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Global Economic Outlook
Japan: September 2010 Outlook Update
By Mikka Pineda
- Ongoing neglect of structural reform could lead to more of the same: public debt and economic stagnation.
- The end of subsidies and reluctance to increase public spending will lead to a drop in production and consumer spending.
- Infrastructure investment and low inventories overseas will boost Japanese exports in 2010, but a self-sustaining recovery will not take root until private sector demand can stand on its own without government support.
Outlook Update: A Polarized Recovery
Japan's economic recovery will be based on manufacturing exports, akin to its resurgence in 2005-07. In Q2 2010, real GDP growth skidded to 0.4% q/q from 1.2% in Q1, revealing the fragility of the recovery. We nonetheless raised our forecast for GDP growth in calendar year 2010 to 2.6% from 2.2% previously. Official GDP revisions confirmed our belief that discrepancies between the GDP data and coincident indicators would lead to upward adjustments to capex and inventory figures. Growth will nonetheless moderate in H2 as payback for the temporary gain from the fiscal stimulus. In calendar year 2011, GDP growth will ease to 1.5% as domestic demand falters amid an export slowdown and a lack of government support.
Japan’s leading indicators suggest Q3 was another period of weak but still positive GDP growth. During the summer heat wave, surveys of consumer sentiment and business conditions showed relative optimism from manufacturers, small and medium-sized enterprises (SMEs) and consumers, as well as increased capex plans. Mining and manufacturing inventories rose in Q3, suggesting demand has been lower than producers expected. However, consumers may rush to buy tobacco products ahead of the tobacco tax hike in October, providing a one-off boost to Q3 consumer spending.
Figure 1: Capex Outlook and Inventories
Growth will contract in Q4 as fiscal stimulus measures expire and demand from China and Europe slows. Already, leading indicators point to fading momentum in Q4: The composite leading index found all but manufacturers pessimistic about economic conditions in Q4. PMIs in Q3 began sliding back toward contraction after an all too brief and meager expansion since July 2009. Subsidies for eco-friendly appliances are scheduled to end in December, which would set off a rush to purchase consumer durables if it weren’t for planned production cuts that will decrease employment and overtime pay. Manufacturers plan to cut automobile production in Q4 after subsidies for eco-friendly vehicles end in September.
Figure 2: PMIs
The polarized nature of the recovery speaks to the lack of reform to reduce dependence on manufactured goods exports. Non-manufacturers and small manufacturers will suffer from a strong yen, sluggish consumer spending and reduced public sector construction spending. Small manufacturers face stiff competition from parts suppliers in emerging Asia yet cannot move production overseas. Meanwhile, non-manufacturers struggle with overregulation, consumer malaise and falling construction orders from the public sector.
RGE predicts core consumer inflation will average -1.3% y/y in 2010 and -0.4% in 2011 due to anemic demand growth. Like the meager inflation seen in 2008, any extant inflationary pressure in 2010 will come predominantly from cost-push sources, like rising food and energy prices, rather than growth in domestic demand.
How We Differ From Consensus: A Mere Cyclical Rebound
RGE and the major financial institutions forecast a modest recovery for Japan in 2010, powered by exports to Asia. None of these institutions' recent reports, however, conveys much hope that 2010 will bear more than a cyclical rebound within a multi-year period of structural decline due to Japan's aging population, capital supply overhang and need for fiscal reform. Growth forecasts have inched up from a mean of 3.0% in April 2010 to 3.1% in August, while forecasts continue to diverge on the degree of strength attributed to the recovery in domestic demand.
RGE stands on the bearish side of the range, along with others who believe GDP will contract in Q4. Bearish forecasters believe private investment and public works spending will shrink compared to 2009 and consumption will stagnate amid a jobless recovery. Those on the bullish side believe capex will accelerate rapidly and consumer spending will return to trend thanks to fiscal stimulus measures and rapidly falling unemployment.
Risks: Rocky Recovery
Risks to our 2010 forecast are skewed to the upside. Low steel inventories may trigger purchases from emerging Asia and the OECD to replenish supplies. An extension of subsidies and the success of the corporate lending program of the Bank of Japan (BoJ), due to open in September, could trigger a private demand surge that extends beyond durables, pushing GDP growth closer to 3.1%.
If growth dips far below trend in the U.S. and Europe—the latter a particular risk after the implementation of the eurozone's fiscal austerity packages—Japan could briefly dip back into a recession, with growth falling to as low as 1.1% in 2011. Though the EU accounts for only 11.4% of Japanese exports, Japanese manufacturers are also vulnerable to falling demand for the production inputs for finished goods that Asia and the U.S. export to the EU.
Beyond 2010, Japan faces high hurdles to growing faster than 3.0% y/y. Assuming no radical changes in demography or productivity, real GDP will not return to its 2007 level until 2012 at the earliest. Decades of financial support for inefficient "zombie companies" sucked most of the public sector's resources to induce a recovery. Deficit spending ceases to stimulate when consumers expect a future backlash in the form of higher taxes or social spending cuts.
Policy Implications: Tough Love From the BoJ
The BoJ will maintain its struggle against deflation. Persistent weakness in real demand will keep Japan's output gap negative until late 2011, but inflation will not rise meaningfully enough for the BoJ to hike the 0.1% benchmark lending rate until 2012. Having been locked in deflation for more than a decade, the BoJ will take care to avoid extinguishing the first few sparks of inflation.
The BoJ will remain reluctant to intervene to weaken the yen. As long as Japan’s real interest rates remain positive and higher than those of the U.S. and eurozone, unilateral intervention cannot stop flows into the yen for more than a brief period. The BoJ could launch a prolonged attack on the yen, as it did in 2003-04, but the high cost of that campaign—about JPY35 trillion—deters a repeat.
Figure 3: Annual Core CPI Inflation
Among other factors discouraging intervention, the strong yen can stimulate the economic restructuring Japan needs. “Hollowing out” the manufacturing base in low-profit margin goods would free up resources for expanding the production of non-tradables and high-profit-margin goods that are not sensitive to yen strength. Also, a strong yen raises purchasing power for imports, boosting consumption and removing the need to prop up domestic production of low-value goods. Rather than fight a losing battle with manufacturing economies blessed with cheap, growing labor forces, Japan could focus more on services exports such as architecture as well as much-needed domestically oriented services like health care and child care and higher-value-added production (particularly in sectors of the information economy such as biotech). Moving production overseas may raise unemployment in the short term but would clear the way for a more balanced economy in the long term.
Japan's high turnover of prime ministers has destroyed policy continuity. Fortunately, Prime Minister Naoto Kan fended off a leadership challenge from Ichiro Ozawa at the September 14 election, minimizing the threat of massive fiscal expansion and the loss of central bank independence. The threat of a double-dip recession could reorient policy makers toward fiscal stimulus; however, there is little they can or want to do in the way of budgetary measures given Japan’s heady public debt. Rather, they will debate a consumption tax hike, a corporate tax cut and, we hope, legislative measures (including deregulation and privatization) to restructure the economy.
Japan's gross public debt to GDP ratio, which was 189.3% in 2009, is the highest among developed economies, yet a sovereign debt crisis like that of Greece is not imminent. Debt-servicing costs in Japan remain very low, in part due to chronic deflation. Unlike Greece, Japan maintains a current account surplus and a net foreign asset position. Locals hold around 95% of Japan's debt, whereas foreigners hold more than three-quarters of Greece's debt. The rise in Japanese corporate and household deposits will persist amid hesitance to spend or invest. Flush with these deposits, Japanese banks will continue to sink them into JGBs. Ongoing asset price declines and global financial instability deter aggressive investment in risky domestic or foreign assets.