Will Japan’s quake rock the world economy?

Will Japan’s quake rock the world economy?

By Michael Schuman | March 16, 2011 | +



After a stress-inducing day on Wall Street, investors have finally woken to the potential dangers to the world economic order posed by the giant earthquake and tsunami in Japan. The Japanese economy is the world’s third-largest, and its companies play important roles in everything from heavy industry to high-tech to finance. There is no doubt that the pain in Japan will somehow be felt by all of us.

But how much? Despite the jitters in the markets, the fallout from Japan’s trauma for the world economy might in the end be very limited. Here’s why:

I think the main impact of Japan’s crisis will show itself in supply chains. Japan is tightly integrated into global manufacturing networks and is an important supplier of tons of stuff the world needs, from steel to semiconductors. So any disruption of supply of components and materials in Japan will ripple through those supply chains, potentially causing shortages or interruptions that would hamper factory operations around the world. It’s hard to tell at this point how severe the overall impact might be, but based on what’s going on in Japan’s industrial sector these days, problems seem inevitable. Factories are shut across the country, and with power shortages and transport a mess, industrial production is unlikely to get back to normal for weeks. The situation is probably most serious in electronics, since Japan produces 40% of the world’s electronics components, including materials and parts for chips and LCD TVs, as well as advanced batteries. This supply chain problem may be short-term, as companies find new sources of components, and there is enough spare capacity in Japan and elsewhere to replace production lost to quake damage. But that doesn’t mean the disruption won’t be costly.

But beyond that, there is little reason to believe the troubles in Japan’s economy will have a very dramatic impact on the rest of the world. Clearly, industrial output and demand in Japan will take a hit, and so will growth. But that won’t translate into big losses for the global economy, even in its current fragile condition. There are two reasons why. First, though Japan is a big economy, it exports more than it imports, thus a decrease in demand in Japan doesn’t spill over much into the global economy. Only 5% of U.S. exports head to Japan, for example. Morgan Stanley points out that Japan takes in 8% of Chinese exports, but Japanese demand doesn’t add much to the growth of those exports. In 2010, Japan contributed only 1.9ppt to the 31.3% year-on-year growth of China’s exports.

Secondly, Japan has been in a 20-year economic funk, and as a result, the importance of the country in the world economy has been on the decline. China supplanted Japan as the world’s second-largest economy last year. Since the economy doesn’t grow much, it doesn’t contribute much to world growth. BofA Merrill Lynch economists figure the impact of a severe slowdown of Japan’s economy would produce barely a ripple to global growth:

    According to the International Monetary Fund (IMF), Japan represents 8.7% of global GDP as of 2010. Going into last week’s tragedy, we had Japan’s economy growing 1.5% in 2011E. Assuming a drastic scenario, where annual GDP growth comes in flat, then we estimate global GDP would decline by just 0.1ppt to 4.2%. Similarly, Japan’s impact to US GDP will be limited as well…With its long languishing economy, news from Japan no longer has the powerful effect on investor psychology that it once had.

In fact, some economies and companies around the world could come to benefit from Japan’s crisis, as the experts at Capital Economics believe:

    Even though Japan is still the world’s third-largest economy, its reliance on export-led growth means that it has been a passenger of the global recovery rather than a main driver. Other countries may even see some economic benefits from the disaster in Japan, including a share in the subsequent reconstruction work. Some Japanese firms will also have to increase production at their overseas facilities, at least temporarily.

Of course, much of this more optimistic outlook is predicated on the belief that any downturn in Japan will be short and shallow. The thinking is that this natural disaster will follow the usual pattern of most others – the economy takes a hard shock in the short term, only to rebound on the stimulus provided by the reconstruction effort. Here’s how Merrill economists see things:

    As a rough estimate, looking back at past disasters, our team in Tokyo expects GDP to drop roughly 0.5ppt over the full year relative to their baseline of 1.5%. However, the drop is short-lived: they expect a surge in reconstruction to add to growth in the second half and in 2012.

Keith Wade, chief economist at Schroders, feels similarly:

    The expectation is a loss of around 1% to 1½% of GDP in the spring quarter with industrial production bearing the brunt of the adjustment. However, this would then be offset by increased reconstruction spending in the second half of the year and through into 2012.

But there are some economists who have their doubts that the economic pattern from this quake and tsunami will conform to past trends. The concern is that the Japanese economy is already so weak, and the government’s financial position so strained, that it won’t see the usual post-disaster bump. Here’s Capital Economics again:

    For a start, private domestic demand was already fragile before the disaster struck and the public finances in a dire state. The chances of a rapid economic recovery are slim but the chances of a major fiscal crisis have increased. Given Japan’s importance as a global investor this could have major repercussions around the world.

Peter Morici, a professor at      University of Maryland’s business school, argues that the impact of the quake on Japan might last much longer than history would suggest, and perhaps even have permanent consequences, due to the added nuclear threat caused by the quake, and more importantly, the new realities created by globalization:

    This time could be different. Japan has encountered two disasters-the tsunami and earthquake, and the nuclear explosions-and globalization may make Japan more vulnerable rather than in the past. The double whammy has the potential to keep the Japanese economy shut down longer and globalization offers Japan’s export customers alternatives they might not have enjoyed a decade or two ago. Hyundai and Ford now are good substitutes for Toyota’s cars, and even more so, Caterpillar tractors made in China can replace Komatsu’s land movers. The pause and uncertainty effected by the nuclear shut down will cause production to rev up more outside Japan and take longer to return to full capacity inside the country. Longer term the nuclear disaster will accelerate the implosion of Japan’s economy caused by an aging population, just as Hurricane Katrina caused people and activities to permanently leave more economically depressed areas of the Gulf Region permanently for faster growing places in the United States. Some of New Orleans’ and Mississippi’s lost capital will never be restored-it went elsewhere in the United States. For Japan’s disaster stricken economy that elsewhere may be other places around the world.

The big question, then, is: How will the quake and nuclear fiasco alter the long-term thinking of investors towards Japan? As Schroders’ Wade put it:

    The more long term worry for the equity market and the economy is that companies reappraise the risks of investing and reduce their commitment to the country. That would have a long run effect on investment and growth, making it even more difficult to service that long run debt burden.

So what’s the bottom line? The quake crisis makes it even more imperative that Japan finally undertake the long-overdue reforms necessary to put the entire economy on more solid ground. That means deregulating the domestic economy to stimulate entrepreneurship and investment, integrating more with an expanding Asia and fixing the nation’s troubled finances. Otherwise, Japan might find itself stuck in the same low-growth malaise it was in before the quake, with its role in the global economy moving backwards. The Japanese people have shown their resolve and strong sense of community throughout this terrible disaster. Hopefully Japan’s bickering politicians will discover the same spirit and finally come together to tackle the nation’s severe and long-standing economic problems.