Author: Huw McKay, Westpac and ANU The great misfortune of Japan’s earthquake will shape the contours of economic activity in the country for some time to come. Japanese private sector estimates of the economic cost are centring on 3 per cent of GDP. Those estimates are split roughly half and half between the damage bill and the anticipated activity loss. This essay is not intended to critique the efforts of the forecasting community at this difficult time. Rather, it is to trace the thought processes involved in looking at such a disaster, and to make some observations about the future position of the Japanese economy at various horizons . Turning to the immediate future, activity losses will be spread across all areas of the economy , but will be most visible in industrial production, logistics, utilities, household services and international trade. A proportion of these impacts can be sensibly proxied by an estimate of the short-term decline in hours worked. Around half a million are homeless and are unlikely to be in a position to work for at least a month . The direct negative impact on labour supply from this unfortunate group can be estimated (callous as it is to do so) by scaling the 500,000 to garner their relationship to the labour force. Multiplying that result by measured productivity levels produces an estimated output loss of 0.024 per cent of GDP per month or 0.006 per cent of GDP per week. In addition, power shortages will constrain the capital-intensive sectors. In addition to Tohoku, there is the impact of rolling blackouts on Kanto, where TEPCO, the unhappy owner of the compromised Fukushima nuclear facilities , rules the roost. One month of power disruptions to both Kanto and Tohoku might come in close to a loss of 0.08 per cent of GDP. Offsets to these losses will be available via increased hours worked in other parts of the country and the diversion of orders to factories in other regions running on full power. In some cases, these offsets could be considerable, especially in sectors where capacity utilisation is presently low and the production process in question is not highly specialised. As a large segment of Japanese manufacturing does not meet both of those criteria, it seems unwise to get overly excited about a drastic reorientation in the very short term. In terms of international trade, affected ports process less than 1.5 per cent of Japan’s exports and a little over 2 per cent of imports. This factor is most likely to manifest as sectoral dislocations rather than as negative outcomes of aggregate note. On that point, the range of industries that have been hit hard includes non-ferrous metals, specialty machinery, electronics and auto components, rubber, medical equipment and brewing. Downstream producers relying on inputs from these factories will see the supply chain disrupted for some time. This will in turn disturb wholesale distribution networks around the world, with an eventual impact on shop shelves and retail showrooms. The potential horrors of exposure to nuclear radiation will have a profound impact on consumer behaviour while the danger is perceived to exist. Until the scare dissipates, consumers living within a plausible radius — including Tokyo — are expected to eschew discretionary outings. That implies a precipitate drop in spending on travel, restaurants and other forms of extra-domicile recreation. The impact may be similar to the behaviour observed during cases of viral outbreak, where socialisation temporarily falls toward zero. Here, consumers are shunning the atmosphere, not just groups of people, so the temporary effect could be greater. Turning to the reconstruction phase, local estimates of the monetary cost of rebuilding, spread over two years, would add between 0.125 per cent and 0.25 per cent to activity levels per quarter above any prior baseline. A little less than 70,000 buildings have been damaged, while a further 10,000 have fully or partially collapsed. Looking specifically at the dwelling stock, the Tohoku region has significantly different fundamentals from the national average. The number of persons per dwelling is higher in Tohoku (2.5 versus 2.2 nationally) the average floor space of dwellings is larger (124sqm versus 107sqm nationally) and the proportion of detached dwellings is higher (72 per cent versus 55 per cent nationally). Also, a greater share of Tohoku’s dwellings are wooden (51 per cent versus 32 per cent nationally) or were constructed before 1980 (37 per cent versus 32 per cent nationally), and are thus more likely to suffer critical damage. Rates of owner occupation are considerably higher than elsewhere in Japan (65 per cent across Tohoku versus 51 per cent nationally) despite a persistently higher unemployment rate in the region (5.2 per cent average for the last decade versus 4.7 per cent nationally). Each of these characteristics is relevant for the scale, style, financing and timing of the rebuild. All things considered, the reconstruction of the dwelling stock will be a more protracted process in Tohoku than it would be in the ‘average’ prefecture. As for the energy sector, Japan went into this disaster with a glut of power capacity, having over-invested in prior decades when long run demand projections were rosier. Therefore, it is unlikely that all of the lost capacity will be replaced. A shift in the energy mix away from nuclear capacity can be anticipated, but that might also come from more intensive use of existing infrastructure. In terms of raw material demand, a shift toward conventional fuels and away from nuclear would be expected to benefit LNG, coal and oil, in that order, with Japan’s carbon emissions profile a casualty of the shift. A factor for the medium and long term is whether the Tohoku can hang onto its high-tech manufacturing and components base. The Chinese rare earth embargo severely constrained many firms in the tech arena. Many will be confronting a forced re-location decision in the wake of the disaster. A further wave of hollowing out, directly or indirectly related to the disaster, would be a negative for Japan’s future prospects. The net impact of the near term losses and the gains of the reconstruction phase will leave the level of activity at the end of 2012 just a little below what was anticipated in a pre-disaster baseline. Japan accounts for a little over 5 per cent of PPP World GDP and therefore it contributes around 0.1percentage points to world growth when it expands at its potential rate. Prior to the shock, it was expected to quietly add 0.09ppts in 2011 and 0.12ppts in 2012. The new growth profile alters that to 0.06ppts and 0.14ppts respectively. Huw McKay is Senior International Economist at Westpac Banking Corporation and a graduate scholar at the ANU. Japan’s earthquake and its economic impact The political and policy fall-out from the Japanese earthquake and tsunami Japan’s big society: a Chinese perspective on the earthquake