Earthquake Pushes Japan Back in Recession

• Japan's GDP in Q1 11 contracted much more than expected, suggesting that the shortterm contraction in the wake of the earthquake will be larger than expected. We still expect a strong recovery in H2 11 but it looks increasingly difficult to avoid that GDP growth will be negative for 2011 as a whole.
• Further quantitative easing by Bank of Japan (BoJ) has become more likely, although we do not expect any additional easing measures from BoJ at tomorrow's meeting. We think that BoJ will underscore increasing downside risk, but will remain in waitand- see mode until it has a clearer view on the pace of the recovery.
• Today's weak GDP data underscore that BoJ will trail most of the rest of the world in unwinding stimulus and monetary tightening and for that reason relative monetary policy should eventually support a weaker JPY.

Details

The earthquake and tsunami that hit Japan on 11 March have pushed the Japanese economy back in recession. In Q1 11 GDP contracted 3.7% q/q (Cons: -1.9% q/q AR, DB: -1.3% q/q) and to add insult to injury GDP growth in Q4 10 was revised down to 3.0% q/q AR from previously 1.3% q/q AR in connection with a major revision of Japan's national account data back to 1990. The biggest negative surprise was a large 2.2% q/q AR drop in private consumption. Broadly in line with our expectations inventory cuts subtracted close to 2%-points from GDP growth in Q1 and net exports also subtracted slightly from growth.

Assessment & Outlook

Today's data suggest that the short-term contraction in the Japanese economy in the wake of the earthquake will be larger than expected. The worst impact of the earthquake will probably be felt in Q2, when we expect GDP to contract by 4-5% q/q AR. The economy should start to recover markedly from Q3 and to some degree the larger than expected contraction will be offset by a stronger recovery in H2 11. However, in light of the downward revision for Q4 10, it will now be very difficult to avoid negative GDP growth for 2011 as whole, even though some of the stronger short-term contraction in GDP will be offset by a stronger recovery in H2 11. Our current forecast for GDP growth in 2011 is 0.3%.

Today's GDP numbers also suggest that Japan's economy has been weaker than assumed in BoJ's latest forecast from April. For that reason further QE (most likely expansion of asset purchase programme) from BoJ has become more likely, but we do not expect any additional easing measures in connection with tomorrow's monetary meeting, even though BoJ will underscore increasing downside risk relative to its baseline scenario. For now we expect BoJ to stay in wait-and-see mode as it probably wants a clearer view on the pace of the recovery in the wake of the earthquake before it decides on any additional easing measures. One should also remember that BoJ already has considerable room to expand its balance sheets within the current asset purchase programmes. As can be seen in the chart, BoJ's balance sheet has in recent months expanded faster than in the wake of the collapse of Lehman Brothers in late 2008.

Today's weak GDP data underscore that Japan will trail the most of the rest of the world substantially in both unwinding QE and raising interest rates. We do not expect an interest rate hike in Japan to be in the cards until 2013. For that reason relative monetary policy should eventually support a weaker JPY.