The first of these is to be found in the fact that, as has become plain from the latest batch of data releases, Japanese manufacturers are continuing to curb both capital spending, salaries and workforces, making any recovery in domestic demand driven by “second round” effects extremely unlikely. A further reason for having second thoughts is the long term decline in the level of Japan’s trend growth, which has fallen substantially over the last two decades under the impact of its shrinking and ageing workforce. Thus whatever the initial rebound, without the aid of strong demand elsewhere it is completely unrealistic to anticipate strong sustained growth in the Japanese case. And lastly it is evident that whatever the recent optimism Japan's economy still faces major challenges, and in particular the risk of getting caught in yet another deflationary spiral, a danger which was recently highlighted by the announcement that prices fell at the fastet rate in half a century in October.
Indeed, fears that recent figures suggesting a robust recovery may have been a false dawn were only intensified last week when the Prime Minister himself sounded the official alarm that the country risked falling into a “double-dip” recession. With Japan’s export industry still reeling under the weight of the earlier sharp fall, and now bedeviled by both the plunge back into deflation and and soaring yen, Yukio Hatoyama made it plain that additional “measures are required so that the economy will not fall into a double-dip recession”. This warning, it seems to me, is not mere rhetoric, part of a political tussle between the government and the Bank of Japan, but refelects genuine concerns, concerns which have only been added to by the October industrial output data, and the November PMI readings. Clearly, any recovery from such a strong output fall as Japan has suffered was always going to incorporate some sort of initial momentum surge as final demand eventually adjusted to the sharp inventory run-down, but maintaining this momentum get harder and harder as we move forward, and the question we need to ask our selves is, "has all the low lying fruit now been picked".
Certainly the Japanese government fears it might have been, and has now made plain that it is going to introduce a further spending package to fight deflation and to ease the impact of the stronger yen. At the same time they have called on the Bank of Japan to take stronger measures to support growth and avoid deflation. “There’s a risk that excessive currency movements, along with deflation, will hurt Japan’s recovery,” the government statement said. “The government will compile stimulus measures this week and closely monitor currency markets,” it added, without elaborating on the size of the package, while Finance Minister Hirohisa Fujii has been adding to the pressure on the central bank by explicitly suggesting quantitative easing would “help” the economy.
The yen surged to a 14-year high against the dollar last week, only adding to the concern that a stronger currency will bring Japan’s recovery from its worst postwar recession to an early and untimely halt.
False Dawns?
At first sight Japan’s situation seems reassuring, since the economy seemed to have rebounded sharply in the third quarter as strong government stimulus measures sustained consumer spending and exports to rapidly growing Asian neighbours leapt upwards. The preliminary headline GDP reading even outpaced most economists' expectations, since the economy was estimated to have grown by 1.2% over the previous quarter (or at a 4.8% annualized pace).
This was the second consecutive quarter of expansion, following four successive quarters of contraction, and the apparent pace was a marked acceleration over the 2.7% annualized pace of the April to June period. But even before the champagne bottles were uncorked nagging doubts started to appear, in the shape of the domestic demand deflator – a measure of the changes in the price of goods and services - plunged by 2.6%, the fastest pace of price decline recorded since as far back as 1958. This was the third straight quarter of falling prices in Japan, and since there is no real likelihood that this situation is going to be reversed soon the government has now officially recognised that Japan is back in deflation.
In fact Japan's general index of consumer prices fell by 2.5% year on year in October, as compared with a 2.2% drop in the two preceding months. The headline figure was dragged down by a 6.8% drop in the cost of fresh food. Stripping out this component, deflation in core prices slowed slightly, to minus 2.2% compared with minus 2.3% in September. Although transport and communication costs continued to fall, the 4.6% contraction was the smallest fall in six months. The cost of housing fell by 0.3% and the cost of utilities fell by 9%, in both cases showing very little change from the previous month. When energy costs as well as fresh food are excluded, October prices were down by 1.1% after falling by 1.0% in September.
But looking beyond deflation more grounds for concern emerged as analysts realised that the contribution of private consumer spending to growth actual fell back in the third quarter (mirroring an effect I have already drawn attention to in Germany), offering yet more evidence of the limits measures to convert Japan from export to domestic-demand-led growth were up against. Private consumer spending, which accounts for more than half of Japan's GDP, rose 0.7% on quarter, compared with a revised 1% climb in April-June. Worse, almost everyone recognises that both these increases were largely the outcome of the previous Liberal Democratic Party-led government's economic stimulus programme, including as it did handing out cash to consumers and rebates for people buying energy-saving home electronics.
Finally, just last week we learn that revised estimates of capital expenditure by Japanese companies suggest that this fell at a faster-than-expected pace of 24.8% (from a year earlier) during the third quarter, as export pessimism in the face of a steadily rising yen and a struggle to show healthy profit numbers pushed managers towards holding off on new investment.
In fact the July to October data mark the 10th straight quarterly decline in capex spending, and follow a 21.7% year in year drop berween April and June. The latest estimate is being seen by analysts as rather a bad omen, and habinger of bad news about to arrive, since the data will be used to carry out the first revision of the gross domestic product figures, and it is clear Japan is now about to cut the preliminary GDP reading sharply. Estimates of how large the write down will be vary, with anything between 0.9% (3.6% annualised) and 0.3% (or 1.2% annualised), which would mean virtually no real growth at all in the third quarter if you take into account the fact that inventory build-up accounted for 0.4 percentage points of the healine number. In any event this part will be clear when we get the new estimate later this week. Whatever the final number the news will be bad enough, unfortunately however there is more to come.
Industrial Output Slows
It is now abundantly clear that the earlier surge in Japanese industrial output is now slowing, and the latest official data show it rose only 0.5% between September and October, far less than the 2.5% range in economist forecasts, and so despite everything compared to October 2008 industrial output was still down by 15.1%. So while Japanese industry is rebounding, it is hardly surging, and we are left asking ourselves, has all the low lying fruit now been picked?
The results of the November manufacturing PMI survey seem to suggest that they have, since despite remaining above the neutral 50.0 level for yet another month , the seasonally adjusted headline Nomura/JMMA Purchasing Managers’ Index fell from Octobers 54.3 reading to a four-month low of 52.3, suggesting that growth in the Japanese manufacturing sector continued to lose momentum, and that growth in the fourth quarter will be even weaker than the revised third quarter number, and may well be negative. The survey organisers reported slower growth of both output and new business, even if job shedding eased to its weakest rate for fifteen months, while output price deflation the hit the fastest rate since December 2001.
In addition pre-production inventories were reduced for the ninth month running.
Commenting on the Nomura/JMMA Japan Manufacturing PMI data, Minoru Nogimori, Economist of Financial & Economic Research Centre at Nomura, said:
“The Japan Manufacturing PMI fell 2.0 points to 52.3 in November. Although it remains above the key dividing line of 50.0, it fell for the second consecutive month, suggesting that the pace of improvement in operation conditions is slowing. The New Export Orders Index also fell by 1.1 points to 50.5, signalling that the rate of expansion in export orders has obviously slowed. We see growth of Japanese production activity decelerating, owing to the fading impact of economic rebounds overseas, yen appreciation and as government stimulus measures start to wane.”
And Services Wallow In The Mire
And Japanese services are hardly doing better, since the headline seasonally adjusted Nomura Business Activity Index fell for the third successive month to 42.3 in November, from 45.0 in October, indicating that sharp and ongoing contraction in Japanese service sector activity worsened, with conditions deteriorating at an accelerated rate, and indeed at the fastest pace since last May. Again survey respondents frequently mentioned further falls in new business, reflecting Japan’s increasingly uncertain economic prospects. This faster decline in services activity, combined with a slower expansion of manufacturing production, meant that Japanese private sector output fell at the most marked rate for five months during November with the Nomura Composite Output Index posted a reading of only 45.4. The composite index – which gives some orientation for GDP levels - has now remained below the 50.0 mark for three successive months. If this performance is repeated in December it is extremely likely we will see negative quarterly growth in the last quarter of the year.
Commenting on the overall PMI data, Alex Hamilton, Economist at Markit, said:
“PMI figures for November suggested that the recovery in the Japanese economy may be losing steam. Manufacturing output and new business rose at slower rates on the month, largely as a result of subdued external demand and the fading impact of fiscal stimulus measures. That said, it was the struggling services industry that continued to underperform, suggesting that demand from home markets remains fragile. Moreover, Japan appears set to resume its lengthy battle with deflation, suggesting that domestic consumption will remain lacklustre for the foreseeable future as real debt burdens begin to rise and clients delay their purchasing decisions. While GDP growth for Q3 was surprisingly upbeat, the outlook for the wider Japanese economy remains subdued.”
Housing Starts In Freefall
And as if all of this wasn't enough, Japan’s construction industry is unlikely to be a positive force, indeed housing starts may drop next year to a 48-year low as the sluggish economy and falling numbers of young married couples continues to eat into the housing market. The forecast was made byTakeo Higuchi chief executive officer of Daiwa House Industry (Japan’s largest homebuilder), who said starts for financial year 2010-2011 are likely to fall as low as 600,000, following this years 20 percent plus drop to 800,000.
“The property market will remain sluggish for another year or two because Japan’s economy is in bad shape,” Higuchi said in an interview last week. “High unemployment and falling wages are scaring away many potential buyers.” Japanese home sales are forecast to drop 7.2 percent to 1.57 trillion yen in the year ending March. Japan’s started building 1.04 million new housing units last year, a massive and long term fall from the peak of 1.9 million dwellings hit as far back as 1972. Starts of 600,000 would be the lowest rate since 1961.
Export Growth Not Sufficiently Strong
With most of Asia’s economies currently booming, it may seem surprising to many that Japan seems unable to rise up on the back of this wave of high growth, especially since Japan – unlike much of Europe and the United States – is not saddled with financial system problemsof the kind which could be expected to put a brake on economic activity. The problem basically is the pass through rate. Japan has now become so structurally dependent on exports, that there is nothing like sufficient momentum from consumer demand to take up the strain when these fail, while on the other hand the return rate on capital has dropped so low during the present crisis, and the yen has risen so strongly, that manufacturers find themselves with little choice but to systematically curb capital spending and aggressively cut costs, beginning with payrolls of regular employees.
For an autonomous recovery mechanism to go to work we would need to have a recovery in both corporate earnings and household income, but corporate earnings are only being sustained by cutting back capital spending, while employee income has steadily fallen, and is unlikely to revive again without a much stronger recovery in the other advanced economies. That is, Japan now needs to be pulled by the global train, and will certainly not itself be doing the pulling.
Basically during the good years Japan’s economy was being driven by robust global demand for its high-end manufactured goods (passenger cars, IT/digital products), which were made extremely cost competitive by the extremely cheap yen that was produced as a by-product of the carry trade. However all of that now belongs to the world which just fell apart. A man called Ben Bernanke is now running an interest rate and quantitative easing programme at the Federal Reserve which no longer makes the yen the preferred carry trade currency, while frugality has increasingly become the norm among European and US consumers who are desperately trying to deleverage.
One consequence of this is that there has been a shift away from Japan’s high-end goods and toward less expensive Asian products, especially given the loss of price competitiveness produced by the yen’s rapid appreciation. Japan’s factory sector consequently finds itself saddled with substantial excess productive capacity and excess employment and unless there is a significant return to a cheaper yen over a viable time horizon this situation is, quite simply, unsustainable. Rather than simply sitting back and waiting for normal cyclical corrective factors to do their work, what seems to be called for at this point is a thorough overhaul of the national industrial structure, as well as a significant long term structural rethink about how Japan got to this unfortunate situation and what to do about it, and boths of these are likely to take years rather than months. Indeed, even if global demand were to pick up in the short term, Japanese producers may well be more inclined to shift production overseas, rather than renewing and increasing domestic capacity given the uncertainty which now surrounds the future value of the yen. In these circumstances the recent sharp drop in capital spending is hardly surprising.
In is very striking how Japanese industrial activity is weakening just as the rest of Asia is surging. Even if Japan’s exports fell at the slowest pace in a year in October as government spending across the globe boosted demand, shipments abroad were still down 23.2 percent - a vast improvement, it should be noted, when compared with the 30.6 percent decline seen in September. Exports in recent months have been quite solid, with real exports (the seasonally adjusted nominal export value divided by the BoJ’s export price index) up 3.4% month-on-month in October after a 3.0% month on month gain in September, with the result that the October level was 5.1% higher than the July-September average..
Imports have been much weaker, reflecting the underlying dynamic of Japan’s domestic consumption, and fell 35.6 percent from a year earlier in October, which meant the trade surplus climbed to 807.1 billion yen ($9.1 billion), its highest level since March 2008 and well above the 465.5 billion yen median estimate of analysts.
When we come to look at the distribution of exports, shipments to Asia fell 15 percent year on year, easing back from a 22.2 percent drop in September. Exports to China, Japan’s biggest overseas customer, were down an annual 14.3 percent, a slight deterioration from 13.8 percent decline the previous month. Sales to the U.S. fell 27.6 percent, moderating from September’s 33.9 percent decrease while exports to Europe slid 29 percent after slumping 38.6 percent in September.
In fact real exports to all major regions increased on a month-on-month basis in both September and October, with exports to the US and Asia increasing for the eighth- and ninth-consecutive month, respectively. Real exports to the European Union and oil producing countries also rose in both months.
But there are differences, and these differences provide part of the key as to why we need to be cautious. In Asia solid final deman, led by China, lay behind the rise, but in the other two key regios renewed inventory building probably lay behind the rise.
Specifically, real exports to the U.S. increased 5.0% month on month in October following gains of 3.7% month on month in September and 3.0% month on month in August. It is hard to explain such a strong gain by final demand and there is a clear possibility that what we have been seeing is a powerful boost to sales from renewed inventory building by Japanese companies in the expectation of future demand. Real exports to the EU show a similar pattern ,with strong growth being registered (up 7.0% month on month in October after rising 8.2% month in September and decreasing 4.0% month on month in August.
In Asia the same picture of strongly increased real exports is evident, with a rise of 6.6% month on month in October following gains of 5.3% month on month in September and 0.3% month on month in August. However underlying GDP growth rates are much stronger in Asia, and it is likely that the increase is much more driven by final demand. Looking at more detailed data, exports to China gained 3.0% month on month in October after increasing 6.5% month on month in September and 2.0% month on month in August. This upward trend in China exports undoubtedly reflects the continuing positive impact of the various economic stimulus packages as well as some recovery in Chinese exports to industrialized countries. Meanwhile, exports to Asia excluding China surged 8.6% month on month in October after a 4.6% month on month gain in September and a 0.6% month on month drop in August.
What is evident, at this point, is that the global recovery is proving to be more evasive than anticpated, with strong variation between regions and countries, and in the light of this heavily export dependent countries like Germany and Japan, after an initial surge forward are now finding it hard work to maintain momentum.
Japan’s reduced trend growth
Apart from the factors mentioned above, one other reason not to expect some sudden and miraculous “bounce back” in Japan’s economic growth is the steady decline which can be seen in the country’s long term growth pattern (see chart below). This key fact here is surely the historic decline in Japan’s workforce (both ageing and now shrinking) the adverse effects of which are starting to be felt. To make matters worse, some long term consequences of repeated short term interventions (via the use of fiscal policy etc) in the private sector over the years of protracted stagnation we have seen since the 1990s. The impact of this cumulative neglect is to be seen not only in the mounting pile of public debt (gross debt will surely soon pass 200% of GDP, hitting limits never seen before in a developed economy), but also in the way overall labour productivity has been impaired due to substantial labour hoarding in non-efficient sectors. In addition to the short-sighted fiscal policies, expanded credit guarantees, intended to counter tight credit, have had similar adverse side-effects. While such macrostabilisation policies may have temporarily bolstered economic growth, and have certainly helped avoid large scale unemployment, at the end of the day they end up suppressing activity in more efficient and more profitable sectors, and in the long run exercise a downward drag on growth. Unfortunately policymakers seem not to fully realise the longer-term effects of loading on short-term policy package on top of another without adressing the underlying structural issues.
A Setback For Japan Will Be A Setback For The Global Recovery
Wages earned by Japanese workers fell for the 17th consecutive month in October, extending their longest losing streak in six years and adding further evidence that consumer spending is likely to remain subdued. Meanwhile on November 20th the government formally announced that Japan was back in deflation, effectively exerting pressure on the Bank of Japan to react, pressure which was only too evident in last weeks announcement by the bank of a new liquidity facility of roughly JPY10 trillion in three month loans to commercial banks. BOJ Governor Shirakawa, however, was at pains to make clear that even if he was willing to concede that the latest measure could be seen as a form quantitative easing, a term he has manifestly struggled to avoid using previously, there was no overall change in the BOJ’s economic assessment of the Japanese situation. Rather, the measure was designed to address what Shirakawa called the potential adverse effects on corporate sentiment caused by the rising yen and continuing weakness in share prices. Thus Japan's economy yet again slides steadily into deflation, but this time with no evident road-map or "script", or even credible short term hope of coming out again, a fact that is only adding to the general concern which is being expressed about where exactly it is that Japan is headed for. Certainly it would seem to be no good place.
Further, if Japan is indeed teetering back towards recession, the implications will extend well beyond Japan itself, and will more than likely involve significant consequences for the entire group of developed economies, and especially those unable to tap into China's continuing growth via commodity exports. Japan was the first large economy to fall into technical recession in the wake of the Lehman Brothers collapse, but was also the first to heave itself out. Being the first to fall back in again would not be a good omen, for anyone.
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