Japanese Economy Contracts in Q2 2008

Includes: EWJ, FXY, JEQ
by: Edward Hugh

Japan's economy contracted in the second quarter of 2008, bringing the country to the threshold of its first recession in six years, as exports fell and consumers spent less. Gross domestic product was up by 1% over the second quarter of 2007, but down by 0.6% over Q1 2008.

So the recession many observers were anticipating in the last quarter of 2007 may now have arrived in the second quarter of 2008. If this is the case the reason is pretty clear, flows of funds (following the sub-prime related credit bust in the OECD world) into some key emerging markets mainained Japanese exports at a much higher level than could have been anticipated. Now - on the back of rising inflation and central bank tightening those economies themselves are actually slowing. Click to enlarge:

Exports fell the most since the 2001-2002 recession, robbing Japan of the engine that drove its longest postwar expansion, while record fuel and food prices deterred spending at home. Japan joins four more members of the Group of Seven countries in having a quarterly contraction this year, with the others being Germany, France, Canada and Italy. In fact the only two economies in this group which haven't contracted are the US and the UK. Click to enlarge:

Exports were down 2.3 percent, the first drop in three years, while imports fell at an even faster pace of 2.8 percent. The net consequence was that the trade balance was more or less neutral on this quaters GDP performance. The contraction was thus almost entirely due to changes in domestic demand. Consumer spending, which accounts for more than half of the economy, decreased 0.5 percent from the previous quarter. Private demand, which includes company and consumer spending, accounted for 0.4 percentage point of the economy's quarter-on-quarter contraction. Business investment slipped 0.2 percent. Housing investment slid 3.4 percent as homebuyers held back from new condominiums because of rising prices and banks tightened lending to developers. The other 0.2% of the contraction came from a reduction in public investment.

This last point is important, since it draws attention to another important structural feature of the Japanese situation.

The latest IMF report on their Article IV Consultation with Japan makes an important point :

"Fiscal consolidation has paused this year and the authorities' medium-term plans fail to build on recent progress. The FY2008 budget targets a broadly unchanged primary deficit (excluding social security) with a slight increase in total expenditures due to higher social security costs and lower tax buoyancy, while the net public debt ratio is estimated to rise to 94 percent of GDP, up from about 85 percent of GDP three years ago. The authorities' revised fiscal plans continue to target a primary balance by FY2011. Under staff's lower growth projections, the authorities' plans would be insufficient to prevent net public debt from continuing to trend up."

The data down at the bottom of the IMF link is useful since it is possible to see the steady decrease in the government fiscal deficit from 2004, although this is now projected to rise again in 2008. It is clear that there is a substantial reduction in public investment ongoing in Japan, and this has borne the brunt of the plan for reducing the annual deficit (although obviously domestic construction will remain permanently weak) while of course current spending has to trend structurally up due to the growing elderly dependence.

Anyway, the bottom line is even during what many claim to have been "the longest Japanese expansion in recent history" the annual deficit hasn't been able to get much below 3%, and the debt to GDP has climbed steadily - incidentally the 94% number the IMF cite differs from the more widely cited OECD figure of 179% of GDP (2006), since basically it doesn't allow for accumulated liabilities under the social security system.

So now everyone expects slippage on the 2011 fiscal balance deadline, and it will simply be interesting to see how and when the ratings agencies react. As has been seen in Germany, raising consumption tax in an export driven economy is basically a "no-no", and the last time they tried it in Japan (in 1998) they sent themselves off into the most severe recession of the whole lost decade and a half, so what they are going to do to bring the deficit under control is a real head-banger I would say.