Japan’s fiscal fix deepens

March 11, 2011, 10:48 PM UTC

Today, concern over the human suffering in Japan naturally dwarfs any worry about how much it will cost to rebuild earthquake-hit areas.

But as the scale of the tragedy comes into fuller view in coming weeks, the impact on Japan’s unsteady economy and stretched fiscal position – and the implications for markets — will start to weigh heavier.

Carry on, yen

First, the facts. The quake, at 8.9 on the Richter scale Japan’s biggest ever, has killed hundreds of people. An oil refinery caught fire and residents near a nuclear reactor were forced to evacuate.

Japanese stock markets dropped and the cost of insuring against a default on Japanese debt rose 6%, according to CMA Market Data. Bond prices rose as investors pulled back from risky assets.

Like the oil spike that roiled markets in recent weeks, Friday’s quake offers yet another reminder of how vulnerable aging, slow-growing, debt-burdened economies are to a shock even in what is supposed to be a period of global economic expansion.

“Japan’s economic recovery has lost momentum and a large part of the reconstruction costs will add to the government’s significant debt burden,” writes Julian Jessop at Capital Economics. He writes that the disaster could make it even more painful for the latest Japanese government to take long overdue action to produce a plan that would put spending on a more sustainable track.

Economists responding to the news of the quake focused mostly on two issues: how bad the damage stands to be, and how big a burden rebuilding stands to impose on an already stretched nation.

As is always the case in the aftermath of a disaster, reports were mixed, with some commentators saying the affected region is responsible for as much as a sixth of Japanese economic output and others putting the figure at perhaps a third of that. The scale and nature of the destruction will naturally have a lot to say about how daunting recovery is.

“Although the main concentration of industrial Japan appears unaffected, the extent of the infrastructural damage will be severe,” IHS Global Insight economists wrote in a note Friday. “The natural disaster could also upset the country’s nascent economic recovery while exacerbating the country’s ballooning public debt issues, as spending by the Tokyo government will surge to meet emergency response costs.”

The quake strikes another blow at an economy that was already reeling. Japan has been in and out of recession for two decades, and its debt load is more than twice the size of its annual economic output, by one measure — a ratio exceeded only by, um, Zimbabwe.

That’s why despite its high income and standard of living and a trade surplus that allows it to fund its borrowing needs almost exclusively at home, Japan is widely viewed as an economic disaster waiting to happen.

At the same time, buying long depressed Japanese stocks has emerged as one of the top investment themes of 2011, on the assumption that an uneven global recovery and rising inflation will  push up equity values. That idea will be sorely tested in coming weeks.

In any case, no one has any idea whether the fiscal breaking point might come this year, next year or (more likely) years down the road. Early reports that building collapses weren’t widespread perhaps offer some hope that the quake won’t mean a near-term date with fiscal crisis.

“Although the ground shocks were bigger than any that I have experienced before, we have fortunately not seen any collapse of buildings, roads or bridges,” said Soichiro Monji, Daiwa SBI’s chief market strategist.

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