Japan: Buckle Up – Turbulence Ahead (Part I)

Decoupling notion prevails, but a sharp slowdown looks likely

Our US economics team has lowered its 2008 growth forecast all the way to 1.1% and expects a mild recession in the first half of 2008. Meanwhile, our economists covering emerging markets, including China, remain bullish. The decoupling notion – that major economies are likely to still do well even if the US economy slows, thanks to demand from emerging countries – has some support in the markets. In the case of Japan, however, this appears to be off because errant government policies and laws have started to hurt the economy, and the prospects for a convincing strong growth scenario are looking bleak, given not only overseas factors but also weak domestic demand. For our new base scenario, we expect economic growth to slow sharply to 0.9% in 2008 (1.1% in F3/09), and as a risk scenario we point out the possibility of zero growth.

Japan’s economy likely to be hit by a shock before domestic demand fully recovers

Given the weakness in domestic demand, Japan’s economy is all the more dependent on exports. We expect net foreign demand to account for 1.0ppt of our 1.8% estimate for real growth in 2007, given the weakness in real imports but strong growth in real exports. In addition, policy missteps have emerged as a new downside risk to growth. Under such circumstances, a US economic downturn in the first half of 2008 would be a new threat to Japan, and the foreign demand-driven growth scenario for Japan’s economy appears to be approaching a tipping point.

Most Japanese financial institutions have not been affected much by subprime mortgages, but overseas, the liquidity crunch has worsened in December, banks’ balance sheets have grown sharply as a result of a shift from direct financing, and it is even more difficult to issue CP now than in the summer, when the financial markets were in turmoil. These conditions could give rise to a sudden increase in credit costs, and the liquidity crunch could turn into a true credit crunch. Based on what happened in Japan in 1997-98, an economy with liquidity constraints would be fragile and companies are likely to suspend investment projects and hold onto liquidity. In this case, Japan’s economy would not be completely unscathed.

We see a few reasons to be optimistic, though. The US accounts for only a small portion of Japan’s real export growth; most of the growth is now accounted for by Asia and other emerging markets and Europe. Hence, any shocks from the US would probably not be as bad as they were after the tech bubble burst. Since most of Japan’s exports to Asia used to end up in the US, Europe or back in Japan, US economic downturns seriously hurt Japan. However, the amount of exports driven by demand in Asia, for autos and some production goods, for example, has recently risen sharply. Our China economics team believes that China will not be affected by a sharp slowdown in the US economy because the government, which has been struggling to rein in overheated growth, could simply ease up on its efforts to keep domestic demand in check. In addition, the biggest risk for China’s economy is domestic demand staying overheated, rather than a US economic downturn, because in the latter case, the government could boost spending to stimulate the economy. We hope accordingly that Japan’s economy will increasingly decouple from the US economy, with help from solid economic growth in Asia, and forecast only a mild recession, with real growth of around 1% in 2008 (F3/09). However, the economy may not grow at all if Asian economic growth slows sharply.

Risks of domestic demand weakening further because of government policies

Errant government policies have started to hurt domestic demand. First, the availability of consumer financing has dried up and micro businesses as well as small and midsize enterprises (SMEs) are having financing difficulties because Credit Guarantee Corporations (CGCs) started a ‘responsibility-sharing arrangement’ in October. Second, the revised Building Standards Law (BSL) has led to a sharp decline in construction starts. Third, consumption and investment sentiment has been further harmed by the prospect of higher taxes and a return to the 1990s-style fiscal policy. Implementation of the Specified Commercial Transactions Law and the Financial Instruments and Exchange Law (FIEL) can probably be added to the mix too. The FIEL has hampered foreign investors and accelerated yen appreciation. Just to be clear, we do not think that the objectives of these policies are misguided, but hasty moves by bureaucrats to implement such laws, without regard for the economy, have had a considerable impact.

We think that such errant policies will result in a policy-induced slump (‘kansei fukyo’). First, the contraction in consumer credit and financing backed by CGCs has already put a tight squeeze on micro businesses and SMEs. With sharp increases in material and energy costs worsening the terms of trade and labor’s share of income still high, SMEs do not have much leeway to increase wages or capex. The tightening of credit may lead to an increase in bankruptcies among SMEs in Jan-Mar 2008, when cash flow tends to be tight.

Second, housing investment has fallen off sharply because of the revised BSL and is unlikely to recover in F3/09. The condominium market took a heavy hit, particularly since demand had already been weak amid a decline in what households can afford to purchase. Condo starts have slumped in 2007 and are unlikely to fully recover in 2008 because the bottlenecks that have resulted from government inadequacies are likely to take time to clear up. GDP-based housing investment will probably take longer to recover. We estimate the housing weakness alone shaves 0.3ppt from our F3/08 GDP growth forecast, and do not expect a rebound of the same extent in F3/09. If the situation continues until mid-2008, small and midsize builders are likely to go bankrupt and housing spending would be affected, and hence the problems would be more than just bottlenecks.

Third, the government’s discussion of taxes has chilled consumer and investor sentiment. The Cabinet Office’s Council on Economic and Fiscal Policy released an estimate that the consumption tax needs to be increased to double figures, and the government’s Tax Commission is considering raising tax rates and limiting deductibles against income. The need for such a major consumption tax increase is understandable, but we think that the way the idea was floated was not a smart one. More SMEs may go bankrupt, housing investment looks unlikely to recover, and already-cautious consumer sentiment may worsen further as a result of all the talk of tax increases. The prospect of a return to 1990s-style fiscal policy could also harm personal consumption and investment due to Ricardian equivalence. The Specified Commercial Transactions Law and the FIEL, which are nominally designed to protect consumers and investors, actually appear to be dampening consumer spending and investments in financial products.

Spending hurt by lack of rebound in wages, price increases

Real income will likely be squeezed in Jan-Mar 2008 by weak nominal growth in wages/income and a technical increase in inflation from higher oil prices. We estimate that the core CPI will rise 0.6%Y in Jan-Mar, owing to a higher contribution from petroleum-based product prices. The result could be seen as high inflation for market participants inured to prolonged deflation. Also, the inflation that the market is expecting is of the cost-push variety, rather than the demand-pull variety that we had expected to bring an end to deflation. In this case, consumer sentiment is likely to worsen, which would be negative for consumer spending and could be one reason for an even more stagnant tone to the economy in Jan-Mar. Additionally, the reversal of structural reform may slow down productivity growth and worsen cost-push inflation in the longer term.

Risks

We optimistically assume that oil prices will peak out soon, in conjunction with a global slowdown, and at the same time the yen/dollar rate will bottom out. However, we do not think that oil prices or the yen will decline sharply because economic growth in the BRICs is not likely to slow much and oil supplies will probably still be limited. The risk scenario, as we see it, includes a prolonged downturn led by errant policies, further increases in energy prices and sharp yen appreciation.

In this risk scenario, Japan’s economic growth could decline to 0% in 2008. Higher energy prices could seriously hurt SMEs, which are already struggling, through a further deterioration in the terms of trade owing to margin deterioration. The yen appreciation may mitigate the worsening of the terms of trade and benefit the economy, but deflationary effects are likely to take precedence due to faster initial yen appreciation than corporate cost improvements. Also, a slowdown in China’s economy could seriously hurt Japan’s Asia-dependent economy. Our Asian economics team expects China’s economy to continue to grow at a double-digit pace even if the US economy slows sharply, but we see a risk of correction in the Chinese economy as a result of a deterioration in returns on investment due to overinvestment. However, this scenario requires several worst cases to materialize at the same time, and seems for now a low-probability event. If emerging economies slow, oil prices should increasingly adjust and slow the dollar’s slide, since the dollar’s weakness has been the flipside of high oil prices. In this regard, the worst-case scenario is logically inconsistent. We subjectively give it a probability of only 30%.

Possible positive surprises include another bout of euphoria in the asset markets if financial policymakers in major countries succeed in containing the crisis by boldly easing monetary conditions and providing liquidity. Thanks to the strong performance of emerging economies, new risk money in search of the next profit opportunities may continue to gravitate toward markets with high expected returns.

By Takehiro Sato Tokyo
Morgan Stanley
December 12, 2007