By Satyajit Das, the author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives”
The behaviour of financial markets over recent days confirms British Prime Minister Lloyd George’s observation that “financiers in a panic do not make a pretty sight”. While workers in the Fukushima nuclear plant risked death trying to bring damaged reactors under control, financiers cowered in fear. Oscillating between boom and doom, they sought opportunities to benefit from death and destruction.
Instant experts on the nuances of nuclear power generation and the Japanese economy have crowded the airwaves providing ‘analysis’.
In perhaps the most bizarre moment to date, Guenther Oettinger, the 57-year-old former premier of the German region of Baden-Wuerttemberg, told a committee of the European Parliament that the earthquake-damaged nuclear plant was now “effectively out of control” and foretold “further catastrophic events”. He urged people to leave Japan, stating that the “whole thing is in God’s hands”. Financial markets plunged, in part at his comments.
Curiously, Mr. Oettinger had no special information or any expertise in nuclear power generation. His spokeswoman later clarified that: “He just wanted to share his concern and that he was really touched by all the images of people and the victims … ”
As little is known, much, it seems, must be surmised. Without concrete data, people have drawn parallels with the 1995 Kobe disaster (known in Japan as the Great Hanshin earthquake).
The Cost of Tragedy
The only known is that the earthquake, tsunami and its aftermath have destroyed significant infrastructure and inflicted heavy loss of life. The death toll likely to reach several thousand and the destruction of 60,000 homes and other buildings testifies to the scale of the disaster.
Initial estimates suggest that the three most affected prefectures account for a combined 6-8% of Japanese Gross Domestic Product (“GDP”). This is roughly half that of the earlier Kobe earthquake, making it economically less significant. The affected region has manufacturing plants (cars, chemical, electronic and beer), energy infrastructure (as everybody now knows!) as well as agricultural, forestry, and fishery industries.
Losses are currently estimated at between US$100-200 billion. Kobe resulted in approximately Yen 10 trillion of damage (around US$102 billion), equating to around 2.5% of Japan’s GDP at the time. These are only the direct costs. When the full economic, social and human impact is factored in, the real damage will be much larger.
The disaster has disrupted economic activity. A number of industries have been forced to suspend production temporarily. The major issues are the supply of electricity, water, transport, telecommunications and other essential services.
A few days after the disaster, over 1.3 million households had no power or running water. Relief efforts have forced authorities to close some expressways to normal traffic to allow relief supplies to be moved into the disaster area. The government has urged people to conserve power to aid the relief effort and reduce the pressure on electricity generation capacity. Power outages are likely and are expected to continue for some time, as the loss of output may be as high as 20-30% of total capacity.
The problems resulting from the Kobe earthquake were different, as it was one of the world’s busiest ports. The earthquake and damage to the port affected Japanese trade more directly. However, Kobe did not affect energy supplies for the country.
Parallels to Kobe may be misleading for other reasons. In 1995, industry was more heavily based in Japan. High cost structures and a strong Yen have forced Japanese manufacturers to relocate to lower cost locations within Asia or closer to their markets, like the US and Europe. This means that the effects on production may be smaller.
Global supply chains are also now more flexible. This may allow manufacturing to be quickly relocated, minimising disruptions. However, Japan also makes vital components, not available elsewhere, which will disrupt production for a variety of other products throughout the world.
The ‘joker in the pack’ is the problems at the nuclear power plants. At a minimum, given the risk of further problems and the impact on other facilities (including safety checks), further disruptions to power supply cannot be ruled out. This may be significant in a country where 30% of electricity is generated from atomic fission.
Japanese growth, which has been lack lustre in any case, may slow in the short run. Given the high levels of intra-Asian trade (estimated at 40-50% of all trade within Asia), this is likely to adversely affect Asian growth, although the degree is unknown.
Japan is also the third largest economy in the world and the slowdown will affect the global economic outlook. However, as Japan is only around 6% of global GDP, the effect should be modest, but may compound problems elsewhere, such as weak employment, European debt issues and also rising inflation in many countries. The key dynamic here is the overall effect on global demand and supply in aftermath of the crisis.
Another known is that the cost of reconstruction will be high. Optimists see this a catalyst to restarting the moribund Japanese economy. The key issue is how the rebuilding will be financed.
The level of insurance cover is limited. In the case of Kobe, only 3% of property was insured. The level of coverage in the current disaster is estimated at around 15-25%. The rest will have to be financed by governments and individuals drawing on savings.
The government could finance the reconstruction from existing emergency reserves or cuts in other spending. Alternatively the government could pay for rebuilding by raising money through the sale of bonds.
Financial market have assumed that Japan will instead sell its overseas financial investments including US government bonds (holding of around US$900 billion) to finance reconstruction.
Japan currently has net foreign assets worth 57% of its GDP, against net foreign assets of 16% in 1995 at the time of Kobe. If such liquidation and repatriation occurs, then the volumes may be larger than 1995.
The ‘repatriation thesis’ sees US interest rates rising as the Japanese sell US$ bonds and the Yen increasing in value as the dollars are converted into local currency.
But it is not clear that this actually happened following the Kobe earthquake. Currently, there are no signs that the government, insurance companies or private investors are selling or plan to sell foreign assets to finance the rebuilding. Investors are acting on the anticipation of anticipation of events.
There are a number of reasons to believe that the repatriation thesis is speculative. Investors will be reluctant to sell foreign investments as they typically provide higher returns than Japanese assets. The government may prefer domestic financing, to avoid an increase in the value of the Yen, to maintain Japanese export competitiveness. As this was already a concern before the disaster, the imperative to avoid any increase in the value of the Yen will be significant.
The Bank of Japan has already threatened intervention in the currency markets if the Yen stars to appreciate. In addition, the Bank of Japan has injected larger than expected amounts of liquidity into the money markets and reaffirmed its ongoing program of purchasing government and corporate securities. This has two objectives – trying to maintain confidence and also maintain interest rates down at already microscopic levels to keep the Yen weak.
Further On Up The Road
If, as expected, the government chooses to finance the rebuilding by raising debt, then attention will be on the increasingly parlous state of Japan’s public finances.
Even before the disaster, Japan’s government borrowing was over US$12 trillion, around 200% of its GDP, although net borrowing is around 140%. This debt reflects the effect of two decades of government spending in unsuccessful efforts to restore the Japanese economy to health after the crash of the ‘bubble economy’ in 1989.
Japan’s tax revenues now cover less than 50% of its annual expenditure, requiring the government to borrow the rest. Debt is 20 times the Japanese government’s annual revenues.
Japan has been able to sustain this high level of debt for several reasons. It borrows in Yen and from domestic investors, who constitute one of the largest investment pools in the world. The ability to meet interest commitment on this debt is based on low interest rates. Japanese government bonds now pay around 1.5% per annum, having paid rates below 3% for the last 15 years. Investor have accepted low rates because of low inflation or deflation (falling prices) and the absence of other attractive investment opportunities. Since1989,Japanese shares have fallen 75 per cent and Japanese property has fallen in value by 50-70% before adjustment for inflation.
While the additional financing needs for reconstruction will be accommodated in the short-run, it brings forward the day of reckoning. The cost of reconstruction may add additional debt, of as much as 5-10% of GDP.
The major rating agencies – S&P and Moody’s – have maintained Japan’s credit rating at ‘AA’, only slightly below the highest grade of ‘AAA’. However, both agencies have pointed out that the additional costs of the crisis exacerbate deep-seated, existing problems.
Japan’s current debt position is very different from the time of the Kobe earthquake. In 1995, Japanese government debt levels were much lower (net government debt was around 25% versus 140% today). In addition, the global economy was in a more robust position with stronger economic growth. These factors helped Japan absorb the effects of the Kobe disaster.
The high levels of government debt have been accommodated because of high levels of household and corporate savings. But on present estimates, an aging population and low economic growth means that soon domestic private savings will be less than that required to fund the government’s needs. Japan’s current account surplus is also under increasing pressure due to slowing global economic growth and the high value of the Yen.
Traditionally, Japan has been able to finance its government borrowing largely from domestic investors, with foreigners only holding about 5% of the Japanese Government Bonds. In coming years as its own savings pool declines, Japan will need to tap foreign investors. The disaster will accelerate the process.
Japan three problem ‘Ds’ – depression, deflation and demography – have now been joined by two new ‘Ds” – disaster and destruction. The toxic combination is exposing another ‘D’ problem for Japan – debt.
The economic effects will not be confined to Japan, increasingly affecting other countries.
Japan has historically been an important source of finance for borrowers globally, including Australian banks. Japanese investors purchased around 20% (Euro 1 billion) of the debut debt issue of the European Financial Stability Fund, providing financing for the bailout of deeply indebted European countries.
To the extent that savings are now redirected directly or indirectly (through the purchase of Japanese government bonds) towards reconstruction, these funds will not be available to finance foreign borrowers. This contracts the pool of global capital available and its cost.
Policies adopted to deal with crisis and reconstruction may destabilise currency markets. In a world of low growth, countries have used currency values as a means of gaining competitive advantage. To the extent that changes in capital flows affect currency values, attempts by individual nations to cheapen their currencies will increase volatility and affect growth.
Historically, Japan has been a large aid donor. In 2008, to increase its political and economic influence and meet the increasing rise of China, Japan revamped its aid effort creating the Japan International Cooperation Agency (“JICA”). The agency has an annual budget of more than $10 billion, comparable to that of the Asian Development Bank and the US Agency for International Development. This is additional to its commitments to supra-national and multi-lateral organisations, like the IMF and World Bank.
It is not clear what the current disaster means for these aid programs. Any retrenchment will have significant impact on recipient countries.
In the short run, as the affected nuclear power plants are damaged probably beyond repair, Japan may have to import additional amounts of LNG (liquid natural gas) or oil underpinning higher prices for these commodities affecting global inflation and growth.
The problems of the nuclear reactors may also have a long-term impact on power generation. To the extent that it slow downs construction of new and planned nuclear power plants, it may affect the availability of electricity, frequently in emerging countries that face power shortages. This could retard economic growth.
In recent months, two events – the political upheavals in North Africa and the Middle East affecting oil prices and the Japanese tsunami disaster – have highlighted the challenges of economic forecasting. Even inside information from an ‘expert network’ would not have helped.
The events highlight what economists Frank Knight and John Maynard Keynes termed the distinction between ‘risk’ and ‘uncertainty’. As Keynes put it: “By ‘uncertain’ knowledge … I do not mean merely to distinguish what is known for certain from what is only probable … the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence … about these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.”
A major nuclear incident would, of course, change the outlook dramatically with wide and largely unknown ramifications. The rush to don HazMat suits and plot the direction and speed of the radiation plume would give new meaning to the term “momentum”.