Japan: Rising cases and rising tensions

The BoJ left most of its monetary policy unchanged at its latest meeting on 15 and 16 June, keeping its policy rate at -0.1%, its target yield on 10Y Japanese Government Bonds at 0% and maintaining its asset purchase program. The BoJ did increase the size of its lending facility to firms which are low on cash, bringing its total Special Program to fight the COVID-19 crisis from JPY 75 trillion to JPY 110 trillion (21% of GDP).

We think the BoJ will remain on hold for now. Although inflation remains low (the May headline figure came in at 0.0% y/y), the Bank will not likely cut rates, in fear of hurting the profitability of Japanese banks further. It is more likely that the BoJ will await the results of its previous rounds of stimulus measures. However, we do not rule out additional measures, especially if Japan’s economy contracts more than the BoJ expects.

Coronavirus cases have been rising again in Tokyo (figure 1), with new daily cases being consistently above 50 since 24 June. If this number does not decline, chances are that the Japanese government will implement another round of lockdown measures in Tokyo (and possibly areas closely connected to Tokyo). This will directly affect Japan’s economic outlook. Tokyo is Japan’s political and economic center, it represents 20% of the country’s GDP. There will be indirect effects as well, consumers in other prefectures might fear a resurgence and also cut back on travelling, socializing and spending.

Meanwhile, retail sales in May were down by 12% y/y, with motor vehicle sales taking a particularly big hit. Domestic motor vehicle sales of Toyota, Honda and Mazda have dropped by 38% y/y (figure 2), suggesting that the people have significantly cut their spending on big ticket items. In addition, industrial production sank by 24% y/y in May, and the Tankan Large Manufacturers Index (a production sentiment indicator) dropped to an eleven year low (-34) in Q2. Both indicators point to weakness on the production side of the economy. Finally, the external environment also looks grim, with Japan’s exports dropping by a whopping 28% y/y in May.

Together, the data continues to paint a grim picture, of consumer as well as producer weakness and a difficult external environment, which is why we hold on to our view of a deep recession in Japan this year, with a limited recovery next year (Table 1).

Another risk that Japan faces, which could might hamper its economic recovery, is rising political tensions with China. Japan’s government has called China’s move to implement a controversial law in Hong Kong (which effectively reduces Hong Kong’s autonomy) ‘regrettable’. In addition, Japan has offered subsidies worth JPY 220bn to Japanese companies in China to return back home. China, from its end, has condemned Japan for meddling in its affairs. Lastly, a conflict surrounding the Senkaku Islands (which both countries claim) adds more fuel to the geopolitical fire.The Senkaku Islands dispute has broader implication as well, because Japan has a mutual defense treaty with the US. So if Japan is attacked by a foreign country, the US is obligated by the treaty to defend Japan. Hence, the US can be dragged into this conflict as well.

The geopolitical tensions between both countries also feed into the Japanese public opinion towards China. A recent survey by Pew Research indicates that 85% of Japanese have an unfavorable view of China (figure 3).

The implication here is that tensions between China and Japan could rise to the point that the countries start targeting each other with tariffs and sanctions. If that happens, Japan will be hurt more than China. China represents 20% of Japan’s exports, while Japan only represents 6% of China’s exports. In a similar vein, 30% of Japan’s tourists are from China (Figure 4), while only 2% of tourists in China are from Japan. Moreover, 20% of Japanese imported intermediates are from China. So Japan depends more on China than vice versa (although admittedly China depends more on Japan for the knowledge spillovers their trade relation creates).

All in all, it seems that the balance for Japan to increase ties with China (and benefit from its export market and inputs) or decouple (and be less dependent om China) seems to be tipping towards the latter. If that happens, trade between the two countries will be less in the future than it was in the past.