Is Japan Headed For Recession in Q4?

Well, this week really has been a pretty gloomy and forlorn one in Japan, since following hard on the heels of the zero reading on the leading indicators index we now have the September machinery orders data, and the latest edition of the Economy Watchers index (Japanese only at present). First the machinery orders.

Machinery orders fell sharply in Japan in September, far more more than economists had forecast, and this may well be a sign that companies are reducing investment as demand wanes.



Machinery orders in fact declined a seasonally adjusted 7.6 percent to 958.7 billion yen ($8.5 billion) from August, which was the lowest level since May 2005, according to data from the Cabinet Office today. Machinery orders are often thought to indicate corporate investment in about three to six months. Total orders fell from 3.6% in the third quarter, and overseas orders fell 2.2%, but demand from domestic private customers was a plus and grew 3%. The big hit was in government orders, which drpoode a whopping 26.2%. In fact the volatility in government orders makes this data very hard to read, and anyone with any insight into just why this should exist in this way, please feel invited to drop a comment.



One explanation for the downturn is that the recent financial-market turmoil and the yen's 8 percent surge against the dollar since July may have deterred companies from ordering more machinery in September. Certainly the continuing slide in the value of the dollar will not be generating an overly enthusiastic and optimistic atmosphere among exporters.

The quote of the day, tucked away in the Bloomberg coverage, is certainly this one:

``My advice to investors is to fasten your seatbelts,'' said Hiromichi Shirakawa, chief economist at Credit Suisse Group in Tokyo. ``Orders peaked in July, and we're not expecting a rebound until the second half of next year.''

And meanwhile domestic demand remains as weak as it ever was. More confirmation of this is available today with the issuing of latest edition of the Economy Watchers index. Japanese workers, consumers and small businessmenhave become increasingly pessimistic about the current and future economic conditions in Japan according to a survey released today by the Cabinet Office.

The main index of the Economy Watchers Survey fell 1.4 points to 41.5 in October, the lowest reading since March 2003 and the seventh straight month of decline. The index, which gauges the mood among ordinary Japanese workers who can observe economic developments firsthand such as taxi drivers and shop keepers, has now been below the boom-or-bust line of 50.0 for seven straight months.



Three subindexes that dropped in the month were the household spending index, which fell 0.4 points to 41.3, the corporate index, which declined 2.5 points to 41.0 and the employment index, which dropped by 5.0 points to 43.8.



In addition the housing outlook is turning increasingly - and almost alarmingly - negative. In September Japan's housing starts fell by 44% (y-o-y) and this followed falls of 43.3% in August and 23.4% in July. The main cause of the rout was a new building standards law introduced in June. The law was aimed at ensuring building safety measures, but the apparent lack of adequate warning before the law was enforced caused a sudden, drastic increase in paperwork to get a building permit, and a sharp delay in initiating new buildings. But this kick-stop on the permits front now seems to have initiated a more general problem, since it coincided with the global tightening in bank lending conditions.

The watchers survey showed 41.7% of survey respondents said housing-related spending was worse than three months ago.

Is Japan Recession Bound?

Well as Scott said yesterday it is "hard to see how Japan can avoid a recessionary 4th quarter". This is also the gist of Claus's much longer analytical post, and I cannot but agree.

So at this point I think we need to bear a number of issues in mind. The principal one of these is that recent Japanese recessions have tended to be messy long-drawn-out affairs. In fact Japan has had three recessions since the bursting of the stock and property bubbles in the late 1980s early 1990s. The first lasted 32 months from March 1991 to October 1993, and the second dragged on for 20 months from June 1997 to January 1999. The most recent recession ran for a full 14 months from December 2000, following the bursting of the information-technology boom and the impact this had on exports and capital investment. This is perhaps why all those Japanese investors and businessmen are looking with something more than a simple wary eye on the sub-prime turbulence which is coming out of the United States at the present time.

But if Japanese recessions have grown longer, and more intractable, and deflation has proved to be persistent and equally intractable, and if interest rates, even in the longest boom since the end of the 1980s bubble, still have not been able to get raised above the 0.5% threshold, then isn't really time that more people started to ask themselves more questions about just what is (and has been) going on in Japan. Is it just a coincidence that Japan now has the highest median age on the planet? Is it really the case that 30 years of below replacement fertility is so harmless as almost everyone seems to believe? Isn't it worth just allowing ourselves to ask the question whether all this might not be somehow interconnected, because one thing is sure, until we get the right diagnosis there is very little chance we are going to be able to apply the adequate medicine and cure. Now what was it you said that patient had doc? Appendicitis, or simply indigestion. Somehow I think the answers we let ourselves give to the question we allow ourselves to ask might turn out to be pretty important when it comes to the outcome we may lead ourselves to expect.

Swiss Franc Mortgages in Hungary

The use of non-local-currency denominated loans has become a widespread phenomenon in Eastern Europe in recent years. In Hungary the most common currency for such purrposes is the Swiss Franc and around 80% of all new home loans and half of small business credits and personal loans taken out since early 2006 have been denominated in Swiss francs. A similar pattern of heavy dependence on foreign currency denominated loans is to be found in Croatia, Romania, Poland, Ukraine (US dollar) and the Baltic States, although the mix between francs, euros, the dollar and the yen varies from country to country.

So let's look at the extent of the issue in Hungary, and some of the likely implications. First off, here's a chart showing the evolution of outstanding mortagages with terms over 5 years since the start of 2003. As we can see the outsanding debt is now over 5 time as big as it was then.



Now if we look at the growth of forint denominated mortgages over the same period, we can see that while they initially expanded very rapidly, they peaked around the start of 2005, and since that time they have tended to drift slightly downwards.



Then if we come to look at the growth of non-forint mortgages, we will see that since early 2005 the rate of contraction of such mortgages has increased steadily.



Finally, if we look at the distribution of non-forint mortgages between those in euros, and those in "other" currencies (which may contain some yen, and some USD mortgages, but in the main will be Swiss Franc ones) we can see that those in euro form only a very small part of the total.



It is perhaps also worth pointing out that the fashion for non-forint loans is not restricted solely to mortgages, car loans and other longer duration personal loans also tend to be denominated in Swiss Francs or other currencies. The reason for this is obvious, the rate of interest is cheaper. But this non forint loan predominance has two important consequences.

In the first place the Hungarian central bank does not have sufficient control over monetary policy inside the country, being to some significant extent influenced by monetary policy in Switzerland, a country we may note which is not even inside the European Union. Secondly, the difficulties which would present themselves in the event of any substantial reduction in the value of the forint would be considerable - the is known as the translation problem, and is ably reviewed by Claus in this post here - and as a result the central bank is one more time a prisoner of others in terms of monetary policy, since it cannot take interest rate decisions which might influence excessively the swiss franc-forint crossover rate.





The fashion for borrowing in Swiss francs really took off in Eastern Europe after the Swiss National Bank dropped interest rates to 0.75% in 2003 in order to stave-off a perceived deflation threat, a move which at the same time converted Switzerland into the cheapest source of loan capital in Europe. External lending in Swiss francs reached $643 billion in 2006, according to data from the Bank for International Settlements . The huge scale of the borrowing in fact drove the Swiss franc to a nine-year low against the euro, and has lead to an accelerating slide in its value over the last two years - even though by this point the Swiss National Bank had been busy raising rates (Swiss interest rates have now been increased 7 times since the 2003 trough). The extreme weakness in the Swiss Franc is in fact rather perverse (shades of Japan, of course, here), since currently Switzerland enjoys the highest current account surplus in the developed world (some 17.7% of GDP in 2006). At the same time the Swiss hold more than $500 billion in net foreign assets, making them in these terms the wealthiest nation on earth.

A recent issue of the Bank for International Settlements publication Highlights of International Banking and Financial Market Activity has some revealing comments on the Swiss situation(the data used for the report came from 2006):

Total cross-border claims of BIS reporting banks expanded by $1 trillion in the last quarter of 2006. After more modest growth in mid-2006, a pickup in interbank claims accounted for 54% of this expansion. A surge in credit to nonbank entities contributed $473 billion, pushing the stock of cross-border claims to $26 trillion, 18% higher than in late 2005.

The flow of credit to emerging markets reached new heights through the year 2006. Claims on emerging markets grew by $96 billion in the final quarter of 2006, bringing the volume of new credit throughout the year to $341 billion. This amount exceeded previous peaks ($232 billion in 2005 and $134 billion in 1996), both in nominal value and in terms of growth. The current annual growth rate has risen to 24%, having surpassed for the sixth consecutive quarter the previous peak of 17% recorded in early 1997.

Emerging Europe overtook emerging Asia as the region to which BIS reporting banks extend the greatest share of credit. Since 2002, growth in claims on the region has consistently outpaced that vis-à-vis other regions. With a record quarterly inflow, emerging Europe received over 60% of new credit to emerging markets, bringing its share in the stock of emerging market claims to 34%. Less of the new credit went to the major borrowers (Russia, Turkey, Poland and Hungary) than to a number of smaller markets, notably Romania and Malta, as well as Ukraine, Cyprus, Bulgaria and the Baltic states.


The currency denomination of cross-border claims on emerging Europe tilted further towards the euro. In the stock of claims outstanding, the euro and dollar shares were 44% and 31%, respectively, but the gap in the latest flow data was more pronounced (61% and 5%). While the sterling share has remained close to 1%, the yen has lost ground to the Swiss franc, thus continuing a trend seen over the last six years. Yet there is little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending in several countries. Borrowing in the Swiss currency remains on average below 4% of cross-border claims, and exceeds 10% only in Croatia and Hungary.


Nearly 20% of reporting banks’ foreign claims were in the form of funds channelled to emerging market borrowers. Claims on residents of emerging Europe continued to account for the largest share of these funds.

So, although the BIS find "little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending", they do make an exception in the cases of Hungary and Croatia, where they note that lending in Swiss francs to retail clients reaches over 10% (and of course in the Hungarian case well over 10%) of the total retail loans in those countries. Indeed, as I indicate above, swiss franc loans now seem to account for over 80% of all newly generated housing related credit in Hungary. The reason why Hungary has gone for Swiss franc rather than euro denominated loans undoubtedly has to do with the role of the Austrian banking sector in Hungary, as is explained in my fuller posting on this topic linked to below.

Additional References

For fuller examination of just why it is that Switzerland (or for that matter Japan) have such low interest rates, see my "Swiss Franc Loans and Ageing" post.

For an examination of the potential implications of the presence of all these foreign currency loans across the EU10 in the event of any generalised emerging markets crisis see Claus Vistesen "Translation Risk in the Baltics and Other Matters".