China's woes could derail Abenomics

This blog was originally published in Nikkei Asian Review

Just as Japanese growth was starting to pick up from the repercussions of last year's consumption tax hike, a new shock has hit the economy: China's economic woes.

The Japanese economy is already showing clear signs of renewed weakness. First, the stock market has plunged, falling even further than when Japan slipped into a technical recession after last year's tax increase.

This is likely because the slowdown in the Chinese economy was more unexpected than the tax hike and is structural in nature. Unless the Chinese authorities react aggressively to revive their flagging economy, the consequences for Japan look longer-term, more far-reaching and more uncertain.

Deep trade ties  

The economic link between Japan and China is mainly through foreign direct investment and trade. China is the biggest destination for Japanese foreign direct investment, while China is Japan's second-largest trade partner, accounting for 18.3% of exports in 2014, closely behind the U.S., at 18.6%. The volume of Japan's exports to China fell 9.2% in August from a year earlier, and available indicators for July -- industrial production and machinery orders -- have also come in much weaker than expected.

Reverberations from China's slowing demand could exacerbate this trend. A full 54% of Japan's exports last year went to Asian countries. Given the close trade ties between China and the rest of the region, it is clear that China is of greater importance to Japan's exporters than the U.S. As a result, Japanese companies that have strong business ties with China have led the stock market lower over the past month.

The fall in equity prices is in turn expected to hit consumer confidence and result in a negative wealth effect, which will impact personal consumption. These adverse developments are likely to outweigh the gradual improvement in wages and undermine a nascent consumer recovery.

In the face of these growing headwinds, the 1.2% annualized drop in quarter-on-quarter economic growth in the April-June period, which had previously been seen as a temporary correction following the 4.5% annualized expansion of the previous quarter, now looks to have heralded the risk of a technical recession.

Coupled with heightened economic uncertainty and the confidence-sapping indictment of Japan's economic policy inherent in Standard & Poor's downgrade of the country's sovereign debt rating on Wednesday, business investment is expected to fall again this quarter. Without the support of private demand, it will be very difficult for Japan to return to positive growth.

At the same time, deflationary pressures in Japan are likely to intensify because of lower commodity prices and the stagnating economy, pushing real interest rates up even further. These factors will combine to add more pressure on business investment. Additionally, the tail risk of a substantial yuan devaluation threatens a global wave of deflationary pressure.

Yen reversal

As if this were not bad enough, the yen's weakening trend that was previously aiding exporters has been reversed as its status as a safe haven comes back to the fore for investors rushing out of emerging markets. China alone has already lost close to $500 billion in reserves in a little more than a year.

The greenback cannot absorb such an outflow on its own, and unless the Bank of Japan reacts with more quantitative easing, yen appreciation may well continue. Any significant devaluation of the Chinese yuan would further exacerbate the pain for Japanese exporters, both by making their sales to China even dearer and by giving Chinese competitors and edge in certain markets.

Japanese government bonds have shown indifference to the S&P downgrade, largely due to the fact that 95% are held domestically. But with weakening growth and deflation making fiscal consolidation even more challenging, Japan will eventually have to attract more foreign capital to fund its deficit and support its aging population, which will give rise to a much less forgiving government bond market.

Overall, the impact of China's deceleration is a huge shock for Japan, not only because it is happening much more quickly than had been expected but also because the bilateral relationship is a key pillar of the Japanese economy.

The Bank of Japan can help, and probably will soon, but there is a limit to what monetary policy can do in the face of such a huge shock. Ironically, China's troubles, which may so far have afforded Prime Minister Shinzo Abe some schadenfreude, might actually derail his flagship economic project, Abenomics.