So unfair: Japan cannot easily hide from the effects of the American credit bust

TURMOIL in America's subprime and asset-backed markets has hit Japan's publicly traded financial markets more than perhaps any other country's. At the height of the panic in mid-August the Nikkei 225 index fell by 9% in a single week, dipping 16% below its July peak. Despite a recovery of sorts, the Nikkei is still 7% below its starting-point for the year. American shares, where the trouble all began, remain up on the year. Investors are squealing at the injustice of it.

To make matters worse, Japan's currency has surged as hedge funds have unwound their positions in the carry trade—where people borrow cheap yen to sell in order to invest in higher-yielding assets overseas. That has left many ordinary Japanese savers facing not just paper losses as the yen climbed but also steep margin calls from foreign-exchange brokers. The yen has slipped back a bit but not enough to make good on losses.

Why should Japan, so far from the storm's centre, have been hit so hard? Financial innovation of the sort that encouraged risk to multiply elsewhere is scarcely known in Japan. An unusually high proportion of household assets remains under the mattress or in bank deposits. Japanese financial institutions have only the smallest exposure to subprime debt. In general, the appetite for leverage is tiny in comparison with America's or Europe's. Richard Jerram of Macquarie Research points out that the value of all corporate bonds outstanding in Japan is equivalent to just under 10% of GDP, roughly the same ratio as subprime and other high-risk debt alone in America.

The simplest explanation is that Western banks, hedge funds and others hit by higher volatility, liquidity concerns or redemption calls sold whatever they could. The foreign-exchange market is hugely liquid, so carry-trade positions were easily unwound. The market for Japanese shares is also big and liquid—and disproportionately owned by foreign investors. Foreigners own 30% of Japan's listed shares, and typically account for three-fifths of all trading (Japanese institutions tend to sit on their holdings). Huge foreign sell orders—the biggest since the world stockmarket crash of October 1987—sent Japan's blue-chip shares skidding.

However susceptible Japan's financial markets have been to the bursting of America's credit bubble, plenty of analysts argue that the country is insulated from the economic consequences. Japan's five-year-old recovery is led by domestic demand, they say, and by business investment in particular. As for trade flows, America matters less than it did, swallowing just 20% of Japan's exports compared with nearly double that amount two decades ago. Optimists also point out that any American slowdown would presumably be felt most in the construction industry, a sector to which Japanese exports are not heavily exposed.

If these analysts are right, you might expect investors to be snapping up the stockmarket bargains that distressed selling has created. But there are gloomier voices too. Richard Katz of the Oriental Economist, a newsletter, emphasises the continued importance of exports to Japan's economy. The growth in Japan's net exports, as measured by the growth in its trade surplus, has accounted for more than a third of GDP growth since the start of the recovery in 2002. The rise in business investment that has accounted for two-fifths of the recovery is also heavily focused on the export sector and on companies with a high share of earnings from overseas. And even if America's direct impact on Japanese exports is more muffled than before, its indirect one is substantial thanks to “triangular” trade flows. Japan may be more dependent than ever on exports to Asia, particularly China, but Asia in turn counts on exports to the United States.

How badly a slowdown in America might affect Japan depends on its severity. Goldman Sachs estimates that every percentage-point fall in American consumption would reduce Japanese GDP, currently growing at just over 2% annually, by 0.43 of a percentage point. Goldman assumes that American consumption will grow by 2.1% next year. If it fell to zero or worse, Japan would have a problem.

Meanwhile, credit-market turmoil creates a quandary for the Bank of Japan (BoJ). While other central banks consider cutting rates, the BoJ's governor, Toshihiko Fukui, is itching to raise them. By the time he steps down next March, he wants the bank to “normalise” monetary policy (until last year the short-term rate was set at zero, and is now just 0.5%). Until the turmoil, a quarter-point rise in late August had looked assured. Now prospects even for a September hike look dim, since poor second-quarter GDP figures and weak capital expenditure suggest that the economy, not for the first time in this recovery, has hit a soft patch. Core consumer prices have been falling slightly for most of this year.

The case for normalisation is that low rates encourage bubbles to develop and reward inefficient firms. But that argument will be hard to make for as long as stockmarkets are weak, the yen continues to rise and American and European economies remain wracked by credit troubles. No matter whose fault it is.