Investors tell me that Japan is on fire. And on the surface, it certainly seems white hot a stock market that is up some 50% since the spring of 2005 and an economy that our Japan team believes surged by at least a 7% annual rate in the final quarter of calendar year 2005.
If that Chinese-style growth outcome comes to pass, Japan would instantly qualify as the fastest growing economy in the industrial world an extraordinary reawakening for Asia's long-slumbering giant. The global implications of this development cannot be minimized: Can the world's second-largest economy lead the way in the rebalancing of a still unbalanced global economy?
In answering that question, it helps to know where Japan has come from. Significantly, the recovery in the Japanese economy has not materialized out of thin air. After more than a dozen years of 1% real GDP growth, the economy first moved into a 2-3% growth channel beginning in 2003, and then accelerated to a 3.9% average annual pace in the first three quarters of calendar 2005.
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If our Japan team's 4Q05 estimate is even close to the mark, the steady increase in momentum now seems to have moved into rarified territory. According to Takehiro Sato, our resident Japan watcher, the gains in the period just ended showed a Japanese economy firing on all cylinders external as well as internal demand, with the latter driven by especially impressive gains in private consumption, residential construction, and business capital spending.
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For my money, the most important element in this equation is Sato-san's estimate that Japanese consumption growth may have exceeded 5% in the period just ended, pushing the year-over-year growth rate in real consumer demand to 3.6%. It would be one thing if Japan's reacceleration were driven largely by external demand or autonomous investment. But when the consumer finally steps up, it's a different matter altogether insofar as multiplier effects to other sectors of the economy are concerned.
A sustained pickup in Japanese consumption could also be a very welcome development for the global economy. The key here is the import side of the Japanese growth equation the transmission of domestic growth to any country's trading partners and whether Japan's revival of internal demand is sourced mainly at home or partly through foreign production.
Historically, Japan has been a very closed economy. The import share of its GDP averaged only about 7% from the mid-1980s thorough the mid-1990s about half the shares in the rest of the industrial world over this period. In recent years, however, Japan has done a dramatic about-face in embracing the efficiency solutions of low-cost offshore production. The import share of its economy has moved up appreciably in response rising above 12% in late 2005.
Rising import penetration holds out the hope that a revival in Japanese internal demand spells heightened export impetus to the rest of the world moving Japan to centre stage as potentially a new engine of global growth. But there has been an important shift in the mix of Japanese imports in recent years that has altered the transmission mechanism between Japanese internal demand and its traditional trading partners.
As recently as 1999, the US had the largest share of Japanese imports implying that America would benefit the most from accelerating Japanese growth. That is no longer the case. The US share of total Japanese imports has fallen from close to 25% in 1999 to only about 13% today. The reason a stunning surge of Chinese imports.
Japan's purchases of goods from Greater China (the PRC plus Hong Kong) have risen from just 5% of its total imports in the early 1990s to about 22% today. The share of Japanese imports coming from Europe has also drifted down in recent years to about 11%, but it has been on a much gentler downward trajectory than the rapidly plunging US portion.
The shifting character of Japan's imports both their increased share in overall Japanese GDP as well as the rebalancing of the import mix away from the US toward China has important implications for the broader global economy. Import channels don't change over night. A lot of effort goes into the establishment of supply chains, distribution networks, and service operations underscoring the inertia of foreign sourcing patterns. It is hard and very costly to rip out one system (i.e., the low-cost China link) and replace it with another (i.e., the higher-cost American option). That means that the mix of Japan's import demand is likely to remain something quite close to its current configuration in the years immediately ahead.
Consequently, to the extent that Japan is able to sustain its recovery in domestic demand and in the import content of that demand most of the incremental benefit would undoubtedly flow to China and Asia's increasingly China-centric supply chain. By contrast, that would leave US and European exporters largely on the outside looking in with respect to their opportunities to share the spoils of Japan's economic recovery.
This has the potential to be a very important development on the road to global rebalancing. On the surface, Japan's gathering recovery is good news for an unbalanced world. And it comes just in the nick of time. With the asset-dependent American consumer starting to fray around the edges as the US housing market cools, a restarting of the growth engine of the world's second-largest economy is an especially welcome development.
Yet, ironically, Japan's long-awaited economic recovery may do little to temper the world's largest and most serious imbalance America's gaping current account deficit. That's because American exporters have suffered a stunning loss of market share in Japan to China's ever-ubiquitous producers. As a result, the import content of recovering Japanese domestic demand seems likely to be made increasingly in China rather than in the US.
This underscores what has long been the single most worrisome aspect of America's current account imbalance that there is little hope for a fix from the export side of the equation. With US imports currently running nearly 60% greater than exports, an export-led fix for the US current account problem was always a stretch. The loss of market share in Japan by American exporters makes that even more of a stretch.
That underscores the obvious that import compression is the only realistic hope for a meaningful US current account adjustment. And, of course, the obvious way for that to happen would be through a sharp reduction in the excesses of asset-dependent US consumption the one economic development that the rest of the world dreads the most.
Japan's turnaround is nothing short of stunning. As the momentum of its economic recovery builds, the world economy will benefit from a long-overdue restarting of another growth engine. But don't count on Japan to fix the world's imbalances. That's a task that remains very much in the court of the most unbalanced economy of all the United States.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum
