Japanese Finances Are In A Good Position To Recover From The Recent Disaster

The massive 8.9 magnitude earthquake which struck Japan this past week has had far reaching effects, especially on the nation's energy infrastructure. The earthquake severely damaged the Fukushima nuclear power plant, which eventually exploded. Most importantly, the catastrophe impairs Japan's already fragile economy and is expected to have a considerable impact on the country's economic activities in the short run. The larger global economy, however, remains generally unaffected.

I cannot help comparing this latest tragedy to the 1995 Kobe earthquake that occurred in the southern part of the Hyogo Prefecture in Japan. Although the Kobe earthquake measured only a 6.8 on the Richter scale, it caused the Nikkei index (essentially the Japanese version of the Dow Jones) to fall 7 percent, but the index quickly recovered. Industrial production dropped on the month of the quake but resurrected in the following two months as rebuilding began. There was negligible ultimate impact on either the yen or Japanese bond markets. The 1995 quake resulted in the loss of 2.2 percent off Japan's GDP in that year.

Rolling blackouts started on Monday after the quake, affecting businesses and households as the country struggled with its worst crisis since World War II. "If power production output is damaged in a sustainable fashion, that could have a durable impact on the economy," Michala Marcussen, head of global economics at Societe Generale told reporters. He also admitted that current public finances are much weaker that they were during 1995 and there is a pressure for emergency tax hikes. Given that oil prices and the yen are stronger and Japan's debt is much larger, power outages and possible tax rises are likely to outweigh the mild economic aftershock after the Kobe earthquake.

A noticeable hit to GDP, which was only just recovering from contraction at the end of 2010, is likely to be felt over the next several months. In 1995, oil prices were lingering between $17 and $21 a barrel. The yen was at around 100 yen per dollar. Currently, oil prices are above $100 and the Japanese currency is stronger at 82 yen per dollar. The impact from these factors is more unfavorable, as Japan's GDP shrank by an annualized 1.3 percent in the fourth quarter. Before the quake, a Reuter's poll forecasted it was likely to expand 0.5 percent, or roughly 2 percent on an annualized basis, in the first quarter. Nomura, one of the major industrial and financial empire groupings of Japan, anticipates that the largest negative impact on quarterly real GDP growth will emerge from April to June 2011. The overall negative impact of the earthquake on Japan's GDP is expected to be only 0.2-0.3 percent, but that would be enough to slow down Japan's expected economic recovery by several months.

The yen is likely to rise sharply in the coming week, like it did following the Kobe earthquake as Japanese companies gathered capital back into the country, though possible measures from the Bank of Japan (BOJ) may bring two-way flows into the market. The BOJ is likely to inject 2-3 trillion yen through market operations, two to three times the normal amount, to contain short-term borrowing costs. Furthermore, the BOJ most likely will top up the 5 trillion yen in funds it put in place last year to purchase assets including government bonds to private debt—a factor that could weigh on the yen.

Another challenge is Japan's increasing debt, which already doubles the size of its $5 trillion GDP. Merrill Lynch predicts the cost for the rebuilding could be at least 1 percent of GDP, and Nomura forecasts the size of any extra budget for rebuilding to exceed 3 trillion yen. Brendan Brown, economist at Mitsubishi UFJ Securities, said altogether the debt costs could add between 2 to 10 percent of GDP to the already massive debt. This could be an extra blow to Japan dipping credit rating, which was downgraded by Standard & Poor's in January because the country did not have a concrete plan to fix public finances.

Amidst the obstacles that Japan has to face, there are still positive outlooks, as the loss of stocks in Japan is unlikely to halt the market in global equities. "The purely economic consequences will be modest: some reconstruction, some more government spending," said Charles de Vaulx, a manager at New York-based International Value Advisers LLC, where he co-manages the $1.8 billion IVA International Fund including Japanese stock. "No major international consequences, either, except maybe helping drive long-term rates higher." Komal Sri-Kumar, who manages $116 billion as chief global strategist at TCW Group Inc. in Los Angeles, observed that earthquakes rarely cause permanent downturns in an economy. He thinks that rebuilding efforts in a short term economic contraction should give way to medium term economic growth in Japan.

As the rest of the world prays for Japan, I hope that the situation works out for the better. The short-term challenges for the country are difficult, but there is still a bright light at the end of the tunnel.