A vibrant America is crucial to Japan's economy

A vibrant America is crucial to Japan's economy

http://www.ft.com/cms/s/0/a0664b06-60c8-11dc-8ec0-0000779fd2ac.html

By Richard Katz

Published: September 12 2007 03:00 | Last updated: September 12 2007 03:00

Will Japan's large drop in gross domestic product in April-June, a 1.2 per cent annualised decline, prove to be just a temporary bend in the road or the harbinger of more to come?

The answer lies not just in Japan but also in the US. Despite talk that Japan has "decoupled" from the US economy, the opposite is the case. The turbulence in Japan's financial markets unleashed by the US credit crisis is just one sign. More fundamentally, Japan's current recovery is more dependent on US growth than any recovery in decades. That is because this recovery is extraordinarily dependent on exports. While Japan is steadily shifting its exports from the US to Asia, Japan's ability to export to Asia hinges on Asia's own ability to export to the US.


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For most of this year - and indeed since late 1998 - the closing price of the S&P 500 stock index in New York has been followed a half-day later by the closing price of the Nikkei 225 index in Tokyo. The tightness of the linkage can be measured by the correlation index, which goes to a maximum of 100 per cent. Since May, the correlation of daily closings has been high at 87 per cent. This new linkage has arisen partly because foreign investors now account for up to 60 per cent of trades.

Because of the chain connecting Japan's exports, GDP growth and manufacturing profits, stock prices in Japan also echo the ups and downs of the yen/dollar rate. Since 2005, whenever the yen has weakened, stock prices have usually risen; when the yen strengthened, they have fallen. In the past, not only was the connection usually much looser, but sometimes it was in the opposite direction.

The yen/dollar rate, in turn, has since 2002 danced up and down largely depending on the short-term interest rates set by the US Federal Reserve.

The financial links are so tight because the underlying economic links are so tight. Ever since recovery began in early 2002, growth in Japan's trade surplus has provided a stunning third of all GDP growth. The other main impetus has been business investment, which has also supplied an unprecedented third of growth since 2002. However, this investment, far from being a sign of domestic strength, is heavily dependent on export growth.

Given all this, is it any surprise that, since 2001, there has been a 77 per cent correlation between Japanese GDP growth and exports a quarter earlier?

Those who say Japan is "decoupling" from the US would reply that, since 2002, exports to Asia have soared 52 per cent, while exports to the US are flat. But this view overlooks the triangular trade. Much of Japan's exports to Asia and China consist of parts, supplies and equipment used for Asia's own exports to the US. Japan is able to export so much to Asia only because Asia exports so much to the US. If Japan's exports to Asia and China, which buy 40 per cent of Japan's exports, were mainly for the domestic market, they would correlate with the ups and downs of these nations' GDP. Instead, they correlate much better with Asian/Chinese exports to the US. If a US downturn caused the US to cut imports from Asia, Japan's own export drive would stop in its tracks.

Far from becoming "decoupled", Japan's economy has become even more dependent on US growth during this decade. America's high-technology downturn in 2000 sent Japan and its Asian markets into a tailspin and then the US recovery served as the locomotive for recovery. In 2000-2007, the correlation between GDP growth in the US and Japan was 74 per cent. No other comparable period going back to at least 1980 even comes close.

Behind this inordinate export reliance is a recovery strategy that suppressed wages and consumer spending. Falling real wages raised corporate profits and helped finance the resolution of non-performing loans. However, it made Japan hostage to external events. For five years it seemed to work; GDP grew 2 per cent a year on average. Then, in July, the political sustainability of this posture came into question when voters repudiated the party of Shinzo Abe, prime minister, in elections for the weaker house of Japan's Diet. Now the impact of America's woes has raised questions about the strategy's economic sustainability.

Most US economists expect nothing worse than a cut in US GDP growth by 0.5 per cent or so (annualised) for two or three quarters. If this proves correct, the injury to Japan should be limited. But these economists also say the risk of US recession is nearly 30 per cent. If so, Japan will definitely be buffeted by the storm.