The extent of the damage wrought by the Japanese earthquake and tsunami is uncertain at this point. It is too early to know much since the country is still suffering significant aftershocks and tackling its humanitarian crisis. Though Japan faces what is sure to be an arduous recovery process, we are currently inclined to leave our 2011 real GDP growth forecast for the country at 1.8%. Electricity production is a pivotal variable: the longer the outage, the more GDP could suffer. There is likely to be an initial shock to economic growth in Q2 as power loss and supply chain disruptions weigh on business activity; however, in our view, the Japanese economy will likely expand rapidly in the second half of the year as reconstruction takes hold.
While specific estimates are not possible, we believe repair costs from the disaster will stretch into the tens of trillions of yen. In the short term, revenues are likely to fall and costs increase, putting pressure on an already poor fiscal situation. A key factor to watch in the days and weeks ahead will be the response of politicians as they attempt to meet the immediate needs of the country while balancing the longer-term fiscal challenges. Failure to adequately address either could adversely affect Japan’s overall creditworthiness.
The Bank of Japan (BoJ) has already stepped in to support the country. This week, it injected a total of 15 trillion yen (US$184 billion) and announced plans to double its asset purchase program from five to ten trillion yen in an effort to preempt risk aversion in financial markets from spilling into economic activity. No fiscal measures have been announced yet, but it is likely that a supplementary budget will be enacted to fund earthquake relief efforts. Given Prime Minister Naoto Kan’s reluctance to raise taxes or cut existing spending, we feel that the BoJ will be asked to fund the budget via money printing.
The yen has appreciated sharply since the disaster, driven by margin traders unwinding short positions, asset repatriation and market speculation. However, we do not think the BoJ and Ministry of Finance will tolerate these extreme currency moves given the natural-disaster and nuclear shocks buffeting the country and the reduced industrial production.
In the medium term, we are bearish on the yen, believing that an increasingly less dovish US Federal Reserve will provide upward pressure on the dollar as we move further into 2011. Increased money printing by the BoJ to fund relief efforts is also a potential catalyst for yen weakness. While Japanese bond yields have dropped across the curve on an initial flight to safety, we do not believe the terrible events of the past week will evolve into a sustained period of global de-risking at this time (bond yields move inversely to prices). We would expect to see continued demand for Japanese bonds in the near term, with upward pressure on yields thereafter resulting from money printing and inflation. In our estimation, it is possible that an uncontained nuclear situation in Japan could lead to a protracted period of depressed economic activity in the country, but this is not part of our current assumptions.
Globally, the crisis could lead to higher food and energy prices: Japan will not be contributing to the global food supply, its oil imports have been increasing, and a shift from nuclear energy to gas and other sources is plausible. We believe that in isolation, the turmoil in Japan will have a negligible impact on global GDP; however, if oil prices and unrest in the Middle East and Northern Africa were to accelerate markedly, the confluence of events could hamper global economic recovery.
