Japan s economy in the aftermath of the earthquake: V-shaped recovery on the horizon. June Takahide Kiuchi Chief Economist Japan

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1 Nomura Securities Co Ltd, Tokyo Japanese Economic Research Nomura Securities Co., Ltd. Japan s economy in the aftermath of the earthquake: V-shaped recovery on the horizon Takahide Kiuchi Chief Economist Japan Nomura Securities Co., Ltd. Tel: takahide.kiuchi@nomura.com June 211 Please read the important disclosures and analyst certifications on pages gl

2 [As of May 27 th] Real GDP (% y-o-y) Consumer Prices (% y-o-y) Policy Rate (% end of period) Global Developed Emerging Markets Americas United States* Canada Latin America Argentina Brazil Chile Colombia Mexico Venezuela Asia/Pacific Japan Australia New Zealand Asia ex Japan, Aust, NZ China Hong Kong*** India** Indonesia Malaysia Philippines Singapore*** South Korea Taiwan Thailand Vietnam Western Europe Euro area France Germany Greece Ireland Italy Netherlands Portugal Spain United Kingdom Denmark Norway Sweden Switzerland EEMEA Czech Republic Egypt Hungary Israel Kazakhstan Poland Qatar Romania Russia Saudi Arabia South Africa Turkey Ukraine United Arab Emirates The world at a glance We expect the ongoing global recovery to continue despite multiple shocks, but to remain muted in the developed world. We expect most of the emerging economies, led by Asia, to continue their brisk growth after some of them go through a rough path. We see high headline inflation in Europe to nudge the BoE and ECB toward several rate hikes before the Fed and the BOJ start to move. We see inflationary pressures continuing to mount in EM, with policymakers risking falling behind the curve. Downside risks: fiscal crisis escalation in euro area; investment pull-back in China; US fiscal gridlock unnerving markets. The dollar looks set to recover some of its early-211 losses as risk assets face headwinds and euro-zone tensions persist. Note: Aggregates calculated using purchasing power parity (PPP) adjusted shares of world GDP; Real GDP and CPI reported as annual average growth rates; Developed countries: United States, Canada, Japan, Australia, New Zealand, Hong Kong, Singapore, the euro area, and the United Kingdom - all other countries are considered Emerging Markets; BRICS: Brazil, Russia, India and China; EEMEA: Emerging Europe, Middle East and Africa; all values are forecasts. Our forecasts incorporate assumptions on the future path of oil prices based on oil price futures, consensus forecasts and Nomura in-house analysis. Currently assumed average Brent oil prices for 21, 211 and 212 are $79, $88 and $95 respectively, after $62 in 29. *21 and 211 policy rate forecasts are midpoint of -.25% target federal funds rate range. **Inflation refers to wholesale prices. ***For Hong Kong and Singapore, the policy rate refers to 3M Hibor and 3M Sibor, respectively. Policy rate forecasts in are midpoint of BOJ s -.1% target unsecured overnight call rate range. Source: Nomura Global Economics. 2

3 Japan s economy after the quake We have revised down our FY11 Japan real GDP growth estimate by 1.ppt to +.5%, while revising up our FY12 growth estimate by.6ppt to +2.9%. We expect JP real GDP to decline by 1.5% in the coming two consecutive quarters in the aftermath of the earthquake. That real GDP dent would be only one fifth of the 8.1% decline experienced during the two- quarter period after the Lehman shock. The quake will likely cause a significant economic contraction in 211 H1 before an anticipated V-shaped recovery from Q3 due mostly to the quicker-than-expected mitigation of supply chain disruption. The FY11 second supplementary budget of some \13trn, equivalent to 2.6% of GDP, will likely pass through the Diet session held in August or September. Huge reconstruction demand will be on the horizon from Q4 on. Most of the supplementary budget spending is likely to be funded by JGB issuance and possible tax increases in the future. Risks associated with our scenario of near-term V-shaped recovery are: (1) delays in the implementation of the supplementary budget amidst the current political turmoil; (2) slow progress in reconstruction of quake-stricken regions; (3) deterioration of the economic and political environment overseas, e.g., economic slowdown, yen appreciation, and/or higher crude oil prices; (4) slower mitigation of supply-chain constraints. In the medium term, the foremost risk we face is an accelerated shifting of production sites by Japanese companies in the wake of the quake disaster. Strong political initiatives for viable growth strategies could in part reduce the risk, ie, weak economy and unstable financial system brought forth by the two previous big earthquakes. 3

4 Revising down our FY211 growth forecast by 1.ppt Summary of our forecasts for the Japanese economy FY1 FY11 FY12 CY1 CY11 CY12 (E) (E) (E) (E) Real GDP <Domestic demand> <Private> <Public> <Foreign demand> Private consumption Private housing investment Private capital expenditure Changes in inventory investment Public consumption Fixed public capital formation Exports Imports Nominal net exports (as % of GDP) Nominal GDP GDP deflator Industrial production Corporate goods price index Consumer price index Excl. fresh food Unemployment rate Customs cleared trade balance ( trn) Balance of goods ( trn) Balance of goods and services ( trn) Current account balance ( trn) Current account balance ($ bn) As a % of nominal GDP Yen/dollar (FY-average) Crude oil price (FY-ave:$/bbl) Overnight call rate (at FY-end:%) Consumption tax rate (at FY-end:%) Note: Figures in brackets show contribution; Those without brackets are y-y% changes, unless otherwise noted. Source: Nomura Assumptions for our economic forecasts Source: Nomura FY1 FY11 FY12 FY13 Yen/dollar rate (FY-avg) Unsecured overnight call rate (at FY-end: %) Consumption tax rate (at FY-end: %) WTI spot price (FY-avg: $/bbl) We have revised down our FY11 real GDP growth forecast by 1.ppt to +.5% from +1.5%, while revising up our FY12 growth forecast by.6ppt to +2.9% from +2.3%. 4

5 Quarterly forecasts for the Japanese economy (E) 7-9(E) 1-12(E) 1-3(E) 4-6(E) 7-9(E) 1-12(E) 1-3(E) Private consumption (%q-q) (%y-y) Residential investment (% q-q) (%y-y) Private capital investment (%q-q) (%y-y) Changes in private inventories (ppt contribution) Government consumption (%q-q) (%y-y) Public investment (%q-q) (%y-y) Changes in public inventories (ppt contribution) Net exports (ppt contribution) (%q-q) (%y-y) Exports of goods and services (%q-q) (%y-y) Imports of goods and services (%q-q) (%y-y) Real GDP (%q-q) (%q-q,annualized) (%y-y) GDP deflator (%y-y) Industrial production (25=1) (%q-q) (%y-y) Consumer price index (25=1) (25=1,seasonally adjusted) (%y-y) excluding fresh food (% q-q) (%y-y) Unemployment rate (%) Note: (1) Actual data up to 211 Q1; Nomura estimates and projections thereafter. (2) Quarterly values, indices and unemployment rate are seasonally adjusted figures (excluding domestic corporate goods prices). (3) Even in cases where value = -., this is shown as.. Source: Cabinet Office, Ministry of Economy, Trade & Industry, Ministry of Internal Affairs and Communications, BOJ, Nomura estimates 5

6 The quake likely to depress real GDP by 1.5% Our real GDP growth forecast revision Quake s Impact on real GDP (y-y change in real GDP %) Pre-earthquake estimates (3/1) Latest estimates (5/24) (%) Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 (CY) Source: Nomura Note: Figures are cumulative. Source: Nomura We anticipate that the quake will depress real GDP by about 1.5% in Q1-Q We think the depression of GDP will not compare to that following Lehman s bankruptcy in 28, when real GDP contracted some 8.1% over a six-month period. 6

7 Post-quake economic recovery in progress in Japan I. First phase: ~ end-march A stunning contraction of economic activity on both supply and demand fronts II. Second phase: ~August A slow recovery under supply-side constraints: supply chain bottlenecks and power shortages III. Third phase: ~September Economic growth vigorously resuming due in large part to diminished supply-side constraints and reconstruction demand coming on stream in earnest 7

8 A sharp economic contraction likely to have ended by end-march Industrial production index Daily trend in March consumer spending (25=1) (CY) Note: Dotted section plots index as calculated by Nomura using growth rate for production forecast index. Source: Nomura, based on METI () -2 Consumer spending (days) Source: Nomura, based on Ministry of Internal Affairs and Communications(MIAC) Industrial production rose 1.% m-o-m in April after 15.3% decline in March. The manufacturers expect a sharp recovery in May (+8.% m-o-m) and June (+7.7% m-o-m). Family Income and Expenditure Survey suggested that economic activity, after experiencing a rapid contraction just after the earthquake, would bottom and start to resume in late March. 8

9 Sluggish consumer spending, particularly on services () Department store sales by region after the Great Hanshin-Awaji Earthquake Nationwide Ex Kobe (CY) Note: Excluding Kobe refers to all-japan department store sales excluding sales at department stores in Kobe. Source: Nomura, based on Japan Department Stores Association data Consumer spending on goods and services after the Great Hanshin-Awaji Earthquake (94 Q4 = 1) Private-sector final consumption Durable goods Semidurable goods Nondurable goods Services (CY) Source: Nomura, based on Cabinet Office data The foremost uncertainty over consumer spending is related to spending on services, particularly leisure. We think consumer spending could recover to the level before the earthquake in 212 Q2. 9

10 The labor market remains stable after the earthquake Employment Statistics 就業者数失業者数失業率労働力率有効求人新規求人雇用者数 15 歳以上倍率倍率 新規求人数 Calendar year, Quarter or Month Labour force Effective ratio Ratio of new Unemployment rate Employed persons Employees Unemployed persons participation of job offers job offers to New job offers rate(15-) to applicants applicants 万人 前期比 % 前年比 % 万人 前期比 % 前年比 % 万人 前期比 % 前年比 % % % 倍 倍 前期比 % 前年比 % 1, 1, 1, %p-p %y-y %p-p %y-y %p-p %y-y x x %p-p %y-y persons persons persons 96 暦年 6486 NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA.5 32 NA NA NA NA.2 34 NA NA NA NA NA NA NA NA.1 35 NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA. 265 NA NA NA NA NA NA NA NA. 334 NA NA Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q (*)Q (e)(*)q 月 月 月 月 月 月 月 月 月 月 月 月 月 月 月 月 月 月 月 月 (*)3 月 (*)4 月 With companies wary of cutting headcount or wages, it is unlikely that chain reactions will be set in motion, whereby lower income results in a sharp drop in consumer spending and pushes down output. 1

11 Supply chain constraints being removed in the near term Likely availability of sufficient volume of parts (for processing companies For processing companies 6 29 Already sourced For material companies Expected to be sourced by July7 Not expected to be sourced until October Not expected to be sourced until after October Already sourced Expected to be sourced by July 7 Not Expected to be sourced until October Not Expected to be sourced after October Alternative sourcing partners for raw materials and parts North America Europe China India Other Asia Latin America Australia Middle East & Japan Note: (1) Survey carried out 8 15 April, targeting 55 companies (33 in materials industries, 22 in processing industries). (2) Other Asia: Asian economies except China and India. (3) Multiple responses allowed for countries and regions. Source: Nomura, based on Ministry of Economy, Trade & Industry data 8 9 Materials industries Processing industries (no. of companies) At production sites in the affected areas, 9% of the companies indicated that they would resolve the problems by summer 211. With respect to supply chain problems, 7% of processing companies and 8-9% of material-producing companies said they expected to have sufficient parts and materials by October. The companies appear to have made progress and have found alternative suppliers for raw materials and parts two areas in which it is taking longer for production to restart both in Japan and overseas, especially in Asian economies. 11

12 Auto production back to normal by July at the earliest Japanese automaker s domestic production plans Data file Annualized volume CY1 Q4 = 1 Annualized volume CY1 Q4 = 1 % q-q Impact on industrial units ' units ' units ' units % q-q CY1 Q4 2,31 1, 2,232 1, CY11 Q1 1, , Q2 1, , Q3 1, , Q4 2,799 1,216 2,715 1, CY12 Q1 2,844 1,236 2,944 1, Q2 2, ,269 1, Q3 2, , Q4 2,4 1,43 2,328 1, CY13 Q1 2,5 1,86 2,588 1, Source: Nomura We forecast -25% to -45% growth for domestic auto production for FY11 in 21 March. We revised our forecast for FY11domestic auto production to -3.5% in 18 April. Faster-than-expected progress in restarting production of microcontrollers for automobiles has meant that normalization of auto production has been brought forward substantially from initial expectations. Cooperation between government and the auto industry should work. Automakers should be able to secure sufficient volume of related components, including microcontrollers, and normal production should resume in July at the earliest, in September at the latest. 12

13 Supply chain problems in ex-japan Asian countries Share of Japanese manufacturers in Asia s car market (21) Slowdown of real GDP growth when auto production decreases 5% Car production by Japanese manufacturers (including jointventure Total car production Share of Japanese manufacturer s (A) (B) (A/B) (%) Data coverage China 2,336,3 9,575, Sales; Passenger 24.4 sedan vehicles Taiwan 255,16 33,449 Production; Passenger 84.1 and commercial vehicles Malaysia 158,5 567,715 Production; Passenger 27.9 and commercial vehicles Thailand 738,377 8,357 Sales; Passenger 92.3 and commercial vehicles Indonesia 665, ,635 Sales; Passenger 87. and commercial vehicles Philippines 129, ,49 Sales; Passenger 76.8 and commercial vehicles India 1,352,21 2,819, Production ; Passenger vehicles Percentage point Philippines China Taiwan India Malaysia Indonesia Thailand Source: CEIC data, Sinotrust and Nomura Global Economics Source: CEIC data, Sinotrust and Nomura Global Economics Source: Nomura Global Economics Some other Asian countries such as Thailand, Indonesia and Malaysia are likely to be adversely affected by the supply chain disruption in Japan. 13

14 Impact of supply chain disruption on US economy Potential layoffs caused by auto output cut Impact of slower production on Q2 GDP growth Non-Manufacturing Other manufacturing Vehicle body and parts maker Vehicle makers April:5% May:5% June:75% Case 1 April:75% May:75% June:1% Case 2 2, 4, 6, 8, Number of layoffs q-o-q saar % Japanese makers' production level relative to normal capacity Source: BEA; Nomura Global Economics Source: BEA; Nomura Global Economics The supply chain disruption in Japan will likely slow the US economy only temporarily. 14

15 Steady expansion of power supply capacity TEPCO s electricity output projections TEPCO s measures to increase electricity output by end-july (GW) Source: TEPCO Demand at daily peak (55.GW) /3/12 211/3/25 end of July, 211(est.) 25 March projection: total +1GW (1) Resumption after interruption caused by earthquake: +7.6GW Units 1 6 at Kashima thermal power plant and Unit 1 at Hitachinaka thermal power plant (2) Resumption of operation of thermal power plants following long-planned shutdown: +9MW Units 3 and 4 and No. 1 and No. 2 gas turbines at Yokosuka thermal power plant (3) Resumption after regular inspection: +3.7GW Shinagawa thermal power plant Group 1, Unit 1; Yokohama thermal power plant Group 7, Unit 2, etc (4) Installation of gas turbines, etc: +4MW (5) Other measures: -2.6GW Reduction in output from existing thermal power plants in summer Additional output announced on 11 April: total +5.5GW (1) Resumption after shutdown following earthquake and regular inspection: +1.1GW Units 1, 3, and 4 of Kashima Kyodo thermal power plant, and Units 8 and 9 of jointly operated Hitachi thermal power plant (2) Installation of gas turbines, etc: +2MW At Chiba and Sodegaura thermal power plants, etc (3) Use of pumped storage generation: +4GW (4) Other measures: +2MW Source: TEPCO On 15 April, TEPCO raised its previous (25 March) forecast of end-july output from 46GW to 52GW (53.8GW excluding electricity distributed to Tohoku Electric Power). This figure is close to the maximum electricity demand of 55GW anticipated for the average temperature in summer. It indicates that severe power shortages could be avoided. 15

16 Annoying power shortages in summer unlikely Tepco s supply capacity projection for July used to be 46.5GW as of 25 March. The company raised its projection to 55.2GW on 13 May (53.8GW excluding electricity distributed to Tohoku Electric Power). The main reasons for the higher projection are the planned use of pumped storage power generation and the installation of new gas turbines. The 53.8GW projection is close to the maximum electricity demand of 55GW anticipated for the average temperature in summer. We think that a possible substantial reduction in economic activity could be avoided,. Our primary concern remains with the average temperature in the coming summer as the main determinant of air conditioning demand for electricity. When Japan was hit by an unprecedented heat wave last summer, peak electricity demand rose to 6GW. According to our calculations, peak summer electricity demand rises 1.74GW for every one-degree increase in temperature, reducing industrial production by about.3%. According to the Meteorological Agency s three-month weather forecasts, temperatures in the Kanto- Koshinetsu region will be higher than average in July at a probability of 4%, while the probability that they will stay at the same as the average also 4%. It says the probability they will be lower than average is 2%. While temperatures may be slightly higher than average, the heat wave we experienced last summer appears unlikely this summer. Source: Nomura 16

17 End of deflation in sight in 213 CPI CPI and output gap Systemic factors Energy Core core CPI Food (ex alcohol) Core CPI () 1/4 Abolition of public high school fees Reduction o f private high school tuition fees Higher medical treatment reimbursements Forecasts 1/1 Hike in tobacco tax (yy/m) Note: (1) Core CPI is general index excluding fresh food and core core CPI is general index excluding food (excluding alcoholic beverages) and energy. (2) Regulatory factors refer to elimination of public high school tuition fees, reduction of private high school tuition fees, increase in medical treatment reimbursement fees in April 21, waiving of some expressway tolls in June 21 (reflected in CPI from July 21), and increase in tobacco tax rate in October 21. Source: Nomura Global Economics, based on MIAC data () (%) 8 Forecasts Core CPI (lhs) -6 Core core (ppt contribution, lhs) -8 Output gap (rhs) (CY) Note: Output gap = (actual GDP potential GDP) / potential GDP. Source: Nomura, based on various materials We look for underlying CPI after the benchmark change in August 211 to return to a positive trend in 213. The earthquake impact could be almost neutral to the price situation. 17

18 Expecting trade balance will move into surplus in Q4 Projected recovery in real exports Composition of imports by commodity (21) ( bn) Projections Nondurable consumer goods 6.5% Durable goods 6.6% Other 2.5% Food and other direct consumer goods 8.5% Capital goods 23.6% Industrial raw materials 52.3% (yy/m) Capital goods + industrial raw materials = 75.9% Source: Nomura Source: Nomura, based on JETRO data We expect the trade balance to remain in deficit through to Q3, but then to move into surplus from Q4 as exports recover as domestic production recovers. On the other hand, we expect imports to slow before long. Looking at imports by commodity, the ratio of final demand goods is no more than slightly under 3%, while the remaining 7%-plus comprises production-related goods, such as producer goods and capital goods. We expect the decline in domestic production levels to tend to depress imports. 18

19 First supplementary budget:.41% boost for real GDP Expenditure items of first supplementary budget for FY11 ( bn) Items of expenditure Disaster recovery , temporary homes Rubble/wreckage clearance Public works ,21.9 Repairing damage to roads, harbors, sewerage, etc Rehabilitating farmland and farm buildings 5. Building 1, social housing units for those affected Repairing damaged buildings 416. Repairing 2, schools Making schools quake-resistant 34. Disaster relief loans 64.7 Tiding SMEs over cash flow difficulties 51. Cutting mortgage rates 56. Financial assistance to those working in farming, forestry and fisheries 4. Higher tax allocation grants to local governments Other measures Cost of SDF involvement Reductions in/exemptions from health insurance contributions, etc Rehabilitating fishing grounds and breeding facilities 68.1 Total 4,15.3 Source: Nikkei Text Width Estimated economic impact of first supplementary budget for FY11 Total Public works Rubble/wreckage clearance Persona l income Note: Impact on real GDP (in terms of ppt difference from scenario with no supplementary budget). Impact is cumulative. Source: Estimates by Nomura, based on Cabinet Office s Short-Run Macroeconometric Model of the Japanese Economy (28 edition) Text Width First supplementary budget including 4,15.3bn in postquake reconstruction spending was approved on 2 May. The amount is about four times the 1,22.3bn in the first supplementary budget after the Kobe quake, and more than the total of 3,229.7bn in three supplementary budgets at that time. We estimate it will boost real GDP by a relatively large.41% over a one-year period. (ppt) Corporate income 1st quarter nd quarter rd quarter th quarter

20 Assuming a total of 13trn in the second supplementary budget (% q-q) Government spending before and after the Kobe earthquake Public works investment Government consumption Total Rebuilding demand Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q Source: Nomura based on Cabinet Office data (CY) Support for restoration of normal life in affected area Debris disposal Minimization of secondary disaster Rapid restoration of ports Rapid infrastructure build Improved earthquake resistance Housing measures Urban rebuilding Government spending after Kobe earthquake Employment maintenance; unemployment prevention 95/3 second supplementary budget (discretionary reserves in 95/3: 14.8) 34.3 (priority allocation in 96/3: 2.1) 9.6 (priority allocation in 96/3: 1.5) (priority allocation in 96/3: 6.8) (priority allocation in 96/3: 49.5) 19.8 (priority allocation in 96/3: 38.2) 86.9 (priority allocation in 96/3: 18.5) 15. (priority allocation in 96/3: 6.2) 96/3 first supplementary budget Policies to promote restoration of normal life ) Stabilization of housing situation for victims ) Support for victims requiring aged care ) Support for cultural activities aimed at restoring lifestyle with leisure, relaxation 4) Support for cultural activities aimed at restoring lifestyle with leisure, relaxation ) Other Policies for economic recovery ) Transport, telecoms infrastructure to support economic recovery 2) Industry support to promote economic recovery Healthcare, medical care, welfare ) Other 39.7 Rapid restoration of educational facilities Restoration of agriculture, forestry and fisheries facilities Policies for safe urban planning (priority allocation in 96/3: 1.) ) Planning of safe, pleasant urban environment with open space and redundancy in transport infrastructure Economic recovery ) Infrastructure for disaster minimization 12.3 Cross-sectional policies to promote smooth recovery Securing regional security and efficient traffic flow 6.5 Disaster minimization policies (priority allocation in 96/3: 9.) Other Total 1,22.3 1, ) Public facilities for disaster response ) Other Other.4 Total 96/3 second supplementary budget Source: Nomura, based on Ministry of Economy, Trade & Industry data (Project spending basis: 1,41.) Our latest forecasts assume a total of 13trn (with 7trn in public works spending) in the second supplementary budget, expected to be passed in September. As a result, we now project a total of about 17trn will be spent on reconstruction in FY11, 7% more than we initially anticipated. We look for the FY12, FY13, and FY14 budgets to contain reconstruction-related spending of 4trn, 3trn, and 1trn, respectively. Under this scenario, we assume reconstruction-related spending over the four years of about 25trn, with public works spending of 14trn. 2

21 Estimated economic impact of raising the consumption tax Source of funding for first supplementary budget for FY11 ( bn) Sources of funding Freeze of increase in child benefit 28.3 Freeze of abolition of highway tolls 1. Revision of 1, ceiling on highway tolls on weekends/public holidays 25. Reallocation of funds originally allocated to Special Pension Account 2,489.7 Use of special fund to support areas around power plants 5. Cuts in ODA budget 5.1 Cuts in Diet members' salaries 2.2 Costs shouldered by local authorities 55.1 Use of reserves 81. Total 4,15.3 Estimated economic impact of 3ppt increase in consumption tax Real GDP Private final consumption expenditure Private plant & machinery Private residences Exports (ppt) Imports 1st quarter nd quarter rd quarter th quarter th quarter th quarter th quarter th quarter Average annual growth rate Source: Nikkei Note: Impact on main components of real GDP (in terms of ppt difference from scenario with no increase in consumption tax). Impact is cumulative. Source: Cabinet Office s Short-Run Macroeconometric Model of the Japanese Economy (28 edition) Text Width We expect no major adverse economic impact even if the consumption tax were raised. The government may raise JGB issuance backed by future tax increases to finance the rebuilding costs. 21

22 Looming debate on raising the consumption tax We would not expect a large economic impact from a possible consumption tax hike, even if the hike is put in place soon. We anticipate that a possible 3ppt consumption tax hike in April 212 will reduce the average annual growth rate of real GDP in FY12 by only.45ppt. Since we currently forecast FY12 real GDP growth at 2.9% as the economy rebounds from a post-quake slump, a slower growth of about 2.4% due to the 3ppt consumption tax hike would still keep the economy on a steady growth track. We estimate that if public works spending is increased by 7.5trn and the increased spending is funded by the 3ppt consumption tax hike, the positive knock-on effect (multiplier effect) of the increased public works would far outstrip the negative knock-on impact (multiplier effect) of the tax increase, even if the package remains fiscally neutral. We can imagine that, if consumers were well aware (or if the government were to make them more aware) that the increased revenue from the consumption tax was being used for the benefit of those people and areas affected by the quake disaster, the tax increase might have much less negative impact on consumption than it would normally have. However, we think the government is unlikely, as things stand at the moment, to try to fund the lion s share of reconstruction spending by raising the consumption tax. We think this risk is unlikely to become imminent and substantial all of a sudden because additional JGB issuance can be implemented for funding reconstruction. 22

23 Expanding budget deficit General account ( trn, except where noted) Financial surplus and deficit in each sector ( trn) FY: E 12E General account budget Expenditure General expenditure Social security Public works Defense Local allocation tax Special local grants National debt service National debt service ratio (%) Revenues General account revenues Tax and stamp revenues Income tax Corporate tax FY: E 12E Households As % of GDP Nonfinancial corporations As % of GDP General government As % of GDP Overseas As % of GDP Financial institutions As % of GDP Note: (1) Negative number indicates shortage of funds. (2) Based on BOJ s Flow of Funds Accounts. (3) FY5 data exclude net impact of 42.8trn due to transfer of assets and liabilities from public nonfinancial incorporated enterprise to central government in accordance with establishment of Japan Expressway Holding and Debt Repayment Agency. (4) FY6 data adjusted for impact ( 21trn) of funds transferred from public financial institutions to central government as result of transfer of funds from Fiscal Loan Fund special account to National Debt Consolidation Fund special account. (5) FY7 adjusted for movement of 6.7trn in funds from government to financial institutions and corporations following changes in divisional organization when Yucho Bank and Kampo Insurance started business. Source: BOJ, Nomura estimates Consumption tax Other tax Nontax revenues, etc Government bond issues Gov bond dependency ratio (%) vs GDP (%) Nominal GDP Fiscal Investment and Loan Program Local government budget proposals Note: (1) General account data are actual through FY8 and forecasts from FY9. (2) Forecasts do not presuppose fund surplus. (3) Fiscal Investment and Loan Program and local government budget proposals are initial projections. Source: MOF, Nomura estimates 23

24 Five risks threatening V-shaped recovery 1. Delays in implementing budgets due to political instability 2. Slow progress in reconstruction in the quake-stricken regions 3. Deterioration in the external environment, e.g., economic slowdown overseas, yen appreciation, or higher crude oil prices 4. Slow progress in removing supply-side constraints 5. A further hollowing-out of the economy over the medium term Source: Nomura 24

25 Two previous quakes might have been among the factors that helped to destabilize Japan s economy and financial market and trigger deflation Real GDP growth around the time of major earthquakes and World War II Pre- and post quake short-term interest rates (%) Year = -5% World War II (1945) Great Hanshin-Awaji Earthquake (1995) Great Kanto Earthquake (1923) Note: Year is the year of the earthquake or, in the case of World War II, the year in which the war ended. Source: Nomura, based on Angus Maddison website data (years) (%) (%) Overnight call rate before and after Great Hanshin-Awaji Earthquake (1995) (CY) Call rate before and after Great Kanto Earthquake (1923) (CY) Source: Nomura, based on BOJ data The Great Kanto Earthquake of 1923 and the Great Hanshin-Awaji Earthquake of 1995 did not inflict massive damage on the Japanese economy in the short term. Real GDP growth was 1.9 in 1995, the year of the Great Hanshin-Awaji Earthquake, and 2.6% the following year. Real GDP growth was 1.4 in 1923, the year of the Great Kanto Earthquake, and 5.% the next. However, both earthquakes might have been among the factors that helped to destabilize Japan s economy and financial markets and trigger deflation. 25

26 We should also look at how Japan rose from ashes after World War II Real GDP before and after major earthquakes and World War II Real long-term GDP growth Great Kanto Earthquake (1923) World War II (1945) Great Hanshin-Awaji Earthquake (1995) (years) Real GDP ($mn), natural logarithm Trend line (polynomial approximation) Great Kanto Earthquake (1923) WorldWar II (ended in 1945) Great Hanshin-Awaji Earthquake (1995) (CY) Note: (1) Year is the year of the earthquake or, in the case of World War II, the year in which the war ended. (2) Rebased to 1 when real GDP =. Source: Nomura, based on Angus Maddison website data ( 出所 )Angus Madison homepage At the same time, we must not forget how the Japanese economy rose impressively from the ashes following World War II. Japan lost around one quarter of its capital stock in World War II from 1941 through 1945, but the economy started to grow rapidly from as early as the year after the end of the war, and after eight years real GDP was back to pre-war levels. Moreover, from the period after the war through the mid-197s, the economy grew more rapidly than it had before the war. There are various reasons for Japan s post-war recovery, but a large part of this must almost certainly be due to the success of government policies. 26

27 Concerns over the risk of hollowing-out of Japanese industry Reconstruction Design Council s seven principals Since its first meeting on 14 April, the Reconstruction Design Council in Response to the Great East Japan Earthquake has diligently carried out many debates and a series of site visits. Today, the council announces that it has drawn up seven reconstruction design principles, ahead of the submission of its first set of recommendations by the end of June. From now on, on the basis of these seven principles, while welcoming views from all sectors of industry and all parts of society, and while also deepening our deliberations, we aim to draw up a blueprint for the Japan we hope to see in the future. Principle 1: For those of us left behind, reconstruction is the starting point of our efforts in remembrance of those who have sadly lost their lives. We will preserve the memories of this earthquake for eternity, for example by creating monuments and forests for the repose of the departed, and ensure that the disaster is widely analyzed by academics in a scientific manner, so that its lessons are passed on to future generations, both in Japan and overseas. Principle 2: The basic task is the reconstruction of regions and communities, while bearing in mind the size and diversity of the area affected by the earthquake. The Japanese government will support this by drawing up an overall reconstruction plan and designing a system for reconstruction. Principle 3: We hope to take advantage of latent potential and carry out reconstruction and rehabilitation using technological innovations, in order to revitalize the Tohoku region. We will pursue the possibility that the Tohoku region will become an economic and social entity that will serve as an example for the rest of Japan to follow. Principle 4: We aim to create a region that uses natural energy, and towns that are safe and secure against future disasters, while at the same time preserving the regional society s strong social ties. Principle 5: There will be no revitalization of the Japanese economy without the reconstruction of the areas affected by the earthquake. Without the revitalization of the Japanese economy, there will be no true reconstruction of the affected areas. On the basis of this understanding, we aim to work simultaneously for both the reconstruction of the affected areas and the revitalization of the Japanese economy. Principle 6: We will work for a rapid resolution of the nuclear power-related problems, and will do our utmost to provide support for, and help to rebuild, the areas affected by the nuclear disaster. Principle 7: All of those who have survived the earthquake will see this as our own disaster, and will, as a people, work together toward reconstruction, in mutual understanding. Source: Nomura, Based on Reconstruction Design Council data In our view, the risk of a hollowing out of Japanese industry should be our main concern in the aftermath of the Great East Japan Earthquake. Japan's country risk in terms of the risk of earthquakes, tsunamis, power shortages, nuclear power problems, and yen appreciation has clearly increased since the quake, and conditions facing companies establishing operations in the country have deteriorated. All of this could encourage companies to shift production overseas. Since before the earthquake, the Japanese government had been pursuing a growth strategy aimed at increasing Japan s international competitiveness, boosting its exports, and stemming companies shift overseas. The main elements of this strategy are the tapping of overseas infrastructure demand, the stabilization of exchange ranges, a lowering of the corporate tax rate, and participation in the Trans-Pacific Partnership (TPP). If the economic policies pursued by the government going forward mean that these latter measures are put on hold as the government focuses mainly on the rehabilitation of the areas affected by the earthquake, there is a risk that this will cause the economy to deteriorate over the longer term even if it is revived in the short term, as was the case after the two previous major earthquakes. Bearing this in mind, we note that the fifth of the seven principles as announced by the Reconstruction Design Council on 1 May indicates that the government aims to pursue simultaneously both the post-quake rehabilitation and revitalization of the Japanese economy as a whole. We would welcome the government pursuing rehabilitation policies at the same time as continuing with its growth strategy. 27

28 Nationwide Hokkaido Tohoku Kanto Chubu Kinki Chugoku Shikoku Kyushu Okinawa Important that policy aims to boost industry concentration in Tohoku Ranking of manufacturing sectors by value-added production in Tohoku region in 29 Value-added productivity by region (electronic parts and devices) ( ' per capita) Value As % of regional As % of nationwide total (a) - (b) mn % 1 Food 636, Electronic parts and devices 491, Information and communication 357, electronics Chemical and equipment allied products 33, Non-ferrous metals and products 293, Transportation equipment 267, Fabricated metal products 232, Production machinery 227, Business oriented machinery 193, Beverages, tobacco and feed 192, , 14, 12, 1, 8, 6, 4, 2, Nomura, based on Ministry of Economy, Trade and Industry s (METI) Statistical Tables by Industry Note: 29 data. Data for Okinawa not available Source: Nomura, based on METI s Statistical Tables by Industry Since the late 198s, an increasing number of new IT components and materials plants have been set up in the Tohoku region. The region is one in which the electronic parts and device sector is concentrated, but this sector is still at the stage at which the advantages of industry concentration have not yet been fully realized. If companies in the IT components industry leave the Tohoku region and move overseas, not only would this likely do much to hinder the recovery in production and employment in the region, but it would also reduce the competitiveness of Japanese exports as a whole, including those from the auto and electrical machinery industries, and thus increase the risk of a hollowing out of Japanese industry. It is important to introduce preferential tax and fiscal measures and deregulation via the establishment of special zones, We will be looking for evidence that discussions at the Reconstruction Design Council is considering such measures aimed at boosting industry concentration. 28