A brief look at the possible economic impacts of the DPJ victory

It appears that the DPJ has not promised much change in economic policy. In analysis leading up to the election the NY Times stated that

"The main opposition Democratic Party, which polls indicate will end half a century of nearly uninterrupted rule by the Liberal Democrats, has not offered much more than piecemeal remedies to Japan’s biggest problems. Neither party has proposed politically difficult solutions, like allowing in more immigrants — a no-no in racially homogenous Japan — or raising taxes to help reduce the big public debt burden.

“Both parties are ducking the hard issues,” said Takatoshi Ito, a professor of economic policy at the University of Tokyo. “What they do present is a Band-Aid for these problems, not the real surgery that Japan needs.”

A Wikipedia analysis of the DPJ's economic policy proposals lists the following:

-a restructuring of civil service (meaning layoffs and pay-cuts)
-a monthly allowance for families with children (at 26000 yen per child)
-a cut in the petrol tax; income support for farmers
-free tuition for public high schools
-the banning of temporary work in manufacturing
-raising the minimum wage to 1000 yen
-no increase in sales tax for the next four years

I think that most of these ideas have merit, with the exception of perhaps the farm income support. Agriculture is a sector in Japan that has been heavily subsidized in the past, so additional support is not exactly revolutionary.

Recently, Andy Xie expressed a rather negative opinion regarding Japan's leadership:

“Japan is an enigma. It has been locked in a vicious cycle of economic decline with a strong yen and deflation. Most Japanese people have a strong yen psychology. Politicians and central bank leaders reflect this popular sentiment, which is based on an aging population. Wealth is concentrated among voting pensioners for whom a strong yen and deflation theoretically improve their purchasing power. But I think various theories that explain Japan’s behavior are not good enough. The best explanation is that Japan is run by incompetents, and some are downright stupid. They have locked Japan in an icebox and refuse to come out.”

Strong words. If Japanese citizens are in fact holding out for greater purchasing power due to deflationary psychology, the question is what are the pensioners expecting to spend their savings on?

I think a significant policy that Japan implemented over the last decade has been outsourcing production to China, which provides the labor pool that Japan lacked. This benefited Japanese multinationals, but not domestic workers.

I think, though that this could backfire for Japan as quality will be harder to maintain. The main asset that Japanese companies have now is their reputation for quality goods. If that were to slip, the consequences would be serious.

Corporate Capex in Japan (Q2-2009) - So, is This What a Recovery Looks Like?

By Claus Vistesen (Copenhagen)

Much pomp and circumstance was certainly made in relation to the fact that Japan actually grew in the second quarter at a full annualized 3.7 percent in the second quarter of 2009. Yet, the underlying numbers to suggest a recovery are still sorely missing. Deflation now seem to have taken hold, unemployment is rising fast and although the recent manufacturing PMI provided us with an upbeat signal, the underlying trend still is still that of a very tepid recover, if at all, or just a plain slump.

(quote Bloomberg)

Japanese businesses cut spending for a ninth quarter as the global recession squeezed profits, underscoring the challenge for the incoming government to sustain a recovery from the country’s worst postwar slump. Capital spending excluding software fell 22.2 percent in the three months ended June 30 from a year earlier, after dropping a record 25.4 percent in the previous quarter, the Finance Ministry said today in Tokyo. Profits slid 53 percent.

Sales fell 17 percent, the second-biggest drop on record, indicating global demand hasn’t recovered enough to encourage companies to buy more plant and equipment. Sanyo Electric Co. and Seven & I Holdings Co. are among businesses scaling back. “Companies have too many resources, and until that situation changes, they won’t have to invest in more equipment and they won’t need to hire more people,” said Seiji Shiraishi, chief economist at HSBC Securities Japan Ltd. in Tokyo.

(click on graphs for better viewing)

On a y-o-y and q-o-q basis, the sales of Japanese companies fell 17% and 4.5% respectively. Especially, manufacturing in general and machinery and equipment producers saw a rapid decline in sales. Investment in plants and equipment fell back sharply on an annual as well as a quarterly basis at 21.7% and a full 39.1% respectively. The pronounced fall in Q2 investment owes itself to an abnormally large outlay in Q1 2009 which has consequently been paired in the period just ended. As can be seen in the graphs to the right, the manufacturing sector has been hit much harder than the non-manufacturing sector which is not difficult to understand if you think about the fact that it is this sector of the Japanese economy which is most exposed to the external environment. This is to say, that the manufacturing sector's top line is very sensitive to external conditions on the margin. Between Q4-08 and Q2-09 the cumulative drop in Japanese manufacturers sales was a whopping 35% almost double that of the non-manufacturing sector's corresponding toll of a drop of 18%.

With respect to investment in plants and equipment (corporate capex) the picture is, interestingly, the reverse with the investment by the non-manufacturing sector falling much more sharply during the present turmoil. On a four quarter moving average basis, the change in investment in plants and equipment for of the non-manufacturing sector has been falling ever since the first quarter of 2006 with a cumulative drop of 37%. The corresponding number for the manufacturing sector shows that the investment of plants and equipments have been falling since the third quarter of 2007 with a cumulative drop of 19%.

Finally, in the context of operating profits (that is, profits derived soled from the company's primary operations), the non manufacturing sector is still well in the black whereas the manufacturing sector has moved from a figure much below average in Q4-2008 to outright red figures in Q1-09 and Q2-09. Between Q1 2000 and Q3 2009 the average quarterly profit (nominal) for Japanese manufacturers was a little over 4 billion Yen.

In Q4 2008, the consolidated profit read 761 million yen and in Q1-09 and Q2-09 the numbers had turned into an outright decline with negative profit of 3.5 billion and 645 million respectively. Conversely, the non-manufacturing sector was, albeit still below average, performing much more strongly with solid black numbers throughout the crisis.

No Recovery Here

While there certainly may be places the newly elected party to rule Japan can look for green shoots and evidence of an impending recovery in Japan, corporate capex and profit numbers are not one them. Neither are, of course, the labour market, the deflation debacle, as well as the household sector which leaves us with the obvious question of where then? Second quarter clocked in better than most had expected and ironically, despite the analysis fielded above, upbeat signals from industrial production and the manufacturing sector in general are cited as the main reason. I will let my readers judge for themselves by perusing the graphs above and then also note the following crucial point made by Soc Gen's Gleen B. Maquire in one of their recent economic outlook reports (my emphasis);

The bulk of the contribution to growth came from net exports. Exports increased by 6.3% qoq while imports declined by 5.1% qoq. Overall, net exports contributed 1.6ppt to Q2 growth. The recovery in the Japanese economy is starting to look eerily similar to the 2001-03 recovery when Japan emerged ahead of Europe and the US. This is largely a China dynamic with Japan’s exports to China (and indirectly to the rest of Asia) recovering in step with China’s stimulus measures coming on line.

(...)

Industrial production is responding to robust demand from China for capital equipment and
industrial goods as well as tentative signs of a recovery in the durable goods cycle within Asia and globally.

So, this appears to be an export story in which case positive news from Japan should not surprise us at all. Macquire goes on to argue that since Q2 did not see a bounce back in inventories from the sharp de-stocking of Q4-08 and Q1-09 this, expected, bounce in inventories. I remain skeptical of this claim since I don't necessarily believe that the new level of growth will necessarily support any rapid re-stocking of inventories, but time will of course tell very soon.

Finally and specifically in relation to the analysis above, it is also interesting to ponder the discrepancy between the manufacturing and non-manufacturing sector in relation to the idea of Japan being dependent on exports to grow. Clearly, the manufacturing sector's higher sensivity with respect to the financial crisis and its top line makes sense since external conditions deteriorated very rapidly. Conversely, the domestic economy of Japan was not struck by a major, and relatively large, credit crunch. Hence, we see the top line of non-manufacturers relying more on domestic demand decline less. On the other hand, in relation to corporate capex the manufactures' slump in investment is very exclusively tied to the financial crisis while that of the non-manufacturers seem much more broad based. Once again can we rationalize this through the idea that the manufacturers remain tied to external conditions while that of the non-manufacturers is increasingly tied to the domestic market.

So, does this last niggle make sense? I am not sure, but it would be an interesting thing to check.

Japan Emerges From Recession, But The Slump Continues

Amidst a huge fanfare of euphoria from the press, Japan's GDP expanded by 0.9% quarter on quarter between April and June, or at a 3.7% annualized rate. In doing so it clocked up the first positive growth in five quarters. Many now claim the worst is over is over for Japan, and in terms of the depth of contraction it may well be, but I fear that recovery may be a much more distant prospect than some imagine, and even when it does come may be far more tepid than is being factored in by the consensus. I am not alone in having there doubts. The Financial Times this morning has already begun to qualify its initial response:

"Japan returned to growth in the second quarter after a year of contraction, but economists warned that the recovery remained vulnerable to any faltering in export demand or tightening of the government’s fiscal stimulus spigot........Yet with unemployment still rising and deflationary pressures growing, Japanese Prime Minister Taro Aso acknowledged the world’s second-largest economy was still far from a return to real health. “We are only halfway there,” the prime minister said during a pre-election debate with rival party leaders."

As has Bloomberg:

Japan’s 3.7 percent economic expansion last quarter ended the country’s worst postwar recession. The bounce may be as good as it gets. Growth will slow to an annual 2.9 percent pace in the three months ending Sept. 30, according to the median forecast of 10 economists surveyed after yesterday’s gross domestic product report. Falling business investment and rising unemployment may hamper a recovery that has been fueled by $2.2 trillion in emergency spending by governments worldwide.

Morgan Stanley analyst Robert Feldman was equally forthright and to the point:

“We have our doubts about the durability of this......There’s isn’t enough demand to get us back on a very strong recovery path. We don’t see a huge downside, but nevertheless the upside is pretty limited.”

Exports, and public investment were the main growth drivers in Japan this quarter, while private consumption remained notably weak. The principal impetus came from exports that jumped 6.6 percent (quarter on quarter), led by demand from China. At home, Taro Aso’s 25 trillion yen ($264 billion) in stimulus helped consumer spending rise 0.8 percent on the quarter and lead government investment to climb 8.1 percent. The figures evidently show hallmark of a worldwide rebound in factory demand (after inventories have been run down) and large-scale economic stimulus measures in Japan. The expansion in exports, benefits from economic stimulus measures, and inventory building are unlikely to continue, and growth will most likely slow again, especially after the last quarter of this year, as their impact fades. Deflation will remain a feature of the Japanese economy and I thus expect the BOJ to maintain its policy of monetary easing into the indefinite future.

Personally I do not expect to see anything resembling a full-fledged recovery in Japan until the second half of 2010, although the present slight expansion phase may well continue through the July to September quarter, and certainly the July PMI suggested this.

Thereafter, however, economic growth is likely to slow through to the end of the fiscal year, and we may well see further quarters of negative growth. The principal reasons for this expectation are:

(1) fading support from economic stimulus measures, especially after the elections, when the deteriorating fiscal situation will need to be addressed.

(2) prospects of a slowdown in economic activity overseas, especially in China, which has become a key customer, and

(3) downward pressure from household spending as employment adjustments have an effect.

Industrial Output Improves

Japanese industrial output rose for the fourth month in a row in June and is expected to keep climbing as manufacturers restart production lines halted during the highpoint of the slump. June industrial production was up 2.4 per cent month-on-month, a rate of increase lower than the revised 5.7 per cent growth recorded for May but still an increase.

It is now obvious that the drastic output cuts of the last quarter of 2008 and first quarter of this year have successfully cleared the excess inventory backlog despite the extraordinary speed at which demand declined. The Industry and Trade Ministry (Meti) reported that inventories were down 1.0 per cent month-on-month in June, while the inventory ratio - which compares inventory to actual shipments and is seen as a leading indicator - was down 9.8 per cent. This the sharp fall in the inventory ratio suggests that the driveing force behind the current production growth has shifted from excessive inventory reduction to responding to overseas and domestic demand fuelled by government stimulus policies across the globe.





July PMI survey data provided further evidence that Japan’s manufacturing sector may continue to sustain the economy into the next quarter. The seasonally adjusted headline Nomura/JMMA Purchasing Managers’ Index (PMI) rose to 50.4 in July, from 48.2 in the previous month, pointing to the first improvement in operating conditions for seventeen months. Although only marginal, growth of the sector was slightly faster than the survey’s historical average.

Manufacturing production increased for the second month running in July, rising at the most marked pace since September 2006. Where an expansion of output was signalled, PMI survey panellists frequently linked this to renewed growth of new orders. It was the first improvement in firms’ order books for seventeen months. Those respondents that reported a rise in new order levels widely attributed this to firmer demand from home and overseas, with export sales rising for the second month in a row. The survey organisers stated that anecdotal evidence suggested improved demand from China was providing the main boost to workloads at manufacturers.



Deflation A Done Deal, And Digging In For A Long Winter

The shortfall in demand is already weighing on prices, making it likely that deflation will once again become entrenched in the economy. Consumer prices plunged a record 1.7 percent in June and yesterday's GDP report showed wages fell a record 4.7 percent from a year earlier. Capital spending, which accounts for about 15 percent of the economy, fell 4.3 percent last quarter. A survey published this month by the Development Bank of Japan showed companies expect to cut fixed investment 9.2 percent this fiscal year. Reductions by manufacturers will be the steepest since 1993.



While the falling energy prices that have been the main driver behind the decline in the consumer price index to date, deepening deflation fuelled by job insecurity and massive manufacturing over-capacity could become a major feature of the Japanese economic environment and effectively undermine the economic recovery process. The fall in "core-core" consumer prices, which exclude both food and energy, accelerated to 0.7 per cent in June, while more recent July price data for urban areas of Tokyo showed a fall of 1.1 per cent.

Unemployment On The Way Up

Japan’s unemployment rate rose to a six-year high in June and consumer prices fell at a record pace, adding to evidence the domestic economy is struggling to recover even as exports start to improve. The jobless rate advanced to 5.4 percent from 5.2 percent in May, the statistics bureau said today in Tokyo, higher than the 5.3 percent median forecast of economists surveyed.
Economists expect the jobless rate to rise to a record 5.8 percent as companies cut costs. Deflation may erode profits even as factory output rebounds, further hampering Japan’s recovery from its deepest postwar recession.



In addition there is the so called "hidden unemployment" problem - employees retained by Japanese companies who are effectively surplus to current needs. A recent study by analysts at Nomura found that when indexing the number of those employed and real GDP to the output peak of Q4 2007 the result showed a considerable gap. Based on a simple calculation and assuming this gap to represent the amount of “hidden underemployment”, they arrive at a figure for “hidden jobless” in Q1 2009 of 4.7m. This is far higher than the June unemployment figure of 3.48m. If the hidden jobless are included together with the registered “unemployed”, they calculate that the unemployment rate would leap from 5.4% to 12.2%.

Consumer Confidence Rises

Japan’s household sentiment rose for a seventh month in July, adding to signs the world’s second- largest economy is edging closer to a recovery. The confidence index climbed to 39.4 from 37.6 in June, the Cabinet Office said today in Tokyo. It has improved every month since tumbling to a record low of 26.2 in December. A number below 50 means pessimists outnumber optimists.




The Economy Watchers index, a survey of barbers, taxi drivers and other small businesses who deal directly with consumers, climbed to 42.4 from 42.2 in June, making for a seventh monthly increase.




Storm Clouds Ahead

So despite the sigh of relief that everyone must have gasped on seeing the growth number for the second quarter, it is obvious that Japan's problems are far from over. Unemployment - with or without the hidden variety - is going to remain a problem, and the consensus view among economists expects the unemployment rate to climb to an unprecedented 5.9 percent by next year. On the other hand real wages continue to fall, sliding by 5.2 percent in June from a year earlier, the fastest decline on record.



And while the Bank of Japan this month announced that economic conditions had “stopped worsening”, it also highlighted doubts about the robustness of recovery by predicting the contraction in the fiscal year would be greater than previously forecast. The BoJ now expects gross domestic product to contract 3.4 per cent in the year to March 2010. Bank of Japan Governor Masaaki Shirakawa stresssed that demand for the country’s products and services may well not gain momentum.

It is now highly likely that the next central bank inflation forecast will predict that deflation will extend into 2011, which will force them to prolong their policy of keeping rates near zero for some considerable time. Shirakawa himself has admitted that prices are falling worldwide because of a dearth of demand and excess supply in the wake of the global economic crisis, adding that it will take “considerable time” before price drops moderate.

On top of this there is continuing political uncertainty. Opinion polls show the ruling Liberal Democratic Party is likely to lose the lower house election to the opposition Democratic Party of Japan, which has never held power before. The DPJ has made considerable promises to the Japanese electorate for spending increases, but it is unclear how they will, in fact react give the very strong constraints on public spending which actually now exist. On thing. however, is certain: if they do win the coming elections they will inherit an economy which even after last quarter’s expansion is still at its 2004 level.

Japan still a major factor in US Treasury market

as reported in the US Treasury's TIC report. It's interesting that China did not surpass Japan until September of 2008; and that those two countries dwarf all the other holders. How long can Japan avoid having to redeem some of these assets to fund domestic social programs?