Global Manufacturing Slips Back Slightly In March

Evidence which would enable us to assess the full economic impact of the Japanese earthquake and tsunami is still hard to come by. There is a lot of talk of supply chain disruptions, but little in the way of detailed evidence to back up assertions of the more anecdotal kind. Even the latest set of manufacturing PMI data has decidedly left the jury out on the topic.


Evidently in Japan there was a clear and substantial drop in activity, but that was only to be expected . The Japanese March PMI slumped to a two-year low of 46.4, down from February’s reading of 52.9, the largest one month drop on record.

Commenting on the Japanese Manufacturing PMI survey data, Alex Hamilton, economist at Markit and author of the report said:

“March PMI data provide the first indication of how output at small, medium and large sized Japanese manufacturers was affected by the events following the Tohoku earthquake on 11 March. The PMI slumped to a two-year low, suffering the largest monthly fall in points terms since the survey began in 2001, exceeding the drops seen after 9/11 and the collapse of Lehmans. The latest index reading is consistent with a decline in Japanese industrial production of around 7.0% on a 3m/3m basis".

“Suppliers’ delivery times lengthened at a survey record pace amid widespread disruption in the supply chain resulting from the disaster. These delays could affect production in coming months and drive input price inflation even higher than the two-and-a-half year peak seen in March.”

At the same time it is hard to disagree with this conclusion, presented by Nomura economist Richard Koo in a recent report on the subject:

Any analysis of Japan's position vis-à-vis the rest of the world needs to start with the question of whether Japan was running a trade surplus or deficit. A trade deficit implies the world has lost a customer: ie, demand: whereas a surplus would mean the world has lost a producer, namely, a supplier of products and intermediate goods. Inasmuch as Japan boasts the world's third-largest trade surplus after China and Germany, I think the world has lost an important supplier.


Supplier countries' products are typically in demand for one of two reasons: either they are cheap or they are essential. A key to distinguishing between the two is the exchange rate. When a nation's currency is cheap relative to those of its trading partners, its exports tend to fall into the first ("cheap") category, whereas exports from countries with a fully or over-valued currency tend to fall into the second ("essential") group.

The Japanese yen has been the strongest currency in the developed world since the Lehman-inspired financial shock. Its strength was reaffirmed when it surged into the Y76-77 range against the US dollar in the wake of the earthquake. Japan has continued to run one of the world's largest trade surpluses in spite of an extremely strong currency. Inasmuch as this is evidence that there are many businesses around the world that must buy Japanese products regardless of the cost, I suspect that many of Japan's exports cannot be easily substituted.

But elsewhere, at least on the surface, there was little sign that companies were being held back by any substantial shortage of components.

Digging a little deeper, while manufacturing output strength weakened slightly from February, survey respondents still indicated companies were raising output rapidly. On the other hand it is hard to sort the wood from the trees here, since global output could weaken for any of a number of reasons, most of them nothing whatsoever to do with Japan.

More significantly, manufacturing activity did slow in South Korea, and failed to really recover in China following the end of the new year holiday season. These two countries are among the most closely integrated with the Japanese economy.

Commenting on the China Manufacturing PMI survey, Hongbin Qu, Chief Economist, China & Co-Head of Asian Economic Research at HSBC said:

“The Final March manufacturing PMI confirmed that the pace of manufacturing expansion has stabilised after slowing in February. This implies economic growth is only moderating rather than slowing too much. More importantly, price hikes also started to slow in March. All these confirm our view that quantitative tightening is working. So as long as Beijing keeps tightening for another three to four months, inflation should start to slow meaningfully in 2H2011.”

On the other hand, there has been plenty of earlier evidence that the Chinese economy may now be slowing somewhat, and this for its own domestic reasons. So it is hard to know what is attributable to a Japan impact here, and what isn't.

Certainly it does seem that economies in Asia are now slowing somewhat, and since the region has been one of the main drivers of the global economy, then this slowing will be noticed in those economies which are most dependent on exports.

Curiously, both in Europe and in China the final PMI reading was below the initial flash estimate, which could suggest that problems mounted a bit as the month advanced, with those responses which came in later being slightly less optimistic.

Either way, the big issue isn't the supply chain disruption one - since lost output can (in general) be quickly recovered in this context, especially given the degree of surplus capacity which still exists in the global manufacturing system - rather the question is one of where exactly we are in the current global cycle?

Many Emerging market economies have plenty of scope for continuing rapid expansion, as long as the markets are still willing to fund them. And risk sentiment doesn't seem to be an issue at the moment, although forthcoming monetary policy decisions at central banks in both the developed and the developing world make the mid term outlook rather more uncertain than it was six months ago.

Commenting on the India Manufacturing PMI survey, Leif Eskesen, Chief Economist for India & ASEAN at HSBC said:

"The momentum in India's manufacturing sector held up well in March, suggesting that growth is not an immediate concern. Output growth kept up the pace and the inflow of new orders accelerated, holding promise of a continued strong momentum in output in the months ahead. However, capacity constraints are tight as reflected in the increase in the backlog of works. Also, manufacturer's are facing ever steeper increases in input costs due to tight labour markets and rising material costs, which are increasingly being passed on to output prices. In turn, this calls for further tightening of monetary policy to tame inflation pressures."

Commenting on the Turkey Manufacturing PMI survey, Dr. Murat Ulgen, Chief Economist for Turkey at HSBC said:

“Turkish manufacturing sector performance eased somewhat in March from its record high level in the previous month, though it still remained comfortably stronger than past averages. The slight slowdown in the rate of expansion was caused by output and new orders, both of which also expanded at slightly lower, but still markedly strong rates. There was a solid slowdown in new export order growth, possibly reflective of uncertainties in the Middle East & North Africa region, while backlogs of work fell despite the weaker expansion of output. Employment conditions continued to improve as manufacturers continued to hire more workers to meet robust demand and production. There was a slight decline in stock of purchases in March due to shortages of raw materials, as reported by survey participants, that was also evident in the continued lengthening of supplier delivery times. While both input and output prices rose at slower rates than in February, they both continued to signal pipeline inflationary pressures in the manufacturing industry.”

In the Eurozone,where the headline PMI slipped from 59 in February to 57.5, the results followed a now familiar pattern, with Germany, France and Italy all showing quite robust expansions, while Greece, Spain and Ireland continue to struggle, even if in each case the performance was an improvement on earlier months. Of the three, only Greece continued to show a contraction in activity, even if this was at a slower rate than previously.

Chris Williamson, Chief Economist at Markit said:
“The Eurozone’s manufacturers continued to report buoyant business conditions in March. Despite the slight easing since February, the data are consistent with industrial production growing at a quarterly rate of 2%, spearheading the region’s recovery.

“National divergences are marked, however, with surging output growth driving record job creation in Germany, while weak or falling production led to ongoing job losses in Spain and Greece.

“The record jump in average prices charged for goods will further encourage the European Central Bank to increase interest rates sooner, rather than later, which may drive further divergences among member states as higher borrowing costs hit already weak demand in the periphery.”

Commenting on the final Markit/BME Germany Manufacturing PMI survey data, Tim Moore, senior economist at Markit and author of the report said:

“German manufacturing growth cooled during March, but the latest figures confirm an exceptionally strong performance for the sector across Q1 2011 as a whole. Firms continued to benefit from steep gains in inflows of new business during March, helped by the fastest expansion of export orders for ten months.

“The survey’s fifteen-year anniversary was marked by a series record rise in manufacturing employment levels, as firms continued to step up production capacity in response to steep improvements in order books.

“March data indicated higher levels of purchasing and stocks of inputs, reflecting concerns about lengthening supplier delivery times as well as greater production requirements. Strong global demand for raw materials was cited as the primary reason for supply chain delays, and only a small proportion of the survey panel cited the earthquake in Japan.

“Surging raw material and transportation costs meanwhile meant that factory gate price inflation accelerated to a level last seen in the wake of the January 2007 VAT rise.”

Commenting on the Spanish Manufacturing PMI survey data, Andrew Harker, economist at Markit and author of the report, said:

“The latest PMI survey indicated a continuing divergence between demand in domestic and foreign markets, with the latter proving the main source of new order growth. Meanwhile, a record rise in output prices was recorded, although the rate of charge inflation remains much weaker than that seen for input costs as firms struggle to fully pass on price rises to clients.

Phil Smith, Economist at Markit and author of the Greece Manufacturing PMI said:

“Waning domestic and international demand for Greek manufactured goods continued to hurt the sector during March. Crucially, firms were left with little choice but to absorb sharp input price inflation and find savings elsewhere. To some extent, this came in the form of rapid stock depletion. Hope, however, might be taken from the fact that business wins by surveyed firms fell at the slowest rate for ten months.”

But the issue this raises is that the global economy must now be getting somewhere near the peak of this cycle, at least in terms of manufacturing activity. Central banks across the globe are moving into tightening mode, and much of the low lying fruit has now been eaten, so the issue for the fragile economies on Europe's periphery (who are now totally dependent on movements in demand elsewhere for growth) is how they will fare, not during the highpoint, but as and when the current expansion slows.

In the US, the PMI index, compiled by the Institute for Supply Management, edged down from 61.4 in February to 61.2 in March, but stood at a level close to a 27-year high.



Norbert Ore, chairman of the ISM, said “the component indexes of the PMI remain at very positive levels and signal strong sector performance in the first quarter”. Despite the positive result this month, doubts remain about where exactly we are in the cycle at this point. Danske Bank's Signe Roed-Frederiksen thinks we may be near the peak, which doesn't mean a collapse in activity, but simply that from this point the rate of expansion may slow:

US ISM manufacturing declined from 61.4 to 61.2 in March. This was marginally higher than consensus expectations of 61.0 and our estimate of 60.7. However, details of the eport suggest that the ISM will continue lower over the coming months.

New orders dropped to 63.3 from 68.0 and although inventories declined as well, the drop was more modest. This means that the two order-inventory differentials declined further and continue to signal a downward correction in the ISM index. The ‘new orderscustomer inventory’ differential, which has proven the most reliable on short-term movements, suggests the ISM should decline to around 57. The ‘new orders-inventory’ differential suggests a more pronounced slowdown to 56.

New export orders weakened to 56.0 from 62.5 possibly reflecting the slowdown in Asian growth while supplier deliveries increased to 63.1 from 59.4, indicating a slower pace of deliveries. Prices paid rose further to 85.0 from 82.0 reflecting the increase in commodity prices and upward pressure on input prices.

That said, even a moderate decline from the current level would still leave the ISM index at a healthy level.

Globally, the headline PMI reading was 55.8, well above the historical average and the level of 50 that attempts to separate expansion from contraction, But down from the 57.4 registered in February, largely as a result of the slump in activity in Japan.

As David Hensley, economist with JPMorgan, put it: “There was little visible sign of supply-chain disruptions in the March surveys, but this effect is likely to be more visible in Asian emerging markets in April.”


The main concern expressed by the authors in their monthly report referred to the inflationary threat coming from a rapid rise in the prices of inputs and evidence that manufacturers were passing these on. Certainly, in this sense, the report will do little to deter decision makers at the ECB from raising interest rates when they meet on Thursday.

Surely There Is Nothing “Funny” About What Is Going On In Japan?

As Japanese officials continue to toil away in what we all hope will be a successful bid to avert a worst case scenario nuclear meltdown even while thousands of Japanese still remain missing and unaccounted for, financial market participants across the globe have been struggling with themselves to answer one and the same question: just how serious are the economic consequences of all this devastation likely to be?

Basically, the economic issues raised by Japan's continuing agony can be broken down into a number of categories, and especially we need to think both of global and local impacts, as well as the short term, mid term and long term implications of these.

Short-term Pain, Mid-term Gain?

The short term local consequences are evidently likely to be quite severe. Given that large parts of the country have been (and continue to be) without electricity, that factories have been flooded and part of productive capacity permanently destroyed etc, etc, GDP is bound to plummet quite substantially as output drops and takes time to recover.

At the global level the short term consequences are hard to evaluate. That there will be dislocation to extended supply chains is obvious, the Japanese may well buy less luxury goods, while on the other hand becoming more dependent on imported energy, a development which could well affect oil prices. In terms of global demand, it is important to remember that Japan is a significant net exporter, so in theory one country exporting less should simply leave room for others to step in and fill the gap. But things aren't as simple as that, and global trade inter-linkages mean that local shocks can easily be amplified in a way that conventional economic models find hard to capture. The shock that radiated out from the US during the great depression is a classic example from history. Impacts were much greater than a cursory inspection of direct trade effects would have suggested.

But more than anything the issue which is being raised by Japan is one of confidence, and one of how we think about risk (an issue which has been lurking in the background without being resolved since the start of the financial crisis). Problems in evaluating risk and shocks to confidence levels are hardly good for risk sentiment, and it is an increasein this sentiment which is, at the end of the day, giving momentum to the current expansion in global economic activity. And of course risk-negative phenomena are not only to be found in Japan, a fact of which this weekend's opening of military engagements in Libya is just one more painful reminder.

Low Frequency Events Becoming More Frequent?

The whole of the last week has been characterised by a high level of uncertainty, with oil prices remaining extremely volatile and sharp movements in the value of the yen having such a negative influence on currency markets that the G7 felt itself forced to step in. So while the external economic damage seems at the present to have been contained, with one “bad luck” event after another taking place the momentum behind the current recovery is surely coming under a lot of pressure, and all prudent analysts will doubtless be busy revising downwards their growth forecasts for the second half of the year across the board.

There are two reasons which make me think that such a move is completely warranted. In the first place we have a global system which is completely "tensed" at this point. Many problems generated by the financial crisis have been simply kicked down the road a bit, in a bid to buy the time to find the solutions. What this means is that the whole global edifice is extremely sensitive to the impact of unusual events and sudden shocks. Which means that there is a tendency to find that just when you thought things were getting better you start to discover they are actually getting worse.

Japan has provided us with one very good example of this. Towards the end of last year the Japanese economy had been going through what is euphemistically called a "soft patch" - the economy actually contracted in the last three months of the year - but in January and February there did seem to be signs that things were getting better, and one guage of small-business sentiment (the Economy Watchers Index) had even started to surge.

The Economy Watchers' Survey index for current conditions in Japan rose to a seven-month high of 48.4 in February from 44.3 in January, posting the first rise in two months thanks to a recovery in weather and labor conditions, the Cabinet Office said on Tuesday. But the outlook index was unchanged in February, ending a third straight month of an improvement, leading the government to maintain its assessment of public sentiment. The government repeated that the latest survey showed that "the economy has shown signs of picking up."

This much more optimistic reading, suggesting better weather was lifting confidence, was, ironically, written on Tuesday 9 March, just three days before the deadly earthquake struck. It is a stark, if somewhat tragic, illustration of just how uncertain the world we live in actually is, and of just how difficult it is to forsee certain kinds of phenomena. On another front, who at the start of 2011 would have imagined we would at this very moment be facing a UN backed military invasion into Libyan territory.

Longer Run Impacts

Serious as the short term impacts may well be, in the longer run the shadow which will be cast by what is currently happening in Japan could well be very long indeed, in a way which few today can even contemplate (although see this for a good first pass). The justification for this assertion is not only our increased awareness of our collective vulnerability to the impact of natural disasters, there is also Japan’s pioneer status in one very new and very global phenomenon - population ageing - to think about. As we will see below, the optimistic (I would say denial) prognosis is that Japan will soon valiantly overcome this latest bout of adversity in a similar way to which they overcame the post WWII devastation. The Japanese will surely be valiant in their efforts (one only has to think of the spirit of sacrificeof those poor workers who have been asked to handle directly the reactor problem), but their ability to overcome adversity will not be comparable to that registered in an earlier epoch when they had the wind behind them rather than gusting straight into their faces.

It is for this reason that I recently likened the earthquake and tsunami to another mindset-shaping natural disaster: the Great Lisbon Earthquake of 1755. Both events, for their magnitude, and for the seeming arbitrariness with which they strike any given set of individuals, inevitably leave (and left) searing scars in our psyche, the latter being characterised for the way it opened up the path to what many have termed the modern era, while the latter potentially could draw it to a close.

What I have in mind is this, the Lisbon earthquake lead to a questioning of the "natural order of things" in a way which facilitated a more rational approach to the problems in hand. But the application of this rational approach gave rise to a "second degree" natural order of things, in which (thanks to good governance, an economic hidden hand, and technical expertise) the permanence and stability of the social and economic world around us was almost totally taken for granted.

One good example of this would be the idea of the birth of a "Modern Growth Era", whereby it was assumed that economies would simply grow and grow in perpetuity, driven possibly by the dynamising capacity of ongoing technical change. The curious thing about this kind of interpretation is that Robert Solow, founder of the modern neo-classical growth model, intentionally and explicitly left technology out of his model. From a general equilibrium perspective technology does not necessarily generate economy growth.

And now we are faced with a significant number of advanced economies which may well find themselves, far from growing, actually starting to shrink at some point during the next 50 years. The reason for this, of course, is that working-age populations will be declining and ageing at the same time as the elderly dependent population (and their health and pension needs) will be rising and rising. So it seems we are now about to become aware that the Modern Growth Era was simply that, one particular era in our history as a species and as a group of social and political animals. This era is now, in some countries, starting to draw to a close, and a new one will surely open up. My conjecture is that what is happening now in Japan may well mark a tipping point in our awareness of this process in just the same way as the surge in Sovereign Debt in some countries which occured during the financial crisis marked a turning point in how we think about demography and economics, and in how we see the sustainability of health and pension systems.

Of course, as with all issues, there are still those who remain in denial.

But there is another dimesnion to the Japan crisis and how we see it that ties in with the Lisbon earthquake parallel, and that is our need to change mindset. Basically the issue concerns complexity, and how useful old-mindset linear models are in helping us address the kinds of issue which arise in managing highly interconnected and interlocked economic, social and technological systems.

The Spent Fuel Rods Storage Problem

Evidently examples of inter-connectedness, and the issues this gives rise to, are legion. I have already mentioned trade linkages, and from this point of view it will be highly instructive to watch just how the shock-waves radiate-out (or don't) from their Japanese epicentre in the weeks and months ahead. The global financial crisis was also chock-full of similar examples: Lehman Brothers folded and the rate of infant mortality in Northern India shot up, to name just one. But the unfolding events in Japan give us an almost "locus classicus" version of the problem: what to do with the used fuel rods. Now using a simple and straightforward risk management model, it might even seem to be efficient to store the spent rods in the same enclosures as you put the reactor. They are, after all, easier and cheaper to keep and eye on there, and anyway, this procedure helps overcome the sensitivity of members of the general population to being un the proximity of any form of nuclear waste. But looked at from another point of view, grouping risky elements in close proximity in this way only piles risk on risk in a geometric and not a linear fashion, exposing the entire social and economic system to the impact of a positive feedback melt-down process in almost the most literal sense.

I personally cannot help feeling that something similar is going on in relation to positive-feedback-process risk in connection with the individual units which constitute the Spanish financial system. As long as things don't go wrong, well, they don't go wrong, but if and when they do...............

So while the initial impact will surely constitute what most traditional economists like to call a “shock”, both to the real economy and to the equity and currency markets, this shock is unlikely to knock either the global or the local economy completely off their orbits in the short run. We are not talking (barring that worst case scenario that we all have our fingers tightly crossed won’t happen) about another Lehman type event. We are talking about a major natural disaster in a country with proven response ability. Even if Japan is currently now back in recession, rebuilding will almost certainly mean the local economy bounces back quickly again in the second half of the year. The longer run effects, however, will almost certainly be much more important. On one front the impact may well be to cast a much larger and more intense spotlight on the Japanese economy itself, with increasing questions being asked about the sustainability of its current path giving the declining and ageing population issues which confront it. And on another front, the events of the last week may well end up changing our way of thinking about the world we live in, and how we manage risk and insecurity. One week ago few would have imagined it was possible for a developed country to find itself spinning-off out of control, now the previously "unthinkable" is certainly a lot more thinkable.

At The End Of The Day Isn’t There Something "Funny" About Japan?

Japan’s economy is totally export-dependent, riddled with deflation, has central bank interest rates pegged almost permanently close to zero, while government debt seems to be on a virtually unstoppable upward path. Just to give some idea, IMF Japan projections are for GDP growth of around 1.75% a year between now and 2015. During the same period the government debt to GDP level will rise from 225.8% in 2010, to 234% in 2011 and then onwards and upwards to 249.2% in 2015 - that is the debt is rising at over 5% of GDP a year, while GDP is growing at under 2%. Personally I'm surprised that more people don't think there is something funny about these numbers, especially in the context of ongoing deflation and massive liquidity provision from the central bank.





According to one widely held theory, none of the above matters too much since Japan’s government debt is financed from domestic saving. On this view having near permanent deflation seems to be a massive positive, since it enables money to be printed and debt to be accumulated on a never-ending basis. The perpetual motion machine has finally been invented, and is alive and well and living in Japan. Certainly the situation has all the appearance of permanence, since it would now seem to be virtually impossible for the Bank of Japan to move into reverse gear and raise benchmark rates to what was in earlier days a "normal" level of 5% since how would the government continue to finance itself, whether the savings are domestic or external? And of course, if at some point Japan did come to depend on external funding, and interest rates were forced up to 5% or more...........

It continues to surprise me that more people do not find the whole situation odd: gross government debt to GDP only goes up and up, across all horizons, and this is supposed to be normal and sustainable?



On another version of events, the gross debt argument (gross debt is used simply to be able to make a comparison with other countries, such as members of the EU, where it is gross debt that is measured and quoted) is misleading, since Japan's government also has assets (like land which was acquired during the bank restructuring of the 1990s), and it is the net debt level we should be looking at. I have two responses to this objection. In the first place, the argument fails to take into account the implicit liabilities of the Japanese pension and social security systems. Once this is done you have a number which while still being lower than the gross debt figure is consideably above the hypothetical level of net savings. In the second place, while the values of the Japan government's gross liabilities to its creditors are known and quantifiable, it is much harder to put mark-to-market numbers on the assets being held.

But in any event it is the debt dynamic which is worrying. This is not a cyclical phenomenon, but long term structural, and it is hard to see how this dynamic can be broken at this stage. Looking at the two lines in the above chart, they are moving up almost in tandem. Net debt will hit 130% of GDP this year according to the IMF, and could well be around 155% by 2015, and that was before the earthquake. So I don't really get the point people are trying to make with this argument.

Another issue which leaves me a bit cold is the size-of-corporate-savings one, since what people are saying is unsustainable is government debt. It is simpleton-type thinking to suggest that corporate savings could simply be handed over to the government, since this involves the private sector bailing out the public sector in a way which parallels the way the public sector is often bailing out the private sector in Europe. If things were that simple, don't the people who emphasise this detail imagine someone would have thought of it and done it already?These savings are in private hands, and any attempt simply to appropriate private savings would meet with substantial resistance, not to mention the dangers of capital flight, or larger corporates simply moving offshore.

A Population Which Has Been Allowed To Get Too Old Too Fast?

Evidently what we have here is a clear example of something which only goes on until the day it doesn’t. The underlying problem in Japan is not lack of technical ingenuity, nor is it a shortage of credit; Japan’s fundamental problem is a demographic one. The country has a rapidly ageing population, which after many years of ultra-low fertility and rising life expectancy is now the oldest in the planet, with a median age of 45 and rising. This is the backdrop to all these weird and wonderful economic phenomena we are observing, and is the root cause of the weak domestic demand, and of the ultra-sensitivity of the economy to movements in the external trade balance.





So the big question people need to be asking themselves is just what happens when Japan can no longer deliver the external surplus it needs to sustain economic growth? Trend growth has been falling consistently, and overdecades, in a way which is unlikely to change and logically it will at some stage turn negative.



In particular this is long term contractionary pressure is evident since Japan's workforce is shrinking and ageing. The process is, unfortunately, only compounded by the current "irradiation" problem since it will lower the ability of the country to attract immigrants (at least over the next few years), even were Japan's leaders to give this a priority, which is itself unlikely to happen.





As luck would have it Japan did record its first trade deficit in two years in January, and while this is currently only a passing and transient phenomenon, it does constitute some kind of warning shot for what could one day happen. In fact, the Japanese economy returned to negative growth in the last quarter of 2010, and has been struggling to find the level of exports it needs to sustain growth (even despite the strong emerging market demand) as it has been weighed down since the onset of the crisis by the continuing high value of the yen. Since it is now entirely possible that growth this quarter will also be negative, Japan is now almost certainly technically back in recession.



Japan’s Prime Minister Naoto Kan has already stated that Japan is now facing its worst crisis since the end of World War II, and I think it is hard to disagree with this assessment, both in the context of the current “facts on the ground” and given the major challenge the country faces on the demographic front. This is what the consensus view which holds Japan is likely to suffer a temporary economic hit and then enjoy a boost from reconstruction seems to be missing. Japan is very unlikely to have a “New Deal" like economic recovery, for the simple reason that it cannot really afford to have one due to the pressing need to get the debt dynamics better under control.

Indeed already there is talk of raising taxes to help pay for reconstruction work, since clearly a supplementary budget which incorporates more deficit is the last thing JGB market watchers want to hear about at this moment in time. So even if some increase in government debt now looks inevitable this year, the pressure to claw it back in a near term future will be significant.

Not least of the reasons for such caution will be the growing vigilance the country’s debt is attracting from the rating agencies. Standard & Poor’s cut their Japan rating in January, and while Moody’s have been quick to point out that the current crisis will not affect their analysis, they did change their Japan rating outlook to negative from stable at the end of February on concern that the country’s political gridlock will limit efforts to tackle the debt burden. These concerns will only be heightened in the aftermath of recent events.

According to Marcus Noland, deputy director of the Peterson Institute for International Economics in Washington what Japan is facing “is a Keynesian stimulus program that nobody can argue with”. Unfortunately, this is far from being the case, Japan is at the end and not the start of its "modern growth era" and any attempt to finance a massive reconstruction programme by issuing yet more debt is likely to provoke just what Noland discounts: a lot of argument. Funny how so many people still fail to find anything “funny” about what has been happening in Japan.

Japan has outsourced engineering along with manufacturing

According to this source, Yoshio Watanabe, a professor of electrical engineering at Kanagawa University states that many Japanese companies have outsourced research, development, and engineering overseas in the last twenty years.

The same source states that science, math, and engineering are unpopular fields of study for Japanese students.

One theory regarding the decline in interest in science in advanced countries states:

“Highly developed countries in science and technology tend to face the problem that science literacy declines. This is because, in highly developed countries, outcomes of science and technology
becomes a “Black-box” and difficult to understand the mechanism behind the phenomenon”.

In an interview in 1998, Professor Ryoichi Ito, the President of The Japan Society of Applied Physics described his view of the “black box” problem:

“I think the reason is quite simple; we are surrounded by “black-box” technology. For example, when you open up a traditional watch you can see the cogs moving around; but nothing moves in modern watches. The fact that a television produces a moving image is taken for granted. In the days of the vacuum tube, if you opened up a radio you could see glowing valves and could see something “working”. These days, equipment is all solid state and it is not possible even to begin to imagine how it might function. The only things that you can still see working are bicycles. It’s becoming almost impossible to carry out basic repair to a car by yourself.

Q: Have you noticed any differences in the students who are entering your university nowadays?

Professor Ito: Yes, there have been many changes in the type of students we teach. One characteristic is that most of them have never carried out any experiments. They’ve never soldered joints or used tools to build equipment-or even repaired a bicycle. It’s very difficult to teach them how to carry out experiments. They have never experienced that “small electric shock” that many people used to receive. when playing with electrical equipment. They don’t have a feeling for what electricity is and how to use it in practice.”

This theory is doubtless partially correct.

A more likely cause of decline of interest in science is that scientific research organizations become large and bureacratic; slow to absorb new ideas and methods. Application of scientific advancements become the domain of multinational corporations and government, which suppress innovations that are not produced within their organizational systems. Students in their later teens can observe this and choose other, more rewarding career paths.

The NY Times reported in July 2010 that “large Japanese companies are increasingly outsourcing and sending white-collar operations to China and Southeast Asia, where doing business costs less than in Japan.” However, the Times reports,

“Japanese outsourcers are hiring Japanese workers to do the jobs overseas — and paying them considerably less than if they were working in Japan. Japanese outsourcers like Transcosmos and Masterpiece have set up call centers, data-entry offices and technical support operations staffed by Japanese workers in cities like Bangkok, Beijing, Hong Kong and Taipei.”
Japan is shipping both jobs and people overseas. Per a 2004 JETRO report:

Expanding Japanese Presence In East Asia Reflects Shift To Offshore Production
• At present, 60% of newly established overseas operations of Japanese manufacturers are in China and other parts of East Asia. Unlike Japanese affiliates in Europe and North America, however, these companies tend to sell output to their parent companies in Japan, rather than in the local market.
• The trend reflects efforts by the parent companies to shift production offshore, particularly assembly and finishing operations to the ASEAN4 nations and China.

It will likely turn out to have been a policy mistake for Japanese companies to have shifted production overseas.

What happens if Japan runs a trade deficit

Edward posted this in a comment to the previous post:

"Those who argue that Japan can simply keep eating its own debt indefinitely are right until and unless the economy can no longer run an external trade surplus.

Theoretically, as population ages, this point will be reached, since productivity will fall with rising workforce median age. So we know there is an outer limit somewhere, although we have no idea at this point where that limit is.

Once Japan has a trade deficit it will all be over pretty quickly, since then of course they will have to attract funds to finance the deficit, and this is where things will start to get pretty tricky."

Japanese workers take pay cuts to stay employed

On December 27, Bloomberg reported that "Japanese workers´ willingness to accept wage cuts to safeguard their jobs is lowering prices and deepening deflation". This assertion was attributed to Hisashi Yamada, chief senior economist at the Japan Research Institute in Tokyo. Yamada also asserted that

"Japan´s jobless rate would be around 10 percent, compared with the current 5.1 percent, if companies had fired workers rather than cut pay since Japan fell into a recession in 2008. "

The monthly average wage in Japan has fallen to 315,294 yen, the lowest level since the government started tracking the data in 1990. Assuming an exchange rate of 90 yen to the dollar, that is roughly $3,500 per month, or $42,000 per year.

Presumably Japan's employers are reducing labor cost to offset the effects of a stronger yen versus the dollar and price competition from Chinese goods on profitability.

One effect that the falling wage levels will have is to reduce the ability of Japanese households to put savings into government debt. This will add some volatility to the prices for Japan's government debt.

Falling wage levels also will make it more difficult for Japan to reduce its dependence on exports as the primary source of GDP growth.

A provocative analysis of Japan's economic prospects

I highly recommend WHEN JAPAN COLLAPSES, released today over at The Burning Platform. While the tone of the piece is a bit hyperbolic, the author has gathered a solid set of data shown in chart form to back up his thesis. That is as follows:

"If the market demands an interest rate of anything more than 3.5% to buy their debt then Japan will not have the revenue to service its debt. As the interest rate approaches 3.5% Japan must use all its tax revenue to pay interest on its debt. It becomes readily apparent that Japan will eventually be forced to default on their debt. There are no good options left. A minor uptick in interest rates will sink the 3rd largest economy on the planet. The near failure of a 3rd world country (Greece) turned the world upside down. The failure of Japan would likely touch off a worldwide crash."

The key is that any significant shift away from the current global patterns of trade and investment flows will likely lead to major defaults, as governments and central banks have used their textbook policy options and the results have been maintenance of a delicate balance at best.

Japan's 2010 House of Councillors election: another "twisted Diet" coming up?

Guest Post by Manuel Alvarez Rivera
Election Resources On The Internet

Without doubt, the Democratic Party of Japan (DPJ) has had a decidedly rough ride in power in the ten months since its historic House of Representatives election victory, which brought to an end more than half-a-century of nearly uninterrupted Liberal Democratic Party (LDP) rule. Last month the Japanese public was treated to the all-too-familiar spectacle of a prime minister stepping down following a decidedly short tenure: after less than nine months as Japan's head of government, Yukio Hatoyama left office over his inability to fulfill campaign promises, and was subsequently replaced by Naoto Kan; Kan, who also succeeded Hatoyama as DPJ leader, is Japan's fifth prime minister in less than four years.

Meanwhile, more grief was in store for DPJ. Prime Minister Kan's initially strong popularity ratings steadily slid over the course of the election campaign, and another very familiar political spectacle took take place on election day, when voters finally went to the polls on Sunday, July 11 to renew half the membership of the upper house of Japan's bicameral National Diet, the House of Councillors: the DPJ and its remaining ally, the small People's New Party (PNP) lost their joint upper house majority.

The loss of the upper house (whose electoral system is described in Japan's 2007 House of Councillors election and Parliamentary Elections in Japan) constitutes a major setback to Prime Minister Kan's government: under Japan's 1947 "MacArthur" constitution, bills rejected by the House of Councillors can't become law unless the House of Representatives - the Diet's lower chamber - overrides the Councillors' veto by a majority of at least two-thirds. Consequently, an opposition-controlled upper house is now able to derail the government's legislative agenda, as was the case between 2007 and 2009, when DPJ and its allies controlled the House of Councillors, while LDP and its coalition partners held a large majority in the House of Representatives; not surprisingly, this state of affairs - known in Japan as a "twisted Diet" - led to repeated clashes between the two legislative bodies.

However, the lower chamber retains the final word on a number of important matters, most notably among them the designation of a prime minister. In addition, it is still possible that Prime Minister Kan and DPJ could now find new coalition allies to secure an upper house majority, although the small Your Party, which now holds ten upper house seats following sizable gains in the recent vote, have formally ruled out the idea. Evidentally, Kan and the Democrats have done themselves no favour with their insistence on increasing the five percent consumption tax, which has proven unpopular with potential coalition partners, not to mention voters.

As a result of the election the government has been reduced to 110 seats in the House of Councillors, while the opposition parties will hold 132 seats.

Although DPJ received the largest number of both prefectural district and party list votes, LDP won the largest number of seats by capturing 21 of 29 single-member districts; DPJ, which only carried eight single-member seats, won more seats than LDP in both the multi-member districts and the party list vote, but this was not sufficient to overcome LDP's large single-seat lead. That said, the election outcome wasn't exactly a ringing endorsement for the Liberal Democrats, as Japan's erstwhile dominant party had its lowest party list share of the vote ever. On the other hand, LDP breakaway Your Party (YP), which favors small government, soared to third place in the election, displacing traditional LDP ally New Komeito (NK; an offshoot of the lay Buddhist organization Soka Gakkai).

It may be debatable whether the result polled by DPJ in the recently held House of Councillors election was particularly bad or not, but it is clear that in terms of seats won it was well below the party's already limited expectations. Historical precedent strongly suggests the upper house election setback will in all likelihood lead to the fall of Prime Minister Kan's government; however, only time will tell if this will turn out to be the case.

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You can find fuller details of the recent election results on Manuel's Japan page, here.

Japan's turn to China as a primary export market

According to the Financial Times, "China replaced the US as Japan’s biggest export market last year(2009)".(1) Here's a chart from RIETI showing the relative shares of Japan's total exports:

It's remarkable that the proportion of exports to the USA has practically halved in ten years. Figures from Japan's Ministry of Finance show that Japan actually had a trade deficit with China in 2009, while maintaining a trade surplus with the US.(2) This result would be consistent with the idea that Japanese companies source components from China for products that are in part then exported to the rest of the world.

This shift might cause the focus of Japan's monetary authorities to switch somewhat regarding foreign exchange matters. The dollar/yen rate will be a concern more for the potential effect on Japan's holdings of US Treasury debt than for its effect on exports to the US. Ending the yuan peg by the PRC and the likely resulting appreciation versus the dollar would have the effect of increasing the costs to Japanese manufacturers of parts sourced in China but would also increase the purchasing power for Chinese buyers of Japan's finished goods. At the same time, Japanese manufacturers would be squeezed by the increased cost of components from China for products shipped to the USA given that the yen/dollar exchange rate remained stable. Increasing exports to China would be a logical priority for Japan's economic policymakers.

Japan's population structure

The population pyramid is inverted:

Population growth is zero:

Japan's population is projected to shrink by approximately 32 million persons, or 25%, over the next forty years:

Source: Statistical Handbook of Japan 2009

Assuming an average household size of two persons, this would mean that about 12.5 million housing units would become excess during this time frame. That would be a significant drag on residential real estate values.

At the same time this would imply reduction of commercial real estate values, as fewer consumers would mean less need for retail space; while reduction in employment would mean less need for office/work space.

It seems that domestic sectors will be a drag on economic growth for Japan for the foreseeable future. At the same time, as export markets are stagnant or in recession it is difficult to forecast much growth for Japan's export sector.

Japan - Defying Gravity

By Claus Vistesen: Copenhagen

Popular myth and, allegedly, the laws of aerodynamics have it that the bumblebee should not be able to take flight. Yet still, our good bumblebee refuses to be pulled down by such details and year after year it takes flight as if nothing has happened. This allegory applies, with some imagination, to Japans economy too. Year after year it consequently appears able to simply ramp up domestic debt to cover the shortfall of domestic demand at the same time as low investment demand, a savvy export sector, and a strong net foreign asset position mean that Japan does not have to rely on foreign investors to finance government debt outlays. Together with a central bank stuck in perpetual QE mode due to persistent deflation this has so far constituted the core of Japan's bumblebee moment.

Recent comments and analysis however suggest that while the bumblebee should certainly continue to enjoy the ability to defy gravity, Japan's time just may be up. In particular two pieces of research authored by Societe Generale's Dylan Grice (see here and here) as well as a recent piece by Kenneth Rogoff have added to the concerns that Japan may be headed for a Greek party of their own. In reality of course, the sudden focus on Japan is a direct function of the change in market discourse since end 2009 and the focus on government debt sustainability and how to rein in fiscal policy (if at all). Thus it is only logical to expect the great eye of the market to also turn to the biggest sovereign debtor in the world which just happens to be the oldest (demographically speaking) too.

In order not get confused here is Grice himself;

To recap, the thesis I outlined back in January 1 was that since Japanese households – the biggest effective drivers of JGB demand – are set to dis-save in coming years as they retire (left-hand chart below) there will soon be no one left to finance the government’s nosebleed deficits at current yields. Indeed, the chart below suggests households are already running down assets. And because the interest rates which might attract international investors will inevitably blow up the budget (debt service is already 35% of government revenues at existing yields) there is a very clear and present danger that the government reverts to the well- established historical precedent for cash-strapped governments of currency debasement.

As you can see, the issues here are complex but intellectually they are hugely important since what happens in Japan may tell us a lot about what will happen in other ageing economies such as, most notably, Germany but essentially a whole host of OECD economies (and China) who are set to move in the same direction as Japan. In this sense, I should immediately admit that on an intellectual level I agree with almost everything Grice says and especially his focus on Japan and the nature and extent of dissaving.

But, and in order not to make this into a fan letter, I am going to quibble a little bit with Grice in what follows.

Firstly, and on a very specific point, the chart (in Grice' last note) which shows how Japanese households are actually running down their assets does not fit with the picture I get from my data (BOJ).

Now, I certainly don't want to start the chart wars II here and obviously, there are many ways to define the stock of savings which might prove me as wrong as Grice is right (and vice versa). What is certain is that the incremental flow from household saving (if any) will not be enough to offset the incremental flow of bonds issued by the ministry of finance. This leaves the crucial role of corporate savings which is quite high in Japan and which also seems to be responsible for the Japan's external surplus (on the trade balance at least).

Yet, in order not depart down the path of reinventing the wheel I will immediately refer to my most recent notes on Japan and this in particular in which I butt heads with the FT's Martin Wolf on exactly the issue of (dis)saving in Japan and the distinction between corporate and private savings. Essentially then, this is a question of perspective and timing since I agree with all parties involved here on, at least, two accounts. Firstly, Japan government finances in an extraordinarily bad shape and the future ability of Japan to ever hone up to its liabilities is very, very slim. Secondly, dissaving is very likely to become a binding constraint in Japan at some point which would epitomized by how Japan would need to borrow from foreigners in order to finance an external deficit. In this case, and I agree with Grice here, it is game over.

But how we get from here to there may be just as important as what happens when we get there. In fact, yours truly have just defended his master's thesis on exactly this topic and the overall conclusion, which fits quite well in the present discussion, is as follows;

Ageing societies are not, in the main characterised by aggregate dissaving but rather by the fight against it.

While my thesis councillor did indeed like the entire ouvre he was none to happy about this one. And can can you blame him? Isn't it almost tautology? As I did on my day of graduation I will stand my ground and argue that it isn't.

The crucial issue in my opinion is the change in perspective, from simply sitting back and waiting for the inevitable pop in Japan, Germany etc to starting to examine the main economic characteristics of an elderly economy (such as can be found in Japan, Germany [1] and will be seen in many, more who are yet to come). In a nutshell, such characteristics sum up to a deeply export dependent economy which exactly manages to keep the boat afloat because of higher domestic savings than required to dervice domestic investment demand, thus implying an enduring external surplus. Naturally, and as a very important aside, Japan also has its own central bank who has been administering QE in one form or another for the better part of two decades now, a feauture serves to allow government debt to grow without Japan needing to attract foreign funds.

This perspective provides us with two very important pieces of insight I think. One is that a rapidly ageing economy will not be able to revert to a growth path characterised by external borrowing and thus a net contribution to the unwinding of global imbalances. The second is that the global process of ageing becomes an externality to the whole global macroeconomic system because it puts more and more economies in a situation where they need to maintain external surpluses in order to prevent the forces of dissaving or, more accurately, the slump in internal demand as ageing pushes up the dependency ratio.

Now, think about the discourse we are having exactly at this point in time. It is a perfect mirror on the two points above with the added spice, in the context of the Eurozone, of how economies embarking on internal devaluation are also forced to find growth based on external demand because whatever growth they were able to generate from domestic activities in the first place are now being effectively choked off.

Moving back into the real world, Grice believes that Japan's time may just be up and he specifically points to the fact that Japan needs to roll over 213 trillion while at the same time, the biggest holder of Japanese government bonds has openly announced that it has no inflows with which to suck up extra JGB supply.

I honestly don't know whether he is right. He may be and if so, Japan will stand as a poster example of just how an ageing economy can take it before it folds in on itself in the sense of trying to maintain a modern market economy that is. However, I am inclined to call him on his bet and in this sense I am much closer to Buttonwood's take on the situation;

(...) the huge amount of Japanese debt rolling over this year need not be a problem. Investors will simply recycle their existing holdings. Takahira Ogawa, a sovereign analyst at Standard & Poor’s, thinks there is more scope for the Bank of Japan to buy government debt, as central banks have done elsewhere.

Of course, such measures just postpone the evil day. The crisis will surely arise when Japan becomes dependent on foreigners for finance, or if a sharp rise in inflation or a sudden slump in the currency causes domestic private investors to take fright. But since the country is still running a current-account surplus, the yen is trading at 90 to the dollar (compared with 124 in June 2007) and deflation is forecast for the rest of the year, the apocalypse seems unlikely to occur in 2010.

Thus I would point to the continuing surplus in the corporate sector, the fact that households are not yet drawing down their deposit base, and most importantly; the fact that the BOJ has every right and reason to continue keeping the QE taps open as long as deflation is running at +2% on an annual basis. In fact, here is one of the other feedback loops from ageing right here; namely that as domestic demand simply spirals downwards, the economy gets caught in a deflationary trap (the liquidity trap in monetary policy circles) which only serves to push up domestic government debt thus forcing the central bank's hand on QE and making it even a larger imperative to maintain an external surplus.

However, before I myself try to emulate the bumblebee by defying gravity with another complex argument, I think I will hold off with this one for another day.

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[1] - See this excellent piece by Edward which exactly touches on a similar issue in the context of Germany.

No News from Japan

By Claus Vistesen: Copenhagen

Sometimes no news is more telling than one might initially think and although it was hardly earth shattering for the market that the BOJ chose yesterday to keep its main benchmark rate sitting at 0.1% it does highlight the extraordinary difficulties Japan currently face in terms of sparking its economy back into some kind of forward momentum.

(quote Bloomberg)

The Bank of Japan held interest rates near zero and said it remains committed to fighting deflation as gains in the yen risk stunting the recovery from the country’s worst postwar recession. “I hope that price declines will be overcome as soon as possible,” Governor Masaaki Shirakawa told reporters in Tokyo after his board kept the overnight lending rate at 0.1 percent. “It will take time before we can see prices rising to favorable levels,” he said, adding that the central bank will maintain an “extremely accommodative financial environment.”

Japan’s credit rating outlook was lowered by Standard and Poor’s today, highlighting concern that the world’s biggest public debt will lead to higher borrowing costs in a country already facing falling prices and a strengthening yen. Finance Minister Naoto Kan said today that the BOJ can do more to battle deflation, and people with knowledge of the matter have said it may consider expanding an emergency loan program or increasing purchases of government bonds. “It’s highly probable the central bank will come under pressure to ease policy further as the economy loses steam,” said Teizo Taya, a former central bank board member and now adviser to the Daiwa Institute of Research in Tokyo. “The bank will likely consider expanding the lending facility, while it will try to avoid increasing bond buying as much as possible.”

The statement by the governor Shirakawa really tells it all and one can only second his hope that price declines will soon hit the shores of Japan. Yet, this seems more and more unlikely which is also why the BOJ seems to be moving straight back into full out QE mode at the same time as its peers are set to try, albeit with great difficulty, to restore some kind of normal monetary conditions over the course of 2010.

The BOJ consequently seems to be silently conceding that it will have to cooperate tightly with the MOF in trying to bring some kind of momentum back to Japanese soil. In this concrete case it will mean keeping open the taps to create a bid for the steady flow of Japanese government bonds.

(click on graphs for better viewing)

The core-of-core index has now fallen since January 2008 with the total accumulated decline in the core nominal price level of 6.8%. Now, I don't need, I think, to spell out what this implies for debt and growth dynamics in Japan which just seem to perennially stuck at the moment.

The problem for Japan is really that it is fighting a losing battle on two fronts. Firstly, and quite as most observers would expect Japan is having great difficulty in terms of building up domestic demand (see graph here). Secondly however and much worse; conventional wisdom would have that as the risky assets began to fly back in March 2009 and as the global economy showed the first tepid signs of emerging from the death bed so should the JPY weaken and Japan ride, through the carry trade effect, the global upturn on exports. Yet, this has not been the story so far and while Japan indeed is exporting a lot to service the runaway train China, the new found reluctance of the JPY to react to global risk sentiment is preoccupying.

Measured against the Euro and using the period 2004 to 2009 (more or less) as the base average value the JPY is now 10% and 17% stronger against the Euro and the Buck respectively.

Finally, to add injury to insult S&P moved in Monday with a nudge as it threathened to downgrade Japan's sovereign debt rating less it gets its fiscal book on the mend. As a mitigating factor S&P mentions Japan's strong net external position which acts as an important dam towards the rising flood of public sector debt. Yet, unless Japan succedes in pushing the JPY down on a sustainble basis against its main competitors this dam will break sooner rather than later. Needless to say that if the BOJ decides to abide completely from the implied domestic pressure to continue funding deficit spending, S&Ps hands will be effectively forced. One thing is for sure as Societe Generale's chief Japan economist Takuji Okubo is quoted by Bloomberg;

"The market should be braced for the BOJ keeping its current rate unchanged for a very, very long time".

Indeed, and thus as the big talking point in the rest of the world remain fixed on exit strategies and the need (and peril) of fiscal consolidation Japan continues to be stuck in the mire. My own personal feeling is that it might very well be the BOJ leading the pack of global central banks rather than the other way around, but for now the fact that there is no news from Japan is exactly what makes it news.

A Detailed Look at Savings in Japan

By Claus Vistesen: Copenhagen

In short, if the world economy is to get through this crisis in reasonable shape, credit worthy surplus countries must expand domestic demand relative to potential output. How they achieve this outcome is up to them. But only in this way can the deficit countries realistically hope to avoid spending themselves into bankruptcy.

Martin Wolf (2008)

It is not the first time that I am using this quote by the FT's chief economics commentator and I don't suspect that it will be the last. Of all the attempts by pundits and analysts to pinpoint the crux of the current crisis the observation above is the most important aspect in my opinion and I have argued as such several times (see also Rogoff and Obstfeld (2009) and Baldwin and Daria (2009)). However, I disagree with Mr. Wolf in one critical aspect. Specifically, I don't think that this is simply a question of it being up to them, as it were, in terms of how export dependent/oriented economies may succeed in pushing their growth path onto one increasingly driven by domestic demand. In this way, I believe that the export dependency of Germany and Japan (and a whole batch of economies which will now join them) are ultimately rooted in their demographic profiles where decades of below replacement fertility and rising life expectancy have now condemned them to an economic structure where the growth generated by domestic demand is virtually zero leaving external demand as the only meaningful way to create growth.

This does not mean that the combined external surpluses of these economies do not represent an important and potentially negative externality to the global economic system, but it does crucially mean that we cannot expect Japan, Germany et al to simply revert, through e.g. structural reforms, to a growth path driven by domestic demand that would allow them to suck up excess global capacity through an external deficit.

In order to focus the attention in this ongoing debate I will home in on Japan and concretely, a recent piece in which Martin Wolf actually fleshes out a specific way in which Japan would potentially be able to raise domestic demand to benefit of herself and the global economy. Martin Wolf's piece is worth pondering in its entirety, but in this context I am going to focus on the notion of high corporate savings and whether its release from corporate balance sheets holds the potential for spurring domestic demand in Japan.

My own view is that the underlying structural problem has been the combination of excessive corporate savings (retained earnings) and diminished investment opportunities, once catch-up growth was over. As Andrew Smithers of London-based Smithers & Co notes, Japan’s private non-residential fixed investment was 20 per cent of GDP in 1990, close to double the US share. This has fallen to 13 per cent after a modest resurgence in the 2000s. But no comparable decline has occurred in corporate retained earnings. In the 1980s, the challenge of absorbing these savings was met by monetary policy, which drove the cost of borrowing to zero and sustained wasteful investment. In the 2000s, the challenge was met by an export and investment boom, driven largely by trade with China (see chart).

(...)

Japan’s aim now must be to achieve domestically driven growth. The most important requirement is a big reduction in corporate saving. Mr Smithers argues that this will happen naturally, since savings are largely capital consumption, itself the product of the history of excessive investment. I would add that if ever an economy needed a market in corporate control, to shift cash out of the hands of sleepy managements, Japan is it. Not being beholden to Japan’s corporate establishment, the new government should adopt policies that would change corporate behaviour, at last.

What follows is my take on this argument seen through the lens of a detailed look at the savings behavior of households and corporates in Japan.

Household Savings - (Dis)saving in Japan?

Standard life cycle theory states that consumers run down their assets into old age (dissave) and thus that a rapidly ageing society at some point should move into a state of perpetual dissaving with the consequence in an open economy context being an external deficit (eventually). However, both in theory and in practice this is not so simple and Japan is a good example here. In this way and while the household savings rate (out of labour income) has indeed plummeted in Japan, the economy still has a large and persistent external surplus. Since we know that the government is mired in both current and future debt this has, by definition, to reflect a high level of corporate savings. Thus and with a low savings rate in the household sector the reduction in corporate savings holds perhaps the biggest potential for releasing domestic demand in Japan or so at least is the crux of Martin Wolf' argument as I see it [1].

Most analyses on household saving rates in Japan do not move beyond the representation above which plots net savings as a share of net income. And indeed, this paints an unequivocal picture. The quarterly figure is highly volatile and subject to notable seasonality, but smoothed through a 12 quarter moving average shows us that since 2000 the savings rate of Japanese households have not exceeded 5%. More interestingly is of course is relentless downward trend which shows, more than anything, that the real economic conditions for Japanese households have changed significantly. This perspective which looks at the flow of savings is strongly underpinned by many empirical studies on the savings behavior of Japanese households. The most recent study is Horioka (2009) who presents a timely overview of the literature on the dissaving of the eldery in Japan. The evidence strongly suggests that Japanese consumers dissave into old age and as Mr Horioka ends his article, this is likely to have important ramifications on global imbalances assuming, I guess, that as Japanese consumers steadily move into a state of negative saving the economy will move into a current account deficit. I assume further that this is what Martin Wolf expect would happen if corporate savings were released to the benefit of Japanese households since otherwise Japan would not do much to correct global imbalances.

Now, I cannot refute the amount of evidence presented by Horioka and thus the conclusion in the main. What I can do however is to respectfully take Mr. Horioka to task on the definition of savings and thus what is defined here as dissavings. In this way, Horioka notes that the main source of dissaving by elderly take the form of declining social security benefits, increase in taxes and social insurance premiums, and increasing consumption expenditures. Let us quickly dispense with the last one and agree that Japan has not experienced any meaningful consumption boom in a long time which suggest that dissaving is not likely to take the form of a surge in consumption in any meaningful way (I don't suspect this is what Horioka wants to argue, but it is important for me to point this out).

Since 1997 the growth rate in GDP and private consumption expenditures have languished at a depressing mean reverting trend around the zero percentage annual growth mark. This indicates quite clearly that whatever the extent to which ageing households in Japan have dissaved through increasing consumption expenditures it has not been any meaningful driving force of consumption.

But what about the other two (increase in taxes and social insurance premiums). Are these really dissaving? I don't think so. Rather, these represent a transfer of saving from households to the government and thus an attempt by part of the government to reduce the future cost of age related liabilities and thus to compensate for a strongly negative net asset position by part of the government both in a current but more importantly, in a future perspective. In an ageing economy this is exactly why we would expect the dissaving hypothesis to be in need of significant adjustment since there will be forced savings through the inevitable attempt by the government to stabilize the deteriorating fiscal situation.

As such, the representation above does not paint an adequate picture of household savings in Japan and while this initially may be explained in light of the fact that we should look at the savings of the entire Japananese consumer base and not only the elderly (retired) consumers the rapid and ongoing process of ageing in Japan means that these two argument will inevitably converge over time, a point Horioka (2009) also makes.

Specifically, the account of dissaving above fail to take into account, at least, two important missing links. The first is the simple fact that the rate of savings out of total income is closely related to the annual growth in income which, in Japan's case, has exactly declined significantly in the same period in part because of the deflationary environment but also, I would argue, to reflect the changing productivity structure of the Japanese labour market with an ageing work force.

Between 1998 and 2005 the change in the annual income flow to Japanese households was persistently negative and suddenly; a consistent savings rate in the same period of about 3-5% does not exactly come off as rapid dissaving. In fact, at no point in the graph above has the savings rate been below the annual growth in income which provides a very important qualifying perspective to the idea that the release of corporate savings either as a lump sum transfer or through a steady trickle of dividends would immediately be channeled into discretionary spending. I find this very difficult to believe, but in effect this will be subject to easy falsification if and when corporate savings in Japan became an important policy variable in terms of stimulating domestic demand.

The second missing link relates to the idea that savings may be defined in two overall ways, the first which is a flow perspective is described above and the second is a stock perspective. The best example of the latter is the asset meltdown hypothesis that envisions a sharp decline in asset prices as aged households grind down their stock of assets by selling them to a smaller and shrinking base of working age households who will not be numerous or wealthy enough to support asset prices at the given level.

In the context of Japan, I have argued before how there is no meaningful destocking of assets even if the growth of households' total assets have stalled significantly.

Despite the obvious drawback of only having data from 1997 and onwards the picture is quite clear. Between 1997 and 2009 the overall household balance sheet in Japan has remained pretty "stable" rising from trn 1285 JPY in 1997 to about trn 1440 in 2009 JPY (current prices). I choose to put stable in quotations mark here since the real thing to notice is the lack of expansion (i.e. debt driven asset expansions) by part of Japanese households to reflect the fact that there was no housing bubble let alone any other kind of bubble in Japan in the period in question. The main point is of course that despite a continuing decline in the rate of savings from a flow perspective, Japanese households are not (yet!) engaged in any meaningful de-stocking towards what ever end point the economy would reach if ageing households and indeed the society as a whole began to run down its stock of savings.

In terms of composition, we find evidence of the often cited fact that Japanse households are quite risk averse Nakagawa and Shimizu (2000) holding between 50% and 55% of their total assets in either deposits or currency. In comparison, and while direct holdings of shares and investment trusts have indeed risen over the period, this entry still makes up only about 11% of the total balance sheet in 2009. Naturally, there is some cyclical effect here as the total share (value) of risky assets held directly in portfolio of Japanse households peaked in the years 2005 to 2007 at about 16-17%. Moreover, it is safe to conclude that if we include indirect holdings of risky assets through pension and insurance holdings, the picture becomes more balanced.

Looking at direct evidence of dissaving, we find none in the aggregate. Over the period in question the stock value of time, savings, and transferable deposits have gone up by 11% (i.e. a net addition of savings by the Japanese household) from some bn 665 JPY in 1997 to bn 742 JPY in 2009. Moreover, it is remarkable to see that the amount of currency held by Japanese households have increased by 40% in the same period. This suggests, more than anything, the risk aversion of Japanese households. Finally, I think it is worth to mention that although the amount of bonds held directly by Japanese households is next to none, Japanese households are naturally doing a substantial part of the heavy lifting in terms of financing the ongoing and almost perpetual deficit spending by part of Japan's governments. In this way, the large bulk of deposits as well as insurance and pension funds are very likely to be substantially invested (de-facto) in Japanese government bonds.

As an interim conclusion ans while a first glance suggests that Japan indeed is dissaving through its household sector it is an argument which does not hold entirely up to scrutiny. It is important for me to emphasize two things. Firstly, I don't dispute the analysis in Horioka (2009) and thus the wide range of previous studies that have shown how the life cycle model of savings is well calibrated to a Japanese context. However, I do think it is important to differentiate it with the points above and particularly the notion that Japanese households, as a whole, do not seem to be rapidly dissaving to the extent that many claim. Secondly, I want to reiterate the point that I am not arguing that dissaving will never occur in the aggregate. What I am saying however is that looking at the dissaving of the elderly and concluding that this will lead Japan towards an external current account deficit misses the current and real effect from ageing in Japan. Consequently, the picture of Japan at the present time running an almost perpetual external surplus is one of an economy fighting like hell to avoid obvious end point that would occur in the event of rapid de-stocking/dissaving.

Corporate Savings - Restraining Consumption through Retained Earnings?

Traditionally, economic models such as e.g. an OLG model set in an open economy context does not discriminate between the savings of corporates and households Rogoff and Obstfeld (1996) and Mason (1988) which is often because our economic models are set-up in a representative agent framework where the representative consumer is the sole shareholder of the representative firm and thus must be the sole beneficiary of whatever earnings (retained or otherwise) the company has. In a widely cited study Friend (1985) concludes that there is a moderate degree of substitutability between household and corporate savings which sounds about right to me.

In practice though and although principal agent problems and a thick corporate veil may make the direct link very sluggish, once foreign ownership of the domestic market cap is accounted for (about 20% in Japan's case I would say) there should no problem substituting corporate for private savings. In any case and to the extent that there is indeed a very long way from the dividends of Japanese corporates to the pockets of households it is, I assume, exactly here that Martin Wolf inserts his main argument.

As should be immediately clear here, it is not as if Martin Wolf is shooting blanks here although I don't suspect anyone really suspected that. Consequently, both the nominal value of retained earnings (manufacturers and non-manufacturers excl finance and insurance) as well as its share of total company assets have increased markedly since the mid 1970s. Since the second quarter of 1975 the nominal value of the stock of retained earnings has increased by a little over 270% while the corresponding figure for total assets is 163%. In terms of the share of total assets, the graph above does not tell the whole story as retained earnings as a share of total assets actually reached its low in the mid 1970s at around 5% declining from the mid 20s% in the 1950s. The average quarterly share of retained earnings relative to total assets in a post 1990 context is 14.14% with a steady upward trend throughout the 1990s and 2000s.

So far so good then.

However, as with the case of household saving above, once we dig a bit deeper in the analysis it is not certain that retained earnings constitute the magic bullet. First of all, the representation above is one of stocks and not flows and thus if we express it as flows we get the same picture as above with household savings; namely, that while the stock of savings (in the aggregate) is not being drawn down the flow of savings is steadily declining even if the flow of corporate savings is quite volatile.

Still, the flow of corporate savings have been impressive even in a post 1990 context where the average quarterly growth rate (yoy) has been 4.5% (with a correspondingly high SD of 6.7%). Moreovern, the relationship between the total amount of gross fixed invesment on a quarterly basis and the stock of retained earnings is further indicative here. Between 2000 and 2008, Japanese corporates consequently kept an average of 183% worth of retained earnings on their balance sheet relative to the average value of quarterly gross fixed capital formation. As Martin Wolf evidently points out, this is ultimately a question of a secular decline in investment demand to which Japanese corporations only can do two things; dissave to match the decline in investment demand or let those savings flow out in the form of an external surplus. In the context of Japan and in strict sense of national accounting it is the latter route which has been chosen.

The more interesting question in terms of what those retained earnings are financing (i.e. on the asset side) is almost implicitly answered above although it is not as simple as it looks.

Consequently, conventional wisdom has it that the retained earnings of Japanese corporates are merely sitting on the asset side in the form cash and deposits and thus would be readily and easily available for distribution to shareholders. The more I look at the data however, the more this seems to me to be a myth.

The total amount of cash and deposits as a share of total assets held by Japanese corporates peaked in the first quarter of 1990 at 15.5% and has since declined to about 10% in the 2000s. Now, I might be missing an important liquid asset entry here, but it should serve to differentiate the picture somewhat of Japanese companies as cash hoarders.

Yet, the main picture remains in the sense that even if retained earnings have then gone to finance land acquisitions or the build-up of fixed assets the GDP entry of GFC shows with all certainty that investment activities in Japan have been in secular decline for the past 20 years as the nominal value of GFC peaked in the first quarter of 1991.

It is worthwhile to note however that of the main balance sheet entries on the asset side, "investment securities" is the one that has exhibited the strongest growth rate in a post 1990 perspective. This suggests that a large part of the incremental change in retained earnings in this period has been parked in yield bearing instruments be it government bonds or more importantly foreign securities which have helped Japan gain a substantial boost (far bigger than from goods and services exports) from a positive income balance. Since 2005, the stock of investment securities held by Japanese corporates has been approximately equal to 68% of the stock of retained earnings.

More generally, the flow of investment securities onto corporate balance sheets rose steadily until about 1999-2000 after which we observe a discrete bounce and a much more rapid (and volatile) increase hereafter. From Q1-00 to Q1-01 the stock of investment securities rose 25% and has since increased steadily to about trn 181 in 2008.

This last point in particular serves to differentiate the argument by Martin Wolf even if it is unquestionably true that the share of retained earnings used to finance the asset side appears extraordinarily large in the context of Japanese corporates. Moreover, I cannot of course say for certain what would happen in the event that those retained earnings became the subject of political attention as a tool to muster domestic demand.

Is it Optimal to Dissave?

The standard life cycle model tells us that it clearly is, and especially so when set in the context of a representative agent model aggregated to the macroeconomic level. Sure, we may incorporate bequest motives or uncertainty, but in the limit; dissaving on a microeconomic level will transfer itself to the macroeconomic level. Implicitly, this is the argument advanced when it is held that the retained earnings of Japanese companies can meaningfully be deployed to boost domestic demand in Japan and, most importantly, lead Japan towards an external deficit which would go some way to rebalance the global economy.

Let me be clear. I don't dispute the dissaving argument in itself; especially in a context where fertility "never" recovers (which may well be the practical case in Japan). However, and while dissaving certainly would be the fate for a closed economy, it need not be for an open one. In fact, it should take us very little time to agree that dissaving as a function of old age perhaps even to the extent that the economy moves into an external deficit is utterly undesirable from the point of view of the economy as a whole. Thus, it is my contention that ageing societies are not, in the main, characterised by aggregate dissaving but rather by the fight against it. In Japan's case the high level of private savings reflected primarily in the level of corporate savings becomes a vital shield towards spinning further into negative trend growth and deflation.

Apart from this which is really my main observation on a theoretical level I have two additional points.

Even if we assumed that the retained earnings of Japanese corporates could be effectively channeled to the purses of households, would these same households increase spending? Put differently, what is the underlying demand here? Needless to say, I am quite sceptical here and moreover, it is important to remember that the rate of savings closely follow the growth rate in income. Thus, if suddenly income rose either through a lump sum payment or a steady trickle would the savings rate follow?

Finally, the extent to which Japan may become a global provider of spare capacity not only hinges on the trend of dissaving but also, by definition, on investment demand. This makes the whole issue much more complicated since what we are really looking for is a net effect and since both savings and domestic investment demand can be expected to decline with the transition into old age and it is the mutual pace between the two that determines the external balance. Consequently, empirical as well as theoretical studies have spent considerable time to pin down what this net effect is supposed to be. I will not go into the conclusions from this literature (my upcoming thesis will have much more on this), but merely note that we can observe how countries such as Germany, Japan, Finland etc are running external surpluses, why this surplus is critical for their growth prospects and thus why the salient features of an ageing economy is not dissaving but rather the fight against it.

Once you get this point and extrapolate it to the issue of global imbalances and the convergence of the global age transition towards a, so far, unknown end point you should realize the tremendous mess we have to sort out. In fact, why don't I come full circle and finish off with a most recent quote from none other than Martin Wolf writing in his latest column;

Meanwhile, the eurozone as a whole, having lost its erstwhile internal demand engines, must now hope for faster growth of net exports. So do countries hit by the financial shock, such as the UK and US. So, too, does recession-hit Japan. So, not least, does China. Either the rest of the world has a spending binge, or these countries – which make up 70 per cent of the world economy – are going to be disappointed.

This seems self-defeating to me since there is no way that 70% of the world economy can rely on export driven recoveries let alone export driven growth strategies no matter what kind of binge came upon the rest of the world. Still, I completely agree with Martin that this is indeed the issue. And once you overlay this argument with some basic intuition of how demographics affect savings, consumption and investment you end up with the fundamental challenge for the global economy in terms of staging a comeback from the economic crisis.

So yes Virginia, demographics do matter!

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[1] - Click on pictures for better viewing

List of References

Data for this piece can be obtained by mailing me and I will ship over my excel sheets. However, for those of you who want to check it out yourself here is the database on the corporate balance sheet data and in terms of household data you can get it from the website of the Bank of Japan (search for "household" and you should be able to dig out the relevant files).

Baldwin, Richard & Taglioni, Daria (2009) – The Illusion of Improving Global Imbalances, VoxEU research article (14.11.09) http://www.voxeu.org/index.php?q=node/4209

Friend, Andrew (1985) - The Policy Options for Stimulating National Savings, Conference on Saving and Capital Formation: The Policy Options Philadelphia (May 1985)

Obstfeld, Maurice & Rogoff, Kenneth (2009) – Global Imbalances and the Financial Crisis: Product of Common Causes, Paper prepared for the Federal Reserve Bank of San Francisco Asia Economic Policy Conference, Santa Barbara, CA, October 18-20, 2009

Horioka Yuji, Charles (2009) - The (Dis)saving Behavior of the Aged in Japan, Discussion Paper no. 763 The institute of Social and Economic Research Osaka University

Mason, Andrew (1988) - Saving, Economic Growth and Demographic Change, Population and Development Review, vol. 14 no 1 pp. 113-114

Nakagawa, Shinobu and Shimizu, Tomoko (2000) - Portfolio Selection of Financial Assets by Japan’s Households, Why Are Japan’s Households Reluctant to Invest in Risky Assets? BOJ Research Paperfff

Nakagawa, Shinobu and Yasui, Yosuke (2009) - A note on Japanese household debt: International comparisons and implications for financial stability, BIS Paper no. 46

Obstfeld, Maurice & Rogoff, Kenneth (1996) – Foundations of International Macroeconomics, MIT Press

Wolf, Martin (2009) - The Greek tragedy deserves a global audience, FT column January 19 2010

Wolf, Martin (2009) - What we can learn from Japan’s decades of trouble, FT column January 12 2010