Strategy

Japan: After the earthquake

Japan's fragile economy may take longer to recover from the aftershock.

Economic development around the Japanese city of Sendai had a violent start thanks to Date Masamune, a samurai known as the one-eyed dragon. He lost an eye to small pox as a child and was considered unfit to lead his clan by his mother, who favoured a younger son. Masamune ended the rivalry with his sword. As head of a powerful daimyo, he settled in Sendai in 1600 and started to expand trade in the remote region. Once known for its forests, Sendai lost its green reputation after being destroyed during the Second World War. But economic development in Japan’s City of Trees continued. In 1971, the first ship entered the city’s port, which evolved into a massive container ship facility that facilitates global commerce. In 2005, Sendai exported 57,000 TEUs (20-foot equivalent units) of cargo. Imports totalled 48,000 TEUs.

On March 11, the economic activity that began four centuries ago came to a screeching halt when Sendai was destroyed by Mother Nature, who attacked with the ferocity of a samurai. The combined earthquake and tsunami disaster is at least eight times worse than worst-case scenarios developed for the region by statistical modellers.

Thousands were killed, whole towns were destroyed, and energy and transportation infrastructure was demolished.

Market watchers are now trying to assess just how big an aftershock will hit the global economy. If a full-blown meltdown at damaged nuclear facilities is avoided, many economists argue there will be no material impact. Others insist the estimated US$200-billion worth of damage that has already been done seriously raises the risk of global recession. But both camps agree the world just received a wake-up call on the importance of Japan, which produces about 8.7% of global GDP.

Ever since the financial system imploded, economists have fretted over questions related to regions with acronyms. Will BRIC nations (Brazil, Russia, India and China) support world GDP growth? How long will a rebound in U.S. housing and employment take? What if the EU’s debt-bloated PIIGS (Portugal, Ireland, Italy, Greece and Spain) default? How will revolutions in MENA (Middle East and North Africa) affect oil ?

Japan hasn’t been a hot water-cooler topic for a long time. “People have sort of forgotten just how important Japan is to the world,” says Craig Alexander, chief economist at TD Bank Financial Group. He blames the oversight on Japan’s “years of economic stagnation” and “the rapid emergence of China” as an economic powerhouse.

In the early ’90s, Japan was threatening to replace America as the global driver of wealth, but the island economy’s dependence on exports became an issue thanks to the rise of low-cost Asian rivals. Meanwhile, credit was drained from the economy when the 1992 asset bubble burst. Slow growth and deflation created a lasting economic funk. It was known as “Japan’s lost decade” before stretching into two.

Alexander points out that Japan still boasts a $4.3-trillion economy. “When you look at per capita income,” he says, “the Japanese people are very wealthy. Japan is a major industrial nation, much farther along the development path than China. It is very involved in world trade, with exports of $765 billion and imports of $636 billion.”

Nevertheless, the TD economist thinks the tragedy in Sendai will have limited impact on the world economy. The bank has cut its 2011 real GDP growth forecast for Japan to 1.4%, down from 1.9%, while lifting 2012 to 2% from 1.6% on expectations of stimulus created by rebuilding.

Optimists like Alexander point to an analysis of the 1995 Kobe quake. It caused less damage (US$120 billion), but hit the industrial heartland, which accounted for 12.4% of economic output in 1995. That year, Japan’s GDP expanded by 1.8% and then accelerated to 2.7% in 1996.

Today, the affected region is not as industrialized, accounting for about 8% of GDP. But comparisons to Kobe could prove off base, because global supply lines were harder hit. As Wall Street economist Robert Brusca notes, Japan is the country that wrote “the industrial ballet,” meaning just-in-time inventory methods. And any time this dance is hamstrung, overseas operations of Japanese and non-Japanese companies alike feel the pain, which is why auto and electronics production around the world has been disrupted.

Furthermore, Japanese debt wasn’t a major problem in 1995. Today, with a gross-debt-to-GDP ratio well over 200%, the Asian nation makes Europe’s PIIGS look fiscally responsible. According to sovereign debt expert Alex Jurshevski, head of Toronto’s Recovery Partners, the world now has to worry about how Japan pays for reconstruction. Thanks to the high national savings rate, Japan can borrow the money from its own citizens. But Jurshevski says many more chickens will come home to roost when the aging population stops funding government overspending. If Japan uses its domestic savings to pay repair costs, on the other hand, it could become a net seller of U.S. debt. And that could add to American woes by placing more pressure on the U.S. Federal Reserve central bank to unleash yet another round of so-called quantitative easing.

Japan’s ongoing nuclear crisis also poses a unique threat. Oil prices were already above US$100 per barrel when Japan was forced to shutter 11 nuclear reactors — and not all of them are coming back online. As rebuilding efforts start, the nation’s energy requirements could increase upward pressure on crude prices when the world can least afford it. Political fallout in other nations seems likely to add to this problem by dramatically increasing opposition to nuclear power.

It was a rude awakening, but Japan still matters big time to the global economy — which is why the world now faces another layer of worry.