* In spite of the tragic loss of lives and physical capital damage, usually earthquakes have limited macro effects, on the country and globally. However, the impact of the Japanese earthquake on Japan and globally could be larger for many reasons.
* First, if a nuclear meltdown were to occur—now a lower probability event—the damage on the country and the financial market panic could be severe. This remains a non-zero probability tail risk.
* Second, questions now abound nuclear power as safe and clean source of energy. Less reliance on nuclear implies stronger demand for oil and other fossil fuels and further negative terms of trade effect for net energy importers.
* Third, Japan is suffering power black-outs that are reducing production in a number of manufacturing sectors in Japan – cars, semi-conductors, steel, etc. Japanese inputs are a key intermediate products in the global supply chain. Production disruption will involve Singapore, China, Korea, Taiwan, as well as the U.S. (auto parts for Japanese auto factories in the U.S.).
* Fourth, reconstruction will imply a massive fiscal stimulus. Debt financed fiscal reconstruction would push long rates higher and cast greater doubts about fiscal sustainability (Japan’s fiscal deficit is already close to 10% of GDP, public debt above 200% of GDP and unfunded liabilities are mounting with the aging of the population).
* Fifth, in the short run the strengthening of the Yen—driven by as expectations of repatriation, unraveling of Yen funded carry trades and likelihood of lower gross capital outflows could harm the competitiveness of the traded sector, one of the few drivers of economic growth. While monetization of the fiscal deficit by the BoJ could eventually weaken the Yen after the initial appreciation.
* Sixth, rising oil prices may lead to a double-dip in a country where GDP fell in Q4 and production could remain damaged for a couple of quarters. All this while Japan experiences structural, economic and political challenges: fall in potential growth due to a shrinking population and falling labor productivity growth; fiscal debt sustainability; delay in structural reforms; a dysfunctional political system with four prime ministers in four year and a fifth possibly coming soon.
* Nevertheless, Japan is a net creditor, runs a current account surplus and has large private savings. In the short term, these factors might shield it from a sharp fall of the yen or a crisis on its public debt (which is largely domestically held, in local currency and is of longer maturity).
* ‘Short the yen has proven a loss making for the last few years. A disorderly outcome for the long bonds and for the currency in Japan is unlikely.
* Still, there is no room for complacency in Japan as structural impediments to growth need to be addressed, or another decade of near depression could befell on the Japanese economy.
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