Thursday, June 16, 2011

Is Japan Bouncing Back?

We are optimistic about the ability of the Japanese economy to bounce back from the devastating March earthquake and Tsunami in the short-term, but we need to keep an eye on longer-term challenges.

First quarter 2011 Japan GDP came in at -0.9% q/q, with the earthquake and tsunami derailing what had otherwise been a promising start to the economic year. In particular, inventories moved sharply lower as production was disrupted. Consumption growth slowed to a standstill.

More recent partial activity data tells us the turn-around began in April. After slumping 15% in March, industrial production rose slightly in April. We expect a sharper recovery to follow given the sharp improvement to over 50 (indicating expansion) of the manufacturing PMI in May.

As you would expect the recovery is strongest in the sectors that were hardest hit by the earthquake. The replenishing of inventories will be sufficient to generate strong production in the months ahead, as conditions allow.

However, a critical factor in that initial recovery will be the prospect of power shortages over the coming summer, the peak period for power consumption. This has the potential to constrain the recovery to some extent. If so, it will have a broader impact across Japan than just the earthquake damaged areas.

As with most natural disasters (which we are becoming far too experienced at having to think about!), while the initial economic impact is negative, the longer term impact is likely to be positive as reconstruction starts and then gathers momentum.

The Japanese Government has already announced its first recovery program, estimated at around +0.9% of GDP. This will be financed by a reprioritisation of existing expenditure programs. This has been made necessary by the rating agencies making it clear to Japan that a debt-funded recovery program would not be looked on favourably.

A larger second program is being worked on now and is expected to be announced within the next few months. This is likely to be a bigger program (some Japan analysts are estimating 3% of GDP) and will be financed via “reconstruction bonds”. An interesting feature of this program is that the repayment of the bonds is likely to come from a dedicated tax, which is likely to constrain activity further out.

It’s the scale and nature of this second program that will help determine the economic outlook for Japan over the next few years. The concern at this point is that current political issues, including the possibility of an early election, could delay the finalisation of the program.