Recent data on Japan’s economy has been mixed, to say the least.
The latest readings on the purchasing managers indices (PMIs) point to stagnation or worse.
Last month the Nikkei Composite PMI fell to 50.4 from 50.7 in February, its lowest level in two and a half years.
PMIs are a survey measure for business sentiment, and usually provide a good idea about the future direction of economic growth in the short term.
Any reading above 50 is supposed to indicate expansion – and anything below the opposite – but, in reality, the ‘neutral’ level is thought to be a little higher than 50.
The drop in overall sentiment reflects the falls in both the country’s manufacturing and services sectors. The services PMI, while still decent, edged down 0.3 points to 52.0 last month.
The real blow came from the manufacturing sector, which posted a PMI reading of 49.2. The figure was actually revised up slightly but it still puts Japan’s manufacturers in contraction territory.
That seems mostly negative, so why do we use the word 'mixed'?
Well for starters, it's worth bearing in mind that Japan’s manufacturing plight is hardly unique. A global slowdown in economic activity has caused problems for manufacturers the world over.
For the Japanese in particular, China’s economic slowdown has had a big impact. Exports to the world’s second-largest economy have slumped, and China-focused companies have been forced to slash profit forecasts.
Mind the 'output gap'
But it's not all bad news.
According to latest estimates from the Bank of Japan (BoJ), Japan’s 'output gap' rose to 2.2 per cent in the last quarter of 2018.
This measures how much an economy is producing in relation to how much it could produce if it was at so-called maximum efficiency.
A negative output gap usually indicates a lack of demand and slowing activity, while a positive gap indicates high levels of demand and can eventually lead to inflation pressures and overheating.
A positive output gap essentially means the economy is generating output above its actual capacity, usually due to a tightening labour market or a supply shortfall. For Japan – a country which has been mired in weak economic growth for decades – the slightly positive supply gap is, well, positive.
The BoJ’s 2.2 per cent figure is well above the 1.3 per cent figure in the previous three months, representing the biggest tightening in 26 years. The last time Japan saw an output gap this large, the economy was still in the throes of its infamous asset-inflation bubble in the late 1980s.
All else being equal, this should signal a pick-up in the country’s stubbornly low inflation rate.
Yet the BoJ is expected later this month to unveil its lowest two-year inflation forecast in years.
This is because two things are keeping a lid on economic activity: deteriorating business sentiment and the overseas risks from a slowing China.
According to sources close to the bank, BoJ members are particularly concerned that weakness in Chinese demand could derail Japan’s export-led recovery. This probably means they will maintain their low interest rates stance for now.
Prospects and plus points
In March, BoJ members maintained their view that Japan would reach the elusive 2 per cent inflation target in the second half of this year.
In the April review, the likelihood of this scenario panning out – and what to do if it does not – will undoubtedly be the hot topic. Whatever the case, any signal towards tightening is very unlikely, even with the positive output gap.
For Japan overall, that is a big plus. While the economy has not been inspiring over the last few years, the BoJ’s extraordinary policies have helped.
Dependence on China has hurt the country recently, but importantly China’s weakness has not yet hurt businesses’ capital expenditure in Japan.
With the output gap pointing to a tight economy, there could be impetus for even more capital spending to increase productivity and overcome the tight labour market. That would be a huge positive.
The key point here is while the external side of the equation (China, global growth) has been unkind to Japan, the internal situation looks good.
The labour market remains tight, businesses are willing to invest and – thanks to the BoJ – capital should stay available for a while.
If China or the rest of the world see a turnaround of fortunes later in the year, Japan is well poised to take advantage.
Unfortunately, the prospects of that are a bit mixed. The government in Beijing is running a hefty stimulus program to drag China out of the slowdown, and it could be effective as we move into the end of the year.
But unlike previous stimuli, the current measures are more focused on generating consumer demand and rebalancing the economy. This generates less external demand, and makes Beijing’s measures less beneficial for the traditional exporters to China.
Yet increased consumer demand from China should be of some help for Japan. Given its healthy internal situation, that makes us positive on Japan.
Unlike the EU, it is not plagued with as many structural or political issues. And unlike the US, it is not coming off the boil from a bout of high growth. That makes us think that, despite some mixed data, Japan might well be in for a good year.