Short Lived Recession in Japan but Tough Time for Fukuda

Japan is in recession, but the pain is likely to be far less painful than its US and Europe counterparts. Lack of excesses in terms of capacity, labour and inventories will mitigate the downturn. In spite of the sharp drop in corporate profits and the associated softening corporate sentiment, capex has fared relatively well at around flat yoy for the past two quarters. The continuously strong demand for replacement capital investment will limit the downside. Compared to past downturns in Japan, this recession should be less severe.

I expect a longer pause before policy tightening to resume, perhaps into the later part of 1QCY2010. With the current recessionary environment, clearly the Bank of Japan will not raise rates. It will only begin the normalization process upon that the global economy emerges into a clearer recovery phase. Rates cut, however, are unlikely as negative qoq growth should be contained to just two quarters.

I, however, expect a tough time ahead for the newly formed Fukuda Cabinet. Tax revenue is shrinking in the face of a slowing economy and mounting social security expenses. Until we see a clearer picture on the macro front, it remains a key challenge for this new cabinet to raise the consumption tax. The earliest time possible for a rise in consumption tax by about 2-3% is likely from Q4CY2009.

The Cabinet Office released its revised fiscal and economic forecasts on 22 July 2008 and according to that, the primary balance in FY2011 is expected to be in deficit. This latest numbers suggest that the government target of a positive primary balance is impossible without any new stable revenue sources. Worsening corporate profits were the main background to the FY2007 tax revenue shortfall and I expect the trend to continue into FY08 revenues on the back of deterioration in FY08 corporate profit outlook in Q2 Tankan.

The shortfall, according to some estimates, which is nearly equivalent to a 1-1.5% consumption tax hikes will increase pressure for further bond issuance.