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International Finance Implications of the 2011 Japanese Quake and Tsunami

Jamus Lim's picture

The recent Tohoku disaster---the worst recorded earthquake in Japan, and the worst national crisis since the Second World War---has triggered a veritable wave of analyses (PDF) on the possible economic implications of the disaster.

Much of the analysis has been top-notch, and there is little need to add to the existing discussion. However, it is worth considering one specific aspect of the economic impact of the crisis: the international finance dimension. In particular, it may be a useful exercise to think through the implications that the disaster could have on the current account position of Japan, as well as what they could mean for the Japanese yen.

To structure the discussion, it is useful to recall the current account (CA) identity, where net exports (exports, X, minus imports, M) is decomposed to the various components of national saving (S) net of investment (I):

CA ≡ X - M = Shh + Scorp + Sgov - I,

where hh, corp, and gov are the household, corporate, and government sector, respectively. Let us consider each of these components in turn.

The most immediate effect of the crisis is that, owing to the disruption of production capacity and transportation logistics, exports would fall. However, imports are likely to head in the same direction (for the same reasons), and so the ultimate short-run effect is likely to be a truncation of trade. This is likely to be temporary, however, and small, given the fact that the major damage from the quake and tsunami was concentrated in the prefectures of Fukushima, Iwate, and Miyagi, and output from these regions constitute only about 4 percent of Japanese GDP.

Still, even a momentary offlining of Japanese intermediate goods suppliers will mean a disruption to the greater East Asian production cycle, especially for the supply chains for which Japan is a part. Furthermore, if one believes that international trade is characterized by internal or external economies of scale, then the indeterminacy of the direction of trade may mean a permanent change in the patterns of trade due to this temporary disruption. By and large, however, supply chain managers appear to be taking it all in their stride, and any permanent shifts in trade patterns are more likely to be driven by long run factors.

Furthermore, history suggests that this most pessimistic scenario is unlikely. The Kobe earthquake saw Japanese trade fall by about two months immediately following the event, but subsequent trade flows made up the lost ground. The ultimate recovery from that episode occurred remarkably quickly (subscription required). The only complication this time is continued uncertainty that may arise from an inability to contain the radioactive emissions from the damaged Fukushima First and Second (PDF) nuclear plants.[*] On balance, while the likelihood of such permanent effects is certainly nonzero, without further information on the path of the real exchange rate, it is difficult to gauge whether such effects will persist. To better understand the path of net exports in the longer run, then, we turn to considering the effects of the quake on the various components of national saving and investment.

Much of the historical current account surplus in Japan (see figure) is supported by a combination of three factors. First, Japan has traditionally had high levels of household saving, which has certainly contributed to the ability of the government to sustain a very large debt-to-GDP ratio of 200 percent (although only about 9 percent of Japanese government bonds are held by foreigners). Second, strong corporate performance in foreign markets has generally yielded stable cash flows, which have in turn been used in part for corporate finance but also maintained as corporate saving. Third, the very low rates of return on capital at home meant that investment levels were been fairly subdued.

Source: World Bank staff calculations, from IMF IFS.

Notes: Quarterly current account balances shown on a non-annualized basis.

Even pre-quake, there was already reason to believe that the historically significant current account surpluses in Japan may face pressures for their reversal. Demographic changes resulting from a rapidly aging population (with the highest life expectancy in the world) would lead to drawdowns on household saving, while bond market chatter about the deteriorating creditworthiness of the Japanese government may have eventually led to increased borrowing costs and hence an even greater primary deficit.

Now, reconstruction would likely mean that the Japanese will be led to accelerate the rate in which they reduce their saving. This is likely to occur through a combination of repatriation of private assets held abroad (both by households and corporates), along with increased dissaving by the Japanese government as it bears the cost of post-quake reconstruction efforts. This reduction in saving will moreover be accompanied by an increase in investment, again due to reconstruction and rebuilding. The bottom line is that the decline in saving and increase in investment will translate into a narrower current account surplus over the medium and possibly even the long run.

What does a narrowing current account surplus (or even a deficit) mean for the real exchange rate? Since the current account identity is, well, an identity, we would expect behavioral factors to govern the response of the decline in net exports. The main mechanism by which this is likely to occur is through a stronger yen. Indeed, the immediate aftermath of the crisis saw a sharp strengthening in the yen (see figure), which must surely be in due to changing expectations about financial flow behavior discussed here.[] Ultimately, coordinated intervention by the G7 has led to a stabilization---indeed, even a slight weakening---of the yen. Over time, this weakening is unlikely to continue, as the force of trade flow reversals gets reflected in the yen.

Source: World Bank staff calculations, from Datastream.

Postscript: Elsewhere, Ilan Noy discusses the macroeconomic implications of the disaster, drawing on academic research (including his own) on the subject. Satyajit Das, among others, offers a sober take that considers many financial market considerations.

*. While the struggle to contain the effects of Fukushima remain, the most exhorbitant fears---such as how contamination would render all of Northern Japan unhospitable---are almost surely overblown. Radiation intensity follows the inverse square law, and the risks of exposure fall dramatically as one proceeds away from the Fukushima area. Even in the worse case scenarios, it is likely that the fallout will be less than that seen at Chernobyl, although there are concerns that if the problem is not contained soon, the final costs could in fact be greater.

. There are other plausible explanations for the speed by which the yen strengthened, of course. One would be the surge in demand for the yen as traders were forced to unwind their carry in response to margin calls.

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