27/02/2008

The outlook for Japan

Japan's economy will undoubtedly be affected by the slowdown in the US in 2008, but developments in China and other emerging economies will be more important in determining whether it can avoid recession, according to Andrew Milligan, Head of Global Strategy at Standard Life Investments.

Speaking in advance of a debate on the Japanese economy, the Euromoney Japan Debt Capital Markets Forum, being held at the Queen Elizabeth 11 Conference Centre in London tomorrow (Thursday 28 February), Andrew Milligan, said:

"There are some important questions to be asked about the future direction of Japan's capital markets and also whether this is an opportune time for global investors to alter their positions in Japanese assets generally. The questions include:

"Is recession in Japan inevitable, or can it be avoided? In my view, no it is not inevitable. Although domestic demand has been weak, part of that has related to short term headwinds affecting housing construction, while the pressures on the corporate sector do not look sufficient to bring about another collapse in consumption. External trade and investment remain the primary drivers. Many investors put too much emphasis on trade links with the USA, which are important but need to be put into perspective. Japanese firms are reporting solid demand from many emerging economies in Asia and the Middle East, which looks set to continue as long as supply imbalances keep commodity prices buoyant.

"A second question is to what extent Japan is decoupled from the USA and the world's major economies? I argue that various links between these economies need to be examined. Global trade growth is slowing, affecting Japanese firms, while recent experiences show how quickly contagion spreads across markets. Nevertheless, there is one important area where Japan has de-coupled to a certain extent, namely credit. Japan is far less affected than other regions by the global credit market turmoil. After all, the major problem for domestic banks in recent years has been their inability to generate corporate and consumer loan demand, rather than being over-generous with new credit. Japanese banks have some exposure to US sub prime type debt but this is moderate compared to say their European counterparts.

"Thirdly, the panel considers - will the unwinding of the carry trade cause difficulties for Japan? As far as the external carry trade is concerned, for example European hedge funds borrowing in yen to invest in the US, our analysis suggests that this carry trade has largely been unwound in the past nine months - not a surprise as such styles generally work best in stable financial conditions.

"A key issue for domestic bond markets, and therefore the global cost of capital, is the outlook for the Bank of Japan; when will rates finally be normalised? There is general agreement that the Bank of Japan is in a bind! It had hoped to see a classic business cycle create domestic inflation, but the internal dynamics of the ever evolving Japanese economy prevented this occurring. Could deflation become entrenched again? In my view, it looks much less likely because of the current strength of the corporate and banking sectors compared with years past. All in all, the Bank will need to wait for the next uptrend in the global business cycle before normalising can return to the agenda.

"Using our ‘Focus on Change' approach can help determine the triggers to invest in or pull back from Japanese assets. Many of the triggers will be domestic and micro, such as changes in dividend or M&A policy, but at a macro level - aggressive monetary tightening by a Chinese central bank worried about inflation would have important implications for Japanese assets."