Impact on global economy should be modest. The shock to the Japanese economy will likely affect the rest of world through four broad channels of transmission: (1) trade in goods and services, (2) capital flows, (3) financial market contagion, and (4) commodity prices. But the overall impact will also likely depend on the policy responses in the affected economies and on initial global economic conditions before the shock hit.
Our overall assessment is that the Japan shock will not derail the global recovery because:
1. The global economy was in a relatively robust condition when the Japan disaster hit;
2. Transmission through the four channels above is likely to be relatively limited;
3. Monetary and fiscal policy-makers around the world are likely to provide more support for their economies if the spillover from Japan turns out to be more severe.
Initial conditions matter: A constructive pre-quake global baseline scenario... Going into the Japan events, the global economy displayed significant momentum and breadth, with emerging markets still motoring ahead nicely, though moderating a bit, and US economic growth (apart from weather distortions) accelerating. Global rebalancing has been underway for some time, which is beneficial for medium-term growth prospects, and monetary and fiscal policies have remained very supportive, despite some policy tightening in many emerging economies. We have therefore anticipated global GDP growth of around 4.5% for both 2011 and 2012 in our baseline forecast. Obviously, any shock is easier to digest in a healthy, early- to mid-cycle economy than in a late-cycle phase in which imbalances have built up and policy is already restrictive.
...and three key macro uncertainties. Even though we have a constructive view on the global outlook, we have been closely monitoring three key macro uncertainties that shape the risks around that outlook: (1) the surge in oil prices related to unrest in the Middle East; (2) rising EM inflation pressures that have raised the risk of aggressive policy tightening and thus a potentially sharp slowdown in EM; and (3) the sovereign debt crisis in Europe and a potential migration of sovereign concerns to other mature economies such as the US and Japan. In what follows, we discuss how the Japan shock affects both our constructive global outlook and these three key uncertainties.
Macro trade effects should be small... For most countries, trade with Japan accounts for a relatively small part of their overall economic activity. World exports to Japan account for around 4% of global trade and 1% of global GDP. Thus, the first-round effect of any 10% rise or fall in Japanese imports would amount to a change in global GDP growth of a little more than 0.1pp. Even if one factors in knock-on effects that higher/lower exports to Japan would have on investment and consumer spending in the exporting countries, the impact on global GDP would still be small. For the US and the euro area, exports to Japan account for 0.5% and 0.3% of GDP, respectively, so that the direct effect of even a large swing in Japanese demand would be negligible. Obviously, the Asia-Pacific countries trade more with Japan, and exports to Japan account for a larger share of their GDP. But even here, the direct effect of a change in Japanese import demand would be modest.
...but supply chain disruptions may cause more harm. It is quite likely that Japan's share of global trade alone understates the potential impact of the events in Japan. The fragmented nature of the global supply chain - a reflection of increased ‘vertical specialisation' - is likely to amplify any direct effects. For example, a Japanese auto manufacturer may produce many components of a car in Japan, but have its final assembly plant in China. If the production of component parts in Japan is disrupted, the final assembly plant in China may be affected. This, in turn, would affect China's exports to countries like the US. Hence, China's exports might suffer through two channels: the reduction in exports to Japan itself plus reduced exports to other destinations due to the disruption in Japanese intermediate goods production.
The damage to any given economy will ultimately depend on the magnitude and duration of the fall in Japanese production for a given amount of stocks in downstream industries. The bigger and/or longer the disruption, the less will downstream industries be able to uphold production. Even if a full picture of cross-border vertical linkages were available, the effect of this channel would be difficult to quantify, given the uncertainty surrounding the disruption to Japan and the size of stocks in downstream industries. Japan's outward FDI and export data suggest that cross-border vertical linkages matter mainly for Asian economies. It may thus be more of a regional, rather than global issue. Our Asia team is looking into the Asia linkages in more detail in a separate report. Indeed, they think that supply chain disruptions are more of a concern than the direct reduction of exports due to reduced demand from Japan; vertical linkages imply downside risks to 2011 AXJ growth of about 0.2-0.4pp.
Transmission through capital flows should be limited. Another source of spillover could be the selling by Japanese investors of foreign assets and repatriation of the receipts to cover domestic losses and to fund repair and reconstruction. This would put downward pressure on global equity prices and push bond yields up, thus dampening consumer and business spending. The most important market impact of repatriation of Japanese assets would be to push the yen higher. This would be reinforced by global reinsurers - likely liable for at least part of the damage - who will need to purchase yen to satisfy claims. However, we do not think that Japanese public and private investors are going to dump their foreign assets in size. Perhaps most importantly, G7 central banks have already started concerted FX intervention to prevent the yen from strengthening excessively. Official yen sales and the threat of further intervention should therefore cap yen strength in the near term. In summary, we do not foresee a sizeable transmission of the Japan shock to the rest of the world through the capital flows channel.
Eventual JPY depreciation. Over time, as reconstruction gets underway, supply bottlenecks and shortages of skilled labour and BoJ financing of disaster-related government spending should lift wages, prices and inflation expectations. We estimate that this shift, along with marked widening of yield spreads over JGBs, could drive a sharp yen sell-off (mostly in 2012) and, in turn, a narrowing of Japan's trade surplus consistent with increased domestic expenditures relative to GDP.
Muted contagion through financial markets. The Japan shock has led to a sell-off in global equity markets, reflecting worries about the impact on global growth, uncertainty about the nuclear situation, and a generalized de-risking. Depending on the magnitude and duration of the equity market decline, domestic demand in a number of countries could be reduced through wealth effects on consumer spending and through lower corporate investment. However, so far, the decline in equity prices has been contained and bond yields have declined, which tends to cushion any negative impact on domestic demand. Importantly, the concerted FX intervention by the G7 is a strong message that policy-makers are willing to act decisively to limit contagion. We think it is unlikely that financial markets would call into question the solvency of the Japanese sovereign, which would have the European peripheral crisis spread to a major economy. First, the Bank of Japan will monetise much of the debt. Second, thanks to generations of private saving surpluses, Japanese sovereign debt is overwhelmingly in domestic hands, making an investor stampede improbable.
Commodity prices. Crude oil prices have eased off their highs in response to the Japan earthquake, but uncertainties around oil supply and demand abound. The Middle East risk premium may persist and could intensify, eliminating any relief for global energy consumers from the short-run fall-off in Japanese demand. Indeed, Japanese demand for crude oil could soon be bolstered as losses in energy output from nuclear shut-ins need to be offset. Hence, we think the direct impact on crude oil prices should be fairly muted.
Monetary policy responses expected to vary. In the US and Europe, we don't expect the events in Japan to have a major impact on monetary policies for now. The Fed still looks likely to end QE2 in June as scheduled, the ECB seems set to start raising interest rates next month, and we continue to expect the Bank of England to start raising rates in August. However, a further significant sell-off in equities and other risk assets - leading to a marked decline in business and consumer confidence - could make these three central banks postpone their exit strategies. In AXJ, we think that central banks are likely to slow down or even put on hold the monetary tightening that has been underway. Incorporating an easier Bank of Japan policy stance, global monetary conditions should be somewhat more accommodative going forward, thus supporting global growth.
What to watch. Financial market turbulence aside, the major downside risk to the global economy stems from disruptions to supply chains. The economic data to watch for signs of such risks materializing include industrial production, manufacturing orders and shipping/freight data for quantities; PPIs for prices; and high-frequency data for bilateral trade between Japan and other economies, especially Asian ones. South Korean data already show a drop in imports from Japan, which points to emerging bottlenecks in some manufacturing sectors.
Bottom line. The tragic events in Japan will likely push the Japanese economy into a short and deep recession this year, with GDP shrinking by 1-3%. However, the spillover to the rest of world should be relatively limited. We guesstimate that global GDP growth this year could be shaved by about half a percentage point from our pre-quake estimate of 4.3%. About half of the shortfall (0.25pp) would come from a shortfall in Japanese GDP, the other half from negative spillovers to the rest of the world. Given the close trade and capital flow linkages, Asia-Pacific economies would be affected more than the Americas and Europe. The biggest uncertainty is the impact of Japanese output, transport and export disruptions on the global supply chain. Also, financial market contagion could magnify the impact on other economies. However, with initial conditions in the global economy relatively favourable going into the shock, and policy-makers around the world likely to provide more support if needed, the overall impact on world growth should be modest.
Although the situation remains fluid, we know there have been extensive demand- and supply-side shocks. A steep demand downturn is likely in the near term, given worsening corporate and household sentiment and the spike in risk-aversion in financial markets. The supply shock will be more serious: Logistics face serious disruption, and electric power is in short supply throughout eastern Japan. Such supply constraints will be a major impediment for all economic activities, especially during the April-June quarter. Thus, we believe that GDP in that quarter will likely fall by 6-12% annualized, a scale likely to exceed the 5.4%Q drop in 1Q09 after the Lehman shock.
We look for either a U- or V-shaped recovery in 1H12. It is too soon to quantify accurately the impact of the earthquake and subsequent events, and hence we incorporate the effects of ensuing countermeasures in our economic outlook on a preliminary basis. From the size of the earthquake and the apparent extent of collateral damage, we expect the total damage to substantially exceed the approximately ¥10 trillion caused by the Kobe earthquake in 1995. This damage to the stock of capital will deplete some of Japan's national wealth of about ¥8,000 trillion. The impact on GDP, a flow statistic, depends on the balance of demand and supply shocks.
Over time, we expect the focus of the government's response to shift from the current rescue and lifeline restoration efforts for survivors to reconstruction. The private sector is also likely to embark on reconstruction efforts of its own. As the government starts implementing a fiscally funded reconstruction package, we expect the resulting demand (a flow item) will begin to show up in GDP in the latter part of 2011. Thus, we look for GDP to start picking up from the October-December quarter, and the recovery momentum is likely to be especially solid in 1H12. At that time, we should see evidence of either a U- or V-shaped recovery.
For comparison, we look at how industrial production performed in the wake of the Kobe earthquake and also after the Lehman shock. Production slumped - partly due to a sudden, sharp gain in the yen - after the Kobe quake but picked up again in the latter part of 1995 as fiscal stimulus measures took effect. Given the current state of our knowledge, we tentatively look for GDP to decline by 1-3% in 2011, followed by a modest recovery in 2012, with a range of GDP outcomes from -1% to +3%.
Further, although reconstruction by definition will increase demand, we would stress that we are not saying that GDP will accelerate because of the earthquake.
Policy Responses: Much More to Come
Fiscal and monetary tools to be harnessed together. The government and BoJ are poised to mobilize the forces of fiscal and monetary policy to keep the economy from reaching new lows. The first policy response has come from the monetary side.
The BoJ doubled the asset purchasing program that forms part of its comprehensive easing strategy from ¥5 trillion to ¥10 trillion at the monetary policy meeting immediately after the earthquake on March 14. Together with the provision of massive liquidity to the money market, this represented a strong BoJ commitment to return the economy to sustainable growth.
Purchasing caps for a range of asset classes - mainly risk assets - were raised in an effort to forestall damage to the economy from risk avoidance. The decisions to more than double the purchase cap for corporate debt, where BBB spreads have become quite tight, and for J-REIT purchasing, were a positive surprise in comparison with these asset classes' market size.
Given the downside to production activity threatened by supply-side constraints, we expect several supplementary budget packages to fund restoration work. At present it is impossible to quantify the total cost of damage, and the size of the supplementary budget for restoration will not be known for some time. However, given the likelihood that damage will top that from the Kobe quake, we would expect an initial supplementary budget of ¥10 trillion or so - significantly larger than the one following the Kobe disaster. We think that several supplementary spending packages on a similar scale or larger will probably follow.
These supplementary budgets are likely to mean that new JGB issuance in the fiscal year ending March 2012 will breach the cap on new bond issuance of ¥44.3 trillion in the Fiscal Management Plan, but we do not think that this would impair sovereign credit quality. With a massive negative demand shock looming for Japan's economy, we believe that new JGB issuance can be readily financed domestically, given the decrease in real asset investment and consumption in the private sector. The BoJ can also increase its bond purchases by enlarging its asset purchasing fund or by raising the monthly outright JGB purchases. In this respect, we think that the BoJ's measures taken on March 14 may be only a first step.
Read Full Article »