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Wednesday, June 06, 2007

Momentum in Japan

As David Pilling in the FT notes this morning, the outlook for Japan appears relatively benign in the short term:

There are two main reasons for optimism. The first relates to international interest rates. Both the European and the US economies are fairly strong, making a near-term rate cut unlikely. Interest rates in Japan are rising, but extremely slowly. Headline prices are falling, making it hard for the central bank to fulfil its ambition of normalising interest rates any time soon.

The bank may well raise rates one more time in late summer to a still modest 0.75 per cent. But that is likely to be its last hurrah for several months. As a result, interest rate differentials will remain wide, encouraging investors to move money from Japan in search of more succulent opportunities abroad.

The second reason relates to political pressure. US and European manufacturers have complained that the weak yen gives Japanese companies an unfair advantage. The issue could come up on the margins of the Group of Eight meeting, which starts today in Germany. But few commentators believe that complaints will gain any traction.

Richard Jerram, economist at Macquarie Securities, says: “Politically, Japan is very safe. China is always going to be ahead of you in the queue of countries to complain about. So the risk of a protectionist backlash seems very low.”

Not that everything is plain sailing of course, but if the US really does start to gain momentum again, and the growth in world trade continues at something like the present rate then Japanese exports, which in the first quarter of this year accounted for 17 per cent of Japan's nominal gross domestic product, should keep driving things forward. This figure is a significant rise in comparison with previous historic highs and may be compared, for example, and according to Nikko Citigroup, with the 14.1 per cent achieved in the third quarter of 1985. As the FT goes on to say:

"Almost all economists agree that exports have been the main driver of Japan's five-year recovery. Over that period, the trade surplus has quadrupled from 1 per cent of GDP to 4.3 per cent."

and again from the FT, the rising expectation that growth in the important export markets will continue has been producing a feedback flow on inverstment which has offset the short term drop in machinery orders:

The weakening currency has made Japanese exports more competitive still and provided a windfall for exporters booking profits in yen. That in turn has spurred investment in plant and equipment. This week, strong first-quarter capital spending, up 13.6 per cent from a year earlier for the 16th straight quarterly rise, helped ease recent concerns about weak machinery order numbers.

And again all those lump-sum payments to retiring salarymen seem to be having some short term effect on domestic consumption which has been up slightly of late. As one correspondent in Japan wrote me:

Claus seems puzzled by economic information coming out of Japan recently. Specifically, what passes for good domestic consumption in Japan. Could this have anything to do with the Life Cycle? There have been articles in local papers about the spending of the newly and about to be retired: buying boats, cameras, country homes, going out to eat, etc.

I think the point here is that such spending following lump sum payments is largely one-off, and in the longer term it is still exports - whether of goods or services - which will not only continue to constitute fastest growing part of Japan's GDP, but which will also come to constitute a growing portion. So structurally, with Japan's ageing society, the Japanese economy has become dependent on exports for growth.

The data which has caught so much public attention recently relates, OTOH, to the income stream coming back to Japan from the growing overseas investments - and the part this plays in buoying up the current account surplus, but this is just the point, the numbers being bandied about relate to the significance as part of the surplus, and not as a proportion of the whole external account or of GDP, and this, surely, is the most appropriate measure.

Certainly a lot of Japanese savings have been going to external destinations, and this is then reflected in a growing inward income flow, but there are doubts about how this will evolve moving forward. Over the next three years as the baby boom salarymen retire and receive their lump sum bonuses which they then invest elsewhere in the search for higher yield we can expect the trend to continue.

But the rate of household saving has been declining in recent years, and as the changes in the age structure continue to unfold it is likely that this rate will turn negative at some point: ie Japan will start to dis-save.

Once this process sets in, it is hard to see - short of very dramatic rebound in fertility to the 2.1 Tfr replacement level, of which there is no sign whatsoever - how this process of dis-saving can ever reverse itself.

This would mean that at some point - and on aggregate - the external funds flow would reverse, as more money is repatriated than is sent out, and eventually this will be reflected in the income flows which derive from the capital flows.

One comment I came across recently said this:

"Japanese people collectively sit on the beach, produce nothing, and live well from income earned on their accumulated foreign earnings."

Well, I'm afraid it just isn't going to be like this at all. There are sustainability issues all over the place here, even if they are over a relatively long time horizon.

Or another comment:

"I think this (the positive income flow) is a very smart way for Japan as it keeps the Japanese standard of living at high levels despite the dwindling work force population."

As I say, I don't think this will work at all, and for the reasons I have just explained.

And again, there is the deflation issue, as internal demand fails consistently to raise at the same rate as productivity. Fortunately for Japanese deflation the yen is still running up against historic low levels - at least against the euro. Again the FT today:

"The weak yen is by no means the only reason for a dynamic export performance buoyed by strong global demand and the rapid industrialisation of China. But it has not hurt. Since 2002 – and contrary to normal behaviour during a lengthy expansion – the yen has fallen about 15 per cent in real terms."

Perhaps the principal factor driving the yen down at the moment are precisely the outward investment flows from Japanese retail investors (ie the retiring salarymen). Once the net flows invert, this will have an upward pressure on the yen, but then we will have to see where we are with the deflation situation, since evidently one of the factors tending to push the CPI up towards positive territory is the low value of the yen, which is pushing up the cost of things like fuel imports.

This is all definitely a very complex picture, which is why I suppose, for an economist, it is so interesting.

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