WEEKEND READ: Japan's double blow

Japan's trade surplus has fallen by 86 per cent in a year – a worrying development as the economy tries to cope with a mass unwinding of yen-denominated carry trades.

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Japan’s Finance Ministry has released statistics showing that the country’s trade surplus for the first half of the fiscal year (April-September) has plummeted 85.6 per cent from the previous year. While the Japanese trade balance remains in surplus, it was weakening fast even before global recession loomed.

The figures do not bode well for the state of Japan’s economy, especially as the effect of recession in the United States and Europe has yet to bear down fully on Japan’s export sector. If Japan’s trade slips into the red, it will not be able to add to its currency reserves – ultimately the country’s only means of staving off serious economic dislocation.

Japan’s trade surplus fell to $8.2 billion, the lowest level since the second half of 1981 when the surplus sank to about $6 billion after oil prices spiked. Exports in fiscal year 2008 have climbed so far by only 2.5 per cent to about $429 billion, while imports soared 16.1 per cent to $421 billion. The good news for Japan is that, contrary to estimates by independent economists and the Finance Ministry’s preliminary evidence from the first 20 days of the month, September saw a $9 billion surplus, turning around the anomalous $3 billion deficit in August — though still amounting to a 94 per cent drop on the year.

Japan’s trade balance thus is looking poor, but it is still a surplus. This is not surprising after the unprecedented spike in energy and food prices this summer when oil prices reached nearly $US150 per barrel, Japan’s import costs skyrocketed and the country began approaching recession. Japan is almost entirely dependent on the international market for basic commodities, especially energy costs. Crude oil, natural gas, liquefied natural gas and coal combined rose an average of 76 per cent during the period surveyed, pushing import costs to an all-time record.

Now that the summer’s rough inflation has abated, Tokyo is enjoying a reprieve from high costs. Moreover, in recent months, its currency has rapidly appreciated amid the global financial crisis as investors worldwide have rushed to pay back debts taken out in yen (the so-called carry trade), launching the currency past 100 per US dollar to 97, and pushing 95. These forces will ease the overall cost of Japan’s imports considerably in the coming months.

The risk is now shifting to Japan’s export sector, where a stronger currency will lead to disaster. Japan’s exports grew by only 1.5 per cent in September and a mere 0.3 per cent in August year on year. In the past two years, exports have accounted for more than half of Japan’s average of gross domestic product (GDP) growth rate of 2 per cent, as domestic consumption is mostly stagnant. But now, demand for those exports is about to plummet in Japan’s external markets as the financial crisis sends the United States and the European Union tumbling into a recession that could last several quarters, especially in Europe. These two importers directly account for about a third of Japanese exports, and Japan’s exports to the United States (about 20 per cent of total exports) have fallen by 32.8 per cent in the past two months. Compounding the trouble, the period of November through February is when Japan has been most susceptible to trade deficits in the past 28 years (mainly because of winter heating and energy costs, and the slump in Western markets after the last shipments of Christmas goods). Recession will only make matters worse.

Of course, domestic consumption, though barely growing, still accounts for 57 per cent of GDP, against the export sector’s 15 per cent. And Tokyo will find some comfort in its major East Asian consumers China, South Korea, Taiwan and Hong Kong, which import another third of Japan’s total exports. The proportion of Japanese exports that each of these countries (except Hong Kong) has received have grown the past two years. Tokyo could also benefit by picking up more business if its regional competitors are knocked out by the global recession.

But with the yen as the strongest currency in the world, Japan’s high value-added goods, such as cars and electronics, will look increasingly unappealing to consumers worldwide during tough times. Tokyo may attempt measures to diminish the yen’s value to make its exports more attractive, but the upward pressure of the unwinding carry trade will not easily be reversed.

It is not clear yet how hard the coming recession will hit Japan, but a shrinking trade balance is worrying mostly because of the implications it will have if it becomes a chronic problem, especially given Japan’s endemic financial troubles. Government revenues are falling as the country’s population ages, the budget is deep in deficit and the national debt is the largest in the world. Japan’s trade surplus supplies its foreign currency reserves, which are currently very deep at almost $1 trillion. (This serves as Japan’s rainy-day fund.) But in the long run, if Japan cannot maintain trade surpluses, it cannot replenish its reserves, and it loses its last bit of protection against economic storms.

Stratfor provides intelligence services for individuals, global corporations, and divisions of the US and foreign governments around the world.

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