Japan, Still Stuck

by Claus Vistesen

It did not come as a big surprise that the BOJ chose to hold rates steady once again on the outlook on inflation which seems to be deteriorating somewhat. More gravely for Japan the healthy growth clip of private consumption expenditures recorded in February of 1.3% seems to have ebbed out already in March where consumption expenditures rose a mere 0.1% and although this is an increase not unlike the secular decline throughout 2006 it still begs the question of what actually the outlook is on this reversion in Japan's growth path and the outlook that the BOJ is going to normalize any time soon? Digging deeper into the figures makes for troublesome reading indeed ...

Industrial output continued its decline in March albeit ever so sligthly at -0.6% and with the Japanese trade surplus expanding at a record pace (74% expansion y-o-y in March!) on brisk demand from China I would expect industrial output or that is to say Japanese capex in general to perk up in the coming months although I might still be underestimating the amount capex ramped up in Q4 2006 but I do think that de-stocking will soon come to an end if China continues to thunder along. In terms of consumption expenditures I have already noted that they rose 0.1% but worryingly retail sales posted the sixth consecutive decline in March which of course generally brings into question those heeding the call of the return of the Japanese consumer as a 'big spender'. Below, the figures plot consumption expenditures in % change each month since March 2006 as well as on a seasonally adjusted real index (2005 =100). As we can see it is trending up from 2006 but just how much can we expect to see here with lingering deflation?

And now that we are talking about deflation the following figures plots the CPI index since March 2006. Of course, CPI indices in Japan is a reasearch project in itself but take a look at the CPI index excluding food and energy and tell me on what grounds the BOJ could and should normalize?

In Summary

I am at a loss to understand the recent bullishness on Japan in terms of how we stand before an imminent correction in Japan's growth path. Japan is indeed growing but still driven largely by exports it seems and the return to deflation and specifically the immediate outlook which points to a somewhat lingering nature does not exactly bode well for the future. Clearly consumer spending is trending upwards but hardly anything conclusive can be said at this point on whether we stand before an imminent boom. I remain cautious especially given the outlook on prices which may feed into expectations at some point. Also, if this is a period in Japan where bonuses are rising and where consumers should be spending a lot of money is this really what we can expect? What happens then when things return to normal? I am of course happy that things are looking better but at this point we are just not out of the woods and on that note it is pretty irresponsible to hail the coming of a Japanese consumption boom and of course as always ... anyone got that textbook definition of a sustainable recovery?

Update on Sunday, April 29, 2007 at 09:12AM by CV

As ever, the weekly notes on Japan by Takehiro Sato over at Morgan Stanley follows mine quite nicely in terms of posting date (or more accurately perhaps my posts are following his?) and as such we also get the recent view on the outlook on Japan in the GEF edition this Friday.

As always, Sato's note is well worth a look as he sets out to discern the BOJ's recent report on the economic outlook.

Some of the risks regarding wages/prices and overseas economies cited in the previous October Outlook Report are emerging, but the April Outlook Report maintained the bullish scenario and forward-leaning stance on monetary policy. Overall, the Outlook Report is typically hawkish, but in the fine detail we also get a sense of some wavering on the part of the BoJ. Its statements on the management of monetary policy going forward, too, could be interpreted as a half-step retreat.

The median GDP growth forecast in the policy board’s F2008 outlook is almost unchanged at +2.1%, but the forecast for the core CPI inflation rate of +0.1% has been lowered more than expected from last October’s +0.5% following weak CPI results out the same day. Our impression is that this revision is too small (our forecast, after taking into account nationwide core data for March, is -0.1%), which means there is still some skepticism over the Bank’s outlook, but the downward revision itself was no surprise. The outlook for the economy and prices in F09, released for the first time, calls for steady economic growth of around 2% and relatively major improvement in prices of +0.5%. Under its forward-looking policy orientation adopted since the end of quantitative easing, the BoJ is keen to focus more on price rises to come than on weak price levels currently.

What Now in Japan

by Claus Vistesen

The BOJ is holding at 0.5%, exports are booming, and capex stays afloat. So what will happen in Japan as we venture forward into 2007. Well, this is what I am trying to answer in a recent note over at GEM. Here is an exerpt from my summary.

So, on the economic outlook for Japan going forward I would especially like to stress one thing to watch, and that is the substantial risk of Japan falling back into deflation in March (and perhaps February) on a y-o-y basis. If this happens it will undoubtedly cause some ripples between the MoF and the BOJ where the latter will be accused of acting prematurely on the basis of a backward looking hike in February. The other thing is industrial production which almost inevitably fell in February on a m-o-m basis due to de-stocking on the back of the unsustainably high capex seen in Q4 2006. The evolution of the export surplus from March onwards will determine just how much capex can be ramped up in the months to come, and this again depends on how key economic data coming out of the US (and to some extent also China) evolves. On consumer spending, we should expect to see a small pick-up over the next few months on a m-o-m basis but I am not bullish about the evolution of consumer spending on a y-o-y basis.

Interestingly I might have to revisit my view on Japan slipping into deflation on a y-o-y basis on the back of a dropping headline inflation rate. As such, the headline is ticking slowly back up at the moment and since Japan includes energy in their core inflation figures this is (at least for Japan) some sort of good news. Whether it is too late is of course another story and I maintain my view that Japan will be slipping into deflation in February and March on a y-o-y basis and in the end we really need to exclude energy from Japan's price index in order to get the right picture. Also, I think that it is not necessarily a great disaster if Japan slips into deflation in February and March (I mean the headline will probably be pushing up again in the rest of 2007 unless of course the US totally crashes) but more so the internal power struggle between the MoF and the BOJ will be exacerbated and I am sure that the MoF is poised to strike at the BOJ for raising prematurely should Japan touch base with deflation.

Japan Goes To AA

by Claus Vistesen

Indeed, Japan seems to be in a very vigorous economic mood at the moment with particularly consumption figures looking healthy in Q1. Perhaps the recent upbeat performance in Q4 2006 and Q1 2007 is in part why Standard Poor chose today to raise the credit rating on Japan (i.e. government debt) from AA- to AA.

Japan's debt ratings were raised one level to AA, the third-highest grade, by Standard & Poor's after the government cut borrowing and nursed a recovery in corporate earnings.

The increase in the long-term foreign and local currency debt ratings from AA- was the first by S&P since it assigned Japan the top AAA grade in 1975. Japan was downgraded three times between February 2001 and April 2002 as economic growth stalled amid deflation and banks struggled to dispose of bad loans.

S&P today said the banking system has been restored to ``good health'' and the world's second-largest economy will grow at about 2 percent, twice the pace of growth during the decade after an asset bubble burst 16 years ago. Prime Minister Shinzo Abe's government could improve the rating further if it finds the political will to raise taxes and cut spending, S&P said.

Clearly, this indicates that Japan is on the right way towards a sustainable recovery does it not? Well, there are two aspects of this of coures. First of all we have the actual credit upgrade by S&P. I have no doubt that the credit agencies' analysis on the Japanese banking sector is true in the sense that substantial reforms have been undertaking in order to bring back the sector to kind of efficiency on the back of the slumber in the 1990s. Yet, I am also a bit surprised on the short termism displayed in the outlook on government debt and public finances. Surely the recent efforts by Abe in terms of trimming the public budget and holding off sales of bonds are important but in the longer run should we not look at a rising old age depencancy ratio in order to gauge Japan's solvency and indeed ability to sustain debt at current levels? Ah well, I won't rain on the parade here and of course credit ratings can go south again soon enough and indeed we are perhaps looking at a short term improvement in the governmental debt position, but of course it is the longer term where I am worried. On another note, Bloomberg's surveyed economists point to a quickening in inflation which might prompt the BOJ to raise rates sooner rather than later in 2007 (if at all). This should clearly be seen in a more short term perspective than the credit rating decision above but still there is a pretty clear link since rising real interest rates also meant that yen denominated debt will be more expensive to service and then we do need to look at a rising old age dependancy ratio especially if your medium to long term macroeconomic outlook on Japan includes a reversion to a balanced growth path and thus also interest rate normalization.

In general, on Japan I also want to point towards some other sources before I leave. First of all we have Takehiro Sato's recent analysis on Japan. It is a very comprehensive account and analysis I have to say so be sure to give it a quick glance. Moreover, I also stumbled upon this article in the FT today about how Japanese asset holders (both retail and institutional) is now beginning to contemplate how to make all those assets earn a reasonable rate of return. Now, the interesting thing is of course to how big an extent this will prompt capital to flow abroad from Japan's borders in the search for yield. Lastly, we have Brad Setser's recent post which takes the pulse on another aspects of capital flows from Japan, namely the carry trade which is to say this is what the discussion converges on in the comments section. In reality, Brad sets off to note the recent reserve accumulation data in different central banks, well worth a look!

Japan and the Fertility Trap - A Worst Case Scenario?

by Scott Peterson

The way I understand how a negative scenario for population dynamics could play out in Japan is as follows:

Japan has a large segment of its population that is approaching retirement. When all of those people retire, they expected to be supported by the working population which is now far too small to support the large number of retired persons. Of course, theoretically those retirees should have some significant savings since we've been informed for years that the Japanese are great savers. So the burden of supporting a large retired population with a small labor force might be delayed for a few years. On the other hand, the use of savings by the retirees forms a wave of dis-investment that could torpedo efforts to offset the shrinkage of the workforce with robotic or mechanized production(of which much has been made in the press).

Political and social division ensue. Leaving aside the options the Japanese government has for handling that situation, pretty soon thereafter members of that retired group start dying. In 2006, according to PRB.org's World Population Datasheet, there were 9 births for every 8 deaths in Japan. When the retirees start dying off, that ratio reverses and could go fairly high in the other direction, say 12 people dying for every 8 born. So massive population shrinkage ensues.

Since the population is shrinking, domestic demand naturally is shrinking as well, and therefore Japan becomes even more dependent on exports for positive GDP growth. In reality, once the ratio of births to deaths goes much below 1.0, positive GDP growth is not possible. The shrinkage in domestic demand will be too much for any increase in exports to overcome. And when the yen's value versus other currencies eventually rises to a realistic value, exports will drop off as well.

Since the population is shrinking, real estate prices decline steadily as well. So there could be a negative home equity effect on consumer spending.

Another major problem will be the large national debt built up which now will need to be covered by the output of a much smaller labor force. A default by Japan on its sovereign debt could occur.

Did I leave anything out?