WRITTEN BY: Kevin Lings: STANLIB: Chief Economist

Japan is clearly struggling to cope with the damage inflicted by the world’s fourth largest earthquake recorded since 1900. The quake measured 9.0 on the Richter Scale and generated a tsunami that devastated cities and towns on the main island’s eastern shore. All six reactors at the Fukushima Dai-ichi nuclear power plants are badly damaged, leading to concerns about nuclear contamination of the water and food supply. At least 25 000 people appear to have lost their lives while many more have lost their homes and livelihoods. An estimated 280 000 people are currently homeless. Power, water, fuel and food supplies have also been severely disrupted, while economic activity ground to a halt in much of the affected region.

Assessing the full economic impact of the earthquake will take some time; there is currently just not enough information available. The authorities are only in the preliminary stages of determining the physical damage from the earthquake. The situation at the Fukushima nuclear power plant is still precarious, with increased radiation levels reported in the surrounding area. However, using information provided by a range of sources including the Institute of International Finance, the following comments are perhaps useful.

Previous large scale natural disasters in advanced economies, including the 1995 earthquake in Kobe (Japan), and Hurricane Katrina in the US provide a useful benchmark for estimating the possible economic effects. Kobe is an industrial hub that at the time accounted for a slightly smaller share of Japan’s economic output than the 4 prefectures hardest hit by 11 March disaster. (It is estimated that the region impacted by the tsunami represents around 6% to 8% of the Japanese economy.) A key difference, however, is that the Kobe earthquake was not followed by a tsunami, nor did it greatly disrupt the national energy supply or threaten the safety of nuclear power plants.

Most of the adverse welfare effects of this type of disaster do not show up in measured GDP. This is because natural disasters lower national wealth by destroying part of the physical capital stock, whereas GDP measures only the flow of goods and services produced in a given period. Natural disasters usually disrupt production for only one or two months before activity is boosted by reconstruction demand. However, reconstruction activity is really only replacing the wealth that was previously lost. For example, in 1995 (Kobe), the economy expanded at an annualised rate of more than 3% in each of the first 3 quarters following the quake, despite an estimated cost of damage of $114 billion. A similar pattern was evident following Hurricane Katrina.

The damage from the recent quake is most certainly going to exceed those of the Kobe episode and Hurricane Katrina and could end up somewhere in the region of $250 billion to $320 billion. (3.5% to 7.4% of Japanese GDP) In the short-term there are four main channels through which measured GDP in Japan is likely to be reduced. These are: destruction of capital in the region immediately affected by the disaster, which has causes local production to grind to a halt, disruptions to supply chains, especially in the manufacturing sector, weaker consumer and business confidence,

reduction in energy supply, which is a critical input into most production processes.

The reduction in energy supply is particularly important this time around. 11 out of the over 55 power plants were shut down immediately following the quake, reducing energy supply substantially. (There were 443 operational nuclear reactors in the world, with the US having the most at 104, followed by France with 58). Some of the lost nuclear capacity will not come back on line and will need to be replaced by other technologies. In 2009, Japan sourced 13.4% of its energy supply from nuclear energy, second only to France. Rolling blackouts are also affecting large parts of the main island and are only scheduled to be over in late April.

A very worrying dynamic to the energy problem is the on-going increase in radiation levels. There is evidence that there may have been a partial melting of nuclear fuel within the reactors’ protective structures and that radiation, including small doses of plutonium, has since leaked into the surrounding area. Unlike radioactive iodine-131, which loses half its potency every eight days, plutonium-239 has a “half-life” of 24,000 years. Tokyo Electric Power Company (TEPCO), the private monopoly that owns Fukushima Nuclear plant has not been able to identify where the plutonium comes from. In addition, pools of radioactive water that have been found around turbines near the reactors; it is not clear where these came from either. The worst case, near reactor No. 2 at Fukushima, is 100 000 times more radioactive than water at a nuclear power plant is supposed to be.

The increased radiation and reduced energy supply has been very disruptive to the Japanese business sector. Many large manufacturers had to shut down plants across the country, including most of Japan’s leading global corporations such as Honda, Toyota, Nissan, Mitsubishi, Sony, Toshiba and Panasonic. However, most of these firms are planning to resume production during the course of this week. Also, some of the lost output in the prefectures immediately hurt by the disaster can be replaced by switching production to less affected parts of the economy. Current low capacity utilisation rates across most of the economy will make this easier.

Unless the quake and its after effects lead to a negative confidence feedback loop, the Institute of International Finance (IIF) expects that most of the output loss will be limited to March and April. They project industrial production to contract by 5% in March, before expanding modestly by 2% in April. The resulting damage to GDP could amount to about 1% in Q1, but rise to 2% in Q2 2011, pushing the Japanese economy back into recession. However, the IIF expects that reconstruction activity will start to support output growth in the second half of 2011. Public works are expected to add 1 and 2 percentage points to growth in Q3 and Q4. The net effect for 2011 growth, however, is likely to be negative. Reconstruction spending will continue into 2012. The Japanese recovery was already fragile prior to the earthquake and, in particular, a severe leakage of nuclear radiation could lead to a more prolonged economic downturn.

As an immediate measure, the government announced the use of ￥204bn ($2.5 billion) of its special reserves for disaster relief. In 1995, a total of ￥3 trillion (0.6% of 1995 GDP) in public spending was provided. That amount is likely to be exceeded this time. A plausible assumption seems to be a stimulus package of 0.8% of GDP and tax revenue losses of 0.2%. This would bring the general government balance in FY2011 down to 9.3% of GDP from the previously expected 8.3% of GDP and implies that fiscal policy will be expansionary in 2011 rather than contractionary.