What will the effect of the Earthquake and Tsunami be on the Japanese economy and the rest of the world?

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.

Quantitative Easing

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.

Fiscal Policy

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.

Comment

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.

Market Response

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?

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13 thoughts on “What will the effect of the Earthquake and Tsunami be on the Japanese economy and the rest of the world?

  1. Shaun – an excellent article, and I share your commiserations for the Japanese people as a whole. Yes the picture is as black as you paint and the impact will be long and severe as I read this morning many companies are or have shut down to take stock of the situation. A vast amount of rebuilding will be necessary in the months and years ahead and the thought occurs that this might conceivably help to reduce the deflationary trend of the past. Your views on this would be welcome. The problem with an ageing population will not go away but the tragedy that has occurred may perhaps bring people closer together and help in the reconstruction – it may even convince the Japanese that “foreigners” should play a more active role in business (real business not speculation, that is and to settle there on a permanent basis). I believe I read that the Japanese Post Office is sitting on vast piles of Yen savings – can this also be mobilised?
    Finally, I think we will see a spike in oil and commodity prices – Japan as you rightly point out will have an on-going need for both – but they will to a degree be in direct competition with China and India for a “fair share” of the markets. Thank you.

  2. Wheat is a commodity that concerns me because of the Russian wheat export ban. The farmers are concerned at higher input costs (fertiliser, diesel) and are planning to plant less wheat (source Bloomberg 7 March). The export ban is intended to reduce food price inflation in Russia but may have the opposite effect. In a free market the increase in price is an incentive for farmers to plant more wheat.

  3. Very interesting as ever, Shaun.
    Completely off topic, but what did you think of the Eurozone rescue package?

    • Hi Jiminy
      I will probably discuss it tomorrow in detail- at the moment much is fast moving- but in essence they are still trying to fix a solvency problem with liquidity…….
      There is a marginal improvement for Greece.

  4. it seems to me the policies must be the opposite of what both Japan and the UK are doing.

    1, raise interest rates – well lowering them to virtually zero did not work

    2, Pay your workers more – cut the competition from overseas labour that drags your own people’s wages down

    there will be fall out of businesses going bust – buy hey this is capitalizism ( well maybe bank bail-outs put paid to that! )

    Scary huh ? not going to work huh? the banks will loose money – but the country will gain I think !

    not going to happen either – those with the power will not gain from this the little people probably will.

    Forbin

  5. Are you suggesting that bank owned insurance is nothing but a scam, as governments will make the real payouts? Sounds as if the original underwriters should be investigated.

  6. on the nuclear issue: Japan gets around 30% of its power from nuclear. It uses boiling water reactors with plenty of safeguards, probably the most extensive in the world. It looks to me, from the press releases, that they are being honest. Pouring seawater into the core is an action of last resort, the reactor is then unusable and has to be shut in permanently, they are there with at least three reactors now. Their problems come from the fact that their reactors are about the biggest in the world, I believe 400 MW or greater. They managed to stop the fission reactions, but even when you do that you are left with a decay of the fissile material which still generates a few megawatt of energy, and you have to cool that and get rid of it hence the seawater. I understand they are currently dealing with exposed fuel rods and trying to avoid meltdown. It would be difficult to see what could be worse! They have already admitted that the explosions are hydrogen-based, which comes from the melting alloy cases containing the fuel rods. At best, it looks like they will lose half their generation capacity from nuclear. Power engineers will rapidly work out a way of replacing that with fossil fuel generation, remember they produce millions of generators per year, it is a big industry to them. they will do what China does and fill the gap with microgeneration before a more permanent solution. The effect of this will be increased oil/gas demand and probably a moratorium on nuclear until they work out what to do. The replacement cycle for nuclear is at least 7 to 10 years with a following wind.

    In terms of energy generated by nuclear, this is just about the worst scenario. With a bit of time and provided they contain it, some good lessons will be learnt and it should make the nuclear industry more robust. Reputation and political damage is another matter, talking heads may well whip up sentiment against an industry which had just started to gain credence again.

    • A.P – thank you for a very lucid explanation. I think micro-generation may well be the answer but, as you rightly point out, the “talking heads” may prove its undoing. Incidentally, which companies would gain most from such a programme?

    • Sounds like a major market opportunity for temporary power provider Agrekko, one of the UK’s fastest growing and most successful exporters.

    • In regards to the nuclear power industry I consider them to underestimate the insurance risks. I am required to insure my BMW in case I have a crash and destroy a house or a another car. Consider the cost of relocating and replacing a major city (Tokyo, London or Paris and so on) The Vienna convention currently limits liability to not less than 360 million euro. This is clearly inadequate.

      The cost of comprehensively insuring a nuclear plant with unlimited liability against meltdown will be prohibitive. This makes nuclear power economically nonviable.

  7. A lucid article and equally informative responses as well from the readers.
    I was curious to know the folowing: Recently japan had started to invest in research and development to other countries. Any insights into how this will be impacted given the current setback to its economy?

    • Smita – I would suggest that given the current state internally, any R&D externally would be put on hold and ALL resources of all description will be used for the reconstruction of the homeland. This must be the priority for some while ahead.

      • I agree; that’s logical. The external R&D was essentially an effort to reduce expenses on local R&D . But now the priorities will be , as you say reconstruction of their homeland. And We can only salute their spirit and wish them well.

        I was curious to know if the nuclear reactors in countries under such severe threats like volcanoes and tsunamis are insured using different norms? Aren’t there any guidelines about what should be the location? definitely not coasts likely to be susceptible to thunderstorms, tsunami?

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