Japan's wobbly economy


Nov 14th 2007 From the Economist Intelligence Unit ViewsWire

Will the recovery last?

Japan's economy picked up speed in the three months to September, expanding by 0.6% quarter on quarter to rebound from the previous quarter's contraction. The stronger performance reflected recoveries in private-sector capital expenditure (capex) and exports, offsetting a sharp downturn in housing investment. But with the capex boom moderating, and with the clouds over the US economy and a strengthening yen increasing the risk to exports, Japan's growth in 2008 will become increasingly dependent on the consumer.

The government's Cabinet Office published its first preliminary estimate of third-quarter GDP on November 13th. This first estimate, which is always followed by a second estimate about a month later, is notoriously prone to revision, particularly for key components such as capital spending by companies. (Indeed, the latest release revises the previous two quarters' data for private non-residential investment to show sharper contractions than previously indicated. Overall GDP growth in the second quarter is also revised downwards, to -0.4% from -0.3% previously.) As such, the latest data need to be treated with a degree of caution.

A good performance, under the circumstances With this caveat, the latest data paint a picture of a moderately robust economic expansion, rendered more encouraging in the context of a collapse in private housing investment that knocked 0.3 percentage points off growth in the quarter. Seasonally adjusted private residential investment contracted by a stunning 7.8% quarter on quarter in the three months to September, compounding a revised 4.1% contraction in the three months to June. The weakness of housing investment is likely to have reflected the recent tightening of construction regulations. The rules, which are intended to crack down on the falsification of earthquake-resistance data for buildings, in effect make the construction approvals process more time-consuming. Had the new rules not been in effect, third-quarter GDP growth would almost certainly have been higher than 0.6%. On a positive note, this means that overall GDP growth should receive a boost as the rules' impact on housing investment fades during 2008 and as delayed construction projects are resumed. An upturn in residential investment is likely to compensate for any slowdown in business investment.

Private consumption, the largest component of GDP expenditure, grew by 0.3% quarter on quarter in July-September. This was fractionally better than the revised performance in the previous quarter, but the overall trend of consumer spending growth in the past year has remained a downward one, as growth has slowed gradually from the three-year high of 1.1% recorded in the fourth quarter of 2006. The political uncertainty of recent months may have been one factor contributing to consumers' reluctance to spend. Others include an earthquake in Niigata prefecture in July and the fallout from the US subprime-mortgage crisis in August, which hit the Japanese stockmarket hard. This will have reduced the paper wealth of households. Above all, wages are still falling despite the fact that Japan's economic expansion of the past few years has dramatically increased the demand for labour.

Although the tightness of the labour market should ensure that private consumption growth will be robust in 2008, concerns remain. The Cabinet Office's index of consumer sentiment fell to a three-and-a-half-year low in October, the survey also showing greater reluctance to buy durable goods. Unemployment has also picked up slightly, and structural changes in employment patterns are resulting in the use of more part-time and low-wage workers by companies, depressing consumption.

The bigger picture Consumers will, in any event, tighten their belts if a downturn in the global economy and further fallout from the subprime-mortgage crisis substantially affect profits at Japanese companies. The latest GDP data offer some grounds for hope that the first- and second-quarter contractions in private non-residential investment—an indicator of companies' confidence in the future—were temporary. In the three months to September, businesses' capital investment increased by 1.7% quarter on quarter, contributing a perky 0.3 percentage points to overall GDP growth.

Looking forward, however, the business sector's prospects are mixed. After four straight years of strong expansion, the business investment cycle has peaked. The Bank of Japan's latest "Tankan" index of business sentiment was encouraging in its results for large manufacturers, but small and medium-sized enterprises (which provide the bulk of employment in Japan) were less upbeat. Meanwhile, the Cabinet Office's latest monthly survey of business sentiment was highly discouraging, with the leading index of business conditions falling to zero in September from 27.3 in August and 72.7 in July. In another sign that businesses may be becoming more cautious in their plans, seasonally adjusted machinery orders fell by 14.5% month on month in September, and by 3.6% quarter on quarter in the July-September period.

Much of the concern over Japan's business sector revolves around exports. This was not apparent in third-quarter GDP data, when export growth accelerated to 2.9% and contributed a whopping half a percentage point to headline GDP growth. Import growth slowed to 0.5%, resulting in a 0.4-percentage-point contribution from net trade. However, the very fact that GDP growth remains so reliant on trade is a risk for Japan, especially in light of the current turmoil in the US housing and credit markets. Japanese exports to the US are already under pressure, having fallen by 9.2% year on year in September, the largest decline in almost four years. The Economist Intelligence Unit expects the US's continuing problems to slow its economy sharply in 2008, affecting Japanese exporters. A further problem for exporters is the strengthening of the yen, which reached an 18-month high against the US dollar on November 12th, and which we expect to appreciate further in 2008 and 2009.