giovedì 5 novembre 2009

Away from the empire of the Rising Sun

As in the case of major international economies, Japan showed reassuring signs of recovery over the summer, though the process of economic normalization appears to be far from over. The country’s industrial sector improved sharply, with production up 1.4% m/m in September (against consensus estimates of +1.1% m/m) from +1.6% m/m in August. Nevertheless, industrial production dropped by 18.9% on a year earlier. Another positive signal came from a sharper than expected (+0.9% m/m versus 0.2% m/m) increase in retail sales for September. As in the case of industrial production, retail sales fell 1.4% from the same period a year ago but improved on August (-1.8%). Retail sales are also seen improving further in the coming months due to the resilience shown by the labour market, with the unemployment rate unexpectedly down from 5.5% to 5.3% in September. Therefore, national accounting data due November 16 will likely confirm that Japan has joined all the other countries emerging from recession in Q3.
Although the Japanese economy should continue to show signs of improvement in the short term, its medium-term outlook remains clouded in uncertainty. First, Japan has a long way to go before solving the problem that has plagued its economy the most over the last few years: deflation. The national data for September showed that deflation persisted into September, -2.2% y/y for the cpi measure and -1% y/y for the cpi core. The October’s data for Tokyo even suggested that a further deterioration might be likely in the short term, so that some economists believe that Japan will not move out of deflation for at least two to three years. Indeed, private consumption is highly unlikely to recover any time soon, so as to trigger an increase in retail prices, as the improved employment scenario combined with a 1.6% y/y wage cut in September.
Against this backdrop, there are slim hopes of a recovery led by domestic factors and only a significant improvement in exports could trigger a sharper upturn in the economy.
But exports are hampered by the yen's sharp appreciation in recent months, particularly against the U.S. dollar and, consequently, the Chinese Yuan, which is pegged to the U.S. currency. Compared with the June 2007 peak, the yen has advanced by over 27% against the US Dollar, eroding profit margins for the nation's exporting companies. Based on OCSE Purchasing Power Parity estimate, at current levels the Yen is overvalued by over 30% against the U.S. dollar.
Therefore, a devaluation of the yen is the most efficient way to spur growth in Japan’s economy in the short term even though it appears difficult to implement, given that almost all major international economies rely more or less explicitly on their currency devaluation to revive the economy.
In the medium term, the major cause for concern for the Japanese economy is the high level of public debt. According to the International Monetary Fund estimates, in fact, public debt may rise to 218% of GDP this year, and reach 227% and 246% in 2010 and 2014 respectively. The sharp increase in the supply of government bonds is likely to intensify tensions in the bond market going forward as purchases by domestic investors may soon fall. The savings rate of Japanese families declined from 15% in the ‘90s to around 2% today because of the ageing population and workforce reductions. These tensions have already begun to emerge, with yields on ten-year notes up 11 basis points in October and the cost of the insurance against default in Japan in the credit default swap market exceeding the levels seen in the U.S., Germany and the UK. An increased securities offering and softer domestic demand could therefore lead to increased yields, with severe repercussions on the public budget and investor portfolios. Considering also the possible devaluation of the yen in the medium term and the low bond yields, we warmly recommend not to invest in the Japanese bond market.

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