The Hindu Business Line : Japanese recovery on stable ground?

If one would look at the economic data from Japan, all points to a healthy rebound. Gross domestic product grew at 5.4 per cent in the first quarter and industrial production in April grew at 8.4 per cent. There is also a noticeable jump in exports over the past couple of years. This has led to an improvement in business confidence evidenced by better reading of the diffusion index at the `tankan' survey. Interest rates in Japan have ruled very low for a long time to stave off deflationary pressures.

Does the Japanese bond markets, which has had a very long bull run, now runs the risk of a large sell-off? There is a school of thought that believes that Japanese growth story is primarily due to the sharp Chinese growth over the past couple years.

Chinese administration is currently trying to prevent an overheating of the economy and engineering a soft landing. Would a Chinese slowdown affect the Japanese growth? This article takes a look at the vulnerability of Japanese growth and also the risk to the Japanese Government bond market.

Let us first look at the dependence of Japanese exports to China. Japanese exports to China have grown sharply in the recent years. In the past three years, exports have grown by an annual compounded rate of 26.5 per cent. The share of Japan's exports to China as compared to the overall exports has almost doubled to 12.2 per cent over this period. China is now the second largest trading partner of Japan after the US. If one were to add exports to Hong Kong SAR, then its share would move up to 18.6 per cent. China contributed an astounding 79 per cent of the total export growth in this period. There is no doubt that the Japan's export to China is significant.

What has caused this growth? There is a sharp jump in capital formation in China and industrial machinery exports from Japan to China have moved up. There is evidence that Japanese companies have shifted production bases to China to take advantage of lower production cost. The Japanese exports to the US has dropped in this period; however, the Japanese subsidiaries in China have increased their exports from China. The METI (Ministry of Economy, Trade and Industry) annual survey of sales of Japanese companies overseas shows that roughly 43 per cent of their production in China was destined for external markets in the last financial year. There is a clear linkage of the value of Japanese currency to the export to China. In case the Japanese currency depreciates, it makes more sense to shift production to other countries and vice-versa. Imports from China into Japan have also grown substantially but not as fast as exports. In the last three years, imports grew at 13.7 per cent.

Recently, the growth in exports to China has slowed down partly due to the yen's appreciation. Japanese exports contribute 12 per cent of the real GDP and hence if there were an increase of four percentage points it would raise growth by 0.5 percentage point. If one takes the multiplier effect into account, the domestic demand would double this to one per cent.

We expect that China would have a soft landing and growth would slow down from 9.1 per cent in 2003 to around 8.8 per cent in 2005 and 7 per cent in 2005. Chinese authorities are not keen to raise interest rates as this would encourage more capital inflows into China. It is using indirect policies and controlling sectors to which financial institutions can lend.

As most of the growth of exports to China can be explained by Chinese exports, it makes growth relatively insensitive to a slowdown of domestic demand in China. As the US economy and the rest of Asian economies look in good shape, any growth increase here would negate the impact of Chinese slowdown.

To figure out the impact of China's slowdown we assume that a soft landing would result in slowdown of 0.3 and 1.8 per cent of growth in 2004 and 2005 and the respective figures for hard landing at 0.4 and 2.7 per cent. The impact of this fall in growth on the exports to China and imports is factored in.

Under the Chinese soft-landing scenario, the impact on Japan's GDP over the two-year period would be a fall of 0.26 per cent and under hard-landing fall of around 0.38 per cent.

The Japanese bond market has seen an orderly fall this year and the 10-year benchmark JGB yield have risen to 1.76 per cent from a low of 0.43 per cent seen in June last year. This increase in absolute terms is quite high. However, it would be in the interest of the Japanese economy that this adjustment is gradual. Around 97 per cent of the Japanese government bonds are held domestically. Any sharp increase in yield can have a disastrous impact on the financial institutions and corporates. The most important factor is the investor's faith in the government fiscal management ability. The Prime Minister, Mr Koizumi, has not been able to stick to the debt issuance cap that he had declared and last fiscal Japan has issued 36.6 trillion yen of debt. Though Japan is not much vulnerable to Chinese slowdown, the government would have to stick to fiscal control to ensure that the Japanese bond market is not rattled.

(The author is Senior Manager, Corporate Treasury Sales - Western India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)