Wednesday, 30 November 2011

Japan - Miracles Happen, But They Don't Want To

The miracle of Japan's economy, as revealed by the set of charts in the Flow Essentials, is that things aren't much worse. Of course, the economy was hit broadside by the multiple catastrophes of all sorts which cascaded from the March 11 earthquake and tsunami. But that's not all – Japan's industrial economy has also been facing unprecedented headwinds from the rise of the yen. Consider this: since July 08, the yen has risen 39% against the dollar and 40.7% against the basket of currencies forming the SDR. Now compare it to what happened between the signing of the Plaza Accord at end-1985 and the collapse of Japan's bubble in January 1990: during that traumatic process the yen rose 39% against the dollar, but a mere 20% against the SDR. In other words, the rise of the yen over the last three and half years has been more extreme even than the Plaza Accord period.

At the same time, Japan's historic inability to price its exports continues to astonish, with the result that Japan's terms of trade have now slipped right back to their lowest reaches of 2008. So, since mid-2007, Japan's terms of trade have fallen around 20%, whilst its currency has risen about 40% against the SDR. 

And yet, we do not have collapse. Recent economic history shows Japan's return on capital (ROC) plateauing between 2004 and 2007 before collapsing back to mid-1990s levels during the onset of the financial crisis. Capital spending cuts were made rapidly, and by early 2009, Japan's stock of capital was falling, allowing asset turns and therefore ROC, to start its recovery. The catastrophes of 2011 checked that recovery, but the decline in ROC has been very minor, which in turn has meant the contraction of capital stock has barely accelerated.
The key to this recovery has been the way Japan's real labour productivity has clawed back virtually all of the productivity lost in the financial crisis – and by 3Q, it that productivity, deflated by changes in capital per worker, was still rising 1.6% a year.

Result? Household and corporate cashflows remain positive, and the private sector savings surplus has barely retreated from a high of 10.2% of GDP in 4Q10 to 8.9% in 3Q11. Those cashflows keep flooding into Japan's banks, who's loan/deposit ratios have retreated to 70%, whilst their net holdings of foreign assets leaped.

The problem with miracles, though, is that they fundamentally don't want to happen. Whilst genuinely marvelling at Japan's ability to keep this show on the road, the underlying truth is that the road is getting steeper and tougher all the time. Japan's ability to minimise the damage to ROC in the face of multiple disasters is astonishing – but even so, it is another very long step to rediscover the levels of ROC which seemed attainable in the early 2000s. The likelihood, surely, is that that new build-up of holdings of net foreign financial assets by Japan's banks will be parlayed into a new stock of real industrial assets overseas in the next few years. The ground is laid for a new wave of industrial hollowing out. 

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