Japan Trade Surplus Narrows

This is hard to interpret, but it does seem that we have here more evidence of an investment slowdown in China (as well of course of a decrease of the rate of growth in US consumption), and Japan is one of the first to feel all of this. Now we have to watch for Germany. Note that many commentators are asking for domestic consumption to take the strain, and that doesn't sound at all realistic to me.

Japan's trade surplus narrowed more than expected as U.S. demand cooled, signaling the impetus that exports gave to economic growth last quarter is fading.

The trade surplus fell 24.8 percent to 614.7 billion yen ($5.2 billion) in October from a year earlier, the Ministry of Finance said today in Tokyo. The median forecast of 33 economists surveyed by Bloomberg News was for a surplus of 770 billion yen.

Demand for Japanese exports is cooling after the country's largest export market grew at the slowest pace in more than three years. Waning overseas demand leaves the world's second-largest economy more reliant on its consumers, who reined in spending last quarter, to sustain the longest expansion since 1945. Exports rose 11.6 percent, the slowest growth in six months.

Growth in exports to the U.S. slowed to 13.5 percent in October, after climbing 20.5 percent a month earlier, as demand for automobiles cooled. Shipments to the European Union grew 8.7 percent, slower than the 14.2 percent growth in September. Exports to China expanded 18.4 percent after climbing 19.7 percent the previous month.

Exports measured by volume, which don't take into account price fluctuations, grew 2.2 percent, the slowest since August 2005.

Demand for transportation equipment and electronics, which together make up almost half of Japan's exports, waned last month. Exports of transportation equipment, which include cars, trucks and automobile parts, rose 17 percent from 21 percent in September, the report said. Electronics shipments grew 7.3 percent, down from 11.8 percent.

The Japanese Yen

One of the important features of the current Japanese export driven 'recovery' is the relatively low (indeed vis-a-vis the euro historically low) value of the yen. Surprisingly few commentators have seen fit to comment on this, or on the significance it might have for the debate about whether or not Japan is finally escaping the deflation problem. In the days when people still used to talk about this issue, there was one proposal on the table (principally advocated by Swedish economist Lars Svensson) known as the 'foolproof path' (Professor Svensson's homepage is here, and it contains a whole slew of papers related to this topic).

The foolproof way is to announce (1) an upward-sloping price-level target path to be achieved, (2) a depreciation and a temporary peg of the yen, and (3) the future abandonment of the peg in favor of inflation targeting when the price-level target path has been reached. Then, the BOJ and the MOF just have to behave accordingly.

Now it can easily be seen that a key component of this 'foolproof way' is a substantial depreciation in the value of the yen, and this is what we have seen across 2006. Surprisingly however, and despite the low yen values and extremely high energy costs, Japanese inflation has yet to poke its head above the 1% mark, and with falling energy prices and a slowing global economy is now more than likely (IMHO) headed back into negative - and hence deflationary - territory.

Now one of the important details about the current low values of the yen is that it is in part driven by an outflow of funds from the Japanese themselves:

The yen weakened against the dollar and euro on speculation Japanese investors are seeking the extra yield of U.S. and European assets.

Japan's currency was near a record low against the euro as a government report today showed demand for services in the world's second largest economy fell twice as much as expected in September. The Bank of Japan started a two-day policy meeting today, with economists saying interest rates will stay at 0.25 percent, the lowest among the world's major economies.

``People are looking to the BOJ meeting for more clues on the rate hike outlook,'' said Niels From, a currency strategist in Frankfurt at Dresdner Kleinwort, ``You're still getting big returns from investing in higher-yielding currencies, and the yen should continue to suffer against the euro.''

Now Morgan Stanley's Stephen Yen (who Brad Setser apparently doesn't like at all) had an interesting post about this situation on the MS GEF last week (what Jen calls retail flows are in fact movements of funds by individual investors):


"The accelerated decline in the 'home bias' for mutual funds and retail investors is worth a closer examination. While there is still no definitive explanation of this trend, there is a possibility that it may not be the case that the individual investors' 'home bias' is genuinely lower, but rather that there is just more capital controlled by individuals and therefore more to invest overseas."

"Something that happened 60 years ago may be one contributing factor behind the general weakness in the JPY. During 1946-1949, Japan experienced a mini baby boom. Though it was milder and shorter-lived than the US baby boom (from 1947 to 1964), it nevertheless created a big enough demographic bulge to have consequences now. Relative to a long-term average of around 1.2 million a year in the 'natural' rate of population (birth rate minus death rate), during these four years, the bulge in the demographic profile was close to 2 million, i.e., there was a net 2 million increase in population during this period — an average of 500,000 a year."

"Sixty years later, in 2006, the first wave of these baby boomers reached retirement age. When they received their cash retirement payments, they may have allocated a greater portion of their assets overseas than in previous generations. This may have helped propel an accelerated decline in the collective 'home bias' of mutual funds and retail investment."

Now this is fairly interesting since Jen attempts to link this behavioural change away from home bias to some features of Japan's changing demographics, and in particular to the need (in the uncertain climate of Japan's ongoing problem in funding its pensions liabilities) of finding added yield to cushion any future problems.

Now takes on a lot more interest when you start to think about the fact that a lot of the recent rise in the Japanese stock market was driven by capital inflows - from people with oil surpluses, things like that - on the expectation that the 'recovery' was finally coming. OTOH Jen seems to be indicating that the individual Japanese (institutionally the Japanese will of course always have home bias, which is why you shouldn't expect 'melt down' any time soon, this is one of the big differences between Japan and Italy, IMHO) are sending their money to where they can get higher returns, and in particular the US.

My guess is that people like Brad Setser and Nouriel (and even the likes of Martin Wolfe) with all their dollar-melt-down orientation are completely missing this. So what happens when it becomes obvious that the recovery in Japan isn't sustainable and the BoJ has to back down and re-introduce ZIRP. Well a lot of the foreign money goes out, that's what happens. And the 'retail' flows (as Jen calls individual investors) will keep heading for New York etc. So we are really talking about the Yen potentially holding to very low values (and of course never forget that the renminbi is to some extent weighted to this).

Japanese Third Quarter GDP

Well Japanese GDP maintained its momentum in the third quarter according to the initial data released today:

Japan grew more strongly than expected in the third quarter with strong exports more than offsetting weak domestic consumption to produce annualized growth of 2 per cent......The economy, which grew a revised 1.5 per cent in the second-quarter on an annualized basis, has been expanding for seven straight quarters. Next week, the recovery will enter the record books as the longest - though far from the fastest - period of sustained growth since the war."

"Third-quarter numbers showed that consumption shrank 0.7 per cent from the previous quarter. But exports climbed 2.7 per cent and capital investment, in spite of weak recent numbers, jumped 2.9 per cent, marking the 10th quarterly rise in a row."

and Bloomberg:

Consumer spending, which accounts for more than half of the economy, fell 0.7 percent, twice as much as the 0.3 percent drop expected, amid a spell of bad weather that kept shoppers at home and as wages growth stalled.

So the picture remains pretty much the same, strong export lead growth sustained by capital investment, with shrinking domestic consumer demand. A big part of the burden was carried by growing investment demand:

"Capital spending in the quarter surged 2.9 percent, more than three times the 0.9 percent gain expected. Mizuho Financial Group Inc., Japan's second-largest bank by market value, and Tokyo Electric Power Co., the nation's biggest power company, announced plans this month to invest as the economy grows."

But the big question mark still remains as to whether this is anticipating internal demand which may not arrive, and whether or not this investment is justified if export demand weakens. In other words we may have excess capacity building up again, which obviously would be deflationary in its impact. This is presumably not being lost on the BoJ who are using the growth in such investment spending as an argument for raising rates, but here, as I have been arguing, they are trapped between a rock and a hard place, and indeed it is hard to assess how many of these investment projects are being financed now precisely to avoid having to pay the higher interest rates which the BoJ is threatening to introduce later.

One thing which is striking here is the way in which, despite the inevitable labour market tightening as the population shrinks, wage drift and inflation remain incredibly tame. This is an indicator of just how far the reform process has actually gone in Japan, since there seems to be absolutely no room whatever for wage-push inflation. This is also something of a warning for those who simply argue that more structural reforms will cure the problem, since in the case of Japan at least they seem to have been tried and found partially wanting. Still, there are those who live in hope:

Koji Omi, finance minister, told the Financial Times last week that the recovery remained solid in spite of signs of slowing US demand. It was true, he said, that higher profits had not fed quickly into better wages and stronger consumer demand. However, he said that, with the labour market tighter than at any time in 15 years, he expected wages and consumption to pick up soon.

Right and Wrong on Japan?

This is a cross-post from my own blog Alpha.Sources in which I argue that any economic analysis of Japan must begin with the demographics. I am no fundamentalist but it seems very clear to me that any economic analyses on Japan which do not take the time to look at the structural effect of the demographics on the economy are not worth much I am sad to say.

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We are now ready to another trip around the economic commentaries dealing with the Japanese economy and its sustainable/ongoing recovery. For a list of my recent post on Japan go here.

Let us begin with the those who are getting it right. First off, the FT's Lex column seems to be on the right track concerning Japan. Back in September Lex ran a column asking about what in fact was happening to the Japanese recovery based on disappointing data coming out from June. This week Lex also takes on Japan in one of her columns pointing once again to weak data especially on lending and subsequent consumer spending.

(bold parts are my emphasis in terms of all excerpts presented below)

What recovery? Japanese economic data continue to disappoint. The latest, published on Thursday, show bank lending growth decelerated on an annualised basis in October, for the third month in a row. City banks actually lent less than a year ago.

Borrowers are clearly in short supply. Companies are less willing to invest. Even if they were willing, most have plenty of cash on their balance sheets. Nor is it just borrowers who are thin on the ground. Shoppers too are holding back, as the government knows to its cost: consumption tax revenues fell 3 per cent year-on-year in the six months to September. Private sector economists are slashing estimates for third-quarter growth, due out on Tuesday. Since consumption alone fell 0.9 per cent, it is possible the economy contracted.

Also the FT's David Pilling is scratching the right places in an article discussing how the BOJ might act pre-emptively against inflation and raise rates come next meeting (that is, some time before the end of the year). Yet as Pilling so rightly points to (at least implicitly); what inflation? If we discount the headline Japan is still running deflation and even including energy Japan is flirting with a potential backlash into a vicious deflationary circle.

Speaking to a seminar in Tokyo, Mr Fukui said: “Waiting for inflation to build up in raising interest rates would cause a sharp swing in the economy. Our task is … to take careful action before these conditions appear in order to achieve price stability and keep future economic swings gradual.”

The governor’s comments come against a background of weak headline inflation and concern among some analysts that the economy, which is going through a weak patch, could actually slip back into deflation.

His remarks reinforce the bank’s insistence that it will not tie its policy to the headline rate of inflation, which has been sliding, partly due to technical factors.

Instead, the BoJ, which raised rates in July for the first time in six years to 0.25 per cent, wants room to be able to act against inflationary pressures before they are apparent. It has what some economists consider to be an overly conservative understanding that price stability equates to an inflation rate of between zero and 2 per cent.

This allows no buffer against slipping back into deflation, and the bank has resisted hitching its policy to a specific inflation target.

Jonathan Allum, Japan strategist at KBC Financial Products, said: “The nightmare scenario is that A: you begin to see evidence of economic contraction, B: you get a return to deflation, and C: the Bank of Japan ignores all this and tightens anyway.”

Mr Allum said the economy had been slowing for nearly a year and that it could even contract in the third quarter because of sluggish consumer spending. “Clearly there is a danger that the BoJ is too gung-ho in its view of the economy,” he said. “If energy prices are excluded, as they are in most economies, Japan is still in deflation.”

So these were the ones getting it right. Moving on I should say that I do not have an FT subscription but instead I have chosen some three years ago to go with The Economist. I stand by that decision but in no way because of the magazine's continuing la-la position on Japan. Consequently, The Economist runs a story this week about the 'vigorous' state of the Japanese economy.

The school of Japan-watchers that keeps an eye on the country's economy chiefly out of a morbid interest in terminal decline (ouch :)) has stopped dwindling . It has even taken on new adherents of late. For signs are mounting that the recovery that began in 2002 has slowed—or even, some say, gone into reverse.

The chief worry is that what started as a recovery driven by exports (chiefly to China), and then expanded to one led by business investment, has failed to spread to households, whose spending remains sluggish. Prices still flirt with deflation (see chart). And some economists predict that figures published on November 14th will show that the economy actually shrank in the third quarter.

Is this growing uneasiness justified? Mostly not. Take the economy first. Certainly, its anaemic performance marks this recovery as out of the ordinary, but then it follows long years of extraordinary distress. Habits are hard to change. So even though households now have more income—because companies are hiring more, and raising overtime and bonuses—this has not shown up in consumer spending. Alarm mounted last week when the main survey of household spending recorded a plunge in September of more than 6% compared with a year earlier. Yet this fall is too big to be credible; the survey (like early GDP numbers and other Japanese statistics) is notoriously unreliable.

Meanwhile, expectations are rising, even if habits have not yet caught up. Households' estimates of future inflation and property prices have climbed since the spring. People are not spending gaily, but they are starting to remove money from risk-free havens and invest it again. Deflation had killed the appetite for risk. There are other signs that the recovery is still broadly on track, even if it has, as in 2004, hit a soft patch. The latest bank lending figures seem to confirm this: though growth slowed in October, the year-old recovery in bank lending is still intact.

(...)

Moving forward in Japan? Well, certainly and good all the same! Addressing the Japanese 'dual-economy.'

A priority is to address Japan's so-called “dual” economy. The competitive exporting industries are not matched in agriculture and services, which are shielded from competition, lack economies of scale and are backward in their use of information technology. To boost investment, the government is mulling a cut in corporate income tax and other tax changes. Deep reforms to pensions and health care are also expected.

oh yes, and to use a classic proverb - it's the demographics stupid!

Japan's demography, says Genichiro Sata, the minister for regulatory reform, demands higher growth, and it is the Abe government's intention to impart deep structural change—including even a wholesale restructuring of government, by crunching Japan's 47 prefectures into a handful of American-style states. These are early days. Mr Abe has given little sense yet of his priorities, and many of the proposals are hardly vote-winners. Reformist achievements are yet to be seen. But the charge that Mr Abe has no reformist intentions is getting harder to make.

Ok, am I being too much of a dooms-speaker here on Japan? Perhaps I am but only time will tell really. What I would like to do though is to make a point across the table here. Japan as a society and in this case as an economy is deeply affected by its demographics, subsequent low fertility and more importantly high median age. Demographics are not destiny but if we begin here I feel that much of Japan's current economic plight can be explained in its core. As such, I believe that the continuing lack of consumer spending is not subject to an automatic reversal as The Economist rather naively, I am sad to say, suggests. In fact, low consumer spending is a structural indicator of Japan’s population structure which is also why Japan is running a trade surplus and also why in the end Japanese economic growth is by and large export driven. I hardly think it is a problem of ‘habits which merely take time to adjust.’ This argument has wide consequences for the way we look at Japan and its problem with deflation which after all must also be considered a structural phenomenon in the economy. Even more obvious is the labour supply where many a commentator (although not any linked here!) have argued that the tightening labour market was a cyclical phenomenon pointing to supply having problem keeping up with demand as the recovery really got underway. I am sympathetic to this point since it is theoretically a good point, just not in Japan where the age composition of society is a proxy for tightening of the labour supply and as such is a structural effect of the changing pyramid more than a cyclical fluctuation.

So let us begin with a strong basis of analysis and move our way up from there, that is really all I am pointing to.

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And the Update 11 November based on the latest data on machine orders.

Sadly the data keeps on going the wrong way for Japan.

(From Bloomberg - bold parts are my emphasis)

Japanese machinery orders unexpectedly slumped, signaling economic growth may stall and prevent the central bank from raising interest rates, already the lowest among major economies. Stocks fell.

Non-government machinery orders, excluding shipping and utilities, dropped a seasonally adjusted 7.4 percent to 997.5 billion yen ($8.5 billion) in September from a month earlier, the Cabinet Office said in Tokyo today. Third-quarter orders sank 11.1 percent, the biggest decline ever.

Bonds rose on expectations that the report, an indicator of capital spending plans, will ease the Bank of Japan's concern its key overnight lending rate of 0.25 percent could fuel excessive investment. Next week's gross domestic product report is expected to show corporate spending growth slowed in the third quarter.

`The drop in machinery orders was a surprise,'' said Soichiro Kimura, an analyst at Mizuho Securities Co. in Tokyo. ``It's adding to speculation the report will weaken the central bank's case for raising rates.'' `

(...)

``The gap between the actual economy and the Bank of Japan's view might be widening,'' said Hiromichi Shirakawa, chief economist at Credit Suisse Group in Tokyo.

Sustained growth in exports, the only standout in the quarter, will be key in ensuring business investment keeps rising, Dai-Ichi's Iizuka said.