## Why Has Japan Been Hit So Hard by the Global Recession?

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### Executive Summary
- The Japanese economy has been hit hard by the slump in global demand for advanced manufacturing products such as cars, information technology, and machinery, which account for a larger share of production than in other G-7 economies.
- Worsening domestic financial conditions deepened the current recession by reducing domestic demand, especially business investment.
- The short-term outlook is clouded by an ongoing adjustment to inventories, which have accumulated well above normal levels in both Japan and its export markets.

### I. Interpretation of the Q4 Outturn
- Real GDP fell by 12.1 percent SAAR in Q4/2008; net exports contributed about 10 percentage points to this decline.
- Japan’s Q4/2008 performance was the worst among the G-7 countries, with even deeper output drops in newly industrialized economies (NIEs) such as Korea and Taiwan Province of China.
- Most of the drop in Japan’s exports was caused by sharp retrenchment in overseas demand for:
  - motor vehicles,
  - information technology (IT),
  - capital goods.
- Car-market specific figures:
  - Japan’s car exports fell by 65 percent since September 2008.
  - Shipments to the United States plunged almost 75 percent.
- Exchange rate and trade structure effects:
  - The yen has appreciated by about 30 percent in real effective terms since August.
  - The Korean won depreciated by about 60 percent against the yen over this period.
  - Japan exports about 60 percent of its vehicle production, compared with 20 percent in the United States.
  - The ratio of imports in total manufacturing supply is only about 10 percent in Japan, compared with roughly 25 percent in the United States.
- Worsening financial conditions weakened domestic demand, especially business investment:
  - Stricter lending standards, high interest rate spreads, and significant stock market declines tightened financial conditions to levels last seen during the banking crisis of the 1990s.

### II. Implications of Inventory Adjustment
- Recent and near-term industrial output and export moves:
  - January data indicate a further sharp drop in industrial output (by 10 percent m-o-m) and exports (16 percent m-o-m).
  - These January changes bring the total output loss to almost 30 percent since September.
  - Another 8 percent m-o-m decline in industrial production is expected for February.
  - The Ministry of Economy, Trade, and Industry (METI) production survey envisages a roughly 3 percent production increase in March.
- Inventory dynamics and risks:
  - Domestic inventories have been rising despite drastic production cuts, especially in the IT sector.
  - Producers in most sectors began reducing inventory holdings in January, but inventory targets may be well below pre-crisis levels because shipments are unlikely to recover quickly and many manufacturers need to boost cash balances while working capital finance remains tight.
  - Corporations are therefore likely to continue reducing inventories in the coming months, with negative implications for production.
  - The METI production survey could prove optimistic, particularly for the electronics industry where inventory buildup has been most significant.
- Overseas inventory buildups:
  - Export markets show inventory buildups that add downward pressure on Japanese production as wholesalers and retailers work off elevated stocks.
  - U.S. data through December 2008 show a glut of cars at both wholesale and retail levels; January shipments of Japanese cars to the United States were particularly weak.
  - Evidence of inventory buildups in other export destinations poses a short-term downside risk unless final demand recovers quickly.

### III. Conclusion
- Historical analogy and outlook:
  - During the 2001 recession, industrial production started recovering about 5 months after the peak of the inventory cycle.
  - By analogy, one could expect a bottom in industrial production around May 2009.
- Downside risks and caveats:
  - The global environment is expected to remain weak, and Japan faces headwinds from tight domestic financial conditions.
  - The production and inventory adjustment could therefore take longer during this recession.

*Prepared by the Asia and Pacific Department (Martin Sommer), March 18, 2009 — IMF Staff Position Note SPN/09/05*

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