Japan was today struck by a 8.8 magnitude earthquake and a devastating tsunami over a vast areas in the northern prefectures of Honshu. While people are still waiting to be saved, or searching for their loved ones, the world economy prepares for possible implications on the economic recovery. As petty as the economy seems in the brink of human tragedy, markets reacted immediately to the catastrophe. In matter of minutes, the Yen appreciated to ¥81.8/$; Nikkei index had dropped 1.7% by closing time. It is obvious that the fragile Japanese recovery and exports are at risk - with little means to deal with them but by boosting external trade.
A short one-line text message that merely said 'I'm alive' from a childhood friend in Japan - this peculiar message is how I learned of today's tragic events in Japan. As the news and emails soon started pouring in, we prayed for the safety of our friends' families, for the people in Sendai and elsewhere. Our thoughts are with them as I write.
Although only half a day has passed since then and the sun is just rising over Japan, news media has already started to talk about the impact on the Japanese economy. Although people are still waiting to be rescued, or roam the fields of devastation in search for their loved ones - but markets, speculators or pundits rarely wait. Tokyo Stock Exchange was still trading as the 8.9 magnitude earthquake hit and Nikkei slid 1.7% at closing time - likely to continue as (or if) the markets re-open on Monday.
Some commentators (like Sheila Smith of CFR) have already offered their assessments in vaguest terms possible, as the extent of devastation is yet uncertain. For example, no European or US-based media has yet picked up to the story of how the fires in Kesennuma had turned a city of 70,000 inhabitants into burning inferno, although more than eight hours have passed since the news was first broadcasted on Japanese TV. In fact, it is difficult to understand the intricate workings and equilibriums of the Japan's economy that makes it a unique construct, and how it will affect the fragile recovery and rising commodity prices.
Many have drawn the parallel to the Kobe earthquakes of 1995. One can only hope that the damages and casualties will not be in the same scale: 6,700 lives were lost and caused ten trillion in damages (ca 2.5% of GDP). 1995 earthquake hit the core infrastructure of Japan's most important transport hubs and heavy industry. Although Kobe and the Hyogo prefecture is a bigger economy than Sendai (in the Miyagi prefecture) accounts for less than 2% of country's GDP, the affected areas of yesterday's disaster are homes of significant portions of the export sectors, such as electronics (most notably Sony and Panasonic), but also auxiliary capacities in auto manufacturing (Toyota, Nissan and Honda). Days, perhaps weeks of halted production in two of the most crisis-struck sectors will leave a severe dent in Japan's current account.
The export-lead Japanese economy was already struggling under the strong Yen. Significant trade diversion with lost sales volumes is also expected when Korea's free trade agreement with EU and US comes into force this year. Currency markets immediately added more salt to injury: as a vast flow of repatriation by Japanese multinationals and BoJ is expected, Yen rose further against the dollar, a development that will be untenable – Japanese exports will be squeezed on both cost and revenue side.
Some suggest that rising Yen may provide a cushion to the rising input prices. As Libyan crisis unfolds, Brent oil hoovers around $115 per barrel and the Japanese economy is particularly sensitive to oil prices. Damages to Japan's nuclear power plants offsets any such modest gains through exchange rates by sending energy prices upwards. It might also affect the silent public consensus on nuclear power - a historically sensitive issue.
Finally, Japan today is different from Japan by the mid-90s. The public debt has doubled to 200% of GDP and while Japan pays less than 1.5% on its bonds, the payment still amounts to 27% of tax revenues. Adding the roll of matured debt to the figure, almost 60% of tax revenues are used to pay off debt. It is extremely cynical to argue that Kobe reconstruction was actually good for boost in GDP and there was a visible increase in productivity during the two years that followed. However, unlike Kobe, almost the entire population in Sendai is uninsured (why bother when you don't even need to lock the front door to begin with?) which will inevitably create an unprecedented rise in government spending for reconstruction. And timing is particularly bad - the budgets under DPJ have focused on "people instead of concrete", i.e. social welfare and redistribution programs (such as child support to address the ageing population) instead of funding bridges to nowhere. Politically, the ruling party cannot and should not roll back on these reforms, while it still must foot the bill for the reconstruction and the massive efforts needed for the victims. DPJ is left with few options that do not lead to inflation - and energy prices is not the only concern in this respect: the affected regions are also important for agriculture and the self reliance on rice production, now flooded by the tsunami, with increasing food prices as a result. 97% of Japan's debt is held by the households, who loyally supports Japanese bonds via various instruments for very little returns. Inflation is going to hurt the households badly - who will hold the ruling party accountable, while increasing interest rates will eat up Japan's budget from within.
All these may paint a gloomy picture for Japan's fragile recovery, which stood at 4% growth last year - as modest as it may seem, it is still the highest growth in almost two decades. The longterm confidence in Japan - as a leading world economy with extremely stable and liquid markets - will be unaffected, but the disaster pose severe challenges ahead: it needs to balance further borrowing, repatriation and the stability of the Yen - without hurting Japanese exports. Further borrowing may go against all instincts of thrift - and question is how much more the Japanese households can save, or if Japan dares to go abroad (meaning China) to finance its debt. I would assume not; and monetary interventions have been largely ineffective - the effects from the easing of the Yen last year evaporated in matter of days, proving that unilateral action can do little. The question is whether even a coordinated action with the US Fed and ECB (Japan has pledged support for EFSF) would have any meaningful longterm results to that effect. As for the strong Yen hurting the exports, the answer comes down to boost Japanese exports directly (rather than through currency interventions), for example by catching up with its competitors and by concluding more ambitious free trade agreements. Or as a Japanese friend responded to my condolences today: "the best way to contribute to the reconstruction of my country is the EU-Japan FTA". Of course, we hope for his success, and the well-being of people in Japan.
author: Hosuk Lee Makiyama
original article: http://www.ecipe.org/blog/the-sendai-catastrophe-and-the-japanese-economy