G7 Economies are Slowing But Japan is in a Real Pickle

There is little doubt that the G7 economies are slowing. Recession fears have mounted the most in the US, where policymakers are responding with both monetary and fiscal stimulus. Canada has eased monetary policy and will most likely do so again next week. There has been some fiscal assistance to local governments where the economy depends on a single industry and the minority Conservative government is facing calls for additional fiscal support. The Bank of England also cut rates at the end of last year and is widely expected to cut rates again next month. While recognizing the downside risks to growth, the European Central Bank remains concerned about the upside risks to inflation. The market does not expect the ECB to cut rates until Q3, though we suspect it could come in late Q2.

Policy makers in Japan are arguably in the most difficult position to deal with downside risks to growth. Despite experiencing the longest expansion in more than 50 years and historic increases in commodity prices, Japan has not been able to normalize monetary or fiscal policy. Therefore they seem particularly ill-prepared to deal with the economic downturn.

While economists debate among themselves if and when the US economy will contract, the world’s second largest economy contracted in Q2 07 by 1.8% and the rebound in Q3 was largely a function of net exports. The combination of the recovery of the yen, which is the strongest of the major currencies over the past three months (+7.8%) and 6 months (13.7%) coupled with the slowdown in Japan’s largest export market (US) is likely to weaken this important support for the Japanese economy. Business sentiment and consumer sentiment have deteriorated. The December Tankan survey stood at a two-year low and consumer confidence is at a four year low. The economy looks to have largely stagnated in Q4.

Japanese corporate profits rose a miserly 1.3% in Q3 07 after a 14% increase in Q2. Over the past 52-weeks, Japan’s broad equity index the Topix has fallen by almost 21.8%, among the worst performances not only in the G7 but among equity markets globally. One illustration of the impact of the under performance of Japanese shares is that as of earlier this year, the total market capitalization of China, the world’s third largest economy, has surpassed that of Japan, the world’s second largest economy, which in nominal dollar terms is twice as large as China.

Japanese banks reportedly have very little subprime exposure, which has clobbered many of the world’s large investment banks. But Japanese banks have performed miserably and even before the credit crisis hit. Consider that the Topix Bank share index peaked in early April 2006 and has subsequently fallen by nearly 50% with three-quarters of that fall having taken place over the past 12-month.

Japan’s unemployment rate stood at 3.8% in Nov 07, the most current data shows. This represents the lower end of where Japanese unemployment has been for nearly a decade. Yet wage growth has been lackluster. In fact the 0.1% rise on a year-over-year basis in November was only the second positive reading in the first 11 months of last year. Japanese households appear to be tapping into their savings to help make ends meet. According to OECD data, Japan’s savings rate has fallen eight percentage points since 1998, which is a steeper plunge than experienced even by the US. The most recent available data indicates that the once heralded Japanese savings rate has fallen below 3%.

What can Japanese policy makers do to arrest the erosion of the economy and to mitigate the effect of the end of the expansion cycle? Interest rates in Japan are already very low. The overnight rate is set at 0.5%. There is not much scope to cut it without returning to the extraordinary quantitative easing mode that had been previously adopted to counter the deflationary forces. Inflation in Japan remains low by nearly any measure. In November it stood 0.6% above year ago levels. The Bank of Japan continues to warn that the period of deflation is over and that price pressures will gradually rise. At the long-end of the curve, Japan’s 10-year bond yields less than 1.4% annually.

Nor does there seem to be much scope for the government to provide much in the way of fiscal support. The government continues to pay lip service to its goal of a balanced budget by 2011. Debt at the central and local government level as a percentage of GDP is expected to stand at a whopping 147% at the end of the current fiscal year which ends March 31.

Since the ruling Liberal Democrat Party lost last July’s upper house election and Prime Minister Abe resigned, the new Prime Minister Fukuda has come under strong pressure to increase spending. In recent years Japan had cut back on public works spending, which is largely regarded as what Americans call “pork barrel” expenditures. Koizumi had cut public works spending by 3.5%-10.7% a year and Abe cut it by 3.5%. Fukuda’s budget calls for a 3.1% cut in the next fiscal year. Fukuda also projects a modest increase in the primary deficit (which excludes interest payments on bond sales) to JPY5.2 trillion from JPY4.4 trillion in the current fiscal year. It will take nearly a quarter of the JPY83.1 trillion of spending in the FY08 budget to service Japan’s debt, which in dollar terms is roughly the equivalent of Portugal’s GDP.

With interest rates extremely low already, a rate cut would not seem to be a very effective stimulus in Japan and the country still is experiencing a hang over from its past fiscal excesses, traditional policy responses do not seem very promising. Yet there is another resource Japanese policy makers can tap into to stimulate its economy.

At the end of December Japan held nearly $950 bln in currency reserves. As the sovereign wealth funds illustrate, countries that have accumulated vast reserve holdings are thinking of them a great deal differently than major industrialized countries have traditionally regarded their reserves. Japan’s reserve holdings are far and a way in excess of any reasonable need.

This is the rainy day that reserves are theoretically intended for. Japanese policy makers should consider taking a quarter to half of their reserves and give the money back to its citizens. After declining for the past two years, Japan’s population stands near 128 mln. If a quarter of the reserves are distributed equally, each person would receive about $1850. This is about 5.25% of Japan’s per capita GDP. The ratio of consumption expenditures to disposable income stands near 72.5%. This would suggest that about $1340 of the reserve payment may be consumed on goods and services.

In comparison, US officials are talking about a $100-$150 bln fiscal stimulus package for an economy that is more than twice as large as Japan’s. According to press reports US President Bush supports a tax rebate of $800 per person with some tax cuts for business investment as well. Japan needs to focus on consumption rather than investment. If anything, the source of many of Japan’s economic woes, like reliance on exports and relatively low return on capital, appears to stem from excess investment and insufficient consumption.

Drawing down a quarter of Japan’s reserves would still leave Japan with plenty of reserves. If Middle East and Chinese central banks, through their sovereign wealth funds can buy distressed global banks, surely the Japanese can use a fraction of their reserves to stimulate their economy, especially when other policy tools seem largely ineffective to impractical. It would help bolster the support for Prime Minister Fukuda, who has yet to receive a popular mandate. It would steal the thunder of some of Japan’s critics of its vast reserve holdings. It would demonstrate the old adage of where there is the will there is a way.