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Tong (Cindy) Li
Adjunct Fellow; Country Manager, Federal Reserve Bank of San Francisco
Asia and Banking and Capital Markets and China and Finance and Global Economy
Dr. Cindy Li is a country manager and analyst in the Country Analysis Unit of the Federal Reserve Bank of San Francisco. In that capacity, she conducts research of Asian financial sectors and produces analyses of Asian foreign banking organizations.
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Reconstruction will pave the way for Japan's economic recovery
By: Tong (Cindy) Li
March 31, 2011
   
   

Despite a 9.0 magnitude earthquake, a tsunami that left tens of thousands of people homeless and the nuclear crisis that followed, Japan will experience a quick and strong recovery. Why? Spending to recover from the recent disasters will drive growth that's been stuck for years.

A closer look
The Japanese economy has suffered from weak domestic demand for decades. As reconstruction efforts get under way, demand is bound to soar and lead to faster growth in the second half of 2011. Granted, the Bank of Japan has limited room to provide stimulus via monetary policy because real interest rates have been de facto negative for years. Nevertheless, the central bank was quick to respond to the catastrophe: Since the crisis, the Bank of Japan has injected 38 trillion yen (roughly $465 billion) into the economy to ensure sufficient liquidity in the credit market. In addition, collaborative efforts among the G-7 nations seem to have successfully stabilized exchange rates. The remaining economic challenge: How to finance the reconstruction when Japan's fiscal situation is already in dire shape.

The government debt level has been steadily rising in the past two decades. It now stands at 198 percent of GDP, the highest of all countries in the Organization for Economic Cooperation and Development (OECD). It's doubtful that such a high leverage level can be sustained.

Government is borrowing even more
The Japanese government plans to spend $24 billion in its current budget cycle on the reconstruction. Much more will be needed in the next five years, given that the estimated damage to the economy from the earthquake and tsunami ranges from $123 billion to $235 billion, according to a recent report by the World Bank. The government must walk a fine line between providing sufficient stimulus to the economy and maintaining its sound fiscal health in the long term.

Silver linings
Japan's economic history has allowed it to accrue and retain some key advantages. Most Japanese debt has been absorbed domestically. Just 5 percent of government debt is held by foreign investors, which implies lower volatility on the sovereign bond market. In addition, with benchmark interest rates at zero and real interest rates negative, the cost of borrowing remains low. The yield on Japan's government securities is one of the lowest: 1.25 percent for 10-year government bond as of March 28, compared with 3.43 for U.S. and 12.6 for Greece. This has so far made it relatively easy for the Japanese government to finance its spending. Also, Japan has one of the world's largest foreign exchange reserves, which can be tapped into in times of emergency.

Challenges, opportunities, and an example for us all?
In the long run, however, the world's third-largest economy still has "no coherent strategy" to tackle its economic problems, according to S&P. Sovereign risks will remain relatively high in the foreseeable future. In addition to its already-staggering debt-to-GDP ratio and a highly unsustainable pension system, the recent catastrophe will certainly delay a proposed sales tax reform and lead to larger deficits. Japan needs to reconcile its fast-evolving political landscape with consistent long-term economic policy goals that will provide a stable platform for post-disaster reconstruction.

So will Japan be the next Greece? My answer is no. The nation has a culture of loyalty and great cohesion. In the past, the Japanese people have shared the fiscal burden when faced with sovereign debt crises, and they will rise to the challenge once again. The greatest natural disaster can be an opportunity for the Japanese people to pull together as an example for the world to follow.


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