Growth Hits Nadir in Japan After Record Contraction in Q1

Falling Off the Cliff

As expected, Japanese growth sunk to a nadir in the first quarter of 2009. Figures released by the Cabinet Office on Wednesday showed that GDP in real terms shrank by a vertiginous 15.7% in annualised terms in the three months through March after a 14.4% contraction in the last quarter of 2008. It was the largest plunge in growth since comparable records began in 1955. Quarter-on-quarter (q/q), growth declined 4.0% in seasonally adjusted terms following a 3.8% contraction in the three months through March.

Japan’s economy remains acutely exposed to the effective collapse in global demand. Recovery in the economy from its protracted stagnation in the 1990s was fuelled by net exports. Rising external demand supported a recovery in private capital expenditure after more concerted corporate restructuring improved debt-to-equity ratios. However, private consumption growth, which accounts for over two-thirds of GDP, remained below par as household confidence in the economic outlook never fully rebounded. Although Japan’s banking system is relatively sound, liquidity tightened amid the chronic risk aversion that prevailed following convulsions in global financial markets in the third and fourth quarters of 2009. Small and medium-sized enterprises that account for the bulk of production in Japan were particularly exposed to the truncation of short-term credit for both trade and production. Asset prices also experienced significant reversals, while the yen appreciated as carry-forward trades were rapidly unwound. External demand that had been on a declining trend from the second half of 2008 sucked out sharply in the fourth quarter, pulling away the economy’s central support. Companies are now scrambling to slash inventories and cut production capacity, while consumers have been increasingly overshadowed by rising unemployment and stalling income growth.

Outlook and Implications

The full impact of the export shock was made manifest in the first quarter. Exports plunged 70.1% in annualised terms in the three months through March and by 26.0% from the previous quarter, deducting 4.2 percentage points from the overall quarterly growth rate. Industrial production has crumpled in line with the slump in external demand, recording record rates of attrition through the first quarter, according to monthly series. However, the net export position has been partially supported by a concomitant slide in imports, as global commodity prices remain depressed following major corrections in the second half of 2008 and domestic demand weakens. Imports fell 47.7% in annualised terms and by 15.0% from the previous quarter to make a positive 2.7-percentage-point contribution to first-quarter growth. Net exports subsequently subtracted 1.4 percentage points from the q/q growth rate.

Instead, the main detractor to growth was domestic demand as the collapse in exports reverberated through the economy. Overall domestic demand contracted by an annualised 9.8%, with private demand contracting 12.8%. In q/q terms, private demand shrank 3.4% following a decline of 1.1% in the fourth quarter of 2008, deducting 2.7 percentage points from the quarterly growth rate while ongoing inventory adjustments cut 0.3 percentage points from quarterly growth. The slump was concentrated in private investment constrained by falling earnings, tight credit conditions, excess capacity and the profoundly weak economic outlook. Excess capacity in the economy was highlighted by the rise in inventories recorded in late 2008, which deterred production as companies sought to shift their merchandise holdings. Private non-residential investment contracted 35.5% in annualised terms and by 10.4% (q/q) following a 6.7% quarterly decline in the fourth quarter. Investment has now recorded negative quarterly growth since the second quarter of 2008. Residential investment also took a huge hit, falling 20.0% in annualised terms and by 5.4% q/q, reflecting the depressed state of real estate. Gross fixed capital formation, which aggregates residential investment, non-residential investment and public investment, sank 27.5% in annualised terms while contracting 7.7% from the previous quarter.

As production capacity has been downscaled and investment cut, labour demand has begun to weaken, forcing unemployment higher. The unemployment rate rose to a four-year high of 4.8% in March from 4.4% in February. In a further indication of labour market weakness, the jobs-to-applicants ratio fell to 0.52, the lowest level in seven years, foreshadowing further hikes in the overall unemployment rate. Households have been further undermined by the negative wealth effect of falling asset prices, while cuts to already super-low interest rates, reducing earnings from savings on which the sizeable pensionable sector of the population remain dependent for income. Under the influence of these forces, the downturn in private consumption growth is gaining traction, contracting by an annualised 4.2% and by 1.1% on the quarter following a 0.8% decline in the three months through December. Household consumption fell 4.3% annualised and by 1.1% q/q. The only modestly positive contribution to growth was government consumption, which rose 0.3% q/q to make a positive 0.1-percentage-point contribution to the quarterly growth rate.

Hitting Bottom?

The main question now is whether the hideous first-quarter figures mark the economy’s nadir. In the most basic sense, growth cannot continue to contract at these rates indefinitely. Authorities have intervened with aggressive macro-economic stimulus. After lowering its leading interest rate to 0.3%, the Bank of Japan has reverted to quantitative easing measures to flood the financial system with liquidity and relieve funding constraints. Concurrently, the government has announced a series of fiscal stimulus measures culminating in a record ¥10.0-trillion (US$99 billion) package announced in early April. Measures announced prior to the record spending package were worth a cumulative ¥12 trillion, or 2.0% of GDP. The record spending package will focus on bolstering social security nets for non-government workers, investment in health and medical services, expansion of the resources of state-owned financial institutions for alleviating continuing constraints in the financial system, and commitment to clean energy initiatives. This massive fiscal stimulus should begin to come on stream in the second half of the year, providing some fillip to growth.

However, the government is limited in its scope to bolster domestic demand indefinitely given the weak state of national finances. IHS Global Insight forecasts that the budget deficit will balloon to 8.8% in 2009 as spending accelerates and revenues atrophy. The public debt level is expected to exceed 220% of GDP by the end of the current fiscal year. New bond sales will rise to a record ¥44.1 trillion in the current fiscal year, ending March with total bond sales rising to a historic high of ¥130.2 trillion. The balloon in public debt leaves public finances exposed to any adjustments in interest rates, following their eventual normalisation in the event of economic recovery. A sustained revival in the economy remains tied to recovery in external demand. Monthly indicators have pointed to a possible bottoming out of the downturn. Exports increased month-on-month in March, buoying industrial production to its first positive growth since September 2008. Japanese production should remain sensitive to any, even marginal, shifts, in external demand as the inventory adjustment gathers speed. Concurrently, consumer confidence rose to a 10-month high.

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