Nikkei Business, 28th April 2005

Recent data on the economy have been almost universally bad, but comment remains cheerful. As I explained in my January article, Japanese policy makers are driven to optimism by their lack of policy options. If the economy is weak, the Bank of Japan cannot cut interest rates nor can the Ministry of Finance cut taxes.

In the face of poor exports, poor output, falling consumption and a disappointing TANKAN, the high confidence being expressed about the economy is not rational. Being irrational is not, however, the same as being wrong. Good luck is always possible. Economic forecasters have a poor record of success, not because they are stupid, but because it is so difficult.

The key to the economy is exports and Japan sends 20% of hers to the US and 20% to China. Those to America should be doing well, as the US economy is robust and its trade deficit is rising rapidly. The problem is China, whose imports have slowed sharply this year.

This could be just a blip, or it could be the result of domestic demand in China failing to grow as fast as the country’s ability to produce goods. Happily, a blip is quite likely, partly because Chinese data are even more suspect than those of most other countries and partly because the Chinese New Year was in February in 2005 and January in 2004. This naturally distorts comparisons between this year and last.

The Chinese economy seems to be growing so rapidly that, even if domestic demand is rising at 8% p.a., this may be slower than the growth in the economy’s capacity to produce goods. If this is happening, then imports are likely to grow more slowly than exports and the trade surplus will expand, which fits the data that we have had so far this year.

China is well placed to use exports to offset any relative weakness in its domestic demand. The government pegs the renmimbi to a fixed exchange rate against the US dollar. As the dollar has been weak against the euro and the yen, this has meant that the renmimbi has also become even cheaper than it was before.

If China is exporting its way out of trouble, then it will affect Japan in several ways. It will have a direct impact, as China is such a large importer of Japanese goods. It will also have an indirect effect, as Chinese exports may replace those of other Asian countries, thus weakening their ability to buy from Japan.

In addition there is a new threat to Japan, which comes from more direct competition. An example of this is steel, for which China has recently moved from being a major importer to an exporter. As Chinese goods become increasingly sophisticated, this threat of direct competition will grow.

If exports do not continue to support the Japanese economy, there is not much hope of domestic demand filling the gap for any length of time, but consumption could provide temporary support if Japanese households decide to save less money.

Without a fall in savings, consumption cannot rise until wages start to pick up and the situation is being made more difficult by personal disposable incomes being hit by higher premiums for the national pension scheme and by increases in income and residential taxes.

The best news recently has been the weakness of the yen. This is unlikely to boost exports in the short-term, as these mainly depend on domestic demand in China and the US. A falling exchange rate, however, gives a boost to the profit margins of exporters, which is important for investment.

Japanese companies invest far too much to be able to make a good return on capital. While this depresses returns for shareholders, it supports demand in the economy for the short term. If demand weakens, then investment is likely to fall and, because it is so high, it could fall a long way.

A weak yen which supports profit margins is thus very desirable both in the short and the long run. In the short run it should lessen the severity of cut backs in investment. In the long-term it will make Japanese exports more competitive, which is the key to any sustained economic recovery. This is because a rise in the external trade surplus is essential to offset the negative effects on demand that will come from the inevitable long-term decline in investment and the need to reduce the budget deficit.