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!

Double Dip Alert In Japan

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.

The first of these is to be found in the fact that, as has become plain from the latest batch of data releases, Japanese manufacturers are continuing to curb both capital spending, salaries and workforces, making any recovery in domestic demand driven by “second round” effects extremely unlikely. A further reason for having second thoughts is the long term decline in the level of Japan’s trend growth, which has fallen substantially over the last two decades under the impact of its shrinking and ageing workforce. Thus whatever the initial rebound, without the aid of strong demand elsewhere it is completely unrealistic to anticipate strong sustained growth in the Japanese case. And lastly it is evident that whatever the recent optimism Japan's economy still faces major challenges, and in particular the risk of getting caught in yet another deflationary spiral, a danger which was recently highlighted by the announcement that prices fell at the fastet rate in half a century in October.

Indeed, fears that recent figures suggesting a robust recovery may have been a false dawn were only intensified last week when the Prime Minister himself sounded the official alarm that the country risked falling into a “double-dip” recession. With Japan’s export industry still reeling under the weight of the earlier sharp fall, and now bedeviled by both the plunge back into deflation and and soaring yen, Yukio Hatoyama made it plain that additional “measures are required so that the economy will not fall into a double-dip recession”. This warning, it seems to me, is not mere rhetoric, part of a political tussle between the government and the Bank of Japan, but refelects genuine concerns, concerns which have only been added to by the October industrial output data, and the November PMI readings. Clearly, any recovery from such a strong output fall as Japan has suffered was always going to incorporate some sort of initial momentum surge as final demand eventually adjusted to the sharp inventory run-down, but maintaining this momentum get harder and harder as we move forward, and the question we need to ask our selves is, "has all the low lying fruit now been picked".

Certainly the Japanese government fears it might have been, and has now made plain that it is going to introduce a further spending package to fight deflation and to ease the impact of the stronger yen. At the same time they have called on the Bank of Japan to take stronger measures to support growth and avoid deflation. “There’s a risk that excessive currency movements, along with deflation, will hurt Japan’s recovery,” the government statement said. “The government will compile stimulus measures this week and closely monitor currency markets,” it added, without elaborating on the size of the package, while Finance Minister Hirohisa Fujii has been adding to the pressure on the central bank by explicitly suggesting quantitative easing would “help” the economy.

The yen surged to a 14-year high against the dollar last week, only adding to the concern that a stronger currency will bring Japan’s recovery from its worst postwar recession to an early and untimely halt.

False Dawns?


At first sight Japan’s situation seems reassuring, since the economy seemed to have rebounded sharply in the third quarter as strong government stimulus measures sustained consumer spending and exports to rapidly growing Asian neighbours leapt upwards. The preliminary headline GDP reading even outpaced most economists' expectations, since the economy was estimated to have grown by 1.2% over the previous quarter (or at a 4.8% annualized pace).



This was the second consecutive quarter of expansion, following four successive quarters of contraction, and the apparent pace was a marked acceleration over the 2.7% annualized pace of the April to June period. But even before the champagne bottles were uncorked nagging doubts started to appear, in the shape of the domestic demand deflator – a measure of the changes in the price of goods and services - plunged by 2.6%, the fastest pace of price decline recorded since as far back as 1958. This was the third straight quarter of falling prices in Japan, and since there is no real likelihood that this situation is going to be reversed soon the government has now officially recognised that Japan is back in deflation.



In fact Japan's general index of consumer prices fell by 2.5% year on year in October, as compared with a 2.2% drop in the two preceding months. The headline figure was dragged down by a 6.8% drop in the cost of fresh food. Stripping out this component, deflation in core prices slowed slightly, to minus 2.2% compared with minus 2.3% in September. Although transport and communication costs continued to fall, the 4.6% contraction was the smallest fall in six months. The cost of housing fell by 0.3% and the cost of utilities fell by 9%, in both cases showing very little change from the previous month. When energy costs as well as fresh food are excluded, October prices were down by 1.1% after falling by 1.0% in September.

But looking beyond deflation more grounds for concern emerged as analysts realised that the contribution of private consumer spending to growth actual fell back in the third quarter (mirroring an effect I have already drawn attention to in Germany), offering yet more evidence of the limits measures to convert Japan from export to domestic-demand-led growth were up against. Private consumer spending, which accounts for more than half of Japan's GDP, rose 0.7% on quarter, compared with a revised 1% climb in April-June. Worse, almost everyone recognises that both these increases were largely the outcome of the previous Liberal Democratic Party-led government's economic stimulus programme, including as it did handing out cash to consumers and rebates for people buying energy-saving home electronics.

Finally, just last week we learn that revised estimates of capital expenditure by Japanese companies suggest that this fell at a faster-than-expected pace of 24.8% (from a year earlier) during the third quarter, as export pessimism in the face of a steadily rising yen and a struggle to show healthy profit numbers pushed managers towards holding off on new investment.



In fact the July to October data mark the 10th straight quarterly decline in capex spending, and follow a 21.7% year in year drop berween April and June. The latest estimate is being seen by analysts as rather a bad omen, and habinger of bad news about to arrive, since the data will be used to carry out the first revision of the gross domestic product figures, and it is clear Japan is now about to cut the preliminary GDP reading sharply. Estimates of how large the write down will be vary, with anything between 0.9% (3.6% annualised) and 0.3% (or 1.2% annualised), which would mean virtually no real growth at all in the third quarter if you take into account the fact that inventory build-up accounted for 0.4 percentage points of the healine number. In any event this part will be clear when we get the new estimate later this week. Whatever the final number the news will be bad enough, unfortunately however there is more to come.

Industrial Output Slows

It is now abundantly clear that the earlier surge in Japanese industrial output is now slowing, and the latest official data show it rose only 0.5% between September and October, far less than the 2.5% range in economist forecasts, and so despite everything compared to October 2008 industrial output was still down by 15.1%. So while Japanese industry is rebounding, it is hardly surging, and we are left asking ourselves, has all the low lying fruit now been picked?

The results of the November manufacturing PMI survey seem to suggest that they have, since despite remaining above the neutral 50.0 level for yet another month , the seasonally adjusted headline Nomura/JMMA Purchasing Managers’ Index fell from Octobers 54.3 reading to a four-month low of 52.3, suggesting that growth in the Japanese manufacturing sector continued to lose momentum, and that growth in the fourth quarter will be even weaker than the revised third quarter number, and may well be negative. The survey organisers reported slower growth of both output and new business, even if job shedding eased to its weakest rate for fifteen months, while output price deflation the hit the fastest rate since December 2001.

In addition pre-production inventories were reduced for the ninth month running.



Commenting on the Nomura/JMMA Japan Manufacturing PMI data, Minoru Nogimori, Economist of Financial & Economic Research Centre at Nomura, said:

“The Japan Manufacturing PMI fell 2.0 points to 52.3 in November. Although it remains above the key dividing line of 50.0, it fell for the second consecutive month, suggesting that the pace of improvement in operation conditions is slowing. The New Export Orders Index also fell by 1.1 points to 50.5, signalling that the rate of expansion in export orders has obviously slowed. We see growth of Japanese production activity decelerating, owing to the fading impact of economic rebounds overseas, yen appreciation and as government stimulus measures start to wane.”

And Services Wallow In The Mire

And Japanese services are hardly doing better, since the headline seasonally adjusted Nomura Business Activity Index fell for the third successive month to 42.3 in November, from 45.0 in October, indicating that sharp and ongoing contraction in Japanese service sector activity worsened, with conditions deteriorating at an accelerated rate, and indeed at the fastest pace since last May. Again survey respondents frequently mentioned further falls in new business, reflecting Japan’s increasingly uncertain economic prospects. This faster decline in services activity, combined with a slower expansion of manufacturing production, meant that Japanese private sector output fell at the most marked rate for five months during November with the Nomura Composite Output Index posted a reading of only 45.4. The composite index – which gives some orientation for GDP levels - has now remained below the 50.0 mark for three successive months. If this performance is repeated in December it is extremely likely we will see negative quarterly growth in the last quarter of the year.





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

“PMI figures for November suggested that the recovery in the Japanese economy may be losing steam. Manufacturing output and new business rose at slower rates on the month, largely as a result of subdued external demand and the fading impact of fiscal stimulus measures. That said, it was the struggling services industry that continued to underperform, suggesting that demand from home markets remains fragile. Moreover, Japan appears set to resume its lengthy battle with deflation, suggesting that domestic consumption will remain lacklustre for the foreseeable future as real debt burdens begin to rise and clients delay their purchasing decisions. While GDP growth for Q3 was surprisingly upbeat, the outlook for the wider Japanese economy remains subdued.”

Housing Starts In Freefall

And as if all of this wasn't enough, Japan’s construction industry is unlikely to be a positive force, indeed housing starts may drop next year to a 48-year low as the sluggish economy and falling numbers of young married couples continues to eat into the housing market. The forecast was made byTakeo Higuchi chief executive officer of Daiwa House Industry (Japan’s largest homebuilder), who said starts for financial year 2010-2011 are likely to fall as low as 600,000, following this years 20 percent plus drop to 800,000.

“The property market will remain sluggish for another year or two because Japan’s economy is in bad shape,” Higuchi said in an interview last week. “High unemployment and falling wages are scaring away many potential buyers.” Japanese home sales are forecast to drop 7.2 percent to 1.57 trillion yen in the year ending March. Japan’s started building 1.04 million new housing units last year, a massive and long term fall from the peak of 1.9 million dwellings hit as far back as 1972. Starts of 600,000 would be the lowest rate since 1961.

Export Growth Not Sufficiently Strong

With most of Asia’s economies currently booming, it may seem surprising to many that Japan seems unable to rise up on the back of this wave of high growth, especially since Japan – unlike much of Europe and the United States – is not saddled with financial system problemsof the kind which could be expected to put a brake on economic activity. The problem basically is the pass through rate. Japan has now become so structurally dependent on exports, that there is nothing like sufficient momentum from consumer demand to take up the strain when these fail, while on the other hand the return rate on capital has dropped so low during the present crisis, and the yen has risen so strongly, that manufacturers find themselves with little choice but to systematically curb capital spending and aggressively cut costs, beginning with payrolls of regular employees.

For an autonomous recovery mechanism to go to work we would need to have a recovery in both corporate earnings and household income, but corporate earnings are only being sustained by cutting back capital spending, while employee income has steadily fallen, and is unlikely to revive again without a much stronger recovery in the other advanced economies. That is, Japan now needs to be pulled by the global train, and will certainly not itself be doing the pulling.

Basically during the good years Japan’s economy was being driven by robust global demand for its high-end manufactured goods (passenger cars, IT/digital products), which were made extremely cost competitive by the extremely cheap yen that was produced as a by-product of the carry trade. However all of that now belongs to the world which just fell apart. A man called Ben Bernanke is now running an interest rate and quantitative easing programme at the Federal Reserve which no longer makes the yen the preferred carry trade currency, while frugality has increasingly become the norm among European and US consumers who are desperately trying to deleverage.

One consequence of this is that there has been a shift away from Japan’s high-end goods and toward less expensive Asian products, especially given the loss of price competitiveness produced by the yen’s rapid appreciation. Japan’s factory sector consequently finds itself saddled with substantial excess productive capacity and excess employment and unless there is a significant return to a cheaper yen over a viable time horizon this situation is, quite simply, unsustainable. Rather than simply sitting back and waiting for normal cyclical corrective factors to do their work, what seems to be called for at this point is a thorough overhaul of the national industrial structure, as well as a significant long term structural rethink about how Japan got to this unfortunate situation and what to do about it, and boths of these are likely to take years rather than months. Indeed, even if global demand were to pick up in the short term, Japanese producers may well be more inclined to shift production overseas, rather than renewing and increasing domestic capacity given the uncertainty which now surrounds the future value of the yen. In these circumstances the recent sharp drop in capital spending is hardly surprising.

In is very striking how Japanese industrial activity is weakening just as the rest of Asia is surging. Even if Japan’s exports fell at the slowest pace in a year in October as government spending across the globe boosted demand, shipments abroad were still down 23.2 percent - a vast improvement, it should be noted, when compared with the 30.6 percent decline seen in September. Exports in recent months have been quite solid, with real exports (the seasonally adjusted nominal export value divided by the BoJ’s export price index) up 3.4% month-on-month in October after a 3.0% month on month gain in September, with the result that the October level was 5.1% higher than the July-September average..




Imports have been much weaker, reflecting the underlying dynamic of Japan’s domestic consumption, and fell 35.6 percent from a year earlier in October, which meant the trade surplus climbed to 807.1 billion yen ($9.1 billion), its highest level since March 2008 and well above the 465.5 billion yen median estimate of analysts.




When we come to look at the distribution of exports, shipments to Asia fell 15 percent year on year, easing back from a 22.2 percent drop in September. Exports to China, Japan’s biggest overseas customer, were down an annual 14.3 percent, a slight deterioration from 13.8 percent decline the previous month. Sales to the U.S. fell 27.6 percent, moderating from September’s 33.9 percent decrease while exports to Europe slid 29 percent after slumping 38.6 percent in September.


In fact real exports to all major regions increased on a month-on-month basis in both September and October, with exports to the US and Asia increasing for the eighth- and ninth-consecutive month, respectively. Real exports to the European Union and oil producing countries also rose in both months.

But there are differences, and these differences provide part of the key as to why we need to be cautious. In Asia solid final deman, led by China, lay behind the rise, but in the other two key regios renewed inventory building probably lay behind the rise.

Specifically, real exports to the U.S. increased 5.0% month on month in October following gains of 3.7% month on month in September and 3.0% month on month in August. It is hard to explain such a strong gain by final demand and there is a clear possibility that what we have been seeing is a powerful boost to sales from renewed inventory building by Japanese companies in the expectation of future demand. Real exports to the EU show a similar pattern ,with strong growth being registered (up 7.0% month on month in October after rising 8.2% month in September and decreasing 4.0% month on month in August.

In Asia the same picture of strongly increased real exports is evident, with a rise of 6.6% month on month in October following gains of 5.3% month on month in September and 0.3% month on month in August. However underlying GDP growth rates are much stronger in Asia, and it is likely that the increase is much more driven by final demand. Looking at more detailed data, exports to China gained 3.0% month on month in October after increasing 6.5% month on month in September and 2.0% month on month in August. This upward trend in China exports undoubtedly reflects the continuing positive impact of the various economic stimulus packages as well as some recovery in Chinese exports to industrialized countries. Meanwhile, exports to Asia excluding China surged 8.6% month on month in October after a 4.6% month on month gain in September and a 0.6% month on month drop in August.



What is evident, at this point, is that the global recovery is proving to be more evasive than anticpated, with strong variation between regions and countries, and in the light of this heavily export dependent countries like Germany and Japan, after an initial surge forward are now finding it hard work to maintain momentum.

Japan’s reduced trend growth

Apart from the factors mentioned above, one other reason not to expect some sudden and miraculous “bounce back” in Japan’s economic growth is the steady decline which can be seen in the country’s long term growth pattern (see chart below). This key fact here is surely the historic decline in Japan’s workforce (both ageing and now shrinking) the adverse effects of which are starting to be felt. To make matters worse, some long term consequences of repeated short term interventions (via the use of fiscal policy etc) in the private sector over the years of protracted stagnation we have seen since the 1990s. The impact of this cumulative neglect is to be seen not only in the mounting pile of public debt (gross debt will surely soon pass 200% of GDP, hitting limits never seen before in a developed economy), but also in the way overall labour productivity has been impaired due to substantial labour hoarding in non-efficient sectors. In addition to the short-sighted fiscal policies, expanded credit guarantees, intended to counter tight credit, have had similar adverse side-effects. While such macrostabilisation policies may have temporarily bolstered economic growth, and have certainly helped avoid large scale unemployment, at the end of the day they end up suppressing activity in more efficient and more profitable sectors, and in the long run exercise a downward drag on growth. Unfortunately policymakers seem not to fully realise the longer-term effects of loading on short-term policy package on top of another without adressing the underlying structural issues.

A Setback For Japan Will Be A Setback For The Global Recovery

Wages earned by Japanese workers fell for the 17th consecutive month in October, extending their longest losing streak in six years and adding further evidence that consumer spending is likely to remain subdued. Meanwhile on November 20th the government formally announced that Japan was back in deflation, effectively exerting pressure on the Bank of Japan to react, pressure which was only too evident in last weeks announcement by the bank of a new liquidity facility of roughly JPY10 trillion in three month loans to commercial banks. BOJ Governor Shirakawa, however, was at pains to make clear that even if he was willing to concede that the latest measure could be seen as a form quantitative easing, a term he has manifestly struggled to avoid using previously, there was no overall change in the BOJ’s economic assessment of the Japanese situation. Rather, the measure was designed to address what Shirakawa called the potential adverse effects on corporate sentiment caused by the rising yen and continuing weakness in share prices. Thus Japan's economy yet again slides steadily into deflation, but this time with no evident road-map or "script", or even credible short term hope of coming out again, a fact that is only adding to the general concern which is being expressed about where exactly it is that Japan is headed for. Certainly it would seem to be no good place.

Further, if Japan is indeed teetering back towards recession, the implications will extend well beyond Japan itself, and will more than likely involve significant consequences for the entire group of developed economies, and especially those unable to tap into China's continuing growth via commodity exports. Japan was the first large economy to fall into technical recession in the wake of the Lehman Brothers collapse, but was also the first to heave itself out. Being the first to fall back in again would not be a good omen, for anyone.