Last week, we learned that industrial production rose yet again in Japan clocking in at 1.4% month-on-month in September after having increased by 1.6% in August.

Companies said they planned to increase production in October and November as well, indicating the recovery from a record export collapse in the first quarter is holding up. Growth in China is generating sales for manufacturers including Hitachi Construction Machinery Co., which this week said it has worked off stockpiles that piled up during the recession.

“The pace of the recovery is faster than expected,” said Hiroshi Miyazaki, chief economist at Shinkin Asset Management Co. in Tokyo. Withdrawal of stimulus in the U.S. and Europe may cause output and exports to slow down this quarter, Miyazaki said, “but so far, today’s production report showed few signs of that.”

This is good news for Japan's economy even if it seems that Japan may simply be re-deploying old tricks in which companies are leveraging external demand but the domestic economy remains unable to pick up on the momentum. As ever, the disconnect between the level and flow of domestic activity (and price pressure) created by the domestic economy and the additional boost from external demand and asset income remains one the main perspective through which to look at the Japanese economy.

Within this context, the notion of Japan being dependent on exports to grow has emerged; initially as a strong market discourse and since in a more formal theoretical light in the form of the humble contribution of yours truly. It still represents a powerful market discourse and in fact, the idea of export dependency or reliance on external demand has been propelled to the main scene of the current economic turmoil as it has slowly but surely dawned on market participants and policy makers that the extent to which global imbalances need to be resolved, we have to find someone to run the deficits. And although this may seem a simple task, it has proved decidedly difficult to make the puzzles match in a world where deleveraging remains a key driving force on both the microeconomic and macroeconomic level.

In this entry I thought it would be interesting to look at a topic which combines the two perspectives above, that is; both the theoretical and the more market oriented narrative. On the former, this analysis would seek to move the analytical perspective down a notch from the pure macroeconomic level to a microeconomic level linking data on the company level (company accounts) with macroeconomic data (national accounts). On the latter, the analysis would provide some empirical foundation for the often cited relationship between a positive reading on industrial production/capex and a pick up in external demand, or more precisely the link between corporate activity and exports.

The analysis will be based on data from the Japanese trade ministry (METI) and OECD and will cover the period 1960Q1-2008Q4 (mail me for the excel sheet). On the company side, I will use data on sales (topline) and as well as profits (operating and ordinary). I will also distinguish between the manufacturing and non-manufacturing sector since one might expect, in Japan's case, the accounts of the former to be considerably more sensitive to external demand than in the case of the latter. With respect to national accounts I am using the OECD CARSA methodology which essentially signifies that we have current prices at annual levels with seasonal adjustment.

In line with the spin traditionally served here at Alpha.Sources, I will be looking at an increase in the connection between corporate sales and profits and external demand as an implicit function of age. This is to say, that this disconnect between domestic momentum and the ability of Japanese companies to generate revenues and thus growth based on external demand is a function of the increase in Japan's median age.

The main results of the analysis can be summarized in the following points.

• The positive relationship between the change in Japanese companies' profits/topline and the change in exports or the current account has increased markedly in a post 1990 and specifically post 1998-2000 context. This effect is predominantly a phenomenon observed amongst manufacturing companies.

• The empirical analysis suggest that Japanese manufacturing companies are now highly reliant on external demand to generate sales, profits and thus in some sense investment activity. 

• The sensitivity of the sales of manufacturers to the volume of exports has increased by a factor of 60% from 0.25% to 0.4% around the period where Japan breaches a median age of 40 years.

• The sensitivity of the ordinary profits of manufacturers to the current account has equally increased markedly in the period where Japan has moved to a median age above 40. In the period after 1997 results indicates that a 1 unit (JPY) increase in the change of the current account has led to a 0.23 unit (JPY) increase in the ordinary profits of Japanese manufacturers which compares with a corresponding non-significant relationship in a pre 1998 context.

A Look at Company Performance, the Current Account and Correlation

Regardless of whether one squares the outlook on the Japanese economy, there is no doubt that the dent which the corporates have taken as a result of the economic turmoil is unprecedented.

Notice that I have indexed the charts with 1995 as a base year and then realize that current nominal value of company revenues has dropped to a level comparative to the one observed in 1993-1994 in relative terms. In absolute terms, the aggregate value of sales of Japanese manufacturers stood at some tn 84 and 82 JPY in Q1-09 and Q2-09 respectively which is value not observed since 1989 in nominal terms. This should give us a clear picture of drop in activity and then also the difficulty with which Japan will have in restoring productive activities back to normal whatever this might mean as we move forward.

With respect to Japan's external balance it is a bit more complicated, but there are some important points to remember as we move through the charts. Japan has been running an external surplus since the beginning of the 1980s, but as I have spent an entire academic paper explaining, it is only in the latter part of the 1990s and into the 2000s that this external surplus seems to be connected strongly with output growth. Moreover, it is important to distinguish between net exports and the income balance since the latter has been particularly important driving Japan's external balance in a from the 1990s and onwards

In light of the graph above, we can say that given the sharp decline in domestic growth in a post 1990 context external demand has take over, so to speak, both in terms of keeping national savings higher as well as contributing to headline growth. It is along the same axis that we would then expect the relationship between Japanese companies and external demand to have increased.

Moving on to some simple correlation analysis the following two charts which show the correlation between company sales and exports as well as the trade surplus/GDP will give us a nice initial overview of the data in question.

The representation is in changes (which is not unimportant) and smoothed by taking the correlation as a 4 year moving average (i.e. 16 quarters). The y-axis is ending period which means that a correlation for e.g. 1997 means correlation between 1993-1997.

Simply eye balling these charts does not seem to provide decisive evidence of the hypothesis of export dependency. Sure, we can easily see that the period 1997-2008 has seen a sharp increase in the relationship between company sales and the flow of exports as well as the share of external demand and GDP, but the key point to take away from these graphs is that they appear to be mean reverting (with a very weak positive time trend in the case of the second). This would mean then that the connection currently observed between exports and corporate sales is not unique. However, if we focus the attention on the second graph, it is also pretty clear that it is only in a post 1980 context that we have observed periods in which the correlation between sales and the trade surplus has been consistently and strongly positive. This would then seem to lend some evidence to the idea of export dependency and how this may be a distinct characteristic of contemporary Japan.

Moreover it would seem that it is not possible (except in the case of the correlation between sales and the trade surplus) to distinguish decisively between manufacturing and non-manufacturing. In later sections and using simple ordinary least squares analysis, it is however possible to differentiate this statement considerably.

Before we come to that though, it would be apt to use the initial conclusion above and have a closer look at the post 1980 period. Moreover, and courtesy of a more richer dataset on the macroeconomic level we can now augment the analysis with the income balance and thus the current account. This may seem trivial, but is very important in Japan's case since the income balance in particular has driven the external balance in recent years. From a company point of view and in order to be consistent, I will correct for the importance of the income balance by including company profits as the main gauge for company performance.

This chart (in level form and only for manufacturers) seems to be more supportive of the evidence of export dependency at least if we allow ourself the luxury to look only at the period from 1980s. The chart shows however that the strong positive relationship between the current account and the profits of companies is a relatively recent phenomenon which took off somewhere around 2000. Consequently, in the period from 1983 to 2000 the correlation between the current account and company profits in the manufacturing sector has been negative and in some cases strongly negative.  

From this brief look at correlations, we should be satisfied that when it comes to the period post 1998 (more or less) the performance of Japanese companies have been strongly linked to external demand and income derived from external assets. Yet, this does not provides decisive evidence for export dependency measured as a strong and growing link between the performance of companies and external demand. In order to show this we must turn our attention to a bit more sophisticated statistical techniques although I can promise you that it won't be very fancy.

Some Models to Go With That?

The analysis which proceeds will center on the two following simple models which take the first difference or percentage change as a linear function of the change in either the value of exports or the current account.

The first regression will also be run with the sales of non-manufacturers as dependent variable in order to check the initial conclusion above that it is really not possible to distinguish between manufacturers and non-manufacturers[1].

Now, if you don't care about statistical analysis, you may stop here and move straight to the conclusion or go back to the summary in the beginning where the main results are reported. If you decide however to move on, rest assured that, following the models above, I never move beyond univariate OLS, so things should not get too complicated if you are a little bit familiar with statistical analysis.

Note that throughout the results presented below, the full period will be Q1 1960 to Q4 2008, period 1 signifies the period where Japan had a median age below 40 and period 2 is consequently defined as the period in which Japan had a median age above 40.

If we begin with the first model that plots sales of manufacturers as a linear function of the volume in exports (both in % changes), the results for the full period, period 1, and period 2 regressions return the following results [2].

For those of you who are familiar with the results presented in my earlier work on Japan, these results should be well known. In this way, it appears that the relationship between the sales of manufacturers and the volume of exports has increased markedly, both in terms of the marginal effect as well as in the context of the overall fit of the model. Since this model is a log-log model, we can interpret the coefficient in percentages and in this way, the estimation indicate that the sensitivity of the sales of manufacturers to the volume of exports has increased by a factor of 60% from 0.25% to 0.4%. In words, it means that in the second period the estimation suggests that a 1% increase in exports will lead to a 0.4% increase in the sales of manufacturers whereas the corresponding number is 0.25% in period 1.

Looking at the overall fit of the relationship, the results clearly indicate that this representation leaves out a considerable source of the variation in the sales of manufacturers which is entirely to be expected. As always, it is essentially a qualitative and theoretical question whether the increase in the sensitivity as well as the goodness of fit (from 0.08 to 0.13) represents de-facto export dependency or simply indicates an increased reliance over and above other more important factors.

In relation to the second model which plots operating profits as a linear function of the change in the current account, it is important to note that this model is estimated in the first difference (and thus not log-log) because the current account in some cases has been negative. Moreover, the sample period is shorter than for the first model (1980-2008) since OECD does not have data for the income balance prior to 1980.

On an overall basis these results underpin those from the first estimation although they seem to confirm the hypothesis to a much higher degree. Abstracting from the full period result which serves as an anchor for the overall significance of the relationship, the difference between the model estimated for period 1 and period 2 is striking. Consequently, the first period estimation signifying the period where the median age of Japan is below 40 shows no significant relationship whatsoever, in this sense it appears that the apparent negative relationship implied above from the correlation charts do not pass the simple causality test which OLS represents. The second period regression on the other hand returns a strong and significant relationship which indicates that a 1 unit (JPY) increase in the change of the current account will lead to a 0.23 unit (JPY) increase in the ordinary profits of Japanese manufacturers. On the goodness of fit measure the only thing we can say is that it has increased considerably to signify the increase in relationship between the profits of manufacturers and the current account. However, whether a goodness of fit of 0.15 is high in an absolute sense here is difficult to say without a more thorough and comparative study. But since we have a univariate framework, I believe this result to be quite extraordinary.

Conclusion

I hope by now that I will have either convinced you or scared you off in terms of the importance of whether Japan is dependent on exports to grow or not. I would also hope that the connection to events closer to the market is not too difficult to see. For example, Bloomberg is running the story today that the BOJ, like most other central banks, is either willingly or, dragged kicking and screaming by market sentiment, moving towards the formulation and near execution of the famed exit strategy from extraordinary monetary policy measures. Clearly, interest rates are to remain low for as far as the eye can see, but it is interesting to ponder whether the decision by the BOJ scale back corporate debt purchases is related to optimism on the companies ability to leverage domestic growth or whether it is because they see export markets reving back up in which case it would be back to the same old growth strategy. Another example would be the latest inflation reading which suggests, more than anything, the extent to which the domestic economy in Japan is not able to provide an environment in which companies can operate profitably as well as it indicates how overall domestic momentum is essentially contractory.

It is within this general economic context that the notion of export dependency becomes important and specifically how this might relate to the ageing of Japan's population. In this entry I have tried to take this idea down a notch from the strict macroeconomic level in the form of an analysis of the relationship between external demand measured through national accounts and aggregate corporate accounts. The results, I believe, speak for themselves and strongly suggest I think that Japan indeed is becoming increasingly dependent on external demand to create the growth and income the economy needs to maintain economic growth. Following from this, a number of questions present themselves, not least the most crucial general question relating the issue of export dependency to ageing in a general sense and then on to the discourse on global macroeconomic imbalances. But for now, I will let you digest the data at described and analysed above.

---

[1] - Results of this regression is not formally reported in the text; please mail me if you want my excel sheet and results.

[2] - In order to be really rigorous I would have to formally test for the difference between the two periods (e.g. through a Chow Test or related method), but here it will suffice to look at the change over the period without putting a label of statistical significance on it.

After a nice and entertaining week in Barcelona where I had the privilege not only to hold a seminar at the Universitat Autònoma de Barcelona, but also to meet a host of interesting people, I thought that it would be about time that I finished my piece on the latest data from Japan which admittedly will be a bit backward looking, but hopefully interesting nonetheless. 

Beauty, as they say lies in the eye of the beholder and perhaps this axiom is worthwhile contemplating when thinking about the immediate condition of the Japanese economy or indeed the global economy and her asset markets, but for the sake for simplicity . Consider for example the news, out a week ago, that Japan's current account surplus widened 10% in August over the year. In an economy where external demand is the main driver of economic growth, this is a significant piece of news and should rightly be interpreted as a positive sign. Or should it?

Once we read beyond the immediate headlines it becomes clear that what we are really seeing in Japan is, in fact, a pendant (even if less severe) to the Spanish situation where the improvement in the external balance comes, not from a sustained and independent pick-up in external demand, but rather from the fact that domestic demand is contracting faster than external demand thus pushing up the current account. In Japan, exports slid 37.1% on the year but as imports shed a corresponding 41.2%, the current account improved as a result. Naturally, some would want to insert the point here that since Asia (and in particular China) seem to be the locus of small, but definitely noticeable, upbeat signs in the global economy, Japan should be at the forefront to snap up the gains. Surely this is true, and one wonders how far exports would have tumbled on the year if China had not been there to pick up the slack; yet, as we can see from the figures above; the downward momentum remains in spit. It seems, that beauty indeed is a subjective concept.

With respect to the most recent event as it were in the Japanese economy, the BOJ meeting held last week did not really bring much new to the table with respect to policy measures as rates were kept in QE mode. However, and as Societe Generale's Gleen Maquire points out in a recent publication (the weekly monitor) the point is moving closer with respect to whether the BOJ will extend its extraordinary credit measures or stop them. This would then be a discussion about the much debated exit strategies by part of especially the G3 central banks; how it will be conducted and equally as important when. The current message seems to be that while it is difficult to see the BOJ abandoning ZIRP any time soon, the BOJ is not going to extent the current measures of credit support in the form of the purchase of corporate bonds and commercial paper as well as a special funding program for corporate finance facilitation from the point of view of banks. As Maquire correctly points out and regardless of whether ZIRP is set to continue or not, a withdrawal of these measures would naturally represent a de-facto policy tightening and it is unclear just what the effect will be on the Japanese economy.

Moving on to a piece by piece look at the recent monthly data, August's numbers did bring with it a bit of light (September number will be out at the end of October) although the fundamentals have hardly changed.

Kicking off with domestic consumption, the headline figure reported by the statistical office clocked in a nice increase of 2.6% y-o-y which is of a magnitude not seen since January 2008. It is interesting to differentiate the headline figure of 2.6% (which is a real figure) is in somewhat stark contrast to the nominal decline in the consumption of workers' households of 1.4%. At this point, the average monthly change on an annual basis for the overall consumption index in Japan is -1.2% (up from -1.8% before the 2.6% figure reported from August); I will hold off any premature conclusions of a sustained pick-up in consumption before seeing what is in store in the coming months.

With respect to prices, Japan now looks thoroughly entrenched in deflation;

The general core index thus declined 2.2% over the year with the core-of-core index declining 2.6%. So far in 2009, the core-of-core index has declined 8.3% with an average monthly decline of 1%. This is a strong testament to the strong downward momentum in the domestic economy and underpins the following very reasonable assessment by Glenn Maquire; 

Realistically, it will be very difficult for the Bank to forecast positive inflation over the next two to three years. The Consumer Price Index continues to fall sharply and the output gap remains extraordinarily large by any metric. With the yen now appreciating and political opposition to a stronger yen having passed with the Liberal Democratic Party losing power, Japan is likely to remain more at risk of deflation than inflation over the entire period including calendar 2012.

Especially the point on the output gap is important even if we don't observe this specific data point. I would add the qualifying comment that one thing is the size of the output which in some sense would signify the immediate damage incurred by the Japanese economy in the context of the financial crisis and another thing is the speed (and ability) with which Japan can close this output gap on the basis of domestic activities alone. A point that I would especially emphasise here is the simple fact that the potential growth rate of Japan is likely to be in an almost perpetual decline due to the demographic situation. In this sense, it may increasingly become a question of what in fact the potential growth rate is based on domestic activity (i.e whether it is positive at all) than a matter of closing the output gap.

On the labour market, things improved rather surprisingly in August with the unemployment rate declining from 5.7% in July to 5.8% in August.

In the context of the financial crisis, the unemployment rate has so far increased roughly 2% and although the number in no means is alarming in a relative sense, the prospect of a continuing increase is sure to make cautious consumers even more cautious.

Turning finally to the corporate sector, industrial production has recovered somewhat after the absolutely horrid decline observed in the first half of 2009. The question is the extent to which we should see this as a decisive positive sign or not.

Once again, this is a matter of interpretation but when for example the Swedish bank calls it a "new dawn" for industrial production after looking at the graph above I find it difficult to see exactly where this dawn is. Consequently and while it is certainly true that the index for industrial production has recovered some ground after bottoming out in February 2009, it is still situated 18.3% lower than its average value (measured from January 2003 to July 2009). This compares with an index for all industrial activity running some 7% below its historical average. These numbers are innocuous in themselves, but the important thing is the level of activity which can be supported by the Japanese economy and although we are certain to see some recovery in the data the underlying momentum may ultimately disappoint.

The chart to the right taken from JPMorgan's Global Datawatch is perhaps the clearest picture of what export dependency means in the case of Japan and how it drives the level of industrial activity.

With respect to the Tankan, the survey showed a pick up in sentiment which follows leads nicely the pick up in real economic activity. Pessimists still outweigh optimists by a rather large margin and it shall be interesting to see whether the apparent (and indeed lingering) positive sentiment among global market participants will spill over forcefully into expectations and investment plans moving forward.

Summary - A Beauty or a Beast?

Some of you may feel that I am spinning the story of Japan too much towards the negative sign. I don't believe this is the case however, and although I can see that some positive signs have emerged, I remain skeptical that it will be enduring. Call me a permabear, but 3-4 years of Japan watching has taught me to be careful when it comes to emphasizing positive news on the Japanese economy, and especially so when it comes to the momentum of the domestic economy.

This brings us to the global economy and the simple fact that the extent to which one would narrate the outlook on the Japanese economy in relative positive light would be tantamount to the extent that one also sees a relative benign outcome for the global economy. Here I am also skeptical which is ultimately also why I remain cautious on Japan and especially so in an environment where the JPY does not seem to benefit from low volatility and risk proneness to the same extent as before the Fed engaged in QE. But that is certainly a discussion for another day; for now, I will leave you my dear reader with the judgement on the immediate outlook for Japan's economy remembering full well that beauty indeed lies within the eye of the beholder.

(quote: Bloomberg)

Officials kept the benchmark overnight lending rate at 0.1 percent, and maintained their emergency lending programs to banks and companies. While describing the economy as “showing signs of recovery,” an upgrade from the “stopped worsening” assessment last month, the Bank of Japan said in a statement in Tokyo today that it still sees “downside” risks to growth. Today’s statement reflected global doubts about the strength of a recovery from the deepest recession since the Great Depression. A Bloomberg News poll of U.S. households published today showed Americans plan to refrain from boosting spending even after the biggest drop in consumption in 29 years.

“Most countries are experiencing a recovery, but few can be confident about the sustainability of those recoveries,” said Yoshiki Shinke, a senior economist at Dai-Ichi Research Life Institute in Tokyo. “Japan will be the last country to raise its interest rate” because it has the added problem of deflation, he said. Bank of Japan Governor Masaaki Shirakawa told reporters in Tokyo today that while stimulus measures have helped the economy improve, “we’re not confident about the strength of private final demand after those effects fade.” He added that central bankers are monitoring the appreciating exchange rate, which is contributing to the drop in Japanese consumer prices.

Japan's problems are many fold but the most severe issues in the context of reading the tea-leaves of the recovery is the uncertainty attached to question of whether the current above par environment will linger beyond the last effects of the stimulus (which was front loaded due to the elections) as well as any inventory bounce which may come as Japanese companies rebuild their empty shelves in Q3.

It is difficult not to sympathize with the BOJ in its careful approach here since if you take a look at the underlying demand conditions they are, to put it mildly, sluggish! Only a week ago, I discussed the situation on the corporate level where companies were hit by falling top line sales on the domestic market and, as a result, only very carefully expanding capex. Moving on to other key economic indicators it is pretty poor reading if we look at the domestic economy in isolation.

By far, the most preoccupying problem has to be the fact that Japan's inflation rate is moving beyond sub-zero and essentially into the abyss which is a painful and almost, if you will allow me to be dramatic, tragic outcome after two decades of fight against this very malaise. Now, I know that we are observing one-off effects from high oil prices in the summer of 2008, but try to have a look a the actual numbers. Consequently the index that actually includes energy is currently running (in July) at a rate of decline of 2.2% whereas the index which excludes energy and fresh food is running at an annual decline of 2.6% and thus more than the headline gauge. Clearly, the BOJ would like to see this figure correct or even stabilize over the summer before contemplating tweaking nominal interest rates.

With respect to consumption, the figure tracked as a headline gauge for domestic demand on the consumer side is quite volatile, but it should not escape our attention that despite its volatility, it has been consistent below the 0% growth mark throughout 2009. Thus the average annual growth rate on a monthly basis has been -1.8% so far in 2008 which suggests as a simple yardstick the negative drift we need to apply to the evolution of domestic demand in Japan.

Finally there is the labour market where the unemployment rate has increased rather harshly since the beginning of 2009 following a mean reverting pattern around 4% throughout 2008. 5.7% which was the reading in July certainly won't make any headlines comparing to the eye-popping figure we are seeing in e.g. Spain or elsewhere, but it is worthwhile contemplating this in a relative sense and thus the effect it is likely to have on the behaviour of already cautious households.

Where Goes the JPY?

If the round-up above suggest, in a real economic context, the current shaky condition of the Japanese economy it seems that Japan now has a new issue to deal with; the unduly appreciation of the JPY. Now, of course these days it may be of less use to look at the JPY measured against G7 currencies rather than for example against China, but the graph below should still capture much of the essence.

I think it is very interesting here to observe that in a post-crisis context the JPY has gained about 20% against the Euro and Buck where it has been ranging since the latter part of 2008. Clearly, this has an effect on the real economy in so far as it reduces the competitiveness of Japanese companies relative companies in the US and Eurozone (not to mention the UK); and remember, deflation here is becoming a zero sum game since at the moment the US, the Eurozone, and the UK is also suffering from a bout of deflation or very low inflation.

Of course, this presents Japan with a whole new problem in the sense that while Japan could hitherto expect to get a double boost from an increase in risk aversion as carry trade activity took hold lowering the Yen and allowing Japan to export away, this route is getting increasingly crowded. More specifically, Bernanke has entered the scene and as analysts and commentators start talking about the new "victims" of the global carry trade punt in the form of those brave souls among central bankers who dare raise interest rates before movement in the G3, Japan cannot be certain to be the exclusive funding currency. It has a rival in the form of the USD and notwithstanding the obvious consequences for the global economy that Bernanke is putting up a 0% interest rate on the world's most liquid fiat instrument, Japan might find itself pinched here.

Of course, there is a solution here even though it seems unlikely at the moment, I believe, that it will come to pass.

It was still telling that the branch of RBS in Japan (RBS Securities Japan Ltd) was quoted, by Bloomberg yesterday, personified by chief economist Junko Nishioka for noting, rather dryly I'd might add, that the most efficient way to spur growth in Japan would be through a devaluation. Hmm, that would be fun wouldn't ... a devaluation amongst the G3! Once again, we are left guessing as to just what value of the benchmark USD/JPY that will jolt the MOF and BOJ into joint action; 90, 85, 80, 75 ...? I will leave my readers to do the rest of the guesswork, especially since yours truly has burnt his prediction powers once too many trying to call JPY intervention. So far though, most bets seem off as the incoming Finance Minister Hirohisa Fujii made it quite clear that there will no such nonsense of intervention to weaken the Yen. Also, if Macro Man is right and this is predominantly a Dollar story rather than a Yen story, then what can they do as MM put it earlier this week.

In a general sense, it shall be most interesting to following both intra G3 currency movements and FX in general if and when some economies venture into a decisive tightening mode over the second half of 2009. And for Japan, well she will try to muddle through of course. I am watching the inflation picture closely as well as of course we must watch the extent to which Japan can really couple on to the Asian growth spurt we are currently observing. With respect to policy decisions, I feel confident that the BOJ is locked in at this point to, if not continue QE, then at least to keep nominal interest rates at or very close to the zero bound.

---

[1]: Note, if you correct for stationarity the co-relationship dissipates so I may be over-stepping my bounds here.

(quote Bloomberg)

Japanese businesses cut spending for a ninth quarter as the global recession squeezed profits, underscoring the challenge for the incoming government to sustain a recovery from the country’s worst postwar slump. Capital spending excluding software fell 22.2 percent in the three months ended June 30 from a year earlier, after dropping a record 25.4 percent in the previous quarter, the Finance Ministry said today in Tokyo. Profits slid 53 percent.

Sales fell 17 percent, the second-biggest drop on record, indicating global demand hasn’t recovered enough to encourage companies to buy more plant and equipment. Sanyo Electric Co. and Seven & I Holdings Co. are among businesses scaling back. “Companies have too many resources, and until that situation changes, they won’t have to invest in more equipment and they won’t need to hire more people,” said Seiji Shiraishi, chief economist at HSBC Securities Japan Ltd. in Tokyo.

(click on graphs for better viewing)

On a y-o-y and q-o-q basis, the sales of Japanese companies fell 17% and 4.5% respectively. Especially, manufacturing in general and machinery and equipment producers saw a rapid decline in sales. Investment in plants and equipment fell back sharply on an annual as well as a quarterly basis at 21.7% and a full 39.1% respectively. The pronounced fall in Q2 investment owes itself to an abnormally large outlay in Q1 2009 which has consequently been paired in the period just ended. As can be seen in the graphs to the right, the manufacturing sector has been hit much harder than the non-manufacturing sector which is not difficult to understand if you think about the fact that it is this sector of the Japanese economy which is most exposed to the external environment. This is to say, that the manufacturing sector's  top line is very sensitive to external conditions on the margin. Between Q4-08 and Q2-09 the cumulative drop in Japanese manufacturers sales was a whopping 35% almost double that of the non-manufacturing sector's corresponding toll of a drop of 18%.

With respect to investment in plants and equipment (corporate capex) the picture is, interestingly, the reverse with the investment by the non-manufacturing sector falling much more sharply during the present turmoil. On a four quarter moving average basis, the change in investment in plants and equipment for of the non-manufacturing sector has been falling ever since the first quarter of 2006 with a cumulative drop of 37%. The corresponding number for the manufacturing sector shows that the investment of plants and equipments have been falling since the third quarter of 2007 with a cumulative drop of 19%.

Finally, in the context of operating profits (that is, profits derived soled from the company's primary operations), the non manufacturing sector is still well in the black whereas the manufacturing sector has moved from a figure much below average in Q4-2008 to outright red figures in Q1-09 and Q2-09. Between Q1 2000 and Q3 2009 the average quarterly profit (nominal) for Japanese manufacturers was a little over 4 billion Yen.

In Q4 2008, the consolidated profit read 761 million yen and in Q1-09 and Q2-09 the numbers had turned into an outright decline with negative profit of 3.5 billion and 645 million respectively. Conversely, the non-manufacturing sector was, albeit still below average, performing much more strongly with solid black numbers throughout the crisis.

No Recovery Here

While there certainly may be places the newly elected party to rule Japan can look for green shoots and evidence of an impending recovery in Japan, corporate capex and profit numbers are not one them. Neither are, of course, the labour market, the deflation debacle, as well as the household sector which leaves us with the obvious question of where then? Second quarter clocked in better than most had expected and ironically, despite the analysis fielded above, upbeat signals from industrial production and the manufacturing sector in general are cited as the main reason. I will let my readers judge for themselves by perusing the graphs above and then also note the following crucial point made by Soc Gen's Gleen B. Maquire in one of their recent economic outlook reports (my emphasis);

The bulk of the contribution to growth came from net exports. Exports increased by 6.3% qoq while imports declined by 5.1% qoq. Overall, net exports contributed 1.6ppt to Q2 growth. The recovery in the Japanese economy is starting to look eerily similar to the 2001-03 recovery when Japan emerged ahead of Europe and the US. This is largely a China dynamic with Japan’s exports to China (and indirectly to the rest of Asia) recovering in step with China’s stimulus measures coming on line.

(...)

Industrial production is responding to robust demand from China for capital equipment and
industrial goods as well as tentative signs of a recovery in the durable goods cycle within Asia and globally.

So, this appears to be an export story in which case positive news from Japan should not surprise us at all. Macquire goes on to argue that since Q2 did not see a bounce back in inventories from the sharp de-stocking of Q4-08 and Q1-09 this, expected, bounce in inventories. I remain skeptical of this claim since I don't necessarily believe that the new level of growth will necessarily support any rapid re-stocking of inventories, but time will of course tell very soon.

Finally and specifically in relation to the analysis above, it is also interesting to ponder the discrepancy between the manufacturing and non-manufacturing sector in relation to the idea of Japan being dependent on exports to grow. Clearly, the manufacturing sector's higher sensivity with respect to the financial crisis and its top line makes sense since external conditions deteriorated very rapidly. Conversely, the domestic economy of Japan was not struck by a major, and relatively large, credit crunch. Hence, we see the top line of non-manufacturers relying more on domestic demand decline less. On the other hand, in relation to corporate capex the manufactures' slump in investment is very exclusively tied to the financial crisis while that of the non-manufacturers seem much more broad based. Once again can we rationalize this through the idea that the manufacturers remain tied to external conditions while that of the non-manufacturers is increasingly tied to the domestic market.

So, does this last niggle make sense? I am not sure, but it would be an interesting thing to check.

The DPJ has won 300 seats in the 480-seat lower house, ending 50 years of almost unbroken rule by the Liberal Democratic Party (LDP), NHK TV says. DPJ leader Yukio Hatoyama hailed the win as a revolution and said people were "fed up" with the governing party.

Prime Minister Taro Aso has said he will resign as head of the LDP, taking responsibility for the defeat. Japan is suffering record unemployment and its economy is struggling to emerge from a bruising recession.The DPJ has said it will shift the focus of government from supporting corporations to helping consumers and workers.

and here is the Economist;

IN A land of volcanoes and earthquakes the seismic shift is all too common. But for decades Japan’s political landscape has not reflected the country’s geological uncertainty. A general election on Sunday August 30th should change all that. Opinion polls suggest that when voters go to the polls for the powerful lower house of the Diet (parliament), the opposition Democratic Party of Japan (DPJ), will trounce the Liberal Democratic Party (LDP), thus ending over 50 years of nearly continuous rule.

The magnitude of the defeat facing Taro Aso, the prime minister and LDP leader, is startling. A poll in Thursday's Asahi Shimbun suggests that the LDP’s representation in the Diet could be more than halved to about 100 seats. The DPJ could take as many as 320 of the chamber’s 480 seats.

Needless to say, this is significant not least for its economic ramnifications which I hope that I will have some time to deal with later this week (meanwhile see this by Edward).

I should stress immediately that this is not a virtue but rather a vice, but I do think that exploring  conventional economic theory (and moving beyond?) is an important part of the process. In the end, the argument should be amendable to plain English and, as it were, plain common sense and intuition as well as, of course, empirical falsification. One thing which I can promise though is that there will be no mathematical models; at least there, I should have provided some comfort. If you want the math, you will have to wait for the thesis.

The best way to frame the following argument is perhaps to insert it in the chronology of the thesis where it appears, in the end, as a perspectivation on aggregate global capital flows. What precedes this is thus an, hopefully convincing, account of the fact that Germany and Japan are effectively dependent on exports to grow as a result of their demographic profiles.

Some Thoughts on Export Dependency

First it would be worthwhile taking a look at the following sketch (click to enlarge) which captures a lot of the issues that will be discussed below. Essentially, it attempts to show, as nastily and brutishly short as possible, what export dependency means in the context of what we could call conventional economic theory.

For non-econ wonks it is likely to be quite difficult to read, but in fact; it is fairly simple. The X-axis  represents the age of an economy here exemplified in the phases of the age transition derived from a study by Malmberg and Sommestad that discusses the demographic transition as a transition in age structure (and not population growth). But really, it could just as well be median age where a median age of 40-50 would the limit to the right and, let us say, about 20-25 to the left. The Y-axis is adopted directly from Higgins (1998,  e.g. table 1, p. 350) who uses empirical estimations to model the effect from age on, in this case, the current account. As I, Higgins also use age on the x-axis (age distributions) and on the y-axis he has age coefficients. This basically means that a negative value signifies that the age structure in the economy influences the current account negatively (i.e. pushing the CA towards a deficit) while the reverse is true for a positive value. Essentially, we need not, initially, bother with the numerical value of such age coefficients here, but merely note whether it is positive or negative and then secondarily we may look at the level effect (i.e. whether the effect is numerically large).

I should immediately point out that there are no direct empirical basis for the curves. The line which is labeled trajectory of export dependency is basically a cubed function designed to show a more less linear association between export dependency and ageing with the added and important feature (hence the cubed functional form) that export dependency tends to increase exponentially when you move into very old age. The blue line naturally do contain some empirical foundation in that it originates from an empirical study Higgins (1998) where it is constructed based on empirical estimations. I shall not go into Higgin's empirical framework here since it would take us into the dark world of time series econometrics but merely point out that Higgins manages to come up with what we could call the textbook representation of the effect of ageing on the current account and it is worth pointing out that he is not the only one. Also Supan et al. (2007), Bryant (2006), Henriksen (2002) and Summers et al. (1990) (among a myriad of other studies) postulate either through theoretical elaborations or empirical estimations a relationship which may be approximated by the chart above.

In theoretical terms, the basis for this "hump-shaped" relationship between ageing and the current account is derived in the context of the simple, yet crucial, intuition derived from Modigliani's life cycle hypothesis which states that consumers spend their working age years saving for retirement where they will dissave those accumulated assets. Then, at some point during working age there is a "peak" which is characterised by the time when the saving rate is highest and thus also, indirectly, where the effect on the current account should be largest. Following convention, this is modeled in economics through the idea of overlapping generations and often in the form of a neo-classical growth theory framework or simply a general equlibrium representative agent framework. I shall not open pandora's box and discuss the merit of these methods here but merely point out that I think it is very difficult to argue against the the basic intution which lies behind these models and thus, as it were, the intuition from the life cycle hypothesis.

In essence of course, the real issue is one of calibration and thus one of empirical analysis to see just how this postulated hump may materialise as well as of course realizing that ageing is not the only variable which influences the current account. It is also here that the fun begins and where things very quickly become very complicated. 

In this respect, it is worthwhile focusing the attention on the so-called dissaving phase which should be a natural result of the move towards an ever higher share of the elderly in the population. The basic mechanism here is simply that in standard economic models "old" economic agents will dissave their entire asset and thus as the old cohorts increasingly will outnumber the young cohorts the dissaving of the former will trumph the saving of the latter and lead to dissaving on an aggregate level. All sorts of ill prophecies have been proposed in the context of this dissaving hypothesis, not least that we are facing an asset meltdown scenario in 2050 because there will be far too many elderly wanting to offload their assets to a much smaller base of younger cohorts who cannot support a satisfactory price (yield) level.

Now, the problem here is that empirical studies have shown that the idea of dissaving, while intuitively strong, is difficult to verify to the extent that theoretical models suggest. This is not difficult to imagine I think. By very nature of the uncertainty of the mortality schedule people do not (cannot) dissave to 0 and beyond this there are may be bequest motives. In an open economy context this further creates the rather dubious situation in which economies well into their old age will have to run persistent external deficits because, presumably, savings will have decline far faster than domestic investment demands. I say dubious here because this is exactly where I have chosen to take my stab at trying to amend the theoretical framework.

Consequently, I am not so sure that this is a plausible end point in the context of continuing population ageing. Specifically, I would like to ask the simple question of whether it is actually optimal for any society to dissave as the theory postulates. I don't think it is and while it is certainly not unlikely that economies may actually dissave (defacto) they will still be dependent on exports to grow and thus the difference between the two curves into the latter age transitions represents an externality. This is also why I think that economies, in stead of responding with dissaving, will fight the point at which they reach this stage since when they do it is effectively game over. Imagine for example how the likes of Germany and Japan would ever be able to finance an external deficit brought about solely on the basis of the fact that savings has declined so fast as to not even be able to meet domestic investment demand which in itself will be declining. In this situation, wouldn't it be much smarter to maintain savings persistently higher than domestic investment demand which can of course only be materialized in an external surplus. I think it will and it is this point which you need to keep in mind as we move forward.

Implications for Global Capital Flows

With these considerations in mind, the key question then becomes; what happens when more and more economies grow to become increasingly like Germany and Japan? (As we know they will, at least in the context of the OECD). Naturally, not everyone can maintain excess exports over imports at the same time so something, as they say, has got to give and it is this something, as it were, which is the topic of this entry.

The focus on the implication of ageing on aggregate global capital flows is not new and is, in fact, an integral part of the analysis in Supan et al. (2007), Higgins (1998) and Bryant (2006) which were also mentioned above. However, in the following we are going to relax the condition of dissaving normally assumed in e.g. OLG models and accept that the propensity to run an external surplus will increase as an economy ages.

If we do this, it should not require too much imagination to see the issues that may rise. For starters, I want to reiterate yet again the trivial fact that not all economies can run an external surplus at one and the same time. This means, quite naturally, that what might be optimal from the point of view of a single economy (i.e. maintaining a surplus as it ages) may not be viable or optimal from the point of view of the global economy.

In order to frame the discussion it is natural to take our point of departure in the discourse on global macroeconomic imbalances.

As so many other things, the financial crisis has completely dislocated this system but it still worthwhile to ponder the nature of the global financial system in a post Asian crisis perspective and up until now. Consequently, the global macroeconomic landscape has long been characterized by what many has termed Bretton Woods II in which a large batch of especially Asian and oil exporting economies have been pegging their currencies to the US dollar who in turn have been running a large current account deficit to match the savings surplus in emerging markets such as China, South Korea, the Petroexporters, Brazil and Russia. In fact, if we cut a lateral line through this argument we could say that the world has hitherto been characterized by the Anglo-Saxon economies running external deficits to match surpluses in big emerging markets as well as Japan and Germany.[1] That however changed abruptly with the advent of the financial crisis and it is interesting to note the initial response by market participants and many scholars in their interpretation. Consequently, as it became clear that the US economy had been mortally wounded on the back of the subprime mortgage debacle the US Fed slashed nominal interest rates significantly. As a result the USD plummeted which led many commentators to hail the US economy’s fall from grace and specifically coined the notion of decoupling in which the Eurozone economy and Japan were pinned as the ones taking up the slack in steering forward global demand. Initial versions of the decoupling thesis thus centered on the shift in emerging market exports from the US to Japan and, especially, the Eurozone and thus in the process also a shift from the US dollar to the Euro as a global reserve currency. As it turned out this was nothing but a mirage masked by the fact that US policy makers essentially acted preemptively to a crisis which turned global during the summer 2007 and now most major central banks in the OECD have slowly bitten the bullet and followed Bernanke into quantitative easing to combat the risk of deflation which would be devastating in the context of the debt overhangs some economies face. Moreover, and as a general point, the global economy already decoupled from the US, and indeed OECD, economy a long time ago. Consequently, it is an irrefutable fact that the global economy is undergoing a fundamental change in which emerging economies such as India, Turkey, Brazil, China; Chile etc will ascend to account for an ever larger share of global GDP and growth. The crucial question is then; how will this process and the process of global ageing be transmitted to the global economy through capital flows?

As a starting point to answer this question I would like to draw the attention to comments made by two of the most prominent members of the global financial punditry in the form of US economist Paul Krugman (PK) and the Financial Times’ chief economics commentator Martin Wolf (MW).

Starting with the former[2] he recently pointed to the fact, in the context of Japan, that external demand was instrumental in ending the slump and providing a relative bounce between 2003 and 2007. As PK further goes to argue, this may present a rather ominous outlook since the extent to which we are all, in the OECD, currently stuck in a “Japan-style” liquidity trap the way out may constitute a rather crowded route. As PK poignantly points out at the end of his small piece;

(...) needless to say, we can’t all export ourselves out of a global slump. So, how does this end?

Krugman 2009

This is indeed a good question and MW makes a similar argument in a recent column[3] where he points towards the fact that the global imbalances themselves may prove to be an impediment to a swift global recovery.

 In short, if the world economy is to get through this crisis in reasonable shape, creditworthy surplus countries must expand domestic demand relative to potential output. How they achieve this outcome is up to them. But only in this way can the deficit countries realistically hope to avoid spending themselves into bankruptcy.

Martin Wolf (2008)

This is of course a very appealing proposition and also goes to heart of idea that, at least, one part of the solution of the current global crisis lies in the resolution of global macroeconomic imbalances. But prey tell, how are these surplus countries going to revert towards a growth path characterized by a more balanced external account and perhaps even an external deficit?

It is in this context that the argument presented in this thesis becomes important. Consequently, there is a big risk that these surplus economies (e.g. Japan and Germany) simply will not be able to heed the call of MW. The main reason for this inability is then, in part, exactly to be found in the economic profile of a rapidly ageing economy with a median age pushing 40 year mark and beyond. Japan and Germany as well as the economies next in line to reach their age bracket cannot achieve growth based on domestic demand in a way which would allow them to suck up excess global capacity through an external deficit.

This is a very important point to stress in the context of the global economy and must be stressed with great emphasis.

Some Charts to Go With This

In order to try to make sense of all this consider the supply/demand chart below which plots the supply and demand for savings in the global economy. Following convention, the X-axis represents quantity and the Y-axis represents price. In this specific case, the X-axis can be seen as the total demand (from deficit nations) for excess investment beyond the level which can be achieved through domestic savings. The Y-axis then becomes the price[4] (interest rate) which equates this demand with the level (supply) of excess savings provided by the surplus nations beyond the level which can be absorbed by domestic investment demand

(click to enlarge)

As a natural consequence of the intuition underlying this small model, equilibrium is a forced (and always binding) condition since, by definition, the sum of external deficits must equal the sum of external surpluses in the global economy. 

If we accept the idea behind the theoretical framework presented in this thesis it is very easy to see the implications of a sustained global process of ageing. As is shown in the diagram the supply of excess savings (external surpluses) will increase with ageing [S(1) to S(2)]. But this is not the only effect. Following the simple intuition of a closed system an increase in supply must be meet by a decrease in demand too since we assume that economies are moving from a position as external deficit nations to a position of external surplus nations. In this sense, the constant level of output (quantity) is largely a simplifying trick in the sense that we let the entire adjustment process occur on the return of the excess savings of surplus nations rather than the quantity of excess widgets they can produce to sell abroad.[5] This produces an effect whereby ageing reduces the price of excess savings in equilibrium.

In order to move forward from here we need to mentally relax, as it were, the idea that deficits need to equal surpluses in equilibrium. In concrete terms, we need to understand the idea of equilibrium does not capture the notion of dependency on exports/foreign asset income to grow.

This is amended in the following graph; (click to enlarge).

The key here is the notion of the critical price level [6]. This should be seen as the level needed to sustain an acceptable level of growth in ageing economies and is thus a direct proxy for export dependency. As the global economy ages and assuming that equilibrium must hold at all times, the supply of excess savings and the demand for these savings decrease both lowering the equilibrium price and quantity. However, the critical price level remains. One key implications of this is a systematic oversupply of savings, or glut if you will, produced by the process of ageing and it is very important to understand that this oversupply is very tangible. It represents the value of external surpluses which would be enough for the likes of Germany, Japan etc to maintain a growth rate consistent with expectations and essentially the maintenance of their market economies. In the jargon of the theory, it represents the point at which ageing economies are optimally smoothing consumption and saving as a function of their intertemporal preference for the latter over the former. Of course, it cannot exist as a real entity but it may still have real implications.

The first obvious effect is to make the variation of ageing economies’ output very sensitive to the variation in out of deficit nations and thus global output. In its strictest form, this is how export dependency emerges. Another notable effect would be that it drives down the return in ageing economies to such an extent that it may fuel so called carry trade flows in which traders borrow in low interest rates currencies and invest in high interest rate currencies. Another example would be how these savings may be used to fund temporary and unsustainable build up of credit expansion in economies running external deficits. This is to say that if the equilibrium depicted above essentially is binding in the long run the implied existence of this excess pool of savings may lead to sudden outward jumps of the demand curve and thus the creation of credit bubbles. The main key to take away from this small economic model is thus the idea of an externality of ageing on a global level. This externality arises as a direct function of the implied existence of an excess of savings over demand as the global economy ages. In the context of the theoretical framework above the externality should be seen as function of the crowding of economies in one end of the spectrum on intertemporal preferences for consumption and saving. Crucially, it also means that what we might find to be optimal in the context of a single economy is not optimal on a global level a point which is certain to make standard economic modeling of aggregation from the representative economy level to the global economy very difficult. In empirical terms it means that what one might find to be the optimal path in a time series perspective of one economy may turn out to have radically different implications in the cross section when more or all global economies are involved.  

Further studies should attempt to develop this idea further since it provides a useful venue of analysis as an alternative to the traditional idea drafted from life cycle theory that global ageing will entail dis-saving on an aggregate level.

List of References

David M. Cutler & James M. Poterba & Louise M. Sheiner & Lawrence H. Summers (1990)
"An Aging Society: Opportunity or Challenge?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 21(1990-1), pages 1-74.

Henriksen, Esben (2002) – A Demographic Explanation of U.S. and Japanese Current Account Behavior, Graduate School of Industrial Administration, Carnegie Mellon University

Higgins, Matthew (1998) – Demography, National Savings, and International Capital Flows, International Economic Review, Volume 39 (1998) Issue (Month): 2 (May) pp 343-69

  Borsch-Supan, Axel H; Alexander, Ludwig; and Krüger Dirk (2007) – Demographic Change, Relative Factor Prices, International Capital Flows and their Differential Effects on the Welfare of Generations, NBER Working Paper No W13185

[1] With the German surplus mainly materializing itself in an intra-European imbalance.

[2] Paul Krugman (2009) – The Eschatology of Lost Decades, NYT blog post

[3] Martin Wolf (2008) – Global Imbalances Threatens the Survival of Free Trade

[4] Which is assumed to be exogenously determined for all involved economies through the equilibrium in this system.

[5] Remember that I am assuming that quantity is fixed and that the entire adjustment takes place on the price. In a more realistic representation the adjustment would of course take place on both the price and quantity.

Japan still retains its lead in engineering. A showroom at Panasonic's headquarters displayed a heated, multifunction toilet seat that conserves energy. (Wouldn't leaving the seat cold conserve even more?) The sleek Shinkansen bullet trains roll up to their appointed spots on time. TKX, an 87-year-old Osaka-based company that makes abrasives, has adapted its expertise to cutting silicon ingots into wafers for solar panels.

But social engineering is proving more challenging. Japan's population peaked in 2004 at about 127.8 million and is projected to fall to 89.9 million by 2055. The ratio of working-age to elderly Japanese fell from 8-to-1 in 1975 to 3.3-to-1 in 2005 and may shrivel to 1.3-to-1 in 2055. "In 2055, people will come to work when they have time off from long-term care," said Kiyoaki Fujiwara, director of economic policy at the Japan Business Federation.

Such a decline is cataclysmic for an indebted country that values infrastructure and personal service. (Who is going to maintain the trains, pay for social benefits, slice sushi at the Tsukiji fish market?) The obvious answers—encourage immigration and a higher birthrate—have proved difficult, even impossible, for this conservative society. In the United States, foreign-born workers make up 15 percent of the work force; in Japan, it's 1 percent. And, official protestations to the contrary, they're not particularly welcome. One columnist I met compared the standard Japanese attitude toward immigrants to that of French right-winger Jean-Marie Le Pen. In the 1990s, descendants of Japanese who had emigrated to South America early in the 20^th century returned to replace retiring factory workers. Now that unemployment is on the rise, Japan is offering to pay the airfare for those who wish to return home.

Japan doesn't particularly want to import new citizens, but it doesn't seem to want to manufacture them, either. It's become harder to support a family on a single income, and young people are living at home for longer. And Japan isn't particularly friendly to working mothers—pre-K day care is not widely available, and the phrase work-life balance doesn't seem to have a Japanese translation. (The directory of the Japanese Business Federation, a showcase of old guys in suits, makes the Republican Senate caucus look like a Benetton ad.) The upshot: a chronically low birthrate. Too often, demographic change was described to me as a zero-sum game—rather than being seen as potential job creators, women and immigrants are often seen as taking jobs from men.

As Gross goes on to argue, Japan seems awfully passive about this and while there is certainly merit in discussing whether the size of the Japanese population is moving in the right direction it is the composition which really matters here. You only need to move back one entry here at this space get some kind of indication of the outlook for Japan's population composition. There is really no need to get into the whole discussion about whether economic growth is a goal in itself or whether Japan shouldn't have the right to conduct the policies it wants. Evidently, it has. However, for all those who believe that aggressive population management is desirable either be it through deliberate policies (a la China) or by simply allowing the demographic transition to run its course (i.e. Germany, Japan etc) they should also provide an answer towards the question of what to do with the market economy defined, as it were, by a social contract between generations, some form of paygo pension system, as well as a wide batch of centrally provided goods.

Gross' analysis is not far from the view presented in a recent article by me and Edward published in the summer edition of JapanInc. In this article, we argue that Japan is dependent on exports and that this dependence is a function of its age structure.

We also emphasise that Japan, for all intent and purposes, may be stuck in so far as providing a strong response towards the challenge of ageing;

While it is certainly true that the Japanese economy is currently struggling, it is not entirely true that there is no line of defense. Japan still has both monetary policy and fiscal policy tools at its disposal. The problem is that having spent a decade and a half attempting to fight the twin problems of deficient internal demand and ongoing deflation, the force of these tools has been steadily ground down. Interest rate adjustments, after many years when Bank of Japan (BoJ) rates have been held near zero levels, have little additional push to offer, while less conventional tools (like simply printing even more money via quantitative easing) or strong fiscal stimulus face clear limits in a country where gross debt to GDP is forecast by the OECD to hit 193 percent in 2009. So what can Japan do? Well besides simply grinning and bearing it, the tragedy is that there is not a lot that can be done in the short term. Evidently the Japanese government should give what support it can through highly targeted spending programs. The Bank of Japan, meanwhile, should be moving ahead with an aggressive policy of quantitative easing to provide as much relief as possible to Japan’s struggling households and corporates. But the only real way forward here is to try to slow the rate of population aging, and that means a change in national discourse and priorities, giving more support to those Japanese women who want to have children and radically changing the mindset about the extent to which Japan needs to promote an active immigration policy.

However, if we can all agree that the situation is difficult, it is hardly an excuse for not moving forward on the issues which ultimately will need to be adressed. Japan will need to foster a more conductive policy for increasing fertility as well as a substantial changed is discourse is needed with respect to immigration.

Japan’s consumer prices fell at a record pace in May, adding to the risk that deflation will become entrenched and hamper a rebound from the nation’s worst postwar recession. Prices excluding fresh food slid 1.1 percent from a year earlier after dropping 0.1 percent in the preceding two months, the statistics bureau said today in Tokyo. It was the sharpest decrease since comparable figures were first compiled in 1971.

Bank of Japan Governor Masaaki Shirakawa said last week that price declines will accelerate through the middle of the fiscal year as demand slackens and crude oil continues to trade lower than last year’s record. Retailers including Aeon Co. are cutting prices to attract customers as falling wages and the worsening job outlook damp spending. “Profits fall, then wages come down, then consumers stop shopping,” said Junko Nishioka, chief Japan economist at RBS Securities Japan Ltd. in Tokyo. “And because people aren’t shopping, companies lower prices. That’s the process that we’re starting to see. It isn’t easy to break out of.”

Now, you might think that this sharp decline has fuel/energy prices written all over it. In some sense this is true. In May, fuel prices registered its first annual drop in several months (-3.0% yoy) which clearly adds to the headline grapping number. Yet, the decline in prices in Japan is broadbased and although the -1.1% is clearly pushed down by a high base effect as we enter a period in which 2008 energy prices were comparatively large, the core of core index slid -0.5% which marks a change of -0.4% from the previous month. In short; the recession in Japan is beginning to push the economy into the dark hole it has spent nearly two decades trying to escape (and never really managed). The point here is not to harp about headline inflation and whether it will go up or down since we are clearly going to be in situation over the next couple of months in which headline deflation on an annual basis will skew the overall index downwards. But this is hardly the point since, as we can see, the core or core index is declining fast too which tells us that domestic demand pressures in Japan are clearly negative at this point in time and may remain so for as far as the eye of a trained economist should be willing to see.

Japan may be sinking into deflation that will undermine the nation’s rebound from its worst postwar recession, the Cabinet Office’s chief economist said. Deflation “will exert a significant amount of downward pressure on the recovery,” Jun Saito, an adviser to Economic and Fiscal Policy Minister Kaoru Yosano, said in an interview yesterday in Tokyo. “An increase in deflationary expectations will raise real interest rates and that will restrain business investment.”

Consumer prices excluding fresh food dropped a record 1.1 percent in May from a year earlier, the statistics bureau said today, spurring concern that the economy is slipping back into the deflation that plagued the nation for a decade until 2005. “Declining prices will mean lower profits, less investment and wage cuts that will weaken consumer spending further,” said Hiroshi Miyazaki, chief economist at Shinkin Asset Management Co.

So, where do we go from here you might ask. Well, this is exactly the issue; there isn't a whole Japan can do at this point but to try to position itself in the best possible ways for exploiting the global green shoots through exports. However, when it comes to the domestic economy deflation is an inbuilt part of the edifice.

Today, we're fortunate to have Eiji Fujii, Professor of Economics at Tsukuba University as a guest blogger.

Shaken by the world financial crisis, Japan has recorded the first trade deficit (on the April-March fiscal year basis) in 28 years (see Figure 1). The trade balance of the 2008 Japanese fiscal year was about -725 billion yen. The last trade deficit (on the fiscal year basis) was recorded in 1980 when the second oil crisis hit the economy hard.

Shrinking demand overseas, particularly in the US, is clearly the main factor in this development. However, the unique status of the yen as a safe haven in the midst of the global financial turmoil can also be held partly responsible. In the initial stage, the fact that the Japanese financial sector did not have much presence in international markets worked in Japan's favor as Japanese financial firms had relatively little exposure. However, the irony is that temporary safe haven effect caused a steep appreciation of the currency (see Figure 2). This added further impetus to the decline in Japanese exports already being driven by rapidly diminishing demand around the world for Japanese goods.

It is no surprise to see the Japanese exports to the US and EU plummeting following the financial crisis. But a body blow to the Japanese economy came from the substantial drop of its exports destined to other Asian economies (See Figure 3). Some of these exports may have the US and Europe as their final destinations.

Are the Japanese welcoming the resolution of the long time trade imbalance -- lending overseas too much too long? Clearly not at the moment, when the domestic demand remains rather fragile.

Post written by Eiji Fujii.

Meanwhile and here in Denmark things are definitely getting better. After a March of cold and lots of rain April the Easter days have, in particular, blessed us with a fabulous couple of days of sun and (relative) warmth. I doubt that the Spring is more beautiful anywhere else in the world than in the North mostly because the change in scenery is so striking. Judging by a number of recent analyses, comments and data points it is hard to escape the feeling that perhaps, just perhaps, markets are also feeling a bit of spring sensation too even if the signs are most tentative.

Europe, Still not Ready to Take Off

Starting off in Europe, Morgan Stanley's Elga Bartsch recently engaged in bottom fishing where she essentially voiced the sentiment that although the h01 outlook is grim the data is paving the way for a recovery in h02. To support her argument ms. Bartsch fields data on forward looking indicators such as output plans, the so-called Surprise Gap Index, and the (in)famous second derivative which has set in with respect to demand for orders. Generally though, there is plenty of juice for those who carries a more pessimistic approach. A couple of days ago, the Bank of Italy opted to lift the curtains a little bit on what is certain to be an abysmal Q1 GDP reading; as if it was not enough that Italy suffered that dreadful quake over the Easter. Over at Kaiserstrasse, the messages are getting more "interesting" by the day too. Consequently, Nowotny who heads the Austrian central bank noted that although he did personally think the interest rate should go below 1% it was, of course, open to discussion. Bloomberg interprets it as a sign that the council is split which may of course be the case, but on the other hand I also think the ECB is slowly but surely preparing markets for moves which will take the bank into an area where most believed it would not go. For example, Nowotny explicitly noted the option for the ECB to enter the corporate debt market.

“If you’re aiming at intensifying credit supply, measures which focus directly on credit supply are of interest,” Nowotny said. “For example the purchase of commercial paper, corporate bonds and similar things.”

Such moves would mean that the ECB moved in behind the Fed and the BOJ who have both been supporting credit markets through the purchase of commercial paper (A1 grading in the case of the BOJ) for some time. 

Also the Dutch representative in Frankfurt Noel Wellink voiced a similar sentiment when he noted that the Eurozone would be likely to experience negative price movements in 2009. Mr. Wellink pointed out that there is room to lower interest rates beyond its current level and that other measures could be deemed necessary too. One can only speculate what such measures would be, but something along the lines suggested by Nowotny is probably not far off.

More generally, the situation in Europe is not only tainted by the obvious crisis in EU-15 and the Eurozone, but also very much so by the lingering mess in Eastern Europe. In real economic terms we need to remember that there is indeed a strong link between the Eurozone and the CEE not least in the context of Germany's obvious dependence of exports to the Eastern European economies. Moving to financial markets we also know that many banks in EU-15 are heavily exposed to the whims of the CEE. Obviously, the new mandate for the IMF in the form of capital injection it was handed at the G20 summit will help in the strides to present a workable solution many of the most exposed countries' trouble.

The US, Tiptoeing Analysts

With regards to the US the second derivative discourse is being advanced much more timidly especially in light of the fact that payrolls once again posted an abysmal showing in March which suggests that the real economic slowdown is intensifying. 

Still, some are convinced that the near term at least may indeed bring a bit of spring sensation. Consequently Swiss investment icon Marc Faber was quoted by Bloomberg of saying that the SP500 might rise as much as to reach the 1000 mark within the next three months. If this prediction turns out to be a truism it would mark the biggest so-called sucker rally so far in this crisis and surely one worth pursuing by investors. Faber only, it has to be said, makes a short term forecast based on the fact that since the government (through the new PPIP) essentially is giving away free money and since the Fed seems to committed to reflating the economy companies may have a sound short term earnings horizon. For the equity strategists among you, this is Faber's contention;

“The market very near term has become somewhat overbought and the correction should essentially follow, but I doubt it will go and make new lows in the intermediate future,” Faber said. “The lows in early March at 666 in the S&P will hold and we’ll have another push up into July

With respect to a long term view I attach considerable significance to the report out yesterday that fundraising by US venture capitalists fell by a whopping 39% last quarter as investors understandably chose to shun these investments. The story is pretty straightforward in the sense that startups are literally not finding the same finance opportunities as before and this essentially mean many of them don't make it. Such is of course the darwinian nature of finance, but one wonders whether in fact there wasn't some genuine sound positive NPV projects sacrificed on the altar of the PPIP et al. Whether this is true or not one thing is certain, this kind of investment used to be the hallmark of the US economy and although one can't hardly make any kind of inferences based on this figure alone, seed capital for venture capitalists is probably a part of the macroeconomic investment activity which yields the strongest positive externality with respect to productivity growth (empirical studies anyone?).

As for the overall sweep in terms of a macroeconomic snapshot we can do a lot worse than visit Morgan Stanley's Ted Weiseman and Richard Berner and their respective analyses. If anything Monsieurs Weiseman and Berner seem set to debunk any talk of the second derivate, something which Weiseman addresses specifically when he says;

The key round of early economic figures for March released over the past week was uniformly terrible in absolute terms, though somewhat mixed directionally. A particularly bad employment report stood out, however, against directionally mixed ISM surveys, though with both remaining well below the 50-breakeven level, and some improvement, though to a still-dreadful level, in motor vehicle sales. Weakness in other data, notably in the construction spending and factory orders reports, also pointed to a weaker trajectory for 1Q growth, and we cut our 1Q GDP estimate to -6.0% from -5.1%.

So; Morgan Stanley, for what is worth, is cutting their growth forecasts for the US economy and if you have the stomach for a thorough parsing of the recent US data, Weiseman is the place to go. If Weisman implicitly tried to shy away from the second derivative punt, Berner is very explicit. His main point is consequently that while markets (equities in particular) are embracing the idea of a positive second derivative the recession does not look to be any less sharp and long than it did when we entered 2009. In this respect, I think that the talk of a recovery in early 2010 is largely irrelevant since we need to calibrate first what exactly we mean when we talk about a recovery. If positive or neutral growth is the criteria so be it, but I hardly think that we will be back to normal in any sense of the word.

Asia, a Chinese Conundrum and Japanese Debt Woes

If I am fairly certain that we are not standing before an impending recovery in Europe or the US recent data from China seriously prompts me to consider whether in fact the great tiger is ready to pounce and perhaps save the global economy in the progress. What has caused a lot of commotion was consequently that the Chinese PMI for march actually rose above 50 which indicates expansion. Or did it? As Edward details here there has been considerable confusion over which reading to use, but that did not deter Bloomberg to narrate China (and its recent stimulus package) as the economy to pull its global peers out of the current mire. Add to this that industrial production clocked in a healthy 8.3% increase in March and you get plenty of ammunition on which to build a recovery and even rebalancing story. Of course, this is all a bit of a lame, ermm, Peking duck I think [1] since as Brad Setser eloquently points out with great force, recent trade data indicates that imports are declining more rapidly than exports which makes the fact that exports are not declining more slowly rather innocuous. This is also a point Edward uses to neatly summarize the overall message;

(...) with a growing surplus (at this point, and on a year on year basis) China's economy isn't going to pull the rest of the world anywhere, since essentially it is still draining-off demand from elsewhere.

For more on the recent, mystifying, data from China Pettis' latest tour de force is a fine piece of work and of course Bloomy itself proxied by Kevin Hamlin takes some of the sting off of the bullish China story with today's piece about cooling Chinese growth.

Meanwhile, in Japan things continue to look murky. In particular it seems that investors have realized the growing debt burden of the Japanese society at the worst of times since now would really be a nice time for investors to allow Japan to seriously turn on the fiscal stimulus machine. Of course this is not possible and as we learned recently that while observers certainly realize that the proposed stimulus package by PM Aso totalling some $153 billion will mitigate the situation in the short term, it will also serve to make the future debt burden even more unsustainable. Also do note, that the discourse of Japan's ageing population is popping up all over the place in relation to the immediate short term outlook which suggests to me that we may be close to an inflection point. Basically, yields are beginning to climb for the MOF as it attempts to issue paper to pay for the politicians' plan and it appears that yields, at least in part, are driven by the obvious problem Japan will have in servicing the liabilities as we move forward. This means that the BOJ will have to seriously contemplate how to inflate their way out of this one since this is really the only solution, barring of course that everybody else realizes that this is what Japan has to do in order to avoid deflation. It is of course this last part which is the niggle and which will cause much debate as we move forward. My guess is that we will soon see a BOJ not only buying up short term paper, but indeed trying to manage the whole yield curve.

All this is not without consequences for the JPY, and it is difficult not to concur with Macro Man's Easter poetry styling that it may very soon be raining yen. Meanwhile, the spring sensation in markets is not passing by the JPY either as Bloomberg serves up one of those familiar headlines that the JPY is weakening while the AUD, NZD et al. are strengthening on the back of a heightened appetite for risk.

“There’s some optimism in the markets, which supported yen selling,” said Hidetoshi Yanagihara, senior currency trader at Mizuho Corporate Bank in New York.

This sell JPY on optimism punt is something I have dealt with extensively here at Alpha.Sources not least in the context of this working paper. I recently had a look at the paper and realized that it needs a thorough re-write. So this is, in part, what I am working on at the moment. Of particular interest is the fact that I am trying to model the currency pairs (not the stock indices) as a function of the VIX which has so far given me some quite interesting, if of course entirely intuitive, results. In short, stay tuned on this one.

Spring Time?

While there is still plenty of bad news to focus on, it certainly seems as if markets just as well as Denmark may now be entering a more mild season. Spring in Denmark, however, is known to be extremely volatile. If the Easter served up a nice sunny abode the next week may be rainy and even snowy. One has to think that the same reasoning can be applied to the newfound spring sensation in markets. Far be it from me to take away the punch of the bulls out there, but I would simply note that the fundamentals have not changed one bit since the crisis began. Deleveraging is only begun, unemployment is bound to rise further, and all parts of the real sector are stretched to the limit with respect to spending capacity. Add to this that everyone wants someone else to do the spending for them and you end up with a recipe for a long hard walk upwards. Perhaps it is the second derivative punt that is being misunderstood. Evidently, we were always going to see this effect given the almost cataclysmic way in which all economic data points and indices suddenly cratered. However, the point is not so much whether we are still on our way down (which I think we still are), but more so how long we will stay down and how far we will move back up from the mire and indeed who will be able to lift their economies within a reasonable time frame. It is here that I am still fundamentally pessimistic. Consequently, I too am enjoying Spring time, but as a Dane I am well taught not to get my hopes up.

---

[1] - Sorry

As for the Economist, they are not quite convinced that the story of Japan is also a story about export dependency and thus that this has something to do with demographics. That does not surprise me since the Economist's has, on several, occasions attempted to debunk this argument. Here I won't take directly issue with this claim but rather indirectly by scrutinising the following argument by the Economist; 

The OECD predicts that public-sector debt will approach 200% of GDP in 2010, so the scope for further fiscal stimulus will be limited. Nor can Japan rely on exports for future growth; to the extent that it had enjoyed an export bubble, foreign demand will not return to its previous level. Japan needs to spur domestic spending.

One possible option, which the government is exploring, is to unlock the vast financial assets of the elderly. Japanese households’ stash of savings is equivalent to more than five times their disposable income, the highest of any G7 economy, and three-fifths of it is held by people over 60 years old. Gifts to children are taxed like ordinary income, but if this tax were reduced, increased transfers could boost consumption and housing investment since the young have a much higher propensity to consume. In theory, this could give a much bigger boost to the economy than any likely fiscal stimulus.

Of course, one reason why the elderly are cautious about running down their assets is concern about the mismanaged pension system and future nursing care. Services for the elderly should be among Japan’s fastest growing industries and create lots of new jobs, but they are held back by regulations which restrict competition and supply. Deregulation of services would not only help to improve the living standards of an ageing population, but by helping to unlock savings might also drag the economy out of deep recession.

The key to notice here is that the Economist talks about unlocking the savings of Japan and thus about making those large coffers of assets, primarily held by the mature parts of the population, work. What is Particularly interesting here is the idea to move money from the wealthy old generations to the young and further to implement tax incentives to optimize the effect from this. This sounds intuitively right and seems a sound policy proposal. But there is a big difference between transfers in kind (bequests) and investments (see Molinas' article).The Economist seems to be talking about cutting taxes for transfers in kind which would increase consumption in the sense that that the propensity to consume is higher amongst younger generations. In principal I am not in disagreement here although one has to wonder whether in fact those ever smaller younger generations really do have such a high propensity to consume. Basic ricardian equivalence and life cycle theory suggest that these transfers would be saved just as much by the young as by the old in the sense that as the young cohorts grow ever smaller relative to the burden they have to support through the tax system they also need to start saving earlier (and more) for their own retirement However, the most important point is that the Economist's suggestion effectively amounts to rapid dissaving and, in fact, even more rapid dissaving than if the elderly cohorts were to spend their wealth themselves.  Note that this would effectively be dissaving and thus effectively not a good thing for Japan in the sense that it is not easy to see how Japan would replenish these savings. Moreover, as I have argued time and time again societies do not dissave they same way as their microagents do since this would effectively amount to a society/economy having an end point. Rather, they need to make those savings work.

Enter the article by Molinas.

Now, I could say a lot of interesting things about Molinas' piece and especially about how to operationalize demographics (and deflation) through the use of that illusive subjective discount rate. Essentially, this would allow us to approach the issue through the use of representative agent models and even though this may create a host of issues on its own and essentially be inappropriate, it means that we can start with a model well grounded in traditional neo-classical methodology. This may not be a virtue in itself, and for some not at all, but it is a place to start and an important one in the context of economic modelling.

Anyway, and moving on to the issue at hand there is an important twist in the way Molinas approaches the issue of lack of domestic demand (and thus deflation). Let us look at the following;

Taxation may be the best instrument for fighting deflation in the long run. At the core of deflation lies the problem of elder generations keeping their wealth away from entrepreneurial undertaking. A severe inheritance tax combined with a generous gift tax may reshape the battlefield of the war against deflation in a very favourable way, moving the focus inside households. Aging societies should try hard to mobilise their wealth. The best way of doing so may be establishing strong tax incentives for elders to transfer wealth to the younger generations while they are still alive.

It is important to note the distinction, albeit timid, with the Economist here.

Molinas' suggestion is consequently different in one key aspect. What Molinas suggests is that the eldery be more inclined to invest in the younger generations and that this this is pushed through e.g taxation on stashed savings. Basically, Molinas talks about mobilising the wealth and that this is invested in the (assumed) portfolio of profitable projects held by the younger cohorts. Like the Economist, Molinas talks about using taxation (or the lack thereof) as a weapon and actually my guess is that when Molinas talks about a more generous gift tax he is talking about the same thing as the Economist is.

Now,I am of course molding the arguments of the Economist and Molinas to fit my own agenda here but I still think that a clear message can be taken from these two pieces. Whether it be through transfers in kind or through investment Japan should attempt to channel the vast sum of wealth towards its younger generations in order to make the money work in stead of just sitting in deposits and under the mattress.

At this point, I am intrigued, very intrigued. Consequently and while these two contributions sound plausible they miss some crucial points. As for the Economist, I have already highlighted the fact that Japan is going to fight dissaving simply because they have to. This may sound rather unjust to simply wave off the argument like this. But we should also think about the fact that for Japan as an economy these savings are best mobilised if they are invested to earn a corresponding return [1]. In short, we will see dissaving but it won't solve any of Japan's problems to transfer older cohorts' wealth to younger generations for them to spend.

Moving on to Molinas he goes for the capitalist solution as it were; go forth and invest in the Japanese entrepreneur! This is a very appealing proposal, but tell me something; where are these entrepreneurs again, how many are they and what is the capacity for the young generation to absorb all those savings with the aim of delivering a return that can help Japan generate the income it needs to increase domestic demand and subsequently rid itself of the dreaded deflation.

I am almost done now and in order to move forward on this it is important to realize one major point about the arguments presented above. They are both made in the context of a closed economy. Whether it is in the form of transfers in kind or investment flows both the Economist and Molinas argue within the boundaries of Japan moving money from the elder to the younger cohorts. In doing so however they miss, or neglect, the fact that ageing as a demographic process manifests itself through changes in the age structure of society and thus that the kind of transfer they are talking about are not viable simply because the mismatch between generations is too great (and will grow larger as we move forward). Moreover, and even though it would in principle be possible for Japan to do as proposed above, it would not be rational let along fruitful from the point of view of fighting the slump in domestic demand.

So where do we go from here?

The crucial link to incorporate here is to allow Japan the possibility to trade with the rest of the world. Then I don't think it is implausible to imagine that Japan indeed will fight dissaving through investing its stock of savings, but that this has to be through a leakage. Quite simply, Japan can increase consumption by investing its wealth abroad for a higher return than at home as well as by maintaining a structural excess investment surplus towards the rest of world by letting domestic capex and production decisions respond to foreign in stead of domestic demand (at least on the margin). This finally means that the way Japan as an economy can fight off dissaving and attempt to battle deflation is to rely on the ability to keep a structural surplus towards the rest of the world.

Once we have established this point we can start to look at the real issue at hand here. What happens when everybody gets as old as Japan is now? Think global imbalances and the discussion we are having right at this moment about how to find a batch of economies with the ability to run a sustainable deficit to counter others' need to run a surplus. Basically, there are externalities at work here and essentially market failures. These are produced, in part, by ageing and since we know for sure that one country after the other will venture down Japan's road in terms of demographic structure we would be wise to give these points more than a scant thought as we move forward.

---

[1] Here we could of course also open the can of worms in the form of Japan's public debt and how, at least part, of those well earned savings need to be put aside in order to finance the deficit spending by the government which again is only set to worsen as Japan gets older (and on and on we go).

For the moment, I'll take the middle ground and venture that having shed an awful lot of aggregate value (an entire year of global GDP according to the ADB!), we're a lot closer to where we're going than we were.

It may come to a surprise to my readers given the traditional very bearish sentiment expressed at this space, but I actually agree with Buttonwood and Cassandra here. However, I would simply add the important qualifier that there will be a significant asymmetry in terms of where individual economies are going as a function of where they are and were. No where is this more true in the case of Japan and as we progress to the data and analysis it should be abundantly clear that for all the talk of second derivatives and glasses being half full, Japan still look to be in an extraordinarily bad shape. Initial evidence of this comes from the headline GDP figures which don't seem to be blessed with any second derivative effects.

Final estimates from Q4 2008 suggested that Japan contracted at an annualized 12.1% which puts Japan in the dubious pole position of biggest GDP declines among industrialised economies. Q1 estimates are yet to be released, but no-one expects, I think, an improvement as the incoming data so far has been nothing but extraordinarily poor. Sociétè Generale expects Japan to contract sharply in 2009 with Q1 as an forecast bottom. I am not sure about the bottom in the sense that while it may be a bottom in the sense of the second derivative noted above, it won't likely mark a return to sustained growth.

In this note, I will provide an overview of the recent developments in the Japanese economy. Since we last convened some interesting points have emerged. For one, Japan is back in deflation measured on the US style core price index and for the first time in a very long time Japan is now running a current account deficit. This last point will be studied in some detail since it marks a very important issue for the export dependent Japanese economy both in a historical and a current perspective. Before we begin I should note that this post is very big with a lot of graphs and even an econometric model to boot. I understand full well if this deters some of my readers; I shall not hold it against you.

Prices and Consumption, where art thou?

If there is one thing which has been stable in Japan throughout this crisis it has been the persistent sluggish trend in domestic demand measured by top line household consumption expenditures as well as prices on the other hand. These two data points consequently tell an important part of the story of the lack of domestic demand in Japan or more specifically the lack of visible momentum to pull Japan out of the doldrums. One persistent feature of the initial phases of the crisis where markets and global policy makers primarily looked towards the risk of stagflation was that inflation in Japan exclusively was driven by cost-push factors in the form of headline inflation and not demand pull factors. This idea is a well established one at this point, and materialised itself in the fact that as headline inflation shot through the roof core inflation only budged slightly. It is important to point out that this inelasticity cuts both ways and as headline inflation has abated (for now), so has the spread between the two indices narrowed significantly. The underlying point here is thus two-fold. One the one hand it is dangerous to assume that inflation driven by domestic demand conditions will correlate with external headline inflation pressures which, due to global capacity constraints and global demand conditions, look set to shoot higher the minute we move even slightly beyond the current malaise. On the other hand however, we can clearly see, in Japan, that whatever trend we see for headline inflation domestically induced price pressures in Japan are virtually non-existing and now that the crisis is seriously biting Japan is set once again to retrench into deflation despite the central bank's most ardent efforts to apply measures of quantitative easing.

As I have argued before, I believe a large part of Japan's problem with deflation is demographic. In particular, I think that because Japan is basically unable to achieve growth based on domestic momentum a growth scenario strictly based on domestic activity as the one we are seeing at the moment will be de-facto deflationary. However, since Japan is largely dependent on energy imports in so far as goes its consumption of fossil fuels (i.e. a high passthrough effect) the overall inflation indice will diverge from the core of core index which, in Japan's case, is a good proxy for domestically induced price pressures. Now, I realize that my readers will be skeptical of the demographic link here, but let me at least present results that show the broken link between the general price index and core of core prices (which exclude energy and food). Thanks to a novel data set from Japan' statistical office giving us monthly inflation rates (y-o-y) for all three recorded inflation indices since 1971 we have plenty of ammunition on our hands to proceed. In the following all numbers will be based on de-trended time series which in this case simply means that I am using the first difference.

Consider then the very simple representation below which shows the correlation between the general index and core of core index over the entire sample, from 1971-1996 and from 1997-2008. 

Turning briefly to the consumption expenditures and thus the state of the Japanese consumer it really is (un)steady as she goes. Some analysts have expressed the opinion that the Japanese consumer has held up alright up until this point in the crisis. I am not sure what data these analysts are looking at. All I know is that the headline figure for consumption expenditures is still clocking in one negative number after the other and in this light it is difficult to see from where the much awaited boost in domestic demand is going to come from; note for example here that autosales dropped a healthy 27.9% in January. Add to this that retail sales dropped 5.8% on an annual basis with the subcomponent and you have firm evidence of a slump.

To be fair, the latest reading on consumer confidence did show an uptick in February compared to January as well as the economy watchers index which measures the performance of non tradables showed an improvement, but the accompanying comments from analysts on the ground do not provide much comfort for the outlook where most domestic companies are preparing their operations for a tough recession. Ken Worsley parses the entrails of the consumer confidence report and notes that the slight increase in the willingness to buy consumer durables is a welcome sign although the overall picture is weighed down by a mounting insecurity over job safety and thus income.

Investment, huddling up for hibernation?

If the charts for consumer spending shows us that the Japanese consumer is performing decidedly worse than past years' mean, the corresponding charts and numbers of industrial production and industrial orders resemble clear depression tendencies.

It is important to note the difference between the plots above. Consequently, what we are seeing in Japan at the moment is especially a massive slump in manufacturing and industrial production dragged down by the sharp drop in external demand. In this way, the export sector so important for Japan's growth is inexorably tied together with industrial production. In the last post the graph did not include Q4 2008 and as is readily clear from the charts above Q4 08 was the breaking point for Japan (and most others too).

This picture is confirmed if we look at the monthly reading. Since the data graphed above is from the METI, the data is lacking relatively to the present in that we only have data up until January 2009 (for the monthly chart). However, just look at that line go as if it is being pulled down by gravity itself. Needless to say that the overall index is being dragged down here even if the tertiary index, which accounts for 3 times as much as industrial production in the overall index, is holding up quite well. On an annual basis, industrial production dropped a full 31% in terms of production and 31.6% in terms of shipments. Inventories decreased on a monthly basis, but are still well above their 2000 levels which makes me wonder what kind of information the analysts claiming that Japanese companies had comparatively low inventories going into this were looking at. As for the small bounce in tertiary industry postal services seem to be the main culprit increasing with a full 11%.

As for the link between manufacturing and exports, I am going to let Danske Bank's analysts do the heavy lifting and display their wonderful graph plotting industrial production and exports.

I don't think this requires much interpretation and the main points is well articulated by Danske;

In Japan, manufacturing accounts for about  22% of GDP compared with just 17% and 12% of GDP in Euroland and the US, respectively. For that reason, there is a larger negative secondary impact on particularly investment demand from the recent collapse in global trade and industrial production.

The outlook here is thus completely dependent on where you think global growth is heading. Given the increasing indications that the slump will be prolonged the outlook is bleak. Of course, and coming back to that dreaded second derivative the decline will stabilise at some point, especially as inventories are cut. Yet, the key is the extent to which it will recover to anywhere near past levels. Surely Japan will be ready when the world is about to take off again but there is a lot to suggest that the margins on export led growth will be a lot thinner than they are now since everybody seems to be in the midst of a transition towards the same growth strategy. In this light it seems as if Japanese manufactures may indeed be tucking themselves in for a prolonged hibernation.

Evidence to suggest this came recently from the hands of Morgan Stanley analyst Takehiro Sato who had an excellent analysis looking forward to the upcoming Tankan survej of Japanese industry. The key is that companies are expected to revise down their capex and investment plans drastically. Finally and just to show that the crisis has had a notable effect in the market too just watch the absolute horrible performance of the main Nikkei index.

I am no equity analyst so I shall not belabour this point a lot, but merely note my personal inclination to disregard Japan in terms of the global market portfolio (beta) and in stead going for some alpha through stock picking which is obviously possible even if the overall trend is inexorably down. Go for the ones with exposure outside Japan is my advice, but that should be taken with a couple of truck loads of salt and I am ready to stand corrected any time by those much smarter than me in terms of trading equities.

The External Sector, Wither Growth

Perhaps one of the most interesting news points to come out of Japan since we last convened was the news that Japan had entered a current account deficit for the first time in a long while. This is significant for a number of reasons. First of all, it shows us the extent of the slump in that the trade balance balance has swung so fast and so much into negative territory. However, as I have argued endlessly we also need to look at income and here Japanese savers have been extraordinarily well endowed. Thus I also think that there is a technical issue to deal with here in that the income balance is likely to have swung into negative on the basis of the appreciation of the JPY we have observed in the latter part of 2008 and into the first months of 2009.

The CA deficit is not visible on the graph above but it does not take much imagination to see where the lines are going; especially not since we recently learned that Japanese exports dropped a whopping 49% year on year in February as shipments to the rest of world almost stalled completely. 

Needless to say, the move of Japan's current account into deficit territory has sparked all kinds of interesting points not least in the context of Japan's impending forced rebalancing. It comes to no surprise to me that the Economist was the first to jump the gun hailing Japan's rebalancing act.

Japanese households used to be among the world’s biggest savers and, as a result, the country ran a massive trade surplus. But no longer. They now save less of their income than American households, and Japan’s trade balance moved into deficit last year (see top chart). A long-overdue—and painful—economic rebalancing is under way.

To be fair to the Economist, they do make the important qualifier that since the external balance is coming due to a collapse in external conditions rather than a shift in actual growth path it may not be exactly what the doctor ordered. Yet, the Economist also applies standard life cycle theory to suggest that as Japan grows older so will we start to observe dissaving on aggregate and thus predicts, like all those famous economic steady state models, that Japan according to theory should be running a current account deficit. I think this is way to simple and in order to move forward on this field some important adjustments need to be made to Modigliani's life cycle hypothesis and, crucially, how it applies to aggregate economies. A lot of the confusion arises in the context of Japanese households their low savings rate and the fact that Japan exactly seems to suffering from a dearth in consumption (domestic demand) and surplus of savings. In a recent piece by the New York Times this view is articulated pointing towards the obvious effect that when you have no domestic demand of any meaningful proportion you become de-facto dependent on external demand. However, Stefan Karlsson retorts that low consumer spending in Japan is the result of low growth and not the cause pointing to the historically low household savings rate in Japan.

The plot thickens and at this point we simply need to get some data on the table to see what is actually going on. As a first stab let direct the attention to three crucial issues when applying individual life cycle theory to aggregate outcomes. First, you need to distinguish between working and non-working households as the savings dynamics are bound to differ markedly. Moreover, you need to incorporate some kind of uncertainty buffer to adjust for the fact that the transversality condition does not hold and thus that consumers do not dissave to 0. Secondly, you need to look at the overall stock of savings as well as the flow to increase or decrease this stock. This is very important relative to the measure of the saving rate out of disposable income. Thirdly and intimately related to point two you need to look at the evolution of income and the change in the stock of saving relative to the change in income. With these points in mind, let us consult the data. 

The first graph shows the evolution of annual income and the stock of savings and it represents an important picture since it shows us that Japanese households are indeed sitting on a large pile of savings measured as a stock even if as Scott Peterson showed us recently it is dwindling which indeed constitutes a worrying trend. The key point is of course what to do with those savings. Sure, one can spend them and dissave which is what would happen in a closed economy, but in an open economy the dynamics are likely to be strikingly different. Basically, this stock of savings represents a structural excess of savings on a stock basis and one of the only ways to make it count is to transfer it into income by investing abroad or by investing in export oriented domestic industries [1]. This is the only way that this saving can be transferred into investment and then into income. Consequently, Japan does suffer from a a chronic lack of domestic demand and consumption and it does so exactly because relying on consumption with the current demographic profile is not viable. Persons dissave, but societies do not since they don't have an end point or at least, a market economy has every interest in fighting off dissaving through the leakage of exporting excess saving. In this way, all the opinions introduced above get it wrong I feel because you really need to incorporate realistic assumptions on demographics. Take Mr. Karlsson's suggestion that Japanese households save more? Out of what I ask and assuming that these savings should be accumulated to invest later where would you invest it? At home (to what return) or abroad? This is exactly the key point since moving towards the NYT and their implicit narrative that Japan raises consumption the simple question is that she can't and understanding precisely why this is and what this means for the global economy is absolutely crucial. I shall spare no chance in pointing out this again and again.

Thus, if Japan wants growth it needs to make those savings count and oh boy have those Japs made it count.

Y = C + I + G + X and by definition net national savings defined as Y - C - G = I + X where X is the CA balance. [2]

“Japan’s toxic assets are essentially equities and any pick up in stock markets will be more significant for improving tier one capital,”

The ultimate dilemma for the government/BoJ is that, while a half-hearted fiscal expansion may fail to overcome the downward spiral of the economy, an overblown version risks depressing market confidence in the fiscal policy.

---

[1] - the observed decline in home bias among Japanese investors is an important part of the picture here.

[2] - Readers with basic mathematical inclination will notice that expressing the spread between investment and net exports and foreign asset income as the addition to national savings from external demand, is just a detour of expressing the current account balance as a share of GNI. Thus basic algebra gives;

I/GNI - I+(X-M)/GNI = [I - I + (X-M)]/GNI; (cancelling out the I's) gives (X-M)/GNI.

The annual rebalancing of the Russell/Nomura Japanese stock indexes just concluded, resulting in more than 30% turnover rates for each series in the benchmarking family.

The Russell/Nomura Total Value Index had 212 deletions and 176 additions, while the Russell/Nomura Total Growth Index had 270 deletions and 136 additions.

There are Japanese stock exchange-traded funds from Barclays Global Investors' iShares family, Northern Trust's NETS and from WisdomTree Investments.

JPP and JSC are relatively small ETFs in terms of assets. JSC had close to $73 million in assets through last month while JPP had only $13.5 million.

Among all single-country international ETFs this year, those focused on Japan have held up relatively well in terms of performance. JPP was down 32.15% heading into Monday, while JSC had dropped 23.99% so far in 2008, according to Morningstar data.

That may not seem like impressive performance on the surface, but consider that the broad-based iShares MSCI EAFE Index (NYSE: EFA) for developed international markets has slid more than 45% this year.

The Russell/Nomura Prime Index, which is JPP's index, measures the performance of Japan's top 1,000 float-adjusted stocks. This year, 26 companies came into the Prime Index for the first time and its total market capitalization decreased from 201 trillion yen to 200 trillion yen (as of Oct. 15).

The turnover ratio of the index was 1.6%, which is relatively low compared to previous years, the companies said in a statement.

The number of stocks in the Russell/Nomura Small Cap Index, JSC's underlying index, dropped by 76 companies to 1,100. The small-cap index represents the top 85% and bottom 15% of the Russell/Nomura Japan Equity Index, on a market capitalization basis.

The decrease in JSC's index reflected the larger decline in the capitalization of small-cap companies relative to the overall market decrease.

It is not as if financial markets are short on action at the moment, and financial pundits and analysts are certainly being served an ample amount of ammunition from which to draw inspiration. In this light, I am sorry to report that your author here at Alpha.Sources is still crippled by a lack of stable access to the internet. Not unlike the issue in financial markets and the global economy the problem with the apartment in which he is housed has appeared to run deeper than first assumed As such, the attempts to secure stable access to the World Wide Web have so far been futile. Here is to hoping that I am will be up and running some time this week.

Another thing which does not seem to be running at the moment (apart from the entire global financial edifice that is) is the market for samurai bonds which are yen denominated bonds issued by foreign entities in Japan. Or more specifically, after Lehman’s default many observers have voiced concern that this might effectively blunt what has hitherto been a very sharp business for both issuers and investors.

I have been writing about the samurais before not least because the market for these instruments has been growing tremendously [1] , but also because the capital flows epitomized by the samurais represent an important example of how an ageing economy such as Japan is a net provider of global credit. Coupled with the thesis of decline in Japanese investor’s home bias, the increase in issue of samurai bonds represent an important case study of the symbiotic relationship between old capital intensive and most importantly yield hungry economies and young economies in need of capital. Obviously, the distinction between old and young here is rather crude and as such, one big theme for the samurais in the past year has simply been the manner in which foreign financial institutions have sought Japanese capital due to the relative calm of capital markets in the kingdom of the rising sun. However, from a fundamental supply and demand perspective, I have also shown how the Samurais can be seen in a wider perspective of the necessity of Japan’s savings to go for yield.

In this way, I think that the structural driving forces for the continuing build up of samurai bond assets are quite strong. However, this does not mean that the collateral from the credit crunch will go unnoticed.  

The sudden questioning of the future of the market for samurais is thus not surprisingly closely tied to the almost cataclysmic events in the US financial sector. More specifically, the dramatic demise of Lehman Brothers marked the first spectacular default on a major portion of samurai bonds. As for the actual figure it seems that even Bloomberg has some difficulties delivering a feasible point estimate, but in the region of USD 2 bill worth of samurai bonds outstanding seem a reasonable guess. Given the fact that Lehman is defaulting entirely on its outstanding debt, it has naturally cooled the sentiment of its Japanese creditors somewhat. Tetsuo Ishihara from Mizuho Securities Co. pinpointed it well when he said that; (courtesy of Bloomberg) 

``It will be difficult for independent investment banks to sell samurai bonds after this,''

Of course, with investment banks out of the picture entirely there may not be much need to worry, but the underlying point should indeed be taken seriously. Aozora Bank Ltd., Mizuho Financial Group Inc. and Shinsei Bank Ltd were the biggest of Lehman’s Japanese creditors and in terms of the last of the three, credit default swaps rose 150 basis points as the Lehman bust became reality. Initial reports from the Japanese lender furtthermore suggest that the exposure has cost dearly. So far, the butcher’s bill indicate that net income may decline as much as 80% on the back of the exposure to Lehman.

``These figures leave a very bad impression,'' said Hiromichi Tsuyukubo, a hedge-fund manager in Tokyo at Myojo Asset Management Japan Co., which oversees about $150 million. ``The 38 billion yen to Lehman was already announced but the size of the downward revision is much bigger than expected.''

The sentiment in the wake of the collateral damage has not gone without notice on the supply side either with Deutsche Bank recently shelving plans to issue samurais until markets, or in this case required yield premiums, have found a more calm level.

Once Bitten Twice Shy?

Japanese savers may need yield, but they are not stupid and in general, I would presume a pretty careful bunch (in relative terms). As such, and while it seemed at some point that Japan’s savings not unlike Chinese, Middle Eastern and other SWF money rollers together would bail out the entire US financial system Japanese bond investors may adopt a once bitten twice shy mantle on the back on Lehman’s collapse. This need not however increase Japanese investors’ risk aversion in general and the decline in their home bias in particular. Or as Bloomberg’s William Pesek notes in one of his recent columns;

One reason Japanese banks bet on foreign names like Lehman has been their inability to get domestic consumers to borrow more. It's a key dynamic restraining growth. Fixing it will require hard work from all facets of Japanese society -- including samurai.

This is a point will made, but what if the inability of banks to get Japanese consumers to borrow more is an inbuilt function of the country’s demographic profile? In that case, I would submit that while Lehman may have dented Japanese investors’ appetite for samurais, they will soon head for the trough again. As such, I maintain my thesis grounded in a structural assessment of Japanese savers’ need for foreign yield. Given the low domestic interest rates and the low level of domestically generated growth, foreign debt instruments still look very attractive from the point of view of Japanese savers. Moreover, and given the fact that the unfolding credit crunch is not about to fade in any given sense of the word, the supply side [2] is not going to dwindle as companies will continue to have problems raising capital. This year’s bumper issues from giants such as Wal-Mart and Citigroup suggest as much, although the latter of course was a quite necessary attempt to shore up a credit turmoil struck balance sheet.

Conclusively, I think that structural forces will keep capital flowing from Japan into foreign asset markets and while the distinct market for samurai bonds may have been dented, I still see this market as an integral part of the bigger picture.

[1] Data compiled by Bloomberg suggests that the market grew 61% to 2.6 trillion yen over the past year.

[2] i.e. supply of bonds

It has been a while since I last had Japan under the spotlight where and where I noted that Japan almost certainly would be tumbling into or very close to recession. Since then, data have been pointing only one way really and with the recent downward revision of an already quite awful Q2 GDP reading Japan now seems certain to be flirting with a recession.

As per usual, I will peruse the most recent pile of data but now that Japan stands on the brink of yet another recession in the 21^st century, I also think that it also finds itself confronted with a crucial question. What will happen to spending and the political situation in the wake of Fukuda’s resignation? I am no political specialists, but I will try to highlight the issue from an economic view point all the same.

All the Features of a Recession

As if the initial Q2 GDP reading was not tough enough clocking in at -2.4% y-o-y the revised figure released by the cabinet office of -3.0% suggests that Japan’s economy took a significant beating in Q2. On a quarterly basis Japan’s economy thus pulled the rather dubious trick of completely erasing Q1 0.7% growth rate meaning that growth in H01 2008 stands at 0% q-o-q. The corresponding figure for annual values is -0.2%. Given the sharpness of the contraction it should not surprise many that almost all components of GDP were down. Most important perhaps were net exports which failed to make a positive contribution for the first time in three years.

Especially domestic demand and investment weighed heavily on the head line figure and without neither government spending nor, more importantly, exports with net exports contributing -0.1% this is the figure you get. In general, Japan seems to be caught in somewhat of a vicious circle at the moment. With domestic demand congenitally weak and foreign demand now faltering corporate capex seems certain to fall back. Add to this, a decline in terms of trade due to the increase in imported goods prices as well as a fiscally strained government and you end up with a busted ship as they say in the sci-fi shows.

If we turn our attention to prices it seems that Japan got that last spurt of headline inflation pressure in July with all three indices posting positive rates.

The general inflation index rose 2.3% from a year earlier, but more importantly the US style core-of-core index managed to eek out a full 0.2% print. This brings the average, for this index in 2008, to 0% y-o-y. It is the first time since August 1997 that the core-of-core index posts such a gain. Clearly, and since the increase in inflation comes at a time when the economy is actually shrinking to the tune noted above, this is all about cost push inflation. The deterioration in Japan’s terms of trade represents an important underlying current here since Japan, for the most part, imports energy and food related produces. In so far as goes the domestic value chain inflation has only scarcely found its way to the market in terms of the core-of-core index, a point I have emphasized in my analysis before [insert link here].

Given the rather violent setback of global headline inflation so far in H02 2008 and the imminent outlook of oil dropping to negative growth rates y-o-y towards Q4 Japanese consumers should once again find some solace, if only a little bit, at the pumps and in the supermarket as we move towards the end of the year. Of course, this will probably mean that Japan slips back into deflation in the core of core index, but it is important to understand that this seems to be the rule rather than the exception.

A further breakdown of domestic demand shows us that household consumption expenditures have contracted in every month so far in 2008. Even if the rate of contraction seems to be edging in the right direction, it still indicates that Japan has been hit extraordinarily hard by the recent bout of global stagflation.

Japanese consumers once again cut back on fuel and food expenditures while spikes in expenditures on furniture and clothing kept the index from plummeting completely. A worrying trend in the context of domestic consumer demand is furthermore that household income and wages have almost fallen off a cliff in recent months. Total cash earnings fell back 2.5% in July and household income was down 3.5% on the year. In light of this, it is difficult to expect the Japanese consumer to be able to muster that much debated second bulwark against recession once foreign demand trends down.

As for corporate sector the overall headline news was actually a rare bright spot as industrial production climbed 0.9% in July from June where it fell 2.2%. While certainly down on an annual basis, industrial production still seems to be increasing at levels higher than those seen throughout 2006 and H01 2007. The news from the small services on the ground, in the form of Japanese small merchants, consequently point towards a further deterioration. This is no doubt strongly related to the slump in consumer confidence and spending and shows the extent to which the slowdown in demand is affecting businesses that are dependent on the home market alone.

It is also difficult to see much upside in the July number given the slew of other incoming data. As such, the overall gauges for fixed capital formation in Q2 points towards a sharp de-acceleration of activity and one really finds it difficult to conclude much else than the fact that Japan is now in a recession.

According to Morgan Stanley’s Takehiro Sato one mitigating factor here may be the relative tight management of inventories by Japanese companies in recent years. The point here would be that since Japanese companies do not have a large backload of inventories to scale down, headline production may not have to slump completely. Sato remains skeptical of this analysis and I agree. Clearly, the inventory related argument ultimately depends on the actual rate and severity of the incoming slowdown not least in Japan’s main export markets. It is clear to me that any sharp slowdown signals from China would mean for Japanese corporate capex to see a significant period of downscaling. In fact, with all external deficit economies slowing down sharply, it is difficult to have much faith in the inventory argument. The point here is simply that the level of industrial activity that the domestic sector can support in light of falling external demand may be much lower than many expect.

In this context and while exports continued to de-couple from the US in July imports also rose at record pace. The resulting narrowing of the trade surplus to an almost even balance is exactly what is robbing Japan from part of its growth engine. Clearly, and if the terms of trade are set to improve it could be all back to normal for Japan in H02 2009. However, it seems anything but certain that a correction is also coming in terms of emerging markets even if it will be relatively short lived. On that note, net exports and foreign asset income will be less of a driving force for growth in the latter part of 2008.

What is more, Japan also seems to be sporting its very own miniature residential investment crisis as bankruptcies amongst construction and real estate companies continued to climb to alarmingly high levels in August. Sato digs deeper into this issue and directs attention to the point that one of the main risks facing Japan is that credit dries up leaving even more companies without the possibility to carry on their operations. This tune is well known and has credit crunch written all over it. According to Sato, one of the main risks at the moment is consequently that the sharp contraction of credit and activity in the real estate sector could spread to other sectors. One key development to gauge here would be the trend in overall corporate bankruptcies, especially over the course of H02 2008.

Fiscal Stimulus to the Rescue?

The probability and discussion of fiscal stimulus to revive Japan’s economy got significantly more clouded with the recent decision of Prime Minister Fukuda to step down. The decision itself was not entirely unexpected as the PM, and his cabinet, has had a distinctly hard time getting their will through parliament, as the opposition controlled the lower house. According to Ken Worsley, Fukuda’s resignation is thus a part of a more fundamental strategy to install a special session in the Diet which allows the ruling party (the LDP) to pass a number of bills.

In the middle of all this there is a 2 trillion yen ($18 billion) expansive fiscal deal on the table. If the economy continues to deteriorate one would think that such a deal could be relatively swiftly passed by both chambers of the parliament. With mounting rumors of a general election in November, the current situation looks pretty unpredictable. . As with the impending and much debated consumption tax to widen the budget’s revenue base it seems that priorities in the political system are not yet straight when it comes to moving forwards, or backwards, on the fiscal front.

As could have been expected the candidates to replace Fukuda are rounding up and while I know way too little about Japanese politics to say anything about the individual contenders, it is clear that one issue high on the agenda will be what they intend to do with respect to the fiscal lever and by derivative the much debated reform ghost in Japanese politics. In this connection recent comments from various candidates reveal somewhat of a disagreement. Obviously, the difficulty with which Japan can actually use fiscal policy, saddled with a debt/GDP ratio of +180%, is not new. The outgoing PM consequently stated the following rather incredible claim a few months ago (quoted by Bloomberg).

There is nothing to be done but wait for export markets to recover.

I do find this rather interesting not least because it comes from, at the time, a leader of a country and an economy. Essentially, I agree with Fukuda though. It is very unlikely that Japan will be able to ignite domestic demand to a degree which will make the incoming slowdown milder. This is the nature of export dependency as a result of an ageing economy. However, the sentiment expressed also highlights, I think, a more profound perspective with respect to Japan’s policy makers’ relentless strides to rebalance the economy. Basically, Japan is now set on a growth path which no immediate policy can change. Anything short of a very local Japanese version of the IT induced positive productivity shock [1] would not do the trick, so there is, in fact, not much to be done. Of course, the sentiment turns almost delusional with comments quoted from Hiroaki Muto senior economist at Sumitomo Mitsui Asset Management Co. in Tokyo.

Japan's economy is weak because foreign demand is slumping and the terms of trade have been worsening, not because there are any big domestic structural problems.

I would grant Mr. Muto some of his argument in the sense that the specific deterioration in the terms of trade, this time around, has made matters worse. However, it is precisely because Japan has domestic structural problems that she is export dependent, and therefore it also because of domestic structural issues that Japan’s economy finds itself in a weak position when foreign demand falters.

This display of sentiment also seems to cut across the fistful of potential candidates on offer to replace Fukuda. Some seem to share the outgoing PM’s sentiment while some again seem to believe that a stimulus package, of some kind, would be appropriate. It is also important to note here that an 11.7 trillion yen stimulus deal is on the table. The deal is mainly targeted to alleviate funding conditions for small and medium sized companies. One of the main aspects must clearly be the extra provisions set up in the context of the shared credit responsibility implemented a year ago. Takehiro Sato and Morgan Stanley’s Japan team have been warning before of the adverse effects of letting banks assume part of the responsibility here in the sense that it would lead to a sharp retrenchment of credit to small and medium sized companies. I will let Sato himself provide the details

So alongside this new system created to ease funding problems, the new economic package also brings a wider range of safety net guarantees of different types.

Safety net guarantees lie outside the shared responsibility system, and have been used, as the name says, to provide a safety net for the SMEs that cannot access CGC-backed loans. Originally, about 70 sectors were designated as eligible for credit support based on criteria such as sales performance, but the number has almost doubled in the wake of the errant policy-induced housing shock that followed last year’s revision of the Building Standards Law. The eligibility of a debtor is decided by the external criterion of whether it is included in the specified industries and whether sales are down more than 5%Y for the latest three months, but the number of industries covered could rise as the recession deepens.

If the economy continues to deteriorate one would think that such a deal could be relatively swiftly passed by both chambers of the parliament. However, this seems far from certain with in light of the political limbo in which Japan now finds itself. As with the impending and much debated consumption tax to widen the budget’s revenue base it seems that priorities in the political system are not yet straight when it comes to moving forwards, or backwards, on the fiscal front.

More importantly, Sato also muses on the potential for the Japanese government to pull of the extra emergency provisions without having to issue more paper. I can see the argument in the sense that the government would only have to fork over its part of the cash if the debtor went belly up. In a general perspective however, any kind of slack in terms of loosening fiscal policy, which really only could be financed through the issue of government bonds, would certainly bring forth the rating agencies. Especially, any de-facto abandonment of the objective to balance the budget by 2011 would not be taken lightly [2] .

In any case, and as Sato also explains in some detail, it is not at all certain that fiscal stimulus would help boost the economy but merely shift liabilities from companies and the consumer over to the government. The key argument here is one of Ricardian Equivalence where by economic agents adjust their expectations so as to negate the initial effect from the fiscal windfall. Obviously, the shift in liabilities themselves would not be without advantage since the increased savings by households and companies would likely bring the overall discounted value of Japan’s liabilities down. [3] In essence though, this remains a very theoretical argument and should not distract us from the point that Japan is slowly but sure trending towards an end point when it comes to its public balances. At some point she simply won’t be able to pay and the international institutional set-up (rating agencies) and policy makers (G8 anyone) would be wise to think in alternative solutions here. The alternative in terms of some ageing countries’ abilities to fund their ongoing liabilities will not be pretty at all.

Moreover, if we take Sato’s argument to the extreme the theoretical future discounted value of Japan’s government debt could be made equal to the equivalent future discounted value of the entire stock of company and household savings. However, this is not the way it is likely to materialize.

As such and while I agree with Sato’s initial point that increased savings through deposits are likely to be channeled into cheap government funding, we also know that Japan’s savings are increasingly flowing out towards higher returns. Furthermore, this is a story with both a short term and a long term perspective, where the former is epitomized in Ms. Watanabe and her carry trading efforts and the latter by portfolio and investment outflows. As such, and given the current levels of Japan’s public debt ratio the theoretical process of funneling domestic savings into government bonds may not correspond to practice. I would hold this to be particularly doubtful in light of the fact that the income earned on foreign holdings of stocks and bonds are precisely what drive top line growth in Japan together with goods and services exports.

What Kind of Recession?

Now that everybody seems to agree that Japan is in a recession the focus has naturally turned towards the question of just how it will look. V(W)-shaped, U-shaped or perhaps even L-shaped are all potential scenarios at this point. Official authorities in Japan in the form of the BOJ and the Cabinet Office maintain that this will be a quick recession. The analytical landscape is less convinced though. Takehiro Sato seems to be leaning towards a somewhat nastier scenario. As I have highlighted above, a sharp emerging market correction in China would definitely be catastrophic for Japan. Also Mary Stokes from RGE sees considerable downside risk to Japan’s situation.

I tend to go for the more pessimistic of the narratives noted above. I also concur though that if headline inflation is set to decline as briskly as seems the case, it could just bring the relief Japan needs if she is not to falter completely. In the end however, external demand and asset income will, as ever, be crucial parameters to watch. This ultimately also means that Japan will suffer at the whims of the global economy.

On that note, I see considerable upside in places such as Turkey, Brazil, and India. Japan’s savers would be wise to expose themselves towards these regions in the future in their attempt to hold the most efficient global portfolio. Many great unknowns present themselves though. China’s development is crucial for the global economy, but also the potentially incoming train wreck in Eastern Europe and the instability in Russia could be one of those famous trigger points.

Conclusively, I see Japan limping ahead for the remainder of 2008 where foreign demand, all things equal, will be less of a driving force than hitherto.

[1] Given the rate of technology adoption and diffusion across economies today, it is very difficult to see how Japan would be able to sustain a relative competitive advantage in any sense of the word.

[2] Personally, I think that this is very unlikely to materialize in the first place, but as in other, more fundamental parts of life, commitments matter.

[3] I am assuming here that the government can finance its budget deficit more cheaply than individual consumers and companies.

It has been a while since I last had Japan under the spotlight where and where I noted that Japan almost certainly would be tumbling into or very close to recession. Since then, data have been pointing only one way really and with the recent downward revision of an already quite awful Q2 GDP reading Japan now seems certain to be flirting with a recession.

As per usual, I will peruse the most recent pile of data but now that Japan stands on the brink of yet another recession in the 21^st century, I also think that it also finds itself confronted with a crucial question. What will happen to spending and the political situation in the wake of Fukuda’s resignation? I am no political specialists, but I will try to highlight the issue from an economic view point all the same.

All the Features of a Recession

As if the initial Q2 GDP reading was not tough enough clocking in at -2.4% y-o-y the revised figure released by the cabinet office of -3.0% suggests that Japan’s economy took a significant beating in Q2. On a quarterly basis Japan’s economy thus pulled the rather dubious trick of completely erasing Q1 0.7% growth rate meaning that growth in H01 2008 stands at 0% q-o-q. The corresponding figure for annual values is -0.2%. Given the sharpness of the contraction it should not surprise many that almost all components of GDP were down. Most important perhaps were net exports which failed to make a positive contribution for the first time in three years.

Especially domestic demand and investment weighed heavily on the head line figure and without neither government spending nor, more importantly, exports with net exports contributing -0.1% this is the figure you get. In general, Japan seems to be caught in somewhat of a vicious circle at the moment. With domestic demand congenitally weak and foreign demand now faltering corporate capex seems certain to fall back. Add to this, a decline in terms of trade due to the increase in imported goods prices as well as a fiscally strained government and you end up with a busted ship as they say in the sci-fi shows.

If we turn our attention to prices it seems that Japan got that last spurt of headline inflation pressure in July with all three indices posting positive rates.

The general inflation index rose 2.3% from a year earlier, but more importantly the US style core-of-core index managed to eek out a full 0.2% print. This brings the average, for this index in 2008, to 0% y-o-y. It is the first time since August 1997 that the core-of-core index posts such a gain. Clearly, and since the increase in inflation comes at a time when the economy is actually shrinking to the tune noted above, this is all about cost push inflation. The deterioration in Japan’s terms of trade represents an important underlying current here since Japan, for the most part, imports energy and food related produces. In so far as goes the domestic value chain inflation has only scarcely found its way to the market in terms of the core-of-core index, a point I have emphasized in my analysis before [insert link here].

Given the rather violent setback of global headline inflation so far in H02 2008 and the imminent outlook of oil dropping to negative growth rates y-o-y towards Q4 Japanese consumers should once again find some solace, if only a little bit, at the pumps and in the supermarket as we move towards the end of the year. Of course, this will probably mean that Japan slips back into deflation in the core of core index, but it is important to understand that this seems to be the rule rather than the exception.

A further breakdown of domestic demand shows us that household consumption expenditures have contracted in every month so far in 2008. Even if the rate of contraction seems to be edging in the right direction, it still indicates that Japan has been hit extraordinarily hard by the recent bout of global stagflation.

Japanese consumers once again cut back on fuel and food expenditures while spikes in expenditures on furniture and clothing kept the index from plummeting completely. A worrying trend in the context of domestic consumer demand is furthermore that household income and wages have almost fallen off a cliff in recent months. Total cash earnings fell back 2.5% in July and household income was down 3.5% on the year. In light of this, it is difficult to expect the Japanese consumer to be able to muster that much debated second bulwark against recession once foreign demand trends down.

As for corporate sector the overall headline news was actually a rare bright spot as industrial production climbed 0.9% in July from June where it fell 2.2%. While certainly down on an annual basis, industrial production still seems to be increasing at levels higher than those seen throughout 2006 and H01 2007. The news from the small services on the ground, in the form of Japanese small merchants, consequently point towards a further deterioration. This is no doubt strongly related to the slump in consumer confidence and spending and shows the extent to which the slowdown in demand is affecting businesses that are dependent on the home market alone.

It is also difficult to see much upside in the July number given the slew of other incoming data. As such, the overall gauges for fixed capital formation in Q2 points towards a sharp de-acceleration of activity and one really finds it difficult to conclude much else than the fact that Japan is now in a recession.

According to Morgan Stanley’s Takehiro Sato one mitigating factor here may be the relative tight management of inventories by Japanese companies in recent years. The point here would be that since Japanese companies do not have a large backload of inventories to scale down, headline production may not have to slump completely. Sato remains skeptical of this analysis and I agree. Clearly, the inventory related argument ultimately depends on the actual rate and severity of the incoming slowdown not least in Japan’s main export markets. It is clear to me that any sharp slowdown signals from China would mean for Japanese corporate capex to see a significant period of downscaling. In fact, with all external deficit economies slowing down sharply, it is difficult to have much faith in the inventory argument. The point here is simply that the level of industrial activity that the domestic sector can support in light of falling external demand may be much lower than many expect.

In this context and while exports continued to de-couple from the US in July imports also rose at record pace. The resulting narrowing of the trade surplus to an almost even balance is exactly what is robbing Japan from part of its growth engine. Clearly, and if the terms of trade are set to improve it could be all back to normal for Japan in H02 2009. However, it seems anything but certain that a correction is also coming in terms of emerging markets even if it will be relatively short lived. On that note, net exports and foreign asset income will be less of a driving force for growth in the latter part of 2009.

What is more, Japan also seems to be sporting its very own miniature residential investment crisis as bankruptcies amongst construction and real estate companies continued to climb to alarmingly high levels in August. Sato digs deeper into this issue and directs attention to the point that one of the main risks facing Japan is that credit dries up leaving even more companies without the possibility to carry on their operations. This tune is well known and has credit crunch written all over it. According to Sato, one of the main risks at the moment is consequently that the sharp contraction of credit and activity in the real estate sector could spread to other sectors. One key development to gauge here would be the trend in overall corporate bankruptcies, especially over the course of H02 2008.

Fiscal Stimulus to the Rescue?

The probability and discussion of fiscal stimulus to revive Japan’s economy got significantly more clouded with the recent decision of Prime Minister Fukuda to step down. The decision itself was not entirely unexpected as the PM, and his cabinet, has had a distinctly hard time getting their will through parliament, as the opposition controlled the lower house. According to Ken Worsley, Fukuda’s resignation is thus a part of a more fundamental strategy to install a special session in the Diet which allows the ruling party (the LDP) to pass a number of bills.

In the middle of all this there is a 2 trillion yen ($18 billion) expansive fiscal deal on the table. If the economy continues to deteriorate one would think that such a deal could be relatively swiftly passed by both chambers of the parliament. With mounting rumors of a general election in November, the current situation looks pretty unpredictable. . As with the impending and much debated consumption tax to widen the budget’s revenue base it seems that priorities in the political system are not yet straight when it comes to moving forwards, or backwards, on the fiscal front.

As could have been expected the candidates to replace Fukuda are rounding up and while I know way too little about Japanese politics to say anything about the individual contenders, it is clear that one issue high on the agenda will be what they intend to do with respect to the fiscal lever and by derivative the much debated reform ghost in Japanese politics. In this connection recent comments from various candidates reveal somewhat of a disagreement. Obviously, the difficulty with which Japan can actually use fiscal policy, saddled with a debt/GDP ratio of +180%, is not new. The outgoing PM consequently stated the following rather incredible claim a few months ago (quoted by Bloomberg).

There is nothing to be done but wait for export markets to recover.

I do find this rather interesting not least because it comes from, at the time, a leader of a country and an economy. Essentially, I agree with Fukuda though. It is very unlikely that Japan will be able to ignite domestic demand to a degree which will make the incoming slowdown milder. This is the nature of export dependency as a result of an ageing economy. However, the sentiment expressed also highlights, I think, a more profound perspective with respect to Japan’s policy makers’ relentless strides to rebalance the economy. Basically, Japan is now set on a growth path which no immediate policy can change. Anything short of a very local Japanese version of the IT induced positive productivity shock [1] would not do the trick, so there is, in fact, not much to be done. Of course, the sentiment turns almost delusional with comments quoted from Hiroaki Muto senior economist at Sumitomo Mitsui Asset Management Co. in Tokyo.

Japan's economy is weak because foreign demand is slumping and the terms of trade have been worsening, not because there are any big domestic structural problems.

I would grant Mr. Muto some of his argument in the sense that the specific deterioration in the terms of trade, this time around, has made matters worse. However, it is precisely because Japan has domestic structural problems that she is export dependent, and therefore it also because of domestic structural issues that Japan’s economy finds itself in a weak position when foreign demand falters.

This display of sentiment also seems to cut across the fistful of potential candidates on offer to replace Fukuda. Some seem to share the outgoing PM’s sentiment while some again seem to believe that a stimulus package, of some kind, would be appropriate. It is also important to note here that an 11.7 trillion yen stimulus deal is on the table. The deal is mainly targeted to alleviate funding conditions for small and medium sized companies. One of the main aspects must clearly be the extra provisions set up in the context of the shared credit responsibility implemented a year ago. Takehiro Sato and Morgan Stanley’s Japan team have been warning before of the adverse effects of letting banks assume part of the responsibility here in the sense that it would lead to a sharp retrenchment of credit to small and medium sized companies. I will let Sato himself provide the details

So alongside this new system created to ease funding problems, the new economic package also brings a wider range of safety net guarantees of different types.

Safety net guarantees lie outside the shared responsibility system, and have been used, as the name says, to provide a safety net for the SMEs that cannot access CGC-backed loans. Originally, about 70 sectors were designated as eligible for credit support based on criteria such as sales performance, but the number has almost doubled in the wake of the errant policy-induced housing shock that followed last year’s revision of the Building Standards Law. The eligibility of a debtor is decided by the external criterion of whether it is included in the specified industries and whether sales are down more than 5%Y for the latest three months, but the number of industries covered could rise as the recession deepens.

If the economy continues to deteriorate one would think that such a deal could be relatively swiftly passed by both chambers of the parliament. However, this seems far from certain with in light of the political limbo in which Japan now finds itself. As with the impending and much debated consumption tax to widen the budget’s revenue base it seems that priorities in the political system are not yet straight when it comes to moving forwards, or backwards, on the fiscal front.

More importantly, Sato also muses on the potential for the Japanese government to pull of the extra emergency provisions without having to issue more paper. I can see the argument in the sense that the government would only have to fork over its part of the cash if the debtor went belly up. In a general perspective however, any kind of slack in terms of loosening fiscal policy, which really only could be financed through the issue of government bonds, would certainly bring forth the rating agencies. Especially, any de-facto abandonment of the objective to balance the budget by 2011 would not be taken lightly [2] .

In any case, and as Sato also explains in some detail, it is not at all certain that fiscal stimulus would help boost the economy but merely shift liabilities from companies and the consumer over to the government. The key argument here is one of Ricardian Equivalence where by economic agents adjust their expectations so as to negate the initial effect from the fiscal windfall. Obviously, the shift in liabilities themselves would not be without advantage since the increased savings by households and companies would likely bring the overall discounted value of Japan’s liabilities down. [3] In essence though, this remains a very theoretical argument and should not distract us from the point that Japan is slowly but sure trending towards an end point when it comes to its public balances. At some point she simply won’t be able to pay and the international institutional set-up (rating agencies) and policy makers (G8 anyone) would be wise to think in alternative solutions here. The alternative in terms of some ageing countries’ abilities to fund their ongoing liabilities will not be pretty at all.

Moreover, if we take Sato’s argument to the extreme the theoretical future discounted value of Japan’s government debt could be made equal to the equivalent future discounted value of the entire stock of company and household savings. However, this is not the way it is likely to materialize.

As such and while I agree with Sato’s initial point that increased savings through deposits are likely to be channeled into cheap government funding, we also know that Japan’s savings are increasingly flowing out towards higher returns. Furthermore, this is a story with both a short term and a long term perspective, where the former is epitomized in Ms. Watanabe and her carry trading efforts and the latter by portfolio and investment outflows. As such, and given the current levels of Japan’s public debt ratio the theoretical process of funneling domestic savings into government bonds may not correspond to practice. I would hold this to be particularly doubtful in light of the fact that the income earned on foreign holdings of stocks and bonds are precisely what drive top line growth in Japan together with goods and services exports.

What Kind of Recession?

Now that everybody seems to agree that Japan is in a recession the focus has naturally turned towards the question of just how it will look. V(W)-shaped, U-shaped or perhaps even L-shaped are all potential scenarios at this point. Official authorities in Japan in the form of the BOJ and the Cabinet Office maintain that this will be a quick recession. The analytical landscape is less convinced though. Takehiro Sato seems to be leaning towards a somewhat nastier scenario. As I have highlighted above, a sharp emerging market correction in China would definitely be catastrophic for Japan. Also Mary Stokes from RGE sees considerable downside risk to Japan’s situation.

I tend to go for the more pessimistic of the narratives noted above. I also concur though that if headline inflation is set to decline as briskly as seems the case, it could just bring the relief Japan needs if she is not to falter completely. In the end however, external demand and asset income will, as ever, be crucial parameters to watch. This ultimately also means that Japan will suffer at the whims of the global economy.

On that note, I see considerable upside in places such as Turkey, Brazil, and India. Japan’s savers would be wise to expose themselves towards these regions in the future in their attempt to hold the most efficient global portfolio. Many great unknowns present themselves though. China’s development is crucial for the global economy, but also the potentially incoming train wreck in Eastern Europe and the instability in Russia could be one of those famous trigger points.

Conclusively, I see Japan limping ahead for the remainder of 2009 where foreign demand, all things equal, will be less of a driving force than hitherto.

[1] Given the rate of technology adoption and diffusion across economies today, it is very difficult to see how Japan would be able to sustain a relative competitive advantage in any sense of the word.

[2] Personally, I think that this is very unlikely to materialize in the first place, but as in other, more fundamental parts of life, commitments matter.

[3] I am assuming here that the government can finance its budget deficit more cheaply than individual consumers and companies.

In fact, a recession seems to be almost a foregone conclusion at this point since if we look at the recent messages emanating from official Japanese authorities, they are indeed bracing themselves for something ugly. Perhaps someone from the statistics department sent a primer of the Q2 GDP figures (due 13.08.2008) to parliament? I sure don't know, but the cabinet office recently released a statement in which the slump in industrial production and exports were used as impetus to argue that the cycle has now definitely turned. The secretary general of the ruling LDP party also chimed in as he notes how especially the economic situation en dehors de Tokyo increasingly resembles a recession. Shigeru Sugihara head of the Cabinet Office's statistics department also noted recently how the economy is very likely to have entered a recession. Finally Bloomberg connects the threads by suggesting that the Japanese economy may have shrunk -0.6% in Q2 after an impressive 1% showing in Q1. These numbers are built on the illusive median forecasts at this point but are indicative of what to expect. 

As per usual, this note will feature a look at developments in prices, domestic demand, industrial production (and exports) as well as the JPY. Obviously, the main thrust will be what exactly to expect in terms of the downturn; how serious it will be and how the BOJ and MOF will act. 

Cost-Push Thrust Continues - To the Consumers' Lament

Adding to the pressure on Japanese consumers, prices rose at its highest pace in June as the main inflation index clocked in at an all time high of 2.0%. Moreover, the US style core price index also managed to eek out a slight increase at 0.1%. This is the second time this year that the core of core index is in the positive but on an aggregate basis Japan remains in deflation.

As ever, the point to take away is how headline inflation from cost-push pressures not necessarily will lead to an underlying  effect on core-of-core prices. This is to say that it is difficult for companies to push forward cost-push inflation through the value chain in a situation where real wages are falling and where domestic demand, in general, is structurally weak. This broken link between headline inflation and core inflation and the congeniantly weak demand can be connected to the demographic profile of Japan. Quite simply, Japan does not posses the domestic demand to generate demand-pull inflation to any significant degree and this is reflected in the core-of-core index. Moreover, this is also why those much discerned second round effects are not very likely to materialise in Japan's context domestic demand dynamics do no support this as external demand slows.

Finally, this also underpins the lack of activity in corporate capex to spill-over into the domestic economy as so many pundits have been expecting during the recovery. It is important to understand the dynamics in this regard. As such, macroeconomics 1-0-1 tell us how to treat excess domestic investments over savings as a leakage which leads to an external surplus (otherwise S=I, and capacity for investments would be a lot smalle than is currently is the case). This rather mechanic perspective is important in so far as it shows us how activity in the corporate sector may be responding to external demand rather than domestic demand. And thus, we have the ensuing disconnect between industrial activity and domestic demand.

In light of the fact that oil seems to have peaked, for now at least, it appears that Japanese consumers not to mention companies may have experienced the worst of things. However, Morgan Stanley's Takehiro Sato seems to be less sanguine than official estimates from Japanese authorities. Alongside colleague Takeshi Yamaguchi he estimates that it will take in the region of 6-12 months for the current back drop in energy and food prices to have a material effect. This suggests that the cost-push thrust is set to linger throughout 2008 and perhaps some time into 2009.

Shifting gears over to consumption the Japanese consumer thus seems to have firmly caved in. With wages now falling, in nominal terms too, it does not take much of an economic literate to see that Japanese consumers are getting sandwiched at the moment. Wages in Japan fell back 2.9% (in real terms) in June and this marks a third consecutive drop this year. The meager evolution in wages has been a consistent feature of the Japanese economy throughout this so-called recovery. Yet, now that cost-push inflation is being added to the equation it is predictably feeding strongly into domest consumption expenditures, which still constitute the largest, if shrinking, share of Japan's GDP (55%).

It is now quite clear that domestic consumption in Japan is contracting and even though expenditures in June contracted less than in previous months the overall trend is one of a slump. Given the trajectory of real wages and inflation this is not particularly surprising but does mean that with external demand now also faltering, Japan is left without any kind of real growth engine.

As per ususal Ken Worsley provides the details of the monthly consumption report through which we learn how especially spending in durables and semi-durables contributed to the decline. If SY is right with respect to the lag in which falling energy prices feed through to the price indices it is difficult to expect a rebound in H02 2008.

Corporate Capex and Exports - The Final Dam Breaks

Perhaps the most significant snippet coming in off the wire since we last convened to look at Japan was the news that Japanese exports actually shrank in June on a y-o-y basis. Coupled with a rising import bill as a result of surging headline inflation, it means that the monthly trade surplus decreased a whopping 89% on a y-o-y basis [3].

If the level of Japanese exports is heading inexorably down, the trend in foreign demand composition is also interesting to consider. It shows that while a savvy Japanese export industry indeed did manage to decouple from the US or more aptly recouple to the big emerging markets, it cannot de-couple from the world. This is the nature of being dependent on exports and foreign asset income to grow. In this light, both exports to the US and Europe dropped at a hefty pace in June, the former being the 10th straight decline and the latter seing a second consecutive drop. Exports to emerging markets and not least China expanded, but at a much slower pace suggesting that the current account margin is narrowing. 

Yet, Japan's external balance is not only about exports.

In fact, the recent years' increase in Japan's positive external position owes more to the accumulation of foreign assets than to exports per se. This is also I point I latch on in my note on how Japanese savings, as a function of its demographic profile, will tend to go for yield.

In 2007, the net foreign asset position of Japanese savers (i.e. both companies and households) stood at around 250 billion Yen of which around 75-80% was made up of debt instruments. This makes up a nice cushion off of which to pull income. Add to this the currency gain as the continuation of outflows, due to the low interest rate environment, will tend to keep value of the Yen down (more about that below). I think it is important for investors to lock on to this trend as it tells a lot about global capital flows.

An additional point here would be that since the majority of Japan's foreign asset is in debt, the income flows will be less affected, from the credit crunch, than if it has been tilted towards equity (although one has to assume that asset income will go down with global growth). Obviously and depending on the kind of debt you own, defaults and yield obtained from securities you own and those you buy will depend greatly on where, and in what, you choose to invest.

Ultimately however, the point remains that as Japan external balance is now contracting, in relative terms, it will have a substantial impact on aggregate economic performance.

With exports faltering it should not come as a surprise that industrial output and capex are also slowly but surely trending downwards. On a m-o-m basis production dropped 2.8% and on a seasonally adjusted index (see this graph) it appears that the high levels of the latter part of 2007 are now replaced by one of those famous lower plateaus. In a quarterly perspective, it can also be seen below how the cycle now seems to have turned.

Judged by forward looking indicators and production assements, it appears that the first two quarters of 2008 may well have seen a q-o-q contraction of industrial output. However, it also seems clear that industrial activity may have a long way to fall as it enters the current correction with a lag. Especially the likely reluctance of external demand to reach hitherto heights will make it difficult for Japanese firms to build up production. It would subsequently mean that production plans will need to be further downscaled. 

Sato and Yamaguchi (SY) field some pretty grim numbers for the potential course of industrial activity and manufacturing. They consequently forecast, based on information from previous recessions, that total output may have to come down as much as 6%. SY also indicate that the recent Tankan survey may have been too optimistic in its top line outlook. Should this turn out true, production assessments will have to be further cut.

There is still however some disagreement on the actual outlook here. Bloomberg consequently features a more sanguine analysis in a recent article. The point would then be that forward looking indicators in the form of equipment and machinery orders declined less than forecast. This might be true in so far as goes Bloomberg's own meadian forecast but I think it is quite difficult to see anything remotely positive in the incoming figures. Whether the incoming slowdown will resemble the 2001 recession is another question of course, but at this point I think that it is also an irrelevant one.

The JPY - Macrofundamentals to Take Over?

With the recent turmoil surrounding the near bust of Fannie and Freddie Mae many FX punters would perhaps expect it to be a sure bet to buy some Yen crosses. Consequently, more than notional evidence has suggested how traditional carry trade crosses (CHF and JPY) have been negatively correlated with risky assets. In times of market turmoil and volatility, the only thing a savvy currency trader thus need to do is to pile up on JPY and CHF longs as she was betting on the unwinding of short term highly leveraged carry trade positions. If it was ever so easy.

I am unsure as to whether the correlation is broken entirely, but it is quite obvious that is has weakened significantly in the past two months. As such and while I would still expect the JPY to react on extreme risk aversion two other factors are at work. The first, I think, is related to the recent drop in headline inflation from oil in particular. Not only has this boosted the USD across the board and by derivative the USD/JPY, it has also provided a cushion for stocks and other risky assets. This story has been roaming financial market punditry for the better part of the last month, and suggests the importance investors ascribe to the adverse effects of inflation.

The other factor is more structural in nature and relates to the points made above on Japan's positive income balance and net investment position. In this way, Japan quite literally needs to ship its capital and goods abroad in order to grow. This is a simple reflection of the country's demographic structure and subsequent low domestic interest rate environment. This decline in home bias can thus be considered a lingering structural trend, as it effectively links up with Japan's demographic profile[2]. The conclusion is consequently that the JPY is set to stay weak and steadily weaken against its trade partners. This would apply for the level of the JPY in particular.

If we add the fact that exports of goods and services are now actually falling and the terms of trade shock from a high oil price, the immediate outlook is for further JPY weakness. 

Obviously, I still owe somewhat of an explanation since when does one effect take over from the other?

My immediate response to this question would be that an increased decline in home bias, low domestic interest rates, and the subsequent steady outflow of funds (and goods and services) will dominate and keep the JPY down. In this way, I do not deviate much from Stephen Jen with respect to fundamentals. Yet, this is also a discussion about the nature of capital flows. In this way, the fundamentalist view would hold that the JPY is being held down by plain and simply unlevered outflows or more aptly; diversification out of Japanese risky assets with respect to the market portfolio.

However, there is another perspetive too. If the low JPY is primarily driven by carry trade positions and levered bets against the uncovered interest rate parity it would make sense for the JPY to be sensitive to reversals in the market. This indeed has been the focus of many articles and op-eds over the course of credit turmoil and beyond. For example, we learned recently that the number of margin trading accounts in Japan has now exceeded 1 million and that the funds attacted to these accounts rose 13.5% y-o-y totalling 6.3 billion USD. In this context, the actions of Ms. Watanabe and other savvy Japanese housewives represent an important case in point. Of course, with the recent change of tact in the Aussie and the Kiwi (at least against the USD) one has to wonder whether in fact the fundamentals of the trade is changing, if only for a while.

I will forgive my readers if the conclusion may be a tad bit difficult to discern on this topic. As stated, I hold the view that outflows (levered and non-levered) will continue to keep a lid on the JPY's appreciation. However, the extent to which the JPY will react on sudden spurts of volatility is still something to be aware of, and is likely to depend on the level of levered carry trade positions.

A Recession it is Then - So, What About Policy Response?

I think that SY manage to pin point the situation quite neatly when they note how Japan lost two engines in Q2 2008; personal consumption and exports. Of these two, the latter will by far have the biggest impact since in the case of the former, it never really got past first gear during the present and so-called recovery. 

SY roll out the big forecasting kit in their attempt to give an impression of when Japan's economy may hit the trough; with the assumption being that it peaked in Q4 2007. The conclusion is that Japan is set to hit bottom in Q1 2009 after which it will steadily pick-up. There can be no doubt that this argument is solidly built upon historical performance measures. However, I don't think that the recession as such is the major news point here, in the sense that such things come and go. The key for me is the regularity by which recessions have hit Japan since 2000 and the subsequent nature of the "recoveries". In this way, I am not expecting a recovercy as such, in the sense that unless exports find a new decisive foothold towards external demand, Japan is likely to limping ahead very close to a zero growth rate.

This brings us neatly over to the policy reactions from all this.

Obviously, with growth now slowing the quants in the treasury are being forced into revising their revenue models. Specifically, the objective to balance the budget by 2011 may now be nothing but a good faith declaration on paper with no real bearing towards reality.  One immediate consequence here is obviously that issuing more sovereigns to finance government spending is out. In fact, with a public debt/GDP ratio close to 170%, any faint muttering as such would be sure to prompt the rating agencies into attack mode.

Moreover and as per usual, the prospect of increasing the incoming consumption tax is rearing its head. In May, Economics and Fiscal minister Yosano, from the LDP, consequently suggested that Japan double a planned 5% consumption tax by 2015. No one can deny that the government's top line needs additional input, but it is also important to understand that levying tax on consumers will only further solidfy Japan's growth path whereby domestic demand stays weak and the economy relies on exports to grow. There is nothing wrong with that per se. The problem however is that export dependency will become a structural tendency for many economies during the next decade so Japan will finds its growth strategy more crowded as we move forward. [4] 

Regarding monetary policy, the BOJ held rates steady during their last convention and is widely expected to maintain this stance for the forseeable future. SY are fiddling with the BOJ moving in with a 25 basis point cut in Q2 2009. I am not willing to look that far ahead. Given the already low level of interest rates anything short of a sharp backdrop into deflation or a very severe slowdown would not justify, I think, a move back towards ZIRP.  This may happen and the data should be watched closely in this regard. For now however, I am sticking to my guns that the BOJ is likely to stay on hold.

Notes

[1] See the following notes in particular; Japan - Still Fighting off the Recession; When Will the Strength Ebb Out? and Inflation Returns to Japan - Tightroping Between a Slowdown and Recession

[2] See this note and also Morgan Stanley's Stephen Jen (here and here)

[3] See this chart

[4] See further points on export dependency here

Disclosure (c.f. Seeking Alpha agreement): Trading out of a monopoly money account with the following FX positions: short AUD/USD, short NZD/USD, short EUR/USD, and short EUR/JPY.

Prime Brokerage Asia

There was nothing else written in the email except that. And since nothing notable has really happened to the Japanese yen in the last few months, I can only assume he was asking why the Japanese yen disappeared from our radar.

The only comments we could offer him focused on two things:

1) Inconsistent spurts of risk-aversion and risk-taking plus ...
2) The absence of widespread US dollar selling.

The Japanese yen has been tied to the risk environment. And since neither the risk takers nor the risk averse have dominated the market, the Japanese yen has been given little direction.

Additionally, the Japanese yen has been bogged down by a US dollar that’s trying to find its way. Since March 17th, the dollar has actually appreciated and the yen hasn’t been feeling the love.

And even though our editorial has shifted away from the Japanese yen snooze-fest, we maintain the belief that a massive wave of risk aversion could still very easily descend upon financial markets and prop up the Japanese yen.

The above chart shows USDJPY. Price action appears to show this pair topping out at 10860. A clean break below support at 10500 (red line) could confirm yen strength and open the door to test the next nearest support levels.

And if you haven’t been following the Fannie Mae and Freddie Mac developments, let’s just say things could get awfully ugly; enough even to spark the fearful risk aversion we mentioned earlier. Might be all that’s needed for the break below 10500.

 Regards,

Jack & JR