Until last week, some analysts still believed Japan would escape recession, but the release of the Q2 GDP numbers forced most to change their tune – real GDP in the second quarter (Apr-Jun) fell -0.6% qoq (-2.4% yoy). Consequently, the consensus now seems to be that Japan is experiencing a shallow, short-lived recession, with recovery expected sometime in the first half of 2009. While Japan’s downturn may yet be mild, it’s important to keep in mind that considerable downside risks exist to this scenario. Given the risks detailed below, there’s a strong likelihood analysts will have to revise down their forecasts further.
Before we get into the downside risks, here’s a look at some forecasts:
Already Anemic Consumption Likely To Deteriorate Further
Private consumption has been anemic in recent years and there’s no sign of any improvement on the horizon. If anything, private consumption – which currently accounts for about 55% of Japan’s GDP – looks set to drop off further, as my fellow blogger Claus Vistesen has noted.
Source: Japan’s Ministry of Health, Labour and Welfare
In recent years, consumption has been hurt by stagnant real wages (which have been essentially flat as can be seen in the chart above) and Japan’s deflationary environment (which fostered thinking of “Why buy now when the price will soon be lower?”). Now Japan is experiencing inflation, but this is nothing to cheer about, as I detailed in a recent blog post.
Source: Japan Statistical Office
Flat real wages remain a key contributor to sluggish consumption, but now consumers are facing the double whammy of stagnant wages and rising food and fuel prices. So consumption will likely get even more anemic than it is now (note the almost flat trend line in the chart above). Highlighting consumers’ troubles, Japanese consumer confidence dropped to the lowest level ever recorded in July and summer bonuses dropped for the first time since 2002. While headline inflation may be rising, core inflation (excluding energy and food prices) is essentially zero, coming in at 0.1% in June yoy. What this means is that Japan has barely shaken off deflation. Meanwhile, this cost-push inflation and weak consumer sentiment is hurting companies’ bottom lines (see next risk below), which in turn could push wages even lower – not a pretty cycle.
Companies Not In As Great Shape As Some Press Reports Suggest
A recent Lex column in the Financial Times pointed to Japanese companies as an economic bright spot, suggesting they look well-equipped to weather a downturn with their ‘robust’ balance sheets.
The problem is that the cost-push nature of Japanese inflation, in addition to eroding consumers’ real income, is also eating away at corporate profits. Input costs have soared, but companies are having trouble passing on those costs. In a sign that companies are not all that robust, the number of corporate bankruptcies has risen, particularly among small enterprises, as Kazuhiko Ogata of Alliance Bernstein recently noted.
Residential Investment Not A Growth Savior
A rebound in housing investment was expected to help sustain Japan’s economic growth in 2008. However, GDP data showed housing investment fell an unexpected 3.4% for the three months ended June 30. It’s not surprising house hunting is less en vogue as households are being pinched by stagnant wages and rising food and fuel prices. Hiroshi Shiraishi of Lehman Brothers says residential investment is unlikely to recover much further in coming quarters.
Gloomy Export Outlook
Earlier this year, many analysts were optimistic that Japan could weather a U.S. economic slowdown as exports to emerging markets more than offset falling exports to the U.S. As recently as late July, Daniel Citrin – the IMF’s mission chief for Japan – said exports to Asia and other non-U.S. markets should help the economy avoid recession. While Japanese exports rebounded in July, rising 8.1% yoy after decreasing 1.8% in June yoy, many analysts are skeptical the rebound is sustainable (see Danske and Mitsubishi UFJ).
The reasons Japan’s export machine is waning include: weak U.S. demand, the slowing global economy, and yen appreciation (notwithstanding recent strengthening against the USD).
Sources: Japan’s Ministry of Finance, “The Summary Report on Trade of Japan”; Bank of Japan, “Corporate Goods Price Index”
Most importantly, exports to East Asia (which, including China, accounted for 46% of Japan’s real exports in 2007) are unlikely to permanently offset those lost from the U.S. and EU slowdowns. That is because intra-Asia trade seems unable to offset Asia’s slowing exports to the G-7 economies since most of it is actually for final exports to the G-7, which my colleague Arpitha Bykere noted in a recent post. This point is underlined by the fact that almost 60% of Japan’s exports to China consist of parts and components, rather than finished goods, according to Fitch. Basically, decoupling seems like wishful thinking at this point.
Adding to the export machine’s woes, Japanese companies are facing sharp increases in the import prices of raw materials, but are having difficulties passing on these increases to export prices.
Economic Ramifications Of Japan’s Political Stalemate?
The opposition Democratic Party of Japan (DPJ) won control of parliament’s upper house in July 2007. Prior to this, Japan was effectively a one-party state with the Liberal Democratic Party holding power for all but one year since 1955. The political stalemate between the LDP and DPJ over the last year has at times had economic ramifications. For example, dissonance between the two parties on suitable Bank of Japan nominees resulted in a three-week leadership vacuum at the BOJ earlier this year, which unsettled investor sentiment. While that particular kerfuffle was eventually resolved, the uncertain political environment – and the risk this poses for economic spillover effects – should continue, especially in the run-up to Lower Hous
e elections, which are due no later than September 2009.
Bright Spot: Healthy Financial System
Not all is doom and gloom. Japanese banks’ performance has steadily improved since 2001. Moreover, they have been mostly unscathed by losses related to subprime mortgages. As Ogata notes, Japanese banks’ healthy performance is reflected in the modest level of their excess reserves at the BOJ, as financial instability tends to cause a surge in excess reserves when banks hoard liquidity amid fears of a credit crunch.
The downside risks listed above undermine the consensus view that Japan will only experience a shallow, short-lived recession. In sum, current growth forecasts for the Japanese economy seem overly rosy when these risks are considered.