Japan and the Fertility Trap - A Worst Case Scenario?

by Scott Peterson

The way I understand how a negative scenario for population dynamics could play out in Japan is as follows:

Japan has a large segment of its population that is approaching retirement. When all of those people retire, they expected to be supported by the working population which is now far too small to support the large number of retired persons. Of course, theoretically those retirees should have some significant savings since we've been informed for years that the Japanese are great savers. So the burden of supporting a large retired population with a small labor force might be delayed for a few years. On the other hand, the use of savings by the retirees forms a wave of dis-investment that could torpedo efforts to offset the shrinkage of the workforce with robotic or mechanized production(of which much has been made in the press).

Political and social division ensue. Leaving aside the options the Japanese government has for handling that situation, pretty soon thereafter members of that retired group start dying. In 2006, according to PRB.org's World Population Datasheet, there were 9 births for every 8 deaths in Japan. When the retirees start dying off, that ratio reverses and could go fairly high in the other direction, say 12 people dying for every 8 born. So massive population shrinkage ensues.

Since the population is shrinking, domestic demand naturally is shrinking as well, and therefore Japan becomes even more dependent on exports for positive GDP growth. In reality, once the ratio of births to deaths goes much below 1.0, positive GDP growth is not possible. The shrinkage in domestic demand will be too much for any increase in exports to overcome. And when the yen's value versus other currencies eventually rises to a realistic value, exports will drop off as well.

Since the population is shrinking, real estate prices decline steadily as well. So there could be a negative home equity effect on consumer spending.

Another major problem will be the large national debt built up which now will need to be covered by the output of a much smaller labor force. A default by Japan on its sovereign debt could occur.

Did I leave anything out?

Standing Fast in Japan

by Claus Vistesen

eing a BOJ watcher can indeed be a tough job in terms of forecasting but sometimes it is also pretty easy. Consequently, the BOJ chose today, pretty much as expected, to hold rates steady on the back of a return of deflation in the recent months and also I guess on the back of the outlook that deflation will persist in Q1 07 and perhaps even well into Q2 07 as well. Also of course the slowdown in the US which after all is Japan's biggest export market.

The Bank of Japan kept interest rates unchanged for a second month after consumer prices fell and recent data signaled U.S. economic growth may slow.

Governor Toshihiko Fukui and his policy board colleagues voted unanimously to hold the key overnight lending rate at 0.5 percent, the lowest among major economies, the bank said in a statement today in Tokyo. The decision was expected by all 49 economists surveyed by Bloomberg News.

Fukui later told reporters that the U.S. economy will achieve a soft landing and Japan's consumer prices will rise in the long run after hovering around zero percent in coming months. Confidence among Japan's largest manufacturers slipped from a two-year high on concern a U.S. slowdown may hurt exports, the central bank's quarterly Tankan business survey showed last week.

``There's still a pretty big chance for a rate hike later this year if the central bank can confirm Japan's growth is supported by demand at home, even if the U.S. economy deteriorates,'' said Ryutaro Kono, chief economist at BNP Paribas Securities Japan Ltd. ``We expect the bank to act in the fourth quarter.''

For more on the outlook on the Japanese economy you can check out my recent notes which also dicusses in more detail the outlook in deflation based on recent analysis by Takehiro Sato from Morgan Stanley. More interestingly, we have consumer spending which indeed has shown positive signs as of late and most likely will show a healthy growth clip y-o-y in %. However, remember still that 2006 was a below trend year in terms of consumption expenditure and that consumption expenditure is still below 100 on a real Index 100 (2005) basis. In fact the trend since 2000 is one of secular decline as shown in the figure below.

This of course does not mean that this might not signify a significant pick-up but my main worry is that deflation will entrench itself in Q2 of 2007 which could feed into expectations and since Japanese consumers already are saving a lot the pick-up in consumption expenditure will perhaps be shortlived. For sure, the chance of a y-o-y improvement is there but I do not see a change in the overall trend. Finally and on deflation I leave you with a chart plotting real GDP growth and the evolution of the GDP deflation since 2001. As you can see real GDP has picked up as of late but of course so has a the Japanese trade surplus.

On a very last note I am not chaning my main position here and the outlook on deflation still worries me most although of course the recent pickup in consumption expenditure is most welcome. In terms of interest rate decisions we should expect the G7 ministers and other high lords to pounce on Japan again come next weekend although I expect that the criticism will be less pronounced than last time. I do expect however that European G7 members and officials in particular will spend time on the Yen. However, I do not see the BOJ raising on this side of Q3 with the current outlook in deflation.

Update on Wednesday, April 11, 2007 at 03:55PM by CV

The recent data on manufacturing orders in Japan actually seems to require a revision to the downside of my call on capex spending in Japan in Q1 2007. Consequently, machine orders fell 5.2% in February which clearly suggest that exports are losing steam going into 2007 and since the US after all is the biggest export market (22%) then this might be a sign of a transmission mechanism in the works (de-coupling anyone :)?). This also means that industrial production most likely will have continued its decline in March and April on two accounts Firstly, as a result of de-stocking on the back of high capex in Q4 2006 and secondly, as a result of a real decline in foreign capacity proxied by a US slowdown and perhaps also a cooling in Chinese investment.

A second data piece on Japan which caught my eye was the news that corporate credit growth supplied by Japanese banks fell in March. The decline was, it needs to be said, ever so slight and corporate credit is still growing albeit more slowly it seems. This is of course likely to be a derivative of the points above and an indication that capex in Japan is slowing on an overall basis in the beginning of 2007.

Kazumasa Iwata: the Current State of the Japanese Economy

by Claus Vistesen

have been pretty preoccupied as of late with Japan and as such I thought I would also share with you a recent speech by Deputy governor of the Bank of Japan Kazumasa Iwata on the immediate outlook of the Japanese economy and monetary policy. As you can see he is much more optimistic on the rebound of inflation and consumer spending than I am. Moreover the speech also gives a valuable insight into the policy setting process within the BOJ. Here is an excerpt from mr. Iwata's remarks on consumer prices ...

The year-on-year rate of change in the CPI (excluding fresh food) was flat in January, and depending on developments in crude oil prices and foreign exchange rates, it may turn slightly negative in the short term. From a longer-term perspective, however, consumer prices are expected, over time, to display trend increases given that the economy has expanded at an annual rate of around 2 percent over the last four years and that the expansion is expected to be long-lasting. With the continuing economic expansion, the utilization rates of production capacity and of labor have been rising steadily, and they are expected to increase further. As the recent Tankan (Short-Term Economic Survey of Enterprises in Japan) indicates, corporate managers are increasingly feeling shortages of production capacity and labor, while a positive output gap suggests that demand currently exceeds supply in the economy as a whole.

Note, especially the idea of a positive output gap and how demand exceeds supply in the economy. Methinks that someone is not taking into account the nature of Japanese growth and the relationship between domestic capex and foreign capacity. In short; how do we measure output gaps adequately in an ageing economy such as Japan's or more specifically ... how does ageing affects the operationalization of output gaps? In terms of output gaps Mark Thoma recently pointed to an article from the Dallas Fed by Mark A. Wynne and Genevieve R. Solomon. The article is an excellent intro to the economic operationalization and measurement of output gaps. Of course I have my mandatory adjustments in order to better take into account the fundamentals of ageing but all in all still a very readable article.

Following Up on Japan

by Claus Vistesen

A week ago I had a note on the economic outlook on Japan and now, with the recent data, I think it is time to do a whee round up. First of all, the chance (or risk) for an additional hike by the BOJ seems to have dissipated with the recent inflation data showing a -0.1% (overall consumer prices -0.2%) y-o-y drop in February on the back of a steady (0%) inflation rate in January. The decline was of course widely expected due to the y-o-y deflationary impact from falling energy prices but still it comes at a bad time for the BOJ after having pushed a rate on the basis of Q4 06 GDP figures and general international pressure to normalize interest rates and thus curb the carry trade. Moreover the preliminary data for March also suggest that prices declined -0.1% in. On a brighter spot industrial production 'only' declined 0.2% in February which suggests that Japanese companies won't sustain de-stocking from Q4 06 too much into March and perhaps capex will begin ticking up already in March which again depends on the fundamentals in Japan's major export markets.

On a much more positive note household spending increased 1.3% on a year earlier in February which indeed is good news as this figure is a key indicator for the sustainability and trajectory of the Japanese economy. Moreover, retail sales also showed slight positive signs although they were virtually flat y-o-y.

So, both good and bad news then but does it change anything from what I said in my last note? Firstly, let us look a bit closer on the outlook for inflation where the always excellent Takehiro Sato serves up the cold facts in a recent note over at MS GEF. The first thing to note is that deflation measured by the core index almost certainly will linger into March as I also noted above but more importantly Sato rolls out an argument and calculations which suggest that deflation will persist on a y-o-y basis much further into 2007 which effectively will stall the normalization process at 0.5%. As such, Sato notes the much pessimistic forecast of a 0.3% drop in the CPI index in Q1 2007 which may even be on the upside. In short, this smells rasther nastily of entrenched deflation in the first two quarters of 2007 save for a major hike in energy prices which are after all trending upwards at the moment. Secondly, we have private consumption and retail sales which show promising signs of a y-o-y improvement in Q1 but what about the fundamentals and the looming entrenchment of deflation? Most notably, the recent Tankan Survey (sorry, no link) also shows that consumer expectations of price increases have fallen back considerably which indicates that consumers probably will hold back spending. This is of course difficult to say and indeed the immediate outlook on demographics reveal that a lot retirees will be up for bonuses soon which means that consumer spending as a function of dissavings might be a trend to look out for but at the end of the if deflation sets in with its nasty grip the fundamentals will indeed be tested. Of course monetary policy is the last part of the equation and here I really do not think we should expect much of a hike although of course the G-7 ministers are still wandering around in wonderland poised to strike once again on the low Yen and the need for the BOJ to normalize.

In summary, I think that the recent signs from the internal demand side proxied by household spending are positive but I am truly worried and not at all happy about the outlook on in(de)flation which I fear will feed strongly into expectations and thus also consumer spending in Q2 2007.