Today, following the release of our U.S. and China outlooks, we present another preview from the updated 2009/10 RGE Monitor Global Economic Outlook, which will be available by the end of next week to subscribers. This week we focus on Japan, which will not only underperform the U.S. and EU economically in 2009, but also faces political uncertainty. National elections, scheduled for the end of August, are quite likely to bring some changes to Japanese economic policy, and could also hold ramifications for the U.S. dollar.
RGE Monitor expects the pace of Japanese economic contraction to ease from the sharp decline of Q1 2009, but the road to recovery will be long and bumpy. Inventory restocking is coming to an end and rising commodity prices could curtail a nascent recovery in consumer demand. Meanwhile, public spending is constrained by soaring public debt, and Japan’s export-oriented model of growth seems increasingly unsustainable, given the degree to which deleveraging is stifling external demand from the U.S. and Europe.
Japan’s Lost Decade might thus be more aptly called its “Lost Decades.” The sharp economic slowdown of the early 1990s culminated in a recession in 1998-1999, only to be followed by almost another decade of recessions and paltry growth. Being the most trade-dependent of major industrialized nations, Japan suffered the worst GDP contraction among these countries in Q1 2009, and is on track to perform the worst of the G3 in 2009. Aggregate demand slid precipitously and deflation took hold once again, despite massive fiscal spending and monetary expansion. RGE projects Japan’s recession will persist through 2009, then give way to gradual recovery in 2010.
Feeble Aggregate Demand
Though the pace of economic contraction has slowed since Q1 2009, the inventory-driven rebound in production and exports will at best make for stabilization at low levels, rather than a strong economic expansion. Japan’s recovery will hinge on external demand from the U.S. and Europe–the main final consumers of Japanese goods. Chinese demand, which helped boost Japan in 2005-2007, may be of little help this time. China is the top destination for Japanese exports, but Chinese demand is mostly a function of U.S. and European demand. Most Japanese exports to China are inputs for goods bound for the U.S. and Europe, not finished goods bound for Chinese retail stores or raw materials needed for infrastructure projects.
Meanwhile, domestic demand in Japan has suffered from the poor earnings outlook for both firms and households. Japan’s overcapacity has curbed capital expenditure growth as firms see no need to expand or upgrade capacity when supply exceeds demand and capacity utilization is low. Moreover, falling earnings and tight credit reduce the affordability of new equipment and factories. Rising unemployment and the destruction of household wealth have kept household consumption weak, despite government handouts. Worse yet, wages are decreasing faster than the cost of living.
Japan, which suffered from falling prices from 1999 to 2005, is back in deflation and may be facing a protracted period of price declines due to anemic demand growth and falling wages.Consumer inflation will see its nadir in Q3 2009, due to base effects from lower oil prices, but both headline and core inflation may remain negative even beyond the autumn, given falling demand and wages. RGE Monitor expects annual CPI inflation to be negative in 2009 and 2010. And like the meager inflation in 2006-2008, any extant inflationary pressure will come predominantly from cost-push sources (rising energy and material costs) rather than domestic demand.
Public Debt: Unsustainable?
The sustainability of Japan’s public finances has come under scrutiny in the wake of the ¥15.4 trillion fiscal stimulus package announced in April 2009–the biggest in Japan’s history–which will send public debt soaring to about 200% of GDP by 2010. Japan’s heavy debt load led to the loss of its AAA sovereign rating in May 2009. Reluctant to burden a long-stagnant economy with higher taxes, social spending cuts and lower public investment, policymakers have put fiscal reform on hold until at least 2015. In the meantime, policymakers will probably cajole the Bank of Japan to continue monetizing the public debt. Locals hold most of Japan’s public debt, but a declining saving rate coupled with declining home bias could wreak havoc on Japanese government bonds.
A New Ruling Party for Change?
Due to Prime Minister Aso’s severe unpopularity and his administration’s scandals and economic failings, the 2009 general elections may bring a shift in Japan’s policies, ending fifty-plus years of de facto one-party rule under the Liberal Democratic Party (LDP). The LDP lost its majority of seats to the Democratic Party of Japan (DPJ) in Tokyo local elections in mid-July, foreshadowing a struggle in the August 30 general elections for the Lower House of Parliament. Former LDP-member-turned-DPJ-leader Yukio Hatoyama has a strong chance of becoming Japan’s next Prime Minister.
A DPJ win could bring looser fiscal policy and a greater willingness to use currency intervention, though contradictory remarks from DPJ officials suggest a disunited stance. Nonetheless, the DPJ could bring welcome changes that address Japan’s ailing consumer demand growth and falling birth rate, such as child support and an expanded social safety net. The DPJ also hopes to convert the policymaking process into a less bureaucrat-led cabinet system. Unions at large manufacturers, especially those that produce eco-friendly products and low-priced goods and services, may stand to benefit from the DPJ’s tougher environmental policies and support for low-income families.
Unfortunately, a deeply negative output gap will dampen the economy in the medium-term no matter what policymakers do. A critical test for the winner will thus be attending to the longer-term ramifications of a rapidly aging population, such as a shrinking labor force and consumer market. With Japan’s baby boomers reaching age 65 by the early 2010s, policymakers will need to act quickly to prevent public debt from spiraling out of control when the underfunded pension system meets an onslaught of retirees. Land use reforms that increased homeownership could encourage larger families and higher consumer spending against home equity.
U.S. Dollar Dump a Danger
Some members of the DPJ have vowed to shun U.S. debt, which suggests public pension funds and othe
r quasi-government funds (such as the newly privatized Japan Post Holdings, whose shares are still held by the government) could move to higher-yielding assets if DPJ becomes the ruling party. Diversification of FX reserves and pension funds away from the U.S. dollar could mean sharp losses for the dollar. Japan is the second largest foreign holder of Treasuries after China. The reduction in Japan’s external surplus in 2009 may already have contributed to a reduction in Japanese reserve growth and U.S. debt holdings. Despite the decrease in the U.S. current account deficit and a higher U.S. savings rate, the U.S. would have a very difficult time meeting its financing needs if Japan stopped buying U.S. debt and sold off its dollar assets or signaled the intent to do so. Such a move could precipitate a disorderly decline in the U.S. dollar and the loss of its supremacy as a global reserve currency, especially if other reserve holders followed Japan’s lead. A dollar crash would be undesirable for Japan, though, due to its large U.S. dollar holdings and the desire of its policymakers to aid Japanese exporters through a weak domestic currency. Japanese reserve diversification is thus likely to remain gradual, but the chance of political change come August 2009 raises uncertainty on this point.