SFC Markets and Finance | Japan's Recovery: Natural Disasters, Market Turmoil, and Policy Challenges

南方财经全媒体记者 李依农 上海报道

August 8th, a powerful 7.1-magnitude earthquake occurred off the southern island of Kyushu in Japan. Could this further affect Japan's already vulnerable economy and financial markets? More on the potential impact of this event, let's hear from Chen Zilei, the Director of Japan Economic Research Center at Shanghai University of Foreign Trade and Economic Cooperation.

SFC Markets and Finance: A 7.1-magnitude earthquake occurred near Kyushu, it is often referred to as "Silicon Island." Could this potentially impact the semiconductor and tech industries? What is the current situation?

Chen Zilei: First, the earthquake occurred off the coast of Miyazaki-ken at the Hyuga-nada, which was the epicenter of the earthquake. The magnitude of the earthquake is 7.1. Except for Miyazaki-ken, the affected areas include Kagoshima and Kumamoto. The seismic intensity experienced in these areas ranges between 5 to 6. Compared to the Fukushima earthquake in the past, this one is on a relatively small scale.

In addition, there is a particular concern about the impact of the earthquake, especially the tsunami. The tsunami is estimated to be 1 meter in scale. The scale is not very large. Therefore, the impact of the earthquake on people's lives and property safety is manageable, and the overall impact is also limited.

For the impact on the industry, the primary concern is the nuclear power plant. The Sendai Nuclear Power Plant of Miyazaki-ken is operating normally this time.

Secondly, there was concern about the Shinkansen, including the Sanyo, Kyushu, and Nishi-Kyushu lines. They were affected during the earthquake but returned to normal operation immediately. The only significant impact was on local oil storage tanks—out of 13, some experienced minor leaks, but this did not affect production or operations, nor did it cause any fires.

Overall, based on the information available, the impact of the earthquake on businesses and transportation appears to be limited. The local people's lives were not affected, and while Kyushu Island is an industrial center, the impact on its industrial base, including logistics, production, and operations, remains manageable.

SFC Markets and Finance: Could this earthquake introduce an additional element of uncertainty to Japan's already volatile financial markets and its recovering economy?

Chen Zilei: There is an uncertainty because the epicenter of this earthquake, the Hyuga-nada, is precisely located in the Nankai Trough area of Japan. This area is quite sensitive. Japanese seismologists have long urged the government and society to prepare for the possibility of a super large-scale earthquake here. 

Japan has comprehensive disaster prevention and mitigation systems, and the response to this earthquake has been rapid. There is also a cooperation mechanism between China and Japan focused on disaster prevention and mitigation, and some experience of Japan can be learned from. However, the location of the epicenter this time is sensitive, causing a certain degree of panic in Japanese society.

Whether this earthquake is a precursor to a larger event in the Nankai Trough remains to be seen, and experts will need to assess the situation. However, this uncertainty has indeed affected the mindset of the Japanese public.

Given the current instability in Japan’s capital markets, it’s uncertain whether risks will be magnified. From the current perspective, the degree of impact is still limited.

Although the scale of this earthquake is not large, and the impact is also limited, but the possibility of secondary disasters, like those following the 2011 Tōhoku earthquake and tsunami, should not be overlooked.

We still need to have a sense of risk prevention, particularly concerning the capital markets, which is currently in a period of fluctuation, and the recovering Japanese economy. Even if the impact is not as severe as the 2011 earthquake of the Pacific coast of Tōhoku, vigilance is always needed.

The recent turbulence in global markets has raised some serious questions, especially with Japanese stocks seeing their biggest drop since 1987, and the VIX index, a key measure of market volatility, has hit its highest level since the COVID-19 pandemic. What's driving this sharp shift in market sentiment? Was this just an isolated incident, or could it signal the start of a broader downturn? And more importantly, where does the Japanese economy go from here? To help us unpack these questions, we're joined by Shigeto Nagai, former Bank of Japan official, and Head of Japan Economics at Oxford Economics.

SFC Markets and Finance: What has triggered the recent roller-coaster ride in global markets?

Shigeto Nagai: I believe the main trigger was the sudden rise in uncertainty and concern about the conduct of monetary policy in the United States and Japan, particularly the U.S. monetary policy. The July employment report suddenly sparked an over-pessimistic view of the U.S. economic outlook.

However, the important backdrop to this sharp increase in uncertainty is the unusually cautious and hawkish conduct of monetary policy by the U.S. central bank. The U.S. central bank has been very cautious and hawkish because they are determined to contain inflation expectations. To demonstrate their commitment to fighting inflation, the U.S. central bank has pledged not to start cutting interest rates until they confirm that inflation and wage growth have settled at a level consistent with a 2% inflation target. This was an inevitable choice for them, but at the same time, this very cautious and hawkish approach has raised concerns about being behind the curve, meaning too late to cut interest rates. This kind of unusual stance on monetary policy has led to a sudden sharp rise in uncertainty and concerns about the U.S. economic outlook.

In Japan, during the July meeting, the Bank of Japan, the Japanese central bank, made a surprise move to raise rates without clear evidence of ongoing inflation and introduced new hawkish forward guidance. They stated that real interest rates are very low, so unless there is a significant negative risk to their price outlook, they will not hesitate to continue raising rates in the coming period. This has raised concerns about an earlier and faster pace of interest rate increases, leading to yen appreciation. The Japanese stock market, which had been strongly supported by the weakening yen, really panicked.

These two uncertainties over monetary policy, both in the U.S. and Japan, have been the triggers for the recent roller-coaster ride in the stock markets and global financial markets.

SFC Markets and Finance: You mentioned the impact of U.S. monetary policy, and it is often said that what happens in the US economically and financially does not stay in the US. Are global markets likely to remain volatile until the Fed makes its decision in September?

Shigeto Nagai: As I said, the recent pessimism about U.S. outlook is overblown and it was really triggered by a single employment report for July. So if come new data, we will see more incoming data on prices, labor markets, and growth. I think the financial markets will start to correct this over pessimistic view over the U.S. economic outlook, even without waiting for the September possible rate hike by the U.S. central bank.

SFC Markets and Finance: When do you think the Fed will cut rates?

Shigeto Nagai: Despite the recent roller-coaster ride in the stock markets, we stick to our core that the U.S. central bank will cut interest rates twice within this year, in September and December.

SFC Markets and Finance: Back to the recent volatility in the Japanese stock market, do you think it was overreacted?

Shigeto Nagai: Yes, as you correctly pointed out, I believe it was an overreaction, as evidenced by the strong recovery in the following days. Investors in the Japanese stock markets had become a bit too complacent about the stable and benign market environment driven by persistent yen weakness. Additionally, there are many positive developments ongoing in the Japanese industries, which contributed to this complacency.

Moreover, there were many new entrants to the Japanese stock markets who panicked at the sudden drop in stock prices, an experience they hadn't encountered in recent times. A significant number of new foreign investors have entered the Japanese stock markets with very limited knowledge and experience in Japan.

On the domestic front, many new individual investors have also joined, partly motivated by the Japanese government's savings-to-investment campaign and supported by relatively easy profit-making opportunities in recent months. This high ratio of new entrants and beginners in the Japanese stock market has exacerbated the panic during this recent episode.

SFC Markets and Finance: What's next for the Japanese stock market? Have we hit the bottom already?

Shigeto Nagai: Yes, I think we have hit bottom, and we expect the stock price will gradually recover in line with gradual improvement in economic environment, both in the cyclical economic recovery and further progress in the ongoing structural transformation of the economy.

But at the same time, we should remember that the excessive yen weakness is unlikely to return in the coming month. Thanks to the BOJ's new hawkish forward guidance for monetary policy, which will limit the pace of coming stock price recovery.

So, it is recovering, but don't expect that everything will return to the pre turmoil.

SFC Markets and Finance: Before we delve deeper into the yen and Japan's momentary policy, what advice do you have for investors against the current uncertainties we see in the market?

Shigeto Nagai: Especially for investors to Japanese stock markets, I understand that the financial markets have been disappointed, but I would like to stress this time is different. And all the ongoing structural transformation in the Japanese economy is real.

Japan's economy have been trapped in a deflationary equilibrium for decades, but finally, Japan has initiated a structural transformations to regain its dynamism. This has been driven by a secular shortage of labor against the background of fast aging of the society. This transformation is an irreversible movement.

But at the same time, another important advice to investors of the Japanese stock market is please be patient, because it may take some time to make change in the Japanese society.

SFC Markets and Finance: At the very beginning, you mentioned that one of the reasons behind the stock market volatility was the Bank of Japan's surprising rate hike. Do you think the tightening was too aggressive? And do you anticipate more rate hikes this year?

Shigeto Nagai: The surprising move in July was acceptable, slightly earlier than our expected timing in September. However, the level of the interest rate is still low, so its impact on the real economy is quite limited. In that sense, it’s okay.

Regarding the new hawkish forward guidance for monetary policy, I think it was an inevitable choice for the BOJ to take this approach to counter the yen weakening pressure in the forex markets. So far, they have been successful.

We now expect another hike in October this year, believing that the BOJ truly wants to normalize policy to some extent and as early as possible, unless there is any significant negative news or risks to their price outlook.

At the same time, this new forward guidance may invite speculation about earlier rate hikes by the BOJ, but it has no bearing on the terminal rate, where the rate hikes will end. We still project that the BOJ's or Japan's natural rate, or terminal rate, is around 1%. We believe that rate hikes in the coming period will require more cautious consideration as the policy rates approach the 1% terminal rate.

SFC Markets and Finance: Stabilizing the yen or stabilizing the stock market, does Japan have to choose one over the other?

Shigeto Nagai: Good question. I think the stable yen and stable stock prices can coexist. But you are right in a sense that BOJ is really facing a kind of ultimate choice, which is to choose the yen or interest rate.

Because to stop the yen weakness, BOJ should be more hawkish and keep raising rates. But it will raise the risk of over killing the still vulnerable economy. I think this is a kind of conundrum the BOJ has been facing, and this conundrum will continue in the coming years.

SFC Markets and Finance: How do you think the Bank of Japan can best handle the situation?

Shigeto Nagai: I think it requires a very dedicate balance and maintaining the yen at the comfortable level, at the same time, controlling the pace of rate hikes at the manageable level. And for this dedicate balance to happen, what is necessary and essential is how to communicate with the financial markets, which has been very difficult and challenging.

So far the BOJ has not been scoring good for this market communication things, because simply inviting market confusion so far.

SFC Markets and Finance: There is a view that the yen is one of the most undervalued currencies. What is your take on that? And how do you see the future trend of the yen?

Shigeto Nagai: The yen has been undervalued, especially entering this year. This has been driven by the so-called yen "carry trade," which has been very profitable due to the still wide interest rate differential between the United States and Japan and the very low volatility in the foreign exchange market, which has also facilitated making money through this yen carry trade.

However, the recent adjustment in the forex market has wiped out all the excess earnings accumulated this year due to a sharp rise in market volatility and the uncertainty surrounding the prospect of monetary policy in both the United States and Japan. As a result, all the excess has been wiped out, and the current level around the mid-140 yen per U.S. dollar is not a very comfortable number for many Japanese firms, I believe.

Looking at the prospect for the yen, I think starting next year, the yen will gradually strengthen, reflecting more rate cuts by the Fed and rate increases by the BOJ. However, beyond the short term, we believe that the yen will continue to be weak and remain on a downward trend for two reasons.

First, Japan's weak economic fundamentals compared to the United States mean that the interest rate differential between the two countries will persist in the medium and long term. Second, there is a structural change in Japan's external balance, as represented by the current account balance. Japan used to be a champion of exports, but these days, the trade balance in Japan tends to be more negative, so it is no longer a driver of the yen in the forex market.

On the other hand, Japan is becoming more of a capital exporter. Japan has a huge amount of savings, which will continue to increase due to the aging society, and this money will flow out of the Japanese economy, seeking higher returns in foreign markets. This kind of structural, persistent capital outflow will have a weakening impact on the yen in the long run. In that sense, over the long term, we expect a more secular weakening trend for the Japanese yen.

SFC Markets and Finance: To wrap things up, how do you see the Japanese economy shaping up in the near future? What key factors do you think will play a role in its recovery and growth?

Shigeto Nagai: Sure, as I mentioned, Japan is changing, and this time it’s different. The ongoing change is real. The main driving force behind this transformation is the secular shortage of labor due to the rapidly aging society. I believe this labor shortage will continue to drive both the ongoing economic recovery and the structural transformation of the economy.

Labor shortages will put upward pressure on wages, which will force firms to improve profitability to afford higher wages. Additionally, higher wages will stimulate domestic demand by increasing household income.

A major risk to this relatively benign trend, our baseline projection, is the sustainability of this wage growth feedback mechanism. Most importantly, we need to consider whether the majority of firms in the Japanese economy, particularly small and medium-sized enterprises (SMEs), which typically have lower profitability and productivity than large firms, can catch up in this wage-driven growth feedback mechanism. This is something we should carefully monitor in the coming periods to assess sustainability.

策划：于晓娜

监制：施诗

编辑：和佳

记者：李依农 杨雨莱

制作：李群 蔡于恬 

新媒体统筹：丁青云 曾婷芳 赖禧 黄达迅

海外运营监制: 黄燕淑

海外运营内容统筹: 黄子豪 

海外运营编辑：庄欢 吴婉婕 龙李华 张伟韬

出品：南方财经全媒体集团