Japanese annual trade deficit reflects industrial strategy reversal

Japan's energy and industrial policy that has been in place since the oil crisis of the early 1970's has been overturned.

Reuters reports today that Japan's first trade deficit since 1980 raises debt doubts:

"Japan runs trade deficit of $32 bln in 2011
Dec exports -8.0 pct yr/yr, imports +8.1 pct"

A key is the problem of increased reliance on fuel imports due to the loss of nuclear power. Only four of the country's 54 nuclear power reactors are operating.

To make up the energy gap, Japan increased fossil fuel imports 25.2%, almost one third of Japan's total overseas spending. Imports of oil, gas and coal all increased. Alternatives to fossil fuel will take years, if not decades to implement. These facts suggest that Japanese demand will add significant support to global hydrocarbon prices.

Another issue is offshoring; Businessweek reports that:

"Manufacturers from Panasonic and Honda to Sony Corp. and Toyota Motor Corp., which helped fuel three decades of trade surpluses, are moving output overseas as the yen trades near a postwar high, making exports less profitable."

A declining population also provides incentive for offshoring simply to find workers to staff manufacturing operations. Moving the work offshore also avoids cultural complications from the possible alternative strategy of allowing foreign workers to immigrate.

Japan decided to enter the military arms market

The FT reports that "Japan relaxes weapons export ban", stating that

"Tokyo has relaxed a decades-old ban on arms exports, opening the way for Japanese companies to participate in the international development and manufacture of advanced weapon systems."

This is clearly a move to bolster the country's manufacturing sector and avoid current account deficits, as China's economy has slowed down.

It appears that Japan's economic and budgetary problems are beginning to break down domestic resistance to significant policy changes. Further major changes are likely, although the timing is difficult to predict.

There is still internal resistance to increasing taxes to help with the national budget:

DPJ members bolt party on Noda tax plan | The Japan Times Online

"In a show of defiance against Prime Minister Yoshihiko Noda's policies, in particular a plan to raise the consumption tax, nine Democratic Party of Japan lawmakers submitted their resignations Wednesday to protest Noda's leadership."

Entering a new market, however distasteful, appears to be more appealing to the Japanese public than increased taxes.

Elderly Japanese control most of that country’s savings

According to a BusinessWeek article from 2000 Japan, a Nation of Risk-Takers? (int’l edition)
“Seniors aged 60 years and over own about 70% of Japan’s $11 trillion in household financial assets. Only 9% of that is directly invested in stocks and a mere 2% in mutual funds.”

Eleven years later should mean that Japanese 71 and over hold 70% of $11 trillion or $7.7 trillion in household financial assets. As these individuals pass away, a significant amount is likely to be passed down to heirs. Japan has an inheritance tax that ranges from 10% to 50%; perhaps the Japanese government will realize a tax windfall from the inevitable.

It seems unlikely that elderly Japanese will start cashing out their savings and increasing their spending as the inevitable approaches.

Since much of this savings is held in the form of Japanese government debt, inheritance taxes might reduce the country’s total government debt level.

Is Japan In Danger Of A Deflation Relapse?

"Japan’s V-shaped recovery has now become a statistical fact rather than our forecast. According to retail sales statistics, the level of retail sales in June has already exceeded the level prior to the disaster. Sales of general merchandise and apparel have recovered and replacement demand for vehicles and reconstruction demand for household equipment have lifted sales of these items to above their levels of February".
Takuji Okubo, Societe Generale (see note below).

Is Japan really, as Tukuji Okubo suggests, having a "V-shaped" recovery? On some measures this assertion would be hard to justify, but then, at the end of the day, perhaps it all depends what you mean by "V-shaped" and what you mean by recovery. Obviously, as he suggests, retails sales have just bounced back to a point above where they were when the tsunami hit (see chart below), but look what had been happening to them in the months prior to the disaster. Sales had been losing momentum ever since mid 2010, as had the rest of the Japanese economy. It is well worth reminding ourselves at this point that Japan entered recession (that is had the second of 2 quarters of eceonomic contraction) in the first quarter of 2011 because it had already contracted in the last quarter of 2010. So evidently it is not so hard for the economy to recover to its February point of departure. The more interesting question to ask might be what happens next? If the economy was weak in February, and a global slowdown is now in the works (a slowdown with a financial dimension which exerts constant upward pressure on the yen), then at some point might the next move not be down rather than up?

As we know, Japan's is an export dependent economy, so more than retail sales it is external demand that matters, and as we also know global demand is slowing at this point, which makes things more, and not less, difficult for Japan.

Industrial output has recovered to some extent, but in June it was still 5% below the February level, and nearly 16% below the pre-recession high.

And while the July manufacturing PMI showed that the sector continued to expand, the expansion was only moderate. More significantly new export orders fell for a fifth successive month, with survey respondents mentioning the fall in China and the US in particular.



And if we look at the present level of Japanese exports, we can put this "V-shaped" recovery in some sort of perspective, since in June the level of exports was down 19% from the June 2008 level (ie the level of 3 years ago).



Exporters are dependent on demand for their products elsewhere, and as we can see, demand for Japanese products in the US has remained well below the pre-crisis level.



We find a similar picture as regards exports to Europe, and it is evident that the problem goes back well beyond the recent natural disaster.




More worryingly, exports to China are now stagnating, and here the issue is clearly not absence of potential demand (since German exports to China have been booming) but price, and the recent high values of the yen.



And if we move beyond retail sales (which evidently had a very good month in June) and take a broader look at consumption in the economy, then we find that (according to statistics office date) household spending was still down 4.2% in real terms in June over a year earlier:



While gross income in worker households was down 6.7% over June 2010. So there is still a long way to go on the income side before we can expect a real deman recovery.



The broader weakness in consumer spending was also revealed in the June services PMI, which once more showed quite strong contraction.



Which brings me back to the main point of this post, what are the dangers of Japan slipping back into deflation at this point? The Japanese price indexes had, as was the case in 2008, being moving back into positive territory interannually on the back of the surge in commodity prices, but now, with the global economy slowing, there are clear signs that inflation is heading down again, and the ex-food and energy register only rose 0.1% over a year earlier in June, which is to say by September/October we could easily be back in negative territory again.



This view is reinforced if we look at the price component in the manufacturing PMI, since while input costs were again up sharply in July, they rose at the slowest pace in six months. On the other hand the survey found that the rate of output price inflation was only modest, since capacity issues and competitive pressures continued to restrict firms’ pricing power.




As will be remembered, deflation represents a serious problem for any country with a serious sovereign debt problem, since weak economic growth and price declines can mean sustained periods of nominal GDP shrinkage which simply sends the level of debt to GDP spiralling upwards, as we can see has happened in the Japan case.



For many this problem in Japan is benign, since domestic Japanese savings finance the debt, and this may well be the case for as long as Japanese home bias and the current account surplus can be guaranteed, but if either of these things go then the rate of interest which might need to be paid to attract capital could quickly make the debt dynamics unsustainable. Simply put, Japan cannot afford to "normalise" in the sense of having "normal" rates of interest and low inflation, and this fact alone should be worrying people.

Which brings us back to the starting point in the present piece: the "V-shaped" recovery in Japanese retail sales. While attention this week has been largely focused on debt sustainability in the United States, it should not escape our notice that Japan’s government chose the end of last week to make public plans to spend a minimum of Y19,000bn over the next five years and up to Y23,000bn over the coming decade in order to carry out the reconstruction of the disaster-struck north-eastern coast. There was, however, one deeply significant detail about the plan as presented, and that was that no information was provided on how this pretty significant increase in spending was going to be paid for. Despite earlier speculation no information was included on tax increases which might be implemented to fund the spending. It seems no agreement was possible within the ruling Democratic Party of Japan on the issue.

Earlier proposals had called for emergency tax increases of about Y10,000bn ($130bn), including an increase in income tax and a rise in corporate taxes, to fund reconstruction. But fierce opposition to such tax increases from within the ruling DPJ is said to have made agreement on this impossible. Just as significantly, little progress has been made on the proposal to increase the consumption tax (currently 5%) in order to reduce the mountain of debt, which is perhaps not so surprising since evidently such an increase would quickly bring to an end the current "V-shaped" surge in retail sales.

All in all, the phenomenon is very reminiscent of something which is currently going on out there, over on the other side of the Pacific, raising the possibility that the United States may not the only non-European country currently running the risk of having a credit downgrade in the non too distant future.

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NB, I certainly wouldn't like it to give the impression that I am in any way singling out Takuji Okubo for special criticism here, his report was simply the first I read, and the argument caught my attention, in fact his optimistic assesment of the Japan situation is pretty widespread among bank analysts at this point. The argument advanced in my post is simply an extension of what I have been arguing since the tsunami tragedy hit the country. See Japan’s Economy Struggles For Air (May 6th, 2011) and "Surely There Is Nothing “Funny” About What Is Going on in Japan?" (March 21st, 2011).

This post first appeared on my Roubini Global Econmonitor Blog "Don't Shoot The Messenger".