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Tuesday, January 16, 2007

Japan in a Quandry

To raise or not to raise, that is the question, for the BoJ at least. This seems to be just one more between a rock and a hard place situation. According to Bloomberg:

The Bank of Japan may raise its benchmark lending rate from 0.25 percent, stepping up efforts to head off an investment bubble.

The reason for the fear is not a sudden and excessive rise in consumer related activity (like construction) but a rapid build up in investment (which means more capacity, capacity for which the demand may be lacking in sufficient quantity):

Large companies plan to increase investment in the year ending March 31 by the fastest pace since 1991, the central bank's quarterly business survey showed in December.

``Short-term interest rates are exceptionally low in Japan, in particular against the backdrop of the much improved structural situation of the economy,'' said Jan Lambregts, head of Asian research at Rabobank International in Hong Kong.

Now it is important to keep in mind here that Japan's recent growth spurt is largely driven by export demand, and the investment activity needed to sustain this dynamic. Domestic consumption still remains extraordinarily weak (and the reason for this may well be the age structure of Japan's population, as I attempt to argue here):

Some economists said the bank may postpone a rate increase until February so that it can confirm a revival in consumer spending when the government releases its gross domestic product statistics in mid-February. The 0.9 percent drop in consumer spending was the main drag on growth in the third quarter.

Now obviously containing animal spirits on the investment side is important, but what of the impact of any coming rate hike on domestic consumption, the deflation issue, and of course the costs of servicing Japan's enormous public debt?

A one-percentage-point gain in the yield on Japan's benchmark 10-year bond would increase the country's debt-servicing costs by about 1.6 trillion yen next fiscal year, the finance ministry estimated in December.

The deflation isssue should not be treated lightly, in particular since, as MS's Takehiro Sato pointed out last Friday:

Fundamentals are favorable, but there are a number of headaches for policy makers. Since oil prices are dropping faster than expected, the possibility of a drop into negative territory for the CPI is moving beyond just a risk and becoming the main scenario.

All in all, confrontation may well be looming, between the Japanese government and the BoJ, and if it is not very careful the bank may gain short term advantage by damping down excess investment only at the price of provoking a return to deflation and a loss of its credibility and independence in the longer term.


John Booke said...

If yesterday's Japanese Consumer Confidence survey result for December correlates with the last few months of actual household consumption then the BoJ needn't wait for a signal from GDP data. The drop in confidence was significant and extends a recent down trend.

Edward Hugh said...

Hi John,

Thanks for this. The graph you provide on your blog seems to confirm that confidence peaked back in the march to may 2006 period.

It will be interesting to see who wins out though, since all the pressure internally must be for them to hold, and all the global pressure is for them to raise to try and resolve the carry trade issue. Watch and wait is what Claus and I are doing.