapolate it to the issue of global imbalances and the convergence of the global age transition towards a, so far, unknown end point you should realize the tremendous mess we have to sort out. In fact, why don't I come full circle and finish off with a most recent quote from none other than Martin Wolf writing in his latest column;

Meanwhile, the eurozone as a whole, having lost its erstwhile internal demand engines, must now hope for faster growth of net exports. So do countries hit by the financial shock, such as the UK and US. So, too, does recession-hit Japan. So, not least, does China. Either the rest of the world has a spending binge, or these countries – which make up 70 per cent of the world economy – are going to be disappointed.

This seems self-defeating to me since there is no way that 70% of the world economy can rely on export driven recoveries let alone export driven growth strategies no matter what kind of binge came upon the rest of the world. Still, I completely agree with Martin that this is indeed the issue. And once you overlay this argument with some basic intuition of how demographics affect savings, consumption and investment you end up with the fundamental challenge for the global economy in terms of staging a comeback from the economic crisis.

So yes Virginia, demographics do matter!

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[1] - Click on pictures for better viewing

List of References

Data for this piece can be obtained by mailing me and I will ship over my excel sheets. However, for those of you who want to check it out yourself here is the database on the corporate balance sheet data and in terms of household data you can get it from the website of the Bank of Japan (search for "household" and you should be able to dig out the relevant files).

Baldwin, Richard & Taglioni, Daria (2009) – The Illusion of Improving Global Imbalances, VoxEU research article (14.11.09) http://www.voxeu.org/index.php?q=node/4209

Friend, Andrew (1985) - The Policy Options for Stimulating National Savings, Conference on Saving and Capital Formation: The Policy Options Philadelphia (May 1985)

Obstfeld, Maurice & Rogoff, Kenneth (2009) – Global Imbalances and the Financial Crisis: Product of Common Causes, Paper prepared for the Federal Reserve Bank of San Francisco Asia Economic Policy Conference, Santa Barbara, CA, October 18-20, 2009

Horioka Yuji, Charles (2009) - The (Dis)saving Behavior of the Aged in Japan, Discussion Paper no. 763 The institute of Social and Economic Research Osaka University

Mason, Andrew (1988) - Saving, Economic Growth and Demographic Change, Population and Development Review, vol. 14 no 1 pp. 113-114

Nakagawa, Shinobu and Shimizu, Tomoko (2000) - Portfolio Selection of Financial Assets by Japan’s Households, Why Are Japan’s Households Reluctant to Invest in Risky Assets? BOJ Research Paperfff

Nakagawa, Shinobu and Yasui, Yosuke (2009) - A note on Japanese household debt: International comparisons and implications for financial stability, BIS Paper no. 46

Obstfeld, Maurice & Rogoff, Kenneth (1996) – Foundations of International Macroeconomics, MIT Press

Wolf, Martin (2009) - The Greek tragedy deserves a global audience, FT column January 19 2010

Wolf, Martin (2009) - What we can learn from Japan’s decades of trouble, FT column January 12 2010

Double-Dip Worries In Japan and Germany

Whoever said economists are people who don't ever get anything right?

"Economic growth in Germany probably stagnated in the fourth quarter from the previous three months, the Federal Statistics office said. Still, the figure is “surrounded by uncertainty,” Norbert Raeth, an economist at the office, said in a press conference in Wiesbaden today."

So German GDP was probably more or less flat quarter on quarter between October and December. The figure is surrounded by uncertainty, as I pointed out in this post (Is There A Double Dip Risk In Germany? ), quite simply because German growth numbers at the moment are all about net trade and inventories, with domestic consumption in an entirely secondary role. In fact quarterly movements in private consumption have been slight for some long time now, and it fell 0.9% in the third quarter (making a 0.5 negative impact on growth - see below, the large movement which can be seen between Q4 2006 and Q1 2007 is a distortion produced by the reaction to the 3% VAT increase which came into effect on 1 January 2007).




Imports rebounded in the third quarter, meaning the net trade impact was rather negative, but inventories were built up again (after various quarters of destocking) making a large 1.5 percentage points contribution to a final 0.7 percentage points quarterly growth. Things probably inverted in the fourth quarter, with export levels dropping back in both October and November, while inventories if not actually being run down, most likely were more or less neutral (this is what the IFO survey for the quarter shows) and thus won't count as a massive plus for growth. Eventually the whole inventory story is about second derivatives: when destocking slows down, the second derivative effect, mutatis mutandis, pushes GDP up, and and when restocking slows, this pushes GDP down.

So with nothing substantial to push it up, GDP stagnates. As I started to point out back in mid November:

The question in hand is the Eurozone third quarter growth one, and the story is all about differences (between countries) and these differences in the key cases (France and Germany) are in many ways all about inventories……Now if you look at the chart below, you will see that German growth was in the second quarter was, more than anything, a statistical quirk which resulted from a balancing act between strong swings in inventories and in net trade. In the third quarter, as far as we can see (since we don’t have that ever so important detailed breakdown), this position has quite literally been inverted, as the earlier trade bonus has been eaten away by growth in imports....

That was before we got the detailed breakdown of Q3 growth. On November 28, following the publication of this data, I went on to argue that:

While a positive contribution to growth was made by goods exports, which were up 4.9% on the previous quarter, imports also rose , and by more than exports (up by 6.5%), and the resulting trade balance had a negative effect on growth of –0.5 percentage points. This was more or less the same as the contribution from household consumption (which was also negative by 0.5 percentage points). But what really, really mattered here - see the chart below - was the inventory build-up which added a staggering 1.5 percentage points to growth., while government final consumption expenditure only increased slightly (+0.1%) over the period and effectively had zero impact on the growth number. So, as I said, it is all about inventories in Q3.

Which lead me to conclude that:

In Q4 it is all going to be about trade. Since if German exports hold up, then the run down in inventories need not be that strong, but if exports don’t sustain momentum in December - and what just happened in Dubai is making me very nervous on that front - then German GDP will almost certainly fall back into negative territory in the fourth quarter. On the other hand, if I am jumping the gun slightly here, and German economic activity does manage to eke out some small increase at the end of the year, then I think a return to negative growth in the first quarter of 2010 is almost guaranteed. That is to say, we have a double dip on the horizon. At least, that is my call. Now it is over to you.

Japan's Recovery Also Fails To Convince

Well, my instincts seem to have been more or less good ones, and just to show that my forecast was not simply a fluke (ie that it is backed by some sort of coherent analysis, one that is testable), I would also draw attention to my "twin" post on Japan - Double Dip Alert In Japan, dated 7 December - where I said:

"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".

Just two days laters Japan's third quarter results were revised down, sharply (and for most analysts unexpectedly sharply).

JAPAN'S economy grew much less in the third quarter than initially reported, revised government data showed today, as a strong yen and deflation weighed on economic activity by prompting firms to hold off on new investments. The new data revealed that July-September's real gross domestic product grew 0.3 per cent compared with the previous quarter, much slower than the 1.2 per cent expansion reported last month, and worse than analysts' consensus forecast of a 0.6 per cent rise.

Japan may have contracted in the fourth quarter, at this point I am not surI'm not sure, given the sharp downward revision in Q3. Certainly Japan’s reliance on exports is simply further underlined by the sharp fall in machinery orders from service companies in November. In fact orders from non-manufacturing companies dropped 10.6 percent (from October) to 380.7 billion yen ($4.15 billion), their lowest level since May 1987. In addition core orders from all industries, an indicator of business investment in three to six months, also fell to a record low.

And the Japan composite Purchasing Managers Index (PMI) shows contraction over the whole October to December period. And the drop was lead by Japanese services. The headline seasonally adjusted PMI posted 42.7 in December, up slightly from 42.3 in the previous month, but still pointing to a marked reduction in business activity amongst Japanese service providers. For Q4 as a whole, the headline index averaged a lower reading than in Q3. So, despite manufacturing data pointing to a faster expansion of output, the Composite Output Index (which mirrors GDP) was stuck at a level succesting a solid reduction in private sector activity. The index, which posted 46.5, has remained below the neutral 50.0 threshold for four successive months.

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

“Data signalled that the Japanese service sector continued to underperform in the final month of 2009. On the back of the substantial downward revision to Q3 GDP, firms were the most pessimistic about the outlook for activity since the height of the downturn, suggesting that business conditions will remain fragile in 2010. The fading impact of stimulus measures, the return of deflation and weak underlying demand are all factors that will continue to weigh heavily on service sector activity in the coming months.”

Where Is The Demand?

So what's the point of all this? Well certainly not to say simply "aren't I clever now". The issues is that (for demographic reasons) the German and Japanese economies are totally export dependent (retail sales in Germany have now peaked, and are in long term historic decline, see chart below), and thus it is unrealistic to expect the global recovery to be lead by an expansion in these economies. The recovery will have to come elsewhere (in France, for a start, but with France alone there is not enough) and the export dependent economies can then "couple" to that dynamic. It is difficult to say whether or not the Japanese economy will show some marginal growth in the fourth quarter, since the Q3 revisions make for a much lower base, industrial output has risen considerably on the quarter, but the important services sector has been contracting.



Essentially, until those heavily indebted economies (the US, the UK, Spain, Ireland, Eastern Europe, etc) who formerly ran current account deficits can find a way back to sustainable growth without the aid of large government stimulus programmes, any general recovery will remain extremely weak. And the German result has, of course, implications for four quarter Eurozone growth. As I said in this earlier summary of the Q3 eurozone performance:

So, going back to my original question, is this a whimper recovery, or are we on the verge of a double dip? I think, basically, it is all down to Germany, and those inventories. If external demand weakens in key customer countries then Germany will fall back into negative growth, and with it the whole "eurozone sixteen economy". Since demand in the South and the East of Europe is hardly going to be strong, given the new found need of countries in those regions to run trade surpluses, my inkling is that just this outcome is now a clear possibilty. So while the consensus at the moment seems to be that France disappoints, my view is that it is the German economy we really should be worrying about.

As Gabriel Stein of Lombard Street Research puts it:

The lack of December data obviously adds an element of uncertainty to current estimates, but it does seem fairly clear that German private consumption continued to fall in Q4 2010. Given a deteriorating global environment – monetary tightening now under way in China, an end to the effects of fiscal stimuli and slower inventory drawdown/modest inventory build-up in the US and the UK – the outlook for German exports is unlikely to be that good, particularly with the euro still strong. This is bad news for Germany and for the entire euro area. A weaker euro could ease some of the pain, but that is all it can do.

So, in closing, lets just remember that German GDP fell by 5% in 2009, we are now back round the same level we were at in mid 2006 (see chart below), and we are not exactly springing back up to the old levels. That is the measure of the task we have in front of us.

Moodys on Japan and the Eurozone - Stating the Obvious

By Claus Vistesen: Copenhagen

I shall openly admit that I have always found the exact role of the rating agencies a bit odd in the global financial system. I mean, do we really need them to tell us which bonds are good and which are not? I am not sure and what is more; rating agencies sometimes, if not all the time depending on their ability to stay in front of the curve, seem to wield a tremendously amount of power relative to their role as private actors (after all) in financial markets. For example, they may ultimately decide whether bonds of a given Eurozone economy may be eligible for collateral at the ECB or, even more importantly, they may decide which sovereign bonds that are investment grade or not and thus whether big institutional investors can allocates there or not.

Yet, this reservation notwithstanding, the rating agencies do seem to be some of the only big ticket private market actosr who are able to state the obvious. Specifically in this context, the obvious is directing our attention to the the ongoing travails of some economies in terms of figthting the current crisis with fiscal stimuli while the yoke of population ageing and its effect on public finances steadily pushes the economy's long term prospects into the sinkhole.

In this way, I don't think people should be, or indeed that they have a right to be outraged by the continuing comments (and inevitable) downgrades. How could they possible act otherwise given that they are here and do what they do?

In this sense, the recent messages from Moodys on Japan as well as Greece and Portugal respectively sounds extraordinarily timely to me even if it is stating the obvious;

(Quotes Bloomberg, first Japan and then Portugal/Greece (Eurozone))

The replacement of Japan’s finance minister four months into the government’s term increases concern about the commitment to contain the world’s largest public debt burden, Moody’s Investors Service said. “Japan’s fiscal strategy unknowns deepen” with the appointment of Naoto Kan last week, Thomas Byrne, senior vice president of Moody’s in Singapore, wrote in a note yesterday.

Byrne’s stance contrasts with analysts at Goldman Sachs Group Inc. and Morgan Stanley, who said Kan has indicated a willingness to repair Japan’s finances. The 63-year-old deputy prime minister last week replaced Hirohisa Fujii to become the country’s sixth finance chief in 18 months, tasked with preventing a relapse into a recession while containing the debt. “The revolving door for leadership at the Ministry of Finance does not engender confidence that Japan will put together a credible fiscal strategy to reduce deficits and stabilize the massive government debt overhang in the medium term,” Byrne said.

Kan said on Jan. 7 that it will be a “challenge” to maintain fiscal discipline this year and he will try to secure funds to fulfill the ruling Democratic Party of Japan’s pledges without exacerbating the debt burden. The role change also “raises doubts” over the administration’s commitment to a 44 trillion yen ($480 billion) cap on new Japanese government bond sales for next fiscal year, Byrne said. Kan may “seek to further boost fiscal stimulus to an economy hamstrung by renewed and stubborn deflationary pressures,” he said.

(...)

The Portuguese and Greece economies may face a “slow death” as they dedicate a higher proportion of wealth to paying off debt and investors demand a premium to hold their bonds, Moody’s Investors Service said.

While the two countries can still avoid such a scenario, their window of opportunity ”will not be open indefinitely,” Moody’s said in a report today from London. Portugal, with a negative outlook on its Aa2 rating, has more time “to reverse this trend” while Greece “has significantly less time.” Moody’s cut Greece’s rating to A2 from A1 on Dec. 22.

The premium that investors demand to hold Greek debt instead of German equivalents is six times more than it was two years ago, and the spread has doubled since 2008 in the case of Portugal. Greece had the largest budget deficit in the euro region last year, more than four times the European Union limit of 3 percent of gross domestic product. Portugal’s debt load will account for 85 percent of GDP this year, according to the European Commission.

Naturally, the case of Japan and the Eurozone periphery diverges in a number of notable ways. For starters Japan has its own central bank which will be duly deployed to provide funding for the issuance of government bonds to the extent that private (or foreign) savings are not enough to satisfy demand. Moreover, and as Moody's point 94% of Japanese debt is held by the country's own residents. I find this point less convincing as a mitigating factor since a country may very well go bankrupt with the majority of debt owned by domestic actors. Think about this as simply marking Japan to market given the demographic outlook and thus scything the face value of all those bonds they issue domestically. I.e.e Japan would move from the third/second biggest economy in the world to the "..th". However, since this would ultimately occur internationally through a sharp depreciation of the JPY, it would also boost Japan's competitiveness considerably. More importantly Japan has a large external surplus which means that she is building up claims on the rest of the world in stead of the other way around.

This is not the case for the Eurozone periphery and apart from the obvious fact that Greece, Portugal, Spain etc do not benefit from their own central bank which they could collaborate with in the context of quantitative easing or a prolonged commitment to ZIRP, they are also net external borrowers. According to the data from the IMF, the average annual current account deficit as percentage of GDP between 1999 and 2008 in Greece, Portugal, and Spain was -8.6%, -9.1% and -5.9% respectively.

On this point I agree with Moodys and others that the risk of a sudden balance of payment crisis leading into short term default is not relevant at this point. Rather, the main issue lies in how to make headway on the public debt/fiscal front at the same time as correcting the external deficit which has to correct since these economies are now effectively export dependent. It is very important to understand the very dangerous and decidedly unattractive cocktail that these economies must now swallow and why it is exactly so because of the inability to use nominal exchange rate depreciation as a tool to correct the external deficit. In this sense, what these economies now have to do is to travel the ill-wanted route of an internal devaluation in which domestic price and wage deflation are deployed in order to restore competitiveness. But this is not all. They are consequently also now effectively forced, vis-à-vis the nudge and pressure from Moodys et al, to take serious steps to rein in public deficits and put long term finances back on track. Now, the dilemma should be clear at this point since, as we know, deflation increases the real value of debt and thus it is difficult to see how these economies are exactly to pull this off. We could say, that the Eurozone does not allow them the leisure of inflation to ease their path to recovery.

Now at this point, the Austrian police aka haters of Fiat et al will probably be flashing their badges and tell me to pull over. And so, as I pull over I will tell them that anyone seriously arguing that the inability of Greece et al. to use nominal exchange depreciation to correct is not an aggravating factor simply do not have the faintest idea of what export dependency means modern growth dynamics of ageing economies stuck in a fertility trap about to become a liquidity trap. Really, it is as simple as that and while not everyone can devalue at the same time to become dependent on the same exports (i.e. the real underlying problem as we move forward) we are about to find out what happens when the entire weight of adjustment has to fall on the domestic economy.

Having said this however, I would like to emphasize that while the Eurozone, for reasons just mentioned, may be far from perfect we cannot let it fall apart and thus an internal devaluation in Greece, Spain etc it is. As with the Eurozone itself, it will be a great experiment to see how and whether it will work to salvage these economies.

Plus Ca Change in Japan?

By Claus Vistesen: Copenhagen

Last week was a good lesson in terms of what might, or what might not, happen when policy makers attempt to steer currency markets. Notwithstanding the obvious question of much how clout policy makers de-facto holds with respect to moving currency markets (not a lot I think), the outgoing finance minister in Japan Hirohisa Fujii has on several occasions made it clear that he, for one, is not worried about a stronger Yen only to revert slightly as markets responded with a; "well then, lets go ..." In general however, it does seem as if Fujii's general position has been that a strong Yen perhaps would not be so bad since it would only serve to boost purchasing power. This is of course true, but it also highlights a rather alarming disconnect between the fundamentals of the Japanese economy stuck in export depedency and deflation and policy makers economic analysis (or spin) of the situation.

Now, Fujii has stepped down due to health reasons and perhaps in an attempt to enter the office with a bang instead of a whimper, his replacement Naoto Kan kicked off his first public appearance by noting that he, for one, would like the Yen to be a little bit weaker and that he believed the MOF and the BOJ should cooperate to make it so. Having not forgot the last time in 2002 that Japan intervened by selling Yen, markets reacted swiftly by giving the Yen a nice jolt downwards (against the USD).

Yet, that position lasted only one day;

(quote Bloomberg)

Japan’s Finance Minister Naoto Kan said markets should set currencies, while underscoring the ability to intervene in extreme circumstances and taking account of the yen’s impact on the economy. “Currencies of course should be determined by markets, but I must be aware that I have the right and the responsibility to take action in emergency situations,” Kan told reporters in Tokyo on his second day in office. “I must take into consideration businesses’ expectations.”

It appears then that Mr. Kan has received comment from above as the statement noted above was followed by comments by prime minister Yukio Hatoyama and finance minister delegates that members of governmetn should not really comment much, if at all, on currency markets.

So, will this be the last we hear from Kan on the Yen. Not very likely in my opinion. Japan needs a weaker Yen and slowly Japanese policy makers will wake up to this. In this sense we are likely to see policy makers and delegates tip-toeing in and out on this refrain as the data comes in. Whether this means that we will see actual intervention is another question. I have called for intervention once to many times before. However, I can say with the strongest possible conviction that prime minister Hatoyama's growth target for Japan in the 2010-2020 stint of 2% annually is dubious at the offset and completely bogus if Japan is not able to maintain a stable and growing external surplus towards the rest of the world. In a post-crisis context where many economies look set to follow the same road of export reliance this would definitely need a weakening Yen.

In his annual 10 non-predictions Macro Man revealed the non-intervention by part of the MOF/BOJ as number 8. I have no reason to disagree with him, so for now; plus ca change indeed!