18th March 2011 by Shaun Richards
Firstly let me repeat my message of Friday wishing the Japanese people well in what are very difficult times with many dead and injured. Perhaps the biggest hindrance to a full rescue effort is the fact that 3 nuclear reactors appear to be running wild with their engineers struggling to try to bring them back under control. As Japan’s buildings appear to been built to withstand earthquakes and in general have survived well we get lesson one from this crisis which is that even the most advanced nations should think twice in future before building nuclear reactors in earthquake zones. We of course do not yet know how badly this particular facet of the crisis will play out but in culture where the word for yes hei (hai) can mean both yes and yes maybe and the underlying importance of loss of face means that the Japanese authorities are very unlikely to be telling us the truth about the real situation.
For the full impact of this crisis and to analyse how it is likely to play out we need to consider the underlying state of the Japanese economy.
The Main features of the Japanese economy
1. One issue for Japan has been that whilst it has been a success as a net exporter it has also often suffered from insufficient domestic demand. For UK readers it is in some senses a doppelgänger of us! (although we export more than we think as it is swamped by our even higher imports). Various measures have been tried to solve this but the problem has persisted. I wrote an article over a year ago on this subject and if we look at the data for November 2009 in Japan one can see examples of this. On a month on month basis industrial production rose by 2.6% but retail sales fell by 1.0%.
2. The next Japanese problem is disinflation or negative inflation, and yes I do mean that prices are actually falling and they have been falling for quite some time. The main Consumer Price Index (CPI) for Japan was rebased at 100 back in 2005 and in January of this year it was at 99.4. Yes some 6 years later prices were lower overall than they were in 2005! The monthly change was -0.2% which reinforces the message. The highest level this index reached was 102.7 in August 2007 and so it has spent 33 months lower than this peak. there has been the occasional slight uptick but in general the trend has been for falling prices.
3. The next problem is the size of Japan’s national debt. The severe recession and sizeable fiscal stimulus pushed up Japan’s public debt from 188 percent of GDP in 2007 to 218 percent of GDP in 2009. The International Monetary Fund has published reports saying that it feels the ratio could reach 250% in 2014. These are extraordinary numbers and are only possible because the Japanese purchase approximately 95% of their own government’s debt. Accordingly a loss of faith by overseas investors would have only a minor impact.
4. In spite of her incredibly large national debt Japan has run large fiscal deficits in recent years. For example according to the latest IMF Fiscal Monitor she ran a fiscal deficit of 10.2% in 2009 and 9.6% in 2010 and expected a deficit of around 9% this year but this was pre-earthquake. So deficits are high and showing few signs of falling by much.
To try to solve the problem the Japanese government has announced a record annual budget of 92,410 billion Yen ($1,100 billion, £689 billion) for the fiscal year which begins in April 2011. The government came into power promising to give more money to Japanese households and as time developed promised to cut the fiscal deficit. However as circumstances have evolved they have quite a few problems.
a. Japanese tax revenues for 2011 are expected to be around 41,000 billion Yen
b. Japanese government bond issuance is likely to be 44,300 billion Yen.
These numbers have serious implications. Tax revenues have fallen so far that they are back down to mid-1980s levels and now in both 2010 and 2011 bond issuance will exceed tax revenue which are the only times since the Second World War that such an event will occur.
5. There is also the problem of Japan’s ageing population.With long-term solvency an increasing problem for Japan as a nation then its ageing population structure makes the potential problem worse. Its population is 130,000,000 but its birthrate per woman has dropped to around 1.3. Demographers estimate that a level of 2.07 is necessary to maintain a stable population.Combining this with the fact that people are living longer then the Japanese working population will have to support more older people as this century progresses. This is not a good mix.
The Impact of the Earthquake and Tsunami
There have plainly been influences on Japan’s agriculture, industry and power supply.Paddy fields that have been contaminated by sea water are unlikely to produce any rice crop at all this year and it remains to be seen how much of Japan’s rice output will be affected. Many industries will remain closed on Monday and we will have to wait and see when they reopen. The production of Japan’s power industry will be affected by the problems of her nuclear reactors several of which are likely to be switched off for the long-term.Rather ironically some of them may be pouring out power at this time.
If we look at Japan’s economic output it is bound to be affected by this and as she just had a quarter of negative growth it is quite possible that she could have another recession which would require another quarter of negative economic growth. Many industries may be affected by the power cuts and blackouts which look likely to continue for at least a while. Apart from anything else this will do her national debt and fiscal deficit problems no good at all.
The Policy Response
Bank of Japan
One move that is not available to the Bank of Japan is a cut in interest-rates. The reason for this is that they are already at 0.1%, so there is no room for a cut of any significance. The most appropriate move it can make is simply to supply cash and it started to do this on Friday in its role as a “lender of last resort”. It provided some 55 billion Yen ($670 million) of cash to institutions in the worst hit areas. In addition the Governor of the Bank of Japan promised this according to Reuters.
We will monitor market conditions and plan to provide markets with a lot of liquidity first thing tomorrow morning.
It is likely that the Bank of Japan will offer around 7 trillion Yen to stabilise money markets.
Also the Bank of Japan may consider intervening should the Yen exchange rate weaken substantially. However let us not forget that for quite some time it has been trying to weaken the Yen! Accordingly it may even welcome a fall in the Yen exchange rate particularly against the US dollar.
In the short-term in a surprising occurence we are seeing quite considerable Yen strength with it rising to 81.4 versus the dollar compared to around 83 before the earthquake. So either Japan is repatriating funds – it has large overseas investments- or investors are anticipating this and “front-running” it. As time progresses I find it very hard to see how this can be sustained.
Japan has had several goes at Quantitative Easing or QE in its attempts to deal with its “lost decade” which has now stretched for 20 years. The latest variant of this has the Bank of Japan spending some 5 trillion Yen or around US $62 billion. It is possible that this programme will be increased today with expectations stretching as high as it being doubled although frankly I fail to see how it can help much. Japan’s interest-rates are pretty much the lowest in the world all along her maturity spectrum.
This is a big problem there is a contingency reserve in Japan’s budget but even some 200 billion Yen or US 2.4 billion is unlikely to go far. Japan will have some hard choices to make on this front as the situation develops as one would expect tax revenue to fall and public spending to rise exacerbating her fiscal problems. However in the short-term her government has little choice but to spend.
Not only is Japan’s economic output something that will be adversely affected in the short-term but reconstruction efforts which may help to recover this are going to be very expensive and will lead to further fiscal problems. Another obvious problem in the short and medium term is an energy crisis as nuclear power will be initially restricted and going forwards it is unlikely to be very popular to say the least.
Implications for the rest of the world
The first implication is on energy and oil I feel as Japan will have to increase her demand for these. If there is a substantial impact on her rice crop then she will have to import more food and so we may see more upward inflationary pressures on food prices. Rather ironically rice has been one of the slower movers in the recent rises. When the rebuilding effort really starts then there will be substantial demand for such materials as steel and aluminium.
It will be very expensive for insurers and now we can see that it will be a lot more expensive than was expected on Friday and so we will probably see their share prices fall again.
Nuclear power is likely to see a sustained drop in popularity even in areas which are not in earthquake zones.
In the early part of trading Japan’s Nikkei 225 equity index has fallen by 5%. However care is needed with such numbers as Japan’s markets match quantities and not prices they are not the same as western ones. This means that as I type this some 30 minutes into the trading day many of the main shares have not traded at all with there being not enough buyers to match with the sellers.
Update 1:30 pm UK time
There have been some developments since I wrote this article. The Bank of Japan continued to add liquidity throughout the day and the total amount stretched to 15 trillion Yen. It also added to its asset purchase programme which now totals some ten trillion Yen.So this programme has in effect been doubled in response to this disaster.
I remain of the view that adding liquidity is a wise and proper move for a central bank in response to a natural disaster but still fail to see how more QE will help. However it would appear that some parts of the the Japanese banking system may come under strain (again) with banks in the affected North East of Japan apparently involved in earthquake insurance.
The Nikkei 225 equity index closed down around 6% at 9620. Since then there has been more bad news about explosions and leaks at Japan’s nuclear power stations and futures markets have fallen another 3% or so. Please remember that because of the relationship between interest-rates and dividends at this time futures prices will be below cash ones….
Expect the unexpected
Those who remember the recent discussion on here on this subject which put more formally I was taught as the “serially uncorrelated error term” will have food for thought this morning. Reactors built in the 1970s are being affected by what we are told is a one in a thousand year event. However in practice this event took less than 40 years! If the reactors had lasted a thousand years how many such events would occur?