The tragic earthquake and subsequent tsunami has caused a significant disruption in Japanese economic activity. In the most affected areas, transportation and production interruptions have caused severe supply-chain difficulties. The damage to electrical power facilities, including two nuclear plants, has created power shortages that have had ramifications throughout the country. With Japan’s economy having already slowed in recent months, the recent events are likely to contribute to significant economic weakness in the near-term.
On the other hand, natural disasters in developed economies have typically put into motion a series of policy and other actions that begin to create a positive counter-effect. Specifically, the initial fall in production and consumption often gives way to a pick-up in economic activity driven by a restoration of the damaged capital stock. Historically, government spending, monetary stimulus, and insurance payouts lay the foundation for a reconstruction phase, in which businesses and households rebuild lost and damaged infrastructure.
For example, after the Kobe region earthquake in 1995, Japanese industrial production fell by 2.6% during the month of the earthquake but had fully recovered to pre-earthquake levels just two months later. While there are many differences between the Kobe quake and today in terms of the damage inflicted and the overall economic environment, the general historical pattern of sudden decline followed by a reconstruction-led recovery holds across many examples of natural disasters in various developed economies.
On March 14, the first day of trading since disaster struck, the Japanese stock market dropped 6.2%. An initial sell-off in the aftermath of a natural disaster is a common historical pattern in stock markets, as uncertainty may cause some short-term selling while investors re-assess the outlook. However, the sell-off also makes Japanese equities cheaper, which underscores an important difference between now and the post-Kobe earthquake in 1995.
Japan is the world’s third largest economy, in addition to being a significant link in the global manufacturing supply chain. As a result, lost output in Japan and disruption to industrial production will undoubtedly have a negative near-term impact on the global economy. At the same time, Japan was not considered to be a major driver of the current expectations for a solid year of global growth in 2011. Most global growth was expected to come from developing economies and the United States, with Japan accounting for 0.1% of the expected 4.2% real global GDP growth projected by the International Monetary Fund (see Exhibit 2, below). As a result, a temporary decline in Japanese output would likely not be a show stopper for the global economic expansion.
Another potential impact of the Japanese crisis is on world energy and other commodity markets. In the near-term, the decline in Japanese economic output will likely result in lower crude-oil demand, as Japan is the world’s third-largest petroleum importer. On the other hand, if the damaged nuclear power plants remain off-line, Japan will have to make up the lost electrical output with fossil fuels, such as natural gas. A rebuild of Japanese infrastructure would likely result in more commodity-intensive activity than expected, which ultimately could increase demand for crude oil and other natural resources.
On March 14, stock markets in Asia and most of the rest of the world declined, but for the most part the losses (outside of Japan itself) were relatively modest. While there has been some speculation that Japanese investors may sell U.S. Treasury bonds to repatriate the proceeds to Japan, long-term bond yields in the United States declined on March 14. Still, given the potentially large reconstruction funding facing Japan, any reduction in foreign demand for U.S. assets may raise the prospects for higher volatility in U.S. Treasury rates.
All in all, the fallout from the Japanese disaster may not in and of itself be enough to derail the global economy, but it is one more source of uncertainty for world financial markets to digest. With markets already jittery due to unrest in the Middle East and North Africa and the rise in crude-oil prices, this development interjects another source of volatility in the outlook for asset prices.
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