Japan Update

Since April 8th, the Japanese yen has been the strongest of the major currencies. Yet as is often the case, the yen's performance in the foreign exchange market does not appear to be a reflection of the Japanese economy.

On the contrary, the situation in Japan is arguably even worse than the somber economic data would suggest. The power shortages and damaged factories are taking a larger toll than was initially evident. Press reports, for example, warn that the contagion via the supply chains may have greater global impact, which in turn could impact the manufacturing activity outside of Japan. Toyota, the world's largest auto producer, has indicated that its output collapsed by nearly 2/3 in March compared with a year earlier. Honda's loss of output was similar while Nissan reports its auto output was cut by a little more than half. One press report indicated that Toyota will cuts its output from its Melbourne, Australia plant by half this month and next, citing a shortage of parts that were to be shipped from Japan.

While the disruption emanating from Japan will hit other auto sectors on the margin, the disruption of the Japanese economy itself appears more severe. Moody's today revised this year to 0.0%-1.0% from 1.5% and with downside risks. The anticipated weakness this year will be made up for next year and it sees the Japanese economy expanding 1.5%-2.5% in 2012. Recession in the first half of this calendar year to with a recovery beginning after June. The BOJ may provide new GDP forecasts later this week. The local prices warns that the BOJ could cut its 1.6% forecast for FY2011 in half.

Moody's anticipates that Asia would be the hardest hit from the disruption of Japanese supply chains. Exports of intermediate goods from Japan are relatively larger than final goods exports to countries like China and South Korea.

The disruption from Japan may see some competitors pick up market share at least in the near-term. US chip manufacturers reported a 1.5% (2 month average) in March of its global bookings (according to SEMI, the trade group). Orders are up 22% on a year-over-year basis. The book-to-bill ratio (0.95) is the highest since last November. Japanese chip material suppliers have a 50% share of the world market. April's bookings and shipment figures will give investors a better indicator of the impact from Japan and the need to find alternative sources. This would seem to warn of potential price increases as well as the scarcity is distributed.

National unity in the aftermath of the tragedy appears short-lived. Prime Minister Kan's handling of the crisis has not won him or his government new supporters. In fact the elections over the weekend saw the DPJ lose another parliamentary seat (actually lost five gained three and one undetermined). Three polls out last week found around 70% think the government has mishandled the crisis. Yet despite Kan's weak support, he does not seem likely to resign. More likely, the opposition LDP will have to be brought into the government.

The key issue that brings the political situation to the fore is the reconstruction budget. Kan is expected to present it later this week. It was unveiled last week at JPY4 trillion (~$50 bln). Kan needs a 2/3 majority in the lower house to override a potential veto from the LDP controlled upper house. The LDP has not indicated whether it will support the reconstruction budget.

Meanwhile, in terms of monetary policy, the BOJ meets this week. BOJ Governor Shirakawa indicated earlier today that he is considering expanding a JPY3 trillion yen facility that lends to banks to lend to industry. More than 2/3 of the facility has been drawn upon. The JPY4 trillion reconstruction budget, which is likely to simply the first of several, is not expected to call for new bond issuance. Shirakawa remains reluctant to have the BOJ buy "reconstruction bonds" if/when they are needed, because he says it could lead to excessive inflation. Other observers suspect this is exactly the opportunity that Japanese policy makers should seize to finally break the back of deflation which continues to grip the world's third largest economy.