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JAPAN

At the moment the Japanese economy is experiencing a domestic led recovery, however risk to this outlook is strong. Irrespective of the cooling of the external environment, growth this year (2012) is expected to reach around 2.5% being underpinned by reconstruction spending and a pickup in private construction. Risks to this include the financial turmoil in European and a possible sharper than expected slowdown in China.

Fiscal policy

Fiscal problems are deep rooted in Japan as net public debt has increased almost threefold in the last two decades to more than 125% of GDP. Drivers have been an ageing population, a rise in social security spending (recent rapid increase), persistent weak growth and deflation all which had reduced tax revenues. Any other growth in spending has been slow and there has been a fall in capital spending.

Vulnerabilities here are substantial; the net public debt is higher than in almost all other advanced countries with projections that this debt will continue to increase. This is not the case in many advanced countries where the opposite is projected. The problem is that even a small increase in the sovereign risk premium would make fiscal consolidation more difficult, the result being challenges to financial institutions, harm to growth prospects in Japan and a spillover to global risk premia. Once market confidence is lost it is very difficult to get it back. There is a need for strong structural reform in Japan

Inflation

Core inflation (excluding food & energy) has remained negative, in May (y/y) it was -0.6% and this was the highest level since the depth of the global financial crisis in early 2009. Headline inflation in May (y/y) reached positive territory, coming in at 0.2%, higher fresh food prices had been a major driver of this.

Bank of Japan expect a stronger pick up of inflation due to a further rise in commodity prices as a result of increased demand for food and energy in the relatively fast-growing emerging economies. The expectation is a level of 1% under current policy settings

The Yen

There is concern regarding the Yen’s volatility and disorderly movements caused by speculation. The Yen would appear to be overvalued and this overvaluation is “substantial” NOT “moderate”. One of the major drivers being safe haven capital inflows resulting in a possible over-shooting of the exchange rate. The REEC has appreciated sharply since the fall of 2008 and has included a strengthening by about 40 – 60 % against the Euro and the Korean Won in real terms.

Outlook

Key elements for growth include:

  • Raising potential growth – this is essential for job creation, public debt reduction and to provide resilience against future shocks
  • Exiting deflation – a further easing of monetary policy would accelerate achievement of the BOJ’s new inflation goal of 1%
  • Maintaining financial sector stability – the authorities could strengthen their prudential framework by tightening banks large exposure to lending limits, raising capital requirements for domestic oriented banks and strengthen solvency assessment for insurers.

Source : Selected data from the IMF and Bank of Japan

J Brooks/Trade Economist. 8/8/12