Could Japan’s earthquake cause a debt crisis?

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There is something inherently callous about discussing the economic impact of a natural disaster. The human toll is always of much greater concern and importance than anything happening in the realm of finance. However, us economics types can’t help but immediately begin speculating on what the impact might be, and economists around the world are already crunching the numbers. My colleague Stephen Gandel has posted that the economic fallout from the quake might not be all that severe. But I wanted to focus on an issue that we simply can’t ignore: how the quake will affect the feeble state of Japan’s national finances.

Japan already has the largest debt burden of any industrialized country, at about 200% of GDP, and even though Japan is not yet showing signs of following Ireland, Greece and the rest of the euro zone periphery into a full-blown debt crisis, pressure has been mounting for Tokyo to finally put in place a credible plan to reduce its yawning budget deficits and contain its debt levels. Standard & Poor’s just downgraded Japan’s credit rating in January. After the quake, it will only become more difficult for the Japanese government to curtail is deficits and debt.

That’s because of a combination of factors. First, the government will have to spend money to undertake reconstruction of the cities and infrastructure damaged by the quake and tsunami, putting upward pressure on fiscal spending. Secondly, we’re likely to see at least a temporary hit to growth and some manufacturing, transport and consumption will be disrupted. In normal circumstances, that hit probably wouldn’t be a big deal, but the recovery of the Japanese economy had run out of steam even before the quake hit. Japan’s GDP in the final quarter of 2010 contracted by an annualized 1.3%. With the economy in the doldrums, and a human tragedy unfolding in the country’s north, we can imagine the difficulties Japan’s leaders will have even talking about fiscal austerity programs of the type being implemented in Europe.

Here’s what David Rea, Japan economist at Capital Economics, had to say on this issue in a report:

The timing of the disaster could not have been much worse. The economy had already contracted in the final quarter of last year. This shock may be too small and too late to have much impact on GDP in Q1, but does marginally increase the chance that output will decline in the current quarter as well. Moreover, a large part of the reconstruction costs will probably have to be met by local authorities and ultimately by central government, which is already struggling to bring public debt under control. Overall, it will be that much harder to deliver a credible long-term fiscal plan in the summer if the economy is stuck in recession, the public finances are in an even worse state, and many people are still suffering the after-effects of this disaster…The greater the social and economic damage, the larger the threat to the government’s ability and willingness to ward off a fiscal crisis.

So much of what happens on the fiscal side will depend on the amount of physical damage done by the quake and the overall economic impact it causes. At this stage, that’s impossible to determine, though, as Steve pointed out, the human costs of natural disasters tend to be much greater than the economic ones. However, we can get at least a basic idea of how this quake will hurt the Japanese economy by looking at the impact of the giant Kobe quake in 1995. Economists at BofA Merrill Lynch have kindly run the figures for us. Here’s what they found:

Examining the aftermath of the huge earthquake in Kobe area in 1995 (the Great Hanshin-Awaji Earthquake), we find that the production declined by 3.1% in the hardest-hit prefecture (Hyogo) and 1-2% in neighboring prefectures (Osaka and Wakayama) in the year of the earthquake. Those prefectures were relatively large and accounted for 12.4% of Japan’s GDP, and should have cut Japan’s growth rate by 0.4-0.5ppt in the year, in our view. But there was a large supply capacity in Japan as indicated by the GDP gap of larger than 3% of GDP. As a result, the spare capacity in other areas offset the loss of production in the area hit by the quake and the growth rate remained positive even in the quarter of the earthquake. In addition, according to the estimate of the Cabinet Office, the rebuilding of the ruined capital amounted to 2-3% of GDP and pushed up the growth rate in the following two years. This time, the two hardest-hit prefectures (Miyagi and Fukushima) account for 3.1% of Japan’s nominal GDP. If we include Iwate, Ibaraki and Tochigi, the size of production from the affected areas expands to 7.8%. Assuming the size of the disruption of economic activity is similar to the case of the Great Hanshin-Awaji Earthquake (3-5% decline in Miyagi and Fukushima, 1-2% in Iwate, Ibaraki, and Tochigi), the impact on Japan’s GDP would be 0.2-0.3ppt… But, as in the case of Great Hanshin-Awaji Earthquake, there remains a relatively large spare capacity to offset the production loss in Japan now…In addition, the cost (demand) for the rebuilding of ruined capital could be 1.0% of GDP or larger although it is very difficult to estimate its size at this point.

The bottom line here is that the quake is likely to have minimal impact on the overall economy, if the situation plays out as it did in Kobe. But there is one big difference. 2011 is not 1995. The government is in much worse financial shape than it was 16 years ago, which means policymakers have less scope for greatly increased fiscal spending, and that any meaningful increase in spending could potentially have a negative impact on market sentiment towards Japanese debt.

Another wild card to watch is how the quake will affect Japan’s confused political scene, and thus the government’s ability to implement new policies. Prime Minister Naoto Kan already looked on his way out after his foreign minister resigned earlier in the week, and Kan himself admitted to receiving illegal campaign donations just before the quake hit. The quake may have bought Kan some time, but at best it would delay the political reckoning in Tokyo, and probably delay even further any move to fix the nation’s finances.

This analysis is of course highly speculative at this point, and the real fallout from the quake for the economy won’t be known for many months. Let’s hope that the damage done by the disaster to the Japanese people will be temporary.

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