Brexit’s impact on the Japanese economy
The Brexit shock
The United Kingdom’s referendum on whether to stay or leave the European Union ended with a big surprise to the global economy. As soon as the news of Brexit unfolded on June 24, the markets showed a large volatility. The Nikkei Stock Average dropped by 1286 yen to record 14952 yen, while the yen rate rose by about 7 yen to reach 99 yen to a dollar.
While the market has calmed down since then, the turmoil is far from over: Brexit is expected to exert a significant downward pressure on the global economy for a significant length of time.
UK’s Treasury have estimated before the referendum that the long-term negative impact of Brexit on UK’s GDP can be as large as 3.4 percent to 9.5 percent compared to the baseline GDP which would have realized if UK stayed in the EU; the magnitude depending on the future relationship of UK with the EU. OECD’s estimate is also broadly in line with the Treasury’s estimate. It provides estimates for a number of scenarios which shows that the long-term impact would be a fall of the UK’s GDP in the range of 2.7 percent to 7.7 percent compared to the baseline. Obviously, the impact as large as this could not be unnoticed by other countries, including Japan.
While it is difficult to assess the impact of the Brexit on the Japanese economy quantitatively, it is still important to know how it would affect the economy qualitatively. The latter is the theme of this month’s column.
The impact of Brexit on the Japanese economy can be considered to come through following channels.
International trade channel
The first channel that Brexit could affect the Japanese economy is its impact through international trade. The fall in GDP in the UK, and possibly the EU, would discourage exports from Japan to these economies. Since exports have been providing a large influence on the performance of the Japanese economy in the past, it is of a grave concern.
The share of exports from Japan to the UK and to the rest of the EU is rather limited: According to the Regional Balance of Payments of Japan for CY2015, exports of goods and services to the UK was 3.5 percent of the total goods and services exports, and that to the rest of the EU was similarly 11.0 percent. Since the share of exports of goods and services in GDP is 17.9 percent in CY2015, the share of total exports to the UK is 0.6 percent and to the rest of the EU is 2.0 percent of GDP. It means that even an immediate drop of export to the UK and the rest of the EU by 5 percent would still only be a drag on the GDP by 0.1 percent.
While the direct impact on the Japanese economy through international trade may be limited, the indirect impact through the Asian economies may not be negligible. The ratio of exports to GDP in Asian countries are, in general, larger than that of Japan. That means, even the shares of UK and rest of the UK in exports is not that different in these countries from Japan, it may have a larger impact on the GDP in these countries. This, in turn, can have a significant impact on the Japanese economy since the share of Japanese exports to Asian countries is as high as 47.0 percent in CY2015. A drop of exports to Asian economies by only 0.5 percent can still have an impact on the Japan’s GDP by 0.2 percent. This indirect impact through Asia was behind the recession of the Japanese economy when the European economy stagnated in 2012.
International investment channel
The second channel is the impact through international investment. Both direct investment and portfolio investment can be affected and distracted by Brexit.
In fact, the share of international investment to UK and the rest of the EU is larger compared to that of international trade. According to the Regional Foreign Direct and Portfolio Investment Position at end-CY2015, the share of Japan’s foreign direct investment to UK is 7 percent (of which about a third goes to financial sector), and that to the rest of the EU is 16 percent, of total Japanese FDI. Similarly, the share of Japan’s portfolio investment to UK is 5 percent, and to the rest of EU is 23 percent, of the total portfolio investment.
In the case of international investment channel, the impact may be felt in two different aspects.
On one hand, Brexit will reduce the expected returns on these investments. It should lead to redirection of the future investment to other regions. While the negative impact on European investment could be made up somewhat by increase in investment to other regions, a global slowdown could limit such compensation of lost return.
On the other hand, past investment could be subject to significant capital loss. It should be the case for both direct investment in real estate and investment in real-estate investment funds, especially when it is related to investment to real-estate in London. The balance sheets of investors could be adversely affected by the loss.
Financial sector channel
Third channel is the impact through the financial sector. In particular, when the solvency of the banking sector in UK and the rest of Europe is affected by Brexit, it could have a serious implication for the global financial market.
The non-performing loans is generally considered to be under control in the EU. However, there are countries in some parts of EU that have high non-performing loans (NPL) ratio. According to the European Banking Authority, NPL ratio at end-2015 was as high as 48.9 percent in Cyprus, 46.7 percent in Greece 19.1 percent in Portugal, 18.5 percent in Ireland, and 16.8 percent in Italy, compared to 5.8 percent for the EU on average. Once the real economy in the EU starts to show clear signs of slowing down, some banks in these economies could be under great stress.
EU has significantly strengthened its efforts to improve the financial stability in the EU by introducing a Single Supervisory System, a Single Resolution Board, and a Single Resolution Fund, as a part of the banking union. However, we still should be prepared to deal with any unexpected shocks in the financial sector.
Stock prices channel
The fourth channel is through the stock price volatility. It should lead to realized and unrealized losses in investors’ portfolio and also negatively influence peoples’ expectations about the future path of the economy.
As we have observed, stock prices actually fell significantly in stock markets, not only in the UK and the rest of the EU but also in New York, London, and other parts of the world. One of the sectors whose stock prices showed a significant drop was the banking sector, reflecting the risks that they may have, as was discussed previously.
However, the rebound was also quick and significant. In London and New York, stock prices recovered the fall in less than a week. An important exception was Tokyo which still has not returned to the pre-referendum level. It reflects, in part, the weakness of the Japanese economy which is more vulnerable to external shocks compared to other countries. However, what may be more important is the impact of exchange rate appreciation, which is expected to exert a strong downward pressure on the economy, and hence on stock prices. We will next turn to this aspect.
Exchange rate channel
The fifth channel is the impact though exchange rate fluctuations. In particular, the tendency of the yen to appreciate at times of increased uncertainty when investors shift out of risky currencies into “safe currencies”.
I have discussed why yen in considered to be a safe currency in my Japanese column this February (https://www.jcer.or.jp/j-column/column-saito/20160222.html). My view is that Yen is considered to be a worthy currency to park temporarily one’s funds, not only because Japan has a minimum restriction on currency transactions and a large currency market, but also because Japan has a current account surplus that tends to provide momentum for the exchange rate to appreciate.
In fact, we observed a steep appreciation of the yen immediately after the arrival of the news of Brexit. The yen-dollar exchange rate has not yet returned to the pre-referendum level. We should expect yen to appreciate whenever there is an increase in uncertainty that spurs risk-off behavior.
Urgent need for stronger resilience
Brexit has brought in a significant uncertainty into an already weakening global economy. Japanese economy has to be prepared for a series of turbulences for a significant length of time. To successfully overcome the challenges, the Japanese economy needs to be more resilient. Since the strength of the private demand is far from sufficient, it means that we should make every effort to implement the structural policy agenda and strengthen potential growth.