Japan: More moderate recovery path ahead
This post is a guest contribution by Takehiro Sato and Takeshi Yamaguchi of of Morgan Stanley.
Real GDP in January-March showed a second straight quarter of negative growth as a result of the earthquake, falling 0.9%Q (annualized -3.7%), but we believe that the domestic economy absorbed the direct effects of the quake during March and had already embarked on a recovery trajectory by April. For example, March saw the largest fall in production activity on record, but we expect METI data for April-May to show a swift recovery. April 10 was the deadline for submitting responses to METI’s aforementioned survey of production forecasts, and forecasts for a strong rebound in April-May carry some uncertainty. However, on the other hand, consumer spending was already picking up in April as the ‘stay-at-home’ mood dissipated and we understand it is relatively brisk now, so we think we can reasonably take the view that economic activity, aside from external demand, has been heading gradually back to normal since April. With regard to external demand, however, Japan posted a trade deficit for early/mid-April due to plummeting exports and import substitution, and we expect the deficit to have endured for the whole of April. We expect external demand to exert significant downward pressure on growth, particularly in the April-June quarter.
Positive and Negative Developments Since Our Last Update
Positive developments since we reviewed our outlook on March 31 are (1) besides the avoidance for now of planned power cuts in eastern Japan, upgrades to electricity supply plans which have made it possible to narrow the target for corporate electricity savings in the summer from 25% initially to 15%, and (2) the outlook for earlier-than-expected resolution to supply chain issues as a result of corporate efforts to tackle the obstacles.
Nevertheless, we do not expect the course to recovery ahead to be smooth. Negatives from the angle of the economy are (1) the possibility of production line operating rates remaining low even after operations resume, and potential for supply chain issues to continue having an effect, including fresh suspension of production or further declines in operating rates depending on the situation with parts procurement, (2) the possibility that uncertainty about future electricity supply will linger after the summer and into the medium term, including tighter supplies with suspension of nuclear plant operations and the start of new regular maintenances, and (3) from the angle of external demand, the possibility of slow export recovery and increased import substitution lowering the contribution to growth.
On the policy side as well, negatives include (1) use of virtually the full amount of the first supplementary budget in recombined existing expenditures, preventing much feed-through to stimulation of new demand, and (2) the mounting likelihood that the next large supplementary budget will not be drafted until the summer or later, as a result of issues relating not just to reconstruction plans but to funding sources too. Hence, though we expect downward momentum in April-June GDP to be less severe than we foresaw initially – indeed, in terms of direction we believe the trend is already towards recovery – we do not hold very high expectations of V-shaped recovery momentum from July-September, or October-December.
High Oil Price Is a Looming Risk for Overseas Economies
Conditions in the global economy, previously viewed as a lifeline for the Japanese economy, are also becoming less certain due to the high oil price. In 2007-08, as the oil price moved further into the $100/barrel level, the global economy was already decelerating before the Lehman shock, and did not take long to enter full-fledged recession. The Japanese economy peaked in October 2007, and the US also entered recession a little later in December 2007. The US economy is no longer in recession, but balance sheet correction in the household sector is still curbing upside potential, and our US economic team has also lowered its growth outlook for 4Q11 from +4.0%Y initially to +3.3%Y.
Based on the data so far, US economic momentum in April-June, in employment and elsewhere, looks weak in relation to how far demand was pushed back by heavy snow in January-March. Housing prices are still in a moderate downtrend as well, while there is a strong possibility that a gasoline price stalled far above $4/gallon will curb consumer sentiment. Another risk of some concern is rewinding of excess liquidity in global markets if QEII is abandoned as expected at end-June. This is because the markets seem to have factored for the ending of QEII, but possibly not to the full extent. The outlook for European economies, too, is increasingly unclear as a result of the ECB’s premature rate hike and reignition of sovereign debt worries. In emerging markets, clouds have started to form over the outlook for the Indian and Brazilian economies due to currency appreciation on the back of high primary product prices and dramatic inflows of capital.
Deflation Wins in the Post-Quake Inflation/Deflation Stakes
For prices, domestically we expect a positive year-on-year upturn in the core CPI in April-June in a backlash to the effects of removal of high school education fees, followed by a downturn with the revision of the CPI baseline effective from July data. Although price falls resulting from the revision of standards stem from purely technical factors, they may well be taken to symbolize worsening deflation. Expansion of the output gap due to negative growth up to now may also exert further downward pressure on prices from 2012, at a lag of three quarters or so. Consequently, counter to the consensus that prices will rise due to supply chain problems caused by the earthquake, instead we expect the downtrend to be exacerbated. We think this also has implications for monetary policy, as we discuss later in this note.
Our Outlook Is Revised Down for 2011 and F3/12 Is Unchanged, While We Maintain for 2012 and Revise Down for F3/13
In our third update of the post-quake outlook for the economy, taking account of changes since the end of March, for 2011 (F3/12) we now expect a milder fall in the economy in 1H than we envisaged initially, despite a lower base effect in Jan-Mar, and hence maintain our outlook for F3/12 (while downgrading C2011 outlook). Yet we do not foresee particularly strong recovery momentum for F3/12 2H and later; we revise down our forecasts for F3/13 (maintain for C2012).
On a quarterly basis, for near-term GDP we expect a 3.7%Q annualized fall in April-June and a move from negative to positive growth of 2.3% in July-September, both largely due to changes in the contribution of external demand. The reason why we expect a steep fall in April-June GDP despite industrial production and consumption-related data picking up from April is that we expect a very negative contribution from external demand during the period, due to falling exports and increased substitution with imports. Due to lingering supply chain issues, we expect the trade balance to stay in the red in both April-June and July-September. At the same time, we expect GDP growth as a whole to turn positive in July-September, again mainly on comparative contributions from external demand. From October-December on, as both the first and second supplementary budgets start to roll out, we expect the economy to track at around +4% on an annualized basis, driven by public works investment and government spending.
Fiscal Policy Assumptions: Risk of Delays in the Next Large Supplementary Budget
Since the first supplementary budget merely constituted a reshuffling of existing expenditures, we expect it to have very little effect in stimulating fresh demand. We look for the second supplementary and future budgets to have more impact in this regard, but the debate on funding sources is becoming increasingly fraught. Adding in delays in reconstruction planning and an increasingly disruptive debate on budget funding sources, we think that drafting of the future large supplementary budget is increasingly at risk of being pushed back to July-August or beyond. This raises the risk of the trajectory of V-shaped recovery being milder than we envisaged initially.
For now at least, we do not assume that taxes will be raised to secure reconstruction funds. However, fiscal resources for new supplementary budgets will need to be commensurate with the government’s commitment in its June 2010 Fiscal Management Strategy to a three-year expenditures cap from F3/12. At the moment, there are too many proposals up for debate, and the situation is still too fluid, to be able to conclude whether this will be covered ultimately by indirect taxation (consumption tax, etc.) or direct taxation (income tax, corporation tax, etc.).
Even so, political developments could make a scenario of tax hikes suddenly more probable. In one conceivable situation, a DPJ-LDP coalition might forge a cabinet with a strong interest in fiscal policy balance that advanced a strategy for raising taxes with a view to balancing future budgets. It would also be entirely natural if behind the scenes the MoF was looking at strategic proposals for a consumption tax hike with a limited timeline while voters remain highly receptive to the idea of tax increases – billed for example as a tax to fund reconstruction – to be turned later on into a permanent levy in the name of a social insurance tax. Yet the timeline for raising the consumption tax rate from April 2012 as a tax to fund reconstruction is undeniably tight when we also consider Diet deliberations, and we do not think that it is necessary to factor for expectations of a tax increase during the period of our economic outlook, F3/12-13, that we focus on in this report.
Monetary Policy Developments: We Continue to Expect Increasing Monetary Policy Involvement in Fiscal Policy
Members of both the ruling and opposition parties have called for the BoJ to directly underwrite JGBs to fund the cost of reconstruction. These calls have subsided recently, but even if they do not find fresh voice, we see a strong possibility of the BoJ taking definite action amid expectations of intensified political appeals for an end to deflation from the summer, after the debate on fiscal funding for the second supplementary budget has been reignited and standards for consumer price data have been revised. Our specific expectations include the BoJ deepening its indirect involvement in fiscal financing by increasing the sum of JGBs it purchases from the market. Here we foresee an increase in fund-backed JGB purchases, and in terms of timing look for such action to emerge in about July-August, ahead of the next large supplementary budget. Given the increasing likelihood of delays in such supplementary budget, we think the timing of additional action by the BoJ will also be pushed back. Quite apart from this, we can also conceive of policy developments such as expanded funding support for reconstruction, and low-interest loans and provisions to the proposed reconstruction fund.
Yet even such contributions to fiscal policy are unlikely to have an immediate impact on confidence in either the BoJ or the yen and JGBs. From the outset, the BoJ has more substantial capital than central banks of other leading nations. Its balance sheet is also larger than that of other leading central banks in relation to the scale of the domestic economy, but this stems from factors specific to Japan (notably, the high volume of banknotes in circulation), and since the Lehman shock, the established view of the market is that the BoJ is reluctant to expand its balance sheet – a perception that we think is broadly correct.
Risks to Our Outlook
With regard to the economy, we see the main risks as (1) an unexpected degree of tightening in electricity supply/demand, raising the need for planned power cuts again, (2) production line operating rates remaining depressed for an extended period even if manufacturers resume output more quickly than expected, and (3) supply chain issues and reputational risk eating into companies’ market shares. The main risks we see for policy are (1) a lack of progress in the debate over fiscal funding sources delaying the formulation of the next large supplementary budgets, and (2) an increasingly vocal debate over tax increases dampening consumer sentiment.
To the risks from the economy, we would add that over a horizon of the next year or so there is a risk of increasingly serious electricity shortages as operations are suspended at power generators with the rollout of scheduled maintenances at nuclear facilities nationwide, not just in eastern Japan. In principle, operations at nuclear power plant can only resume after regular maintenance (mandated every 13 months) with local government assent, and this could thwart resumption in many instances. Local leaders in many regions where nuclear power stations are located may well resist reactivation due to the experiences at Fukushima Daiichi. If an outlook for prolonged tightness in electricity supply/demand gains ground, one possible side effect would be to accelerate development of overseas production sites.
From the policy angle, we do not think that tax hikes are an immediate risk. Even if a consumption tax hike was decided, for example, bureaucratic as well as retail-level preparations – updates to retail software and so on – would be needed, so even if the Diet resolved in the extraordinary session this autumn to raise the rate, the physical obstacles to implementation from F3/13 would be considerable. Raising income tax rates would be a possible alternative, but though this would come with no time constraints, depending on the scale of such a hike it could still have a meaningful impact on personal spending if a hike was targeted at high earners with relatively high spending capacity.
Source: Takehiro Sato and Takeshi Yamaguchi, Morgan Stanley, May 20, 2011.
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