Japan - It's All About the R's: The Road from Recession to Recovery

Tetsufumi Yamakawa, Goldman Sachs, London.
This article appeared in the August 2008 issue of Current Economics with permission of the author.

Key Concepts: Recession | Export Growth | GDP | Inflation |
Key Economies: Japan |

The Japanese expansion that began in January 2002 lasted 69 months, surpassing the “Izanagi” Expansion (which lasted 57 months from October 1965 to July 1970). It came to an end, however, in October 2007 and now the economy has entered a recession.

Forecasts for 2008,
% change
Goldman Sachs 1.5 0.2 1.6 3.9 20.4
Consensus1 1.3 0.7 1.4 4.0 20.2
1 Source: Consensus Forecasts, August 2008

Production, a key criterion for determining economic expansions/recessions, peaked in October 2007 and has been gradually declining since then with some monthly fluctuations along the way. An increasingly pronounced slowdown is being seen in exports, which lead production, including formerly strong exports to Europe and Asia. From that, we conclude the present production correction centered on IT-related goods will continue through the July-September quarter and that production will not recover until October-December at the earliest. At the same time, the composite indices of business conditions are declining, reinforcing the view the economy has been in a recession since October-December 2007 (see Exhibit 1).

The recession probably does not come as a surprise to the market, however, as a number of economic indicators have been strongly suggesting the possibility of one since the beginning of the year. Our estimate of the probability of a recession within the next six months, which is based on the inventory/shipment ratio, consumer confidence and other major leading economic indicators, has remained above the “high-danger level” of 60% almost consistently since January. Increasingly strong signs of an export slowdown during that period have made it easy to forecast a production slump. Accordingly, the market’s focus is shifting from the recession itself to the question of how long and how severe the recession will be (see Exhibit 2).

Exhibit 1. Business Conditions DI Suggests Japan is in a Recession Exhibit 2. Recession Probably Has Been Running Above High-Danger Level Since January
Business Conditions in Japan Probability of a Recession in Japan
Note: Shaded area shows recession periods
Source: METI, Cabinet Office
Note: Shaded area shows recession periods
Source: Goldman Sachs Economic Research

The R-Word Again: From Recession to Recovery

We see three important criteria for gauging when the business cycle will move from a recession to a recovery: (1) foreign demand — specifically domestic demand in other Asian countries, (2) the capex cycle, and (3) the employment/income environment and consequent consumption trends. Here, we take a brief look at each of those in turn.

Foreign Demand: Domestic Demand in Asian Countries the Key

Exports are slowing sharply. Exports to the United States (18% of total export volume in January-June 2008) have been running below year-earlier levels for 13 months since March 2007, although they have recently begun to show signs of stabilizing. Meanwhile, those to Europe (14.8%), a key driver of export growth throughout 2007, have begun falling off the cliff despite past euro appreciation against the yen. Exports to the rest of Asia (49%) remain relatively firm, but are showing signs of a more pronounced slowdown. There are particularly strong signs, even in exports to China, of a slump in exports of IT-related goods, which are directly affected by the global IT cycle (see Exhibit 3).

The key to an export recovery is exports to Asia, which account for roughly half of all exports, and trends in domestic demand in Asia, which underlie those exports. Our forecasts for Asian countries (excluding Japan) call for (1) domestic demand to slow in 2008 as adjustments are made to negative real interest rate policies through monetary tightening; and (2) monetary tightening pressures to ease, thanks in part to a decline in inflation, and domestic demand to stabilize in 2009. Based on those forecasts, it is difficult to imagine exports to Asia slowing in the same way those to Europe and the United States have (see Exhibit 4).

Exhibit 3. Slowdown in Exports to Europe
and Asia
Exhibit 4. Slowdown in Exports to Asia to Come to a Halt as Domestic Demand Stabilises
Slowdown in Japanese Exports Slowdown in Exports to Asia
Note: Figures in parenthesis are share of total exports
Source: MOF
Note: Forecasts of exports to Asia are estimated from Asia domestic demand forecasts
Source: MOF, Goldman Sachs Economic Research

A breakdown of exports from other countries in Asia shows that while those countries are almost all growing less dependent on exports to the United States, they are rapidly growing more dependent on exports to other emerging economies, including resource-rich countries. In China, for example, dependence on exports to the United States has declined sharply to 22.8% from 35.1% in the mid-1990s, while by contrast dependence on emerging economies has risen to 41.4% from 12.1%. That strongly suggests to us that emerging economies are no longer being as heavily affected by trends in exports to the United States as they once were and are instead growing increasingly dependent on domestic demand and demand in other emerging economies (see Exhibit 5).

Capex Cycle: Capex Plans Look Cautious on the Surface, However...

There is a strong sense capex will remain stalled for a while amid mounting risks of corporate earnings shortfalls. Machinery orders, capital goods shipments, and other leading indicators of capex suggest a correction is taking place. In addition, a number of surveys show companies’ plans calls for capex to begin slowing or shrinking in FY09 (see Exhibit 6).

While FY09 capex plans appear at first glance to be cautious, that is attributable largely to sharp declines in land investment. Capex plans in the June Bank of Japan (BOJ) Tankan survey (for businesses of all sizes) call for capex to contract for the first time in six years in FY09 by -1.4% overall (compared to +3.6% growth in FY08), with the drops concentrated in the non-manufacturing sector. Excluding land investment, however, plans made in June call for stronger growth in FY09 than in FY08, +3.5% versus +2.4%, suggesting capex is firmer than the overall numbers seem to indicate.

Exhibit 5. Dependence on US Declining, Dependence on Domestic/Intra-Regional Demand Rising in Asia Exhibit 6. Capex Slowing?
Japan's Dependence on the US and Asia Capex in Japan</td>
<td width=
Source: IMF. CEIC Note: For FY2008 capex plan by all corporation size, land investment was -50.1% (of which manufacturing: -51.5%, nonmanufacturing: -49.8%) in the June BOJ Tankan survey.
Source: BOJ

Land investment is slumping largely because it is growing more difficult to obtain financing for real estate purchases due to stricter lending standards. Real estate-related lending by banks is moderating significantly, in contrast to firm lending throughout FY08. If that trend becomes prolonged, the impact on the real economy seems bound to increase in step with declining real estate prices and growth in bankruptcies among smaller businesses. Land investment is not included in GDP-based capex, however, as it amounts to nothing more than land transactions and does not itself create value-added. Forecasts calls for a GDP contraction in April-June in a falloff from the strong growth recorded through January-March, but we see some room for an upside surprise, chiefly in the area of private-sector capex (see Exhibits 7 and 8).

Of course, there are strong headwinds to FY09 capex as corporate earnings decline and production enters a correction phase. It should be remembered, however, that as we have noted, capex plans are being significantly distorted by a sharp decline in land investment. Excluding land investment, the fundamental trend of high cash flow levels underpinning capex remains intact.

Job/Income Environment: Tug-of-War between Cyclical and Secular Factors

The employment/income environment is steadily deteriorating. The employment environment had been improving since 2002, but that trend is now coming to a halt, as reflected in a continued decline in the effective job offers to applicants ratio. Similarly, wages (total cash wages), which began rising early in the year, have been declining again on reduced overtime hours, caused by a production correction, and summer bonuses, resulting from a slump in corporate earnings. We see little room for wages to rise anytime soon especially at smaller businesses, which have little pricing power and where the profit breakeven point remains high (see Exhibit 9).

Exhibit 7. Bank Lending Stalled, Chiefly in Real Estate-Related Lending Exhibit 8. Continued Growth in Capex, Excluding Land Investment
Japan Bank Lending Has Stalled Growth in Capex
Source: BOJ Source: BOJ, Cabinet Office, Goldman Sachs Research
Exhibit 9. Wages Have Begun Declining Again
Declining Wages in Japan
Source: MHLW

In step with the decline in nominal wages, a downward trend in real wages is growing more pronounced as price inflation accelerates. In the current cycle, consumers’ perception of inflation is higher than nominal inflation as price increases are concentrated in food, daily necessities,and other frequently purchased items. Indeed, perceived inflation, which takes into account purchasing frequency in addition to consumption share, has risen to over +4%, well surpassing the nominal inflation rate of around +2%. As that suggests, real wages are perceived to be declining at a much faster pace than they appear on the data (see Exhibit 10).

Meanwhile, demographics and other secular factors are conversely pushing up average wages. Baby boomer retirements have been depressing wages since FY08, as baby boomers are replaced by younger workers with lower wages, but that trend should peak in FY09. Also businesses are shifting from part-time to full-time employment on the outlook for future labor shortages, and that together with a series of legal changes related to the job environment, including revision of the part­timer law, are pushing up average wages. Wages are beginning to decline again amid the tug-of­war between secular factors and cyclical factors, including deterioration in the employment environment due to the economic slowdown/recession.

Heading into FY10, however, we see secular factors dominating cyclical ones, and expect real wages to begin climbing thanks in part to a decline in perceived inflation. We may look for considerable wage increases in FY10, at the time of “Shunto (annual wage negotiation)” as businesses start factoring in price increases especially in daily necessities.

Reflation Trade Revisited

The Japanese stock market continues to perform relatively well. TOPIX has outperformed other major stock indexes with an increase of 11.1% (on an aggregate basis) between March, when Japanese stocks began to rebound, and August 1. That is probably the product of three main factors: (1) following a sharp decline in domestic and foreign investors’ Japanese stock weightings, we think Japanese stocks began to be viewed as relatively safe assets because of their high resistance to global inflation; (2) investment funds that were heavily skewed toward emerging economies in Asia began returning to Japan; and (3) Japanese businesses gained recognition for their high energy efficiency (see Exhibit 11).

Whether or not the relatively strong performance by the Japanese stock market translates into a full-fledged rally with an increase in absolute returns depends largely on three main factors, in our view — whether Japan quickly emerges from the present recession; experiences a re-acceleration in foreign demand in the form of exports to emerging economies in Asia, capex recovery on the back of high cash flow levels; and is able to make the transition to a sustained recovery centered on consumption growth fueled by real wage increases. These are also the preconditions for the Bank of Japan’s abandonment of its current negative real interest rate policy and the resumption of rate hikes.

Exhibit 10. Real Wages Perceived to be Declining Faster Than They Seem to Be Exhibit 11. Japanese Stocks Have Performed Relatively Well, But...
Real Wages Declining in Japan Performance of Japanese Stocks
Source: MHLW, MIC, Goldman Sachs Economic Research Source: Bloomberg
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