Checking up on Japan

(A crosspost from Alpha.Sources.)

Time is indeed a scare ressource and as such I have not been on the spot with some reporting on Japan as the third quarter came out a week ago. This is consequently to make amends on that but also to react on some interesting comments on Japan I have found in the week gone by. Let us begin with the economic data then and to that end Edward Hugh really has the all arguments ready at hand. At first hand we have good news here as Japan managed to expand for the seventh consecutive quarter. Yet the story has not changed much as Edward also points out;

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.

Furthermore, the crucial point is that the lack of consumer spending does not seem to want to push up even in the light of increasing corporate bonuses. This obviously links up with the monetary situation in Japan where the central bank just cannot find the justification to raise rates. This, subsequently, is also keeping a lid on the Yen despite talks in high international circles about how the Yen should be a bit more willing to adjust to the fundamentals. More accurately in my book though, some are beginning to speak of being too much in a rush to normalize monetary policy. Another very interesting aspect of the Japanese economy deals with the tightening of the labour market. Many commentators have claimed this to be a result of a recovery in the making but I believe that we should rather look at it as a structural evidence of a shrinkening labour force. Following this is the discussion about why the tightening labour market is not pushing up inflation/wage growth; as Edward explains ...

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.

What is most interesting here is that if we don't look at demographics in Japan's case we end up with a very thin line of argumentation in which we are down to musings about when the positive growth cycle begins in Japan and consumer spending picks up again ... take for example one of the latest pieces on Japan from Morgan Stanley's Global Economics Forum.

As shown in preliminary Jul-Sep GDP numbers, the contrast between the corporate sector and the household sector has intensified, and this gap is not likely to close for some time. We assume that it will take a year or more for a positive growth cycle to develop, as momentum on the corporate front gradually spreads to the consumer and household level.

On what is this assumption above vested, that is the only thing I ask. When, for example, will people recognize that the life-cycle component of the consumer spending behaviour story is important? It seems wholly unreasonable to me to claim that the situation is any better a year from now based on business cycle analysis. Morgan Stanley claims to be bullish on the economy and cautious on prices (wage growth) the latter position mainly driven by high productivity. On this we are approaching the issue from two sides ... we both agree that prices and wages are not going to pick up anytime soon. However, where I, and also to some extent Edward above, are arguing that consumer spending will remain low and thus keep the core index and wages down as a function of the structural and lasting changes in the labour market structure, Morgan Stanley argues that;

Trying to predict when wages will rise and what the catalyst will be is a difficult task, but if the Japanese economy has been running about a year behind the US economic cycle since the bursting of the IT bubble, it should take about the same amount of time as it did in the US. The US economy bottomed out in early 2002 and wages began to rise just this year. This suggests that the labor distribution rate in Japan is not likely to rise until F3/08 at the earliest, and only then if a knock-on effect from increased hiring does in fact finally translate into higher wages. In such a case, we would expect nominal wages to run more or less flat during the forecast period and for real wages to continue to decline during this time. Accordingly, we maintain our cautious stance regarding consumer spending.

The most decisive answer I can provide here is that Japan is not USA; actually far from it and precisely because Japan is such a special case in terms of population dynamics we cannot expect the economy to behave according to the textbook explanation of business cycles. Once again I am ending this with a point about where to begin our analysis. I am not for example dismissing the recent articles from Morgan Stanley; people are definitely scratching some of the right places but if we want to get this right we need to begin with the beginning and in Japan's case that is quite simply demographics.

The Japan Government Reduces Its Economic Forecast

In many ways this is significant. The Japanese government has just reduced its economic forecast for the first time since December 2004. So it seems that now all the signs are there that the longest economic expansion since the great recession began is now begining to come to an end. Foremost among the weak points is, of cousre, domestic consumption. Rather than repeating myself for the umpteemth time here, I would simply direct you to yesterday's post by Claus Vistesen, where the issues involved are made extremely clear.


Japan's government lowered its evaluation of the economy for the first time in almost two years, after sluggish wage growth prompted a slump in consumer spending.

``The economy is recovering, despite some weakness in consumption,'' the Cabinet Office said in its report for November in Tokyo today. ``Private consumption is almost flat,'' it added, cutting the assessment for the first time since December 2004.

The last time the government lowered its assessment was in December 2004, as stalling global demand prompted a glut in corporate inventories and a slump in production. The world's second-largest economy almost slipped into a recession when slower export growth caused it to contract in the fourth quarter.

Household spending, which has declined every month this year, plunged 6 percent in September, the biggest drop since 2001. Wages were unchanged in the same month, after rising only about 8,000 yen ($68) since January.


Although it lowered the assessment, the government maintained its view that the economy is ``recovering,'' unofficially putting the current expansion in its 58th month, the longest since 1945.

``As far as the monthly economic report is concerned, the economy of Izanagi has been surpassed,'' Ota said, referring to the so-called Izanagi boom that ended in 1970.

During the Izanagi boom, a 57-month period named after a Japanese god, gross domestic product almost doubled, helping Japan emerge as a major economic power. The expansion, sandwiched between the 1964 Tokyo Olympics and the 1970 Osaka world expo, was so named because the economic miracle was compared in significance with Izanagi's creation of the Japanese islands.

Japan's economy has grown at an average 2.5 percent in the current recovery, about a fifth of the average 11.5 percent seen during the Izanagi period, according to Dai-Ichi Life Research Institute, a Japanese think tank.


The biggest difference between Izanagi and the current recovery is that deflation plagued most of the latter, meaning growth relied on exporters as consumers, discouraged by job and wage cuts, spent less. Unemployment surged to a record 5.5 percent during the current recovery, more than four times the average rate between 1965 and 1970, government data show.

``Deflation crippled non-manufacturers, who employ about 80 percent of the workforce, which has made it hard for most citizens to feel the recovery,'' said Hideo Kumano, a senior economist at Dai-Ichi Life Research Institute and a former central bank official. ``The recovery may be the longest since the war, but it certainly isn't the largest.''

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).