• At 2.46pm on Friday March 11, an earthquake measuring 9.0 on the Richter scale occurred off the north east coast of Japan near Sendai, triggering a 10 metre tsunami that was felt across the Pacific Ocean. The earthquake has been ranked as the fifth largest in modern history and the biggest in Japan.

Main Developments

New agencies provide the most accurate and timely compilations of facts of major events. The situation following the great earthquake is clearly still evolving and the economic impact will be felt for years to come. The following report comes from Reuters:

• “Death toll expected to exceed 10,000 from the quake and tsunami, public broadcaster NHK says. About 2,000 bodies found on two shores of Miyagi prefecture, Kyodo reports.
• Japan battles to prevent nuclear catastrophe as there is a hydrogen explosion at the No. 3 reactor of the quakehit Fukushima Daiichi nuclear power plant, which is 240 km (150 miles) north of Tokyo.
• Chief Cabinet Secretary Yukio Edano says the core container at the reactor is intact after the fresh explosion which is unlikely to have led to a large escape of radioactivity.
• Edano says six people were injured after the explosion at the nuclear plant.
• Prime Minister Naoto Kan says the situation at the nuclear power plant remains worrisome and authorities are doing their utmost to prevent damage from spreading.
• Earlier, Tokyo Electric Power Company (TEPCO) said radiation levels at the Fukushima Daiichi nuclear power plant, which is 240 km (150 miles) north of Tokyo, had risen above the safety limit but this posed no “immediate threat” to human health. An explosion blew the roof off at reactor No. 1.
• International Atomic Energy Agency (IAEA) says the lowest state of emergency had been declared at a separate nuclear power plant north of the town of Sendai. But Japan’s nuclear safety agency says there has been a rise in radiation at the Onagawa facility due to leakage from the Fukushima plant and there was no problem with the cooling process there.

• Authorities have set up a 20-km (12-mile) exclusion zone around the Fukushima Daiichi plant and a 10 km (6 miles) zone around another nuclear facility close by.
• Strong aftershocks persisting in the stricken area.
• About 300,000 people evacuated nationwide and almost 2 million households without power in the freezing north.
• The Bank of Japan offers to pump a record US$85 billion into the banking system to soothe market jitters.
• TEPCO says rolling blackout to affect 3 million customers, including large factories, buildings and households.
• Nuclear safety agency rates the incident a 4 on the 1 to 7 International Nuclear and Radiological Event Scale, less serious than Three Mile Island,which was a 5, and Chernobyl at 7.
• Quake triggered tsunami up to 10 metres (30 feet). Waves swept away homes, crops, vehicles and submerged farmland.
• Total insured loss could be up to $15 billion, equity analysts covering the industry say. Disaster-modelling company AIR Worldwide estimates the insured losses from the Japan earthquake at between $14.5 billion and $34.6 billion.”

Financial & economic effects

• The Bank of Japan will expand asset purchases from 35 trillion yen to 40 trillion yen in order to boost liquidity in the economy. The BoJ is
  worried about the impact of the earthquake on household and corporate sentiment.
• The Japanese yen has strengthened against the US dollar since the earthquake on expectation that foreign currency will need to be sold in exchange for Japanese yen to fund the massive rebuilding work. The Australian dollar fell from US100.25c to US99.65c initially after the earthquake. But it rose to US101.60c in US trade on Friday night before easing to US100.75c today.
• The Japanese sharemarket (Nikkei) fell 6.2 per cent on the expectation of weaker short-term prospects for manufacturing companies and the overall Japanese economy. In contrast, shares of construction companies have been well supported.
• Shares of food exporters in the Asian region have been supported on the expectation of higher demand (Sendai is a major food producing region of Japan).
• The Australian All Ordinaries index fell as much as 85 points before retracing to be down 24.6 points (0.5 per cent) to 4710.1 at the close. Uranium stocks fell from favor as investors feared reduced demand in reaction to the explosions at nuclear facilities in demand. In contrast, shares of thermal coal and natural gas producers rose on expectation of demand for alternative fuels following damage to Japanese nuclear facilities.
• Our commodity strategist said: “We expect that a prolonged shutdown of the Fukashima Daiichi power station will increase import demand for fuel oil, coal and LNG, putting upward pressure on coal and gas prices. The quantum of increased coal, LNG and fuel oil demand is hard to estimate and depends on the extent of nuclear outage. But the Fukashima Daiichi nuclear power plant’s capacity translates through to up to 14Mt of thermal coal equivalent – or ~1.5%-2% of world trade per year.”
• Similar to the natural disasters experienced in New Zealand and Australia, the Japanese economy will soften in the short term as production is constrained and consumer and business sentiment are negatively impacted. But activity will be boosted in the medium-term as rebuilding/repair/refurbishment work begins. The Japanese economy contracted by 0.3 per cent in the December quarter and a technical recession (two consecutive quarters of falling output) cannot be ruled out.
• In response to the Kobe earthquake (January 17 1995; magnitude 7.3; damage estimated at US$100 billion) industrial output fell 2.6 per cent in January before rebounding in the following three months.
• The Japanese economy had only been expected to add 0.14 percentage points to the 4.4 per cent global economic growth this year, so the ‘big picture’ impact will be modest.
• Despite high government debt levels (gross debt to GDP stands at 225.9 per cent), Japan should have few problems in securing foreign funding for rebuilding operations. Japan has consistently maintained a current account surplus, estimated at 3.1 per cent of GDP in 2010.

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Key points

• The Japanese earthquake has caused terrible human suffering. In terms of the economic impact, in the short term it will likely depress Japan’s economy as a result of damage to factories, power supply, transport infrastructure and confidence. However, by the second half of the year the rebuilding effort is likely to result in a boost to growth.
• While it has added to short term uncertainty in global investment markets, we don’t expect the earthquake to derail the global economic recovery or growth in Australia. In fact, increased commodity demand associated with rebuilding will ultimately provide a boost for Australia. We continue to see the recent pull back in share markets as a correction, and not the start of a new bear market.

Introduction

It seems the string of disasters in our part of the world this year is not letting up – the Australian floods, the New Zealand earthquake, and now a massive earthquake and tsunami in north east Japan. At this stage the full extent of the damage in Japan is unknown, but it is clear it has resulted in a terrible human tragedy. Right now the focus is on the rescue effort and our thoughts are with the Japanese people and all those affected. This note looks at the likely impact on economic activity, investment markets and Australia.

Economic impact

All natural disasters follow a similar pattern in terms of their economic impact and the Japanese earthquake is unlikely to be any different. The initial impact is negative as production is disrupted as a result of damage to factories, the power supply, transport infrastructure, confidence, and to homes which means workers are focussed simply on survival. This then gives way to recovery as rebuilding kicks in and production returns to normal.

• This was seen in terms of the Kobe earthquake in Japan in January 1995, which claimed 6,434 lives. Japanese industrial production fell 2.6% that month only to be followed by gains of 2.2% and 1% respectively in the subsequent months. In fact it’s worth noting while Japan’s GDP fell 0.7% in the December quarter 2004, it actually rose 0.8% in the March quarter 2005 when the quake hit and rose another 0.8% and 1% in the June and September quarters respectively.
• It was also seen in the Boxing Day Tsunami in Asia of 2004, with initial negative economic consequences in the areas affected followed by a strong rebound. In fact it was barely a blip in the Asian growth story at the time.
• The initial negative effects from recent floods are now being felt in Australia, but there is good reason to expect a rebound in growth from the June quarter.

The areas most affected by the earthquake account for around 8% of Japan’s GDP. It is a centre for auto production with Toyota, Nissan and Honda plants being shut down. Electronics plants have also been affected and damage to fishing and agricultural production is likely to be immense.  That said, given the area directly affected by the earthquake is a smaller part of the Japanese economy than the area affected by the Kobe earthquake in January 1995 it’s possible the economic affect may be smaller this time. According to Bank of America Merrill Lynch the three worst hit prefectures in the Kobe earthquake accounted for around 12% of Japan’s GDP.

However, it is still very early days in assessing the damage and there are some reasons to be a bit more concerned this time around. First, it’s the tsunami which has caused most damage this time, wiping away whole towns and parts of cities, as opposed to just earthquake damage to buildings, roads, etc. This also means the rescue operation may be more involved as will be the clean up before rebuilding can commence. Some areas may now even be unliveable given the shift in land and sea levels. Second, as a result of problems at nuclear power stations, the interruption to power supply may be greater and longer than was the case in 1995. Third, the loss of life this time around is likely to be much greater. This will have a potentially bigger impact on confidence than was the case in 1995. Finally, there is a risk of a serious nuclear catastrophe this time around, which if it occurred would result in a far more disastrous impact.

The most likely outcome would seem to be a set back in activity over the next few months – perhaps 2% or so knocked off industrial production – before rebuilding kicks in boosting growth again during the second half of the year. Post the Kobe quake the rebuilding effort was very quick and efficient and the same is likely this time. The Bank of Japan has already committed to a “massive” liquidity injection into the Japanese banking system. This has initially taken the form of increased short term cash injections, but should also include more quantitative easing (ie using printed money to buy government bonds and foreign exchange). Fiscal stimulus is also likely to be announced soon.

There are three bigger issues for Japan though. Firstly, Japan’s recovery since the GFC has been the most fragile of the G3, ie the US, Europe and Japan. This was highlighted by the fall in Japanese GDP in the December quarter and much weaker levels for consumer and business confidence. See the next chart. The earthquake will likely only add to Japan’s fragility.

More fundamentally is the impact on longer term confidence. The Kobe earthquake arguably damaged Japan’s national confidence in the 1990s adding to the malaise of the last two decades. The latest quake may only add to this sense of longer term malaise.

Finally, while price deflation means Japan has plenty of potential for further monetary easing, further fiscal stimulus will add to already very high public debt levels. Japan’s budget deficit is already 8% of GDP and public debt is around 200% of GDP. This is way above levels at the time of the Kobe quake and is even far worse than Greece. Short term it’s easy to finance as the private sector in Japan is a net lender. Longer term it is more problematic as a rapidly aging population will mean households will likely become net sellers of Japanese public bonds.

What about the global economic recovery?

The Japanese earthquake is unlikely to derail the global recovery. Apart from the likelihood that the negative impact on Japan will be mainly short term, Japan’s importance globally has slipped in recent times. At only 6% of world GDP, Japan only accounted for 0.16 percentage points of the 4.5% or so increase in world GDP last year.

Australian impact

Japan is Australia’s second largest trading partner, but its share of Australian exports has slipped from 25% at the time of the Kobe earthquake to 15% today. Short term economic disruption in Japan could cause a decline in orders for coal, iron ore and other commodities in the next few months. However, this is likely to be no more than a blip as the broader impact is likely to be positive as rebuilding will add to strong global demand for raw materials. Problems with nuclear power stations as a result of the quake, and any resultant rethink of the relative attractiveness of nuclear power globally, will likely be negative for uranium demand but positive for gas and coal demand. There may also be increased demand for food stuffs as the area affected is important in Japanese agricultural production.

It is noteworthy that even though the value of Australian exports to Japan fell in the March quarter of 1995 when the Kobe quake hit, they rose solidly in total – up 13.8% in the March quarter and up 22.2% in 1995 as a whole.

Finally, imports of cars, electronic goods and other manufactured goods from Japan may see a short term disruption but this is unlikely to last long, with other global producers also likely to step into the breach given still significant global manufacturing spare capacity.
At this stage we see no reason to alter our Australian economic forecasts which see year average growth this year of 2.8% and 3.8% in 2012 and the cash rate rising to 5.25% by year end.

Financial market implications

For Japan, the earthquake is negative for shares on the back of worries about the short term economic impact, positive for bonds on “safe haven” demand and probably positive for the Yen as Japan repatriates funds, particularly by Japanese insurance companies. This is pretty much how it played out immediately after the Kobe quake. So far it appears to be playing out this way as well, particularly for the share market which has fallen sharply.

However, after the initial reaction, which the post Kobe experience suggests may last several months, expect the Japanese share market to rebound as rebuilding kicks in and production returns to normal. There is a bit more uncertainty around the Yen – past experience suggests it will strengthen initially but this could be short circuited if the Bank of Japan intervenes (as it should) to help exporters.

Short of a nuclear catastrophe, we don’t see the Japanese earthquake derailing the global economic recovery and nor do we see it derailing the cyclical recovery in global share markets. However, it has come at time when the worry list for investors has suddenly expanded again – to include unrest in the Middle East and oil prices, renewed concerns about European debt and Asian tightening – and so only adds to short tem uncertainty. In this sense it’s too early to say whether the correction in shares that began last month is over or not.

The same applies for Australian shares. The initial reaction in the Australian share market has been negative, but any negative economic impact on Australia is likely to be minor and short lived and Australia is likely to be a key beneficiary of increased raw material demand as Japan rebuilds. With the Australian share market now trading on a forward price to earnings multiple below 12 times, Australian shares are well placed to rebound once the correction in global shares has run its course.

In terms of sector specific impacts the earthquake is likely to be negative for insurers and uranium producers, but positive for gas and thermal coal producers. It should ultimately be positive for commodity producers more broadly as rebuilding demand kicks in.

So far the Japanese quake has taken pressure off oil prices, on the assumption refinery closures in Japan may reduce oil demand. This may be true short term but ultimately it will mean Japan may import more refined fuel. So overall the impact on the oil price is ambiguous, with events in the Middle East likely more important.

Concluding comment

The events in Japan are heartbreaking. However, like all natural disasters the negative short term economic impact should hopefully be less than feared and will give way later this year to rebuilding which will help boost growth.

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