Impact of the Russian Invasion of Ukraine on the Japanese Economy
Economic significance of the Russian invasion of Ukraine
Since the initiation of the Russian invasion of Ukraine on February 24, the world economy has moved into a new stage. Not only did uncertainty surrounding the future of the world economy increase as a result of the invasion, series of economic sanctions announced by the US, EU, Japan and others, and Russia’s retaliation to them, have created a deep rift between the Russian economy and (almost all of) the rest of the world. We do not know when the war in Ukraine ends, but even if it ends, the deep rift is hard to bridge in a short period of time. We need to expect in the medium to long term that we are going to live in a world with two economic blocks that have almost no interaction between them.
The new situation will have a big influence on the performance of the Japanese economy. There would be influences that is still unknown and will only unveil in the future. However, the following are the impacts that has become evident to date.
Rise in primary goods prices
First is the rapid rise in primary goods prices.
The prices of primary goods which had been rising already in response to the recovery of global economy from the recession caused by COVID-19 has been accelerated by the warfare. Crude oil prices, for instance, is closing in to the level that was reached in 2007 after the outbreak of the subprime mortgage problem in the US and before the collapse of the Lehman Brothers.
As a result, Japan’s import price index showed a 34.0 percent increase year-on-year in February 2022. Corporate goods price index also rose by a year-on-year rate of 9.3 percent in the same month, the largest jump on record (since 1981). Consumer price index is also expected to show an increase in February as the preliminary estimate for Tokyo in mid-February showed a year-on-year rate of increase by 1.0 percent.
Similar rise in consumer price index has also been seen in other countries. In those countries, it is accepted as a sign of inflation and central banks are stepping up to exit from the quantitative easing polices that have been introduced, and to start raising policy interest rates.
However, it would not be the case for Japan, where the recovery from the recession is slower than in other countries and where output gap is still large. There is still less hope of overcoming deflation: the mid-February CPI, excluding fresh foods and energy, for Tokyo still showed a year-on-year decline by 0.6 percent. Rather than an improvement in the deflationary situation, worsening of the terms of trade will squeeze the profits of the firms that cannot pass-on the cost increase to their retail prices. It could discourage the momentum towards further recovery, and reinforce the deflationary pressure.
Deficit in the current account
Second is the worsening of the current account.
Japan has basically been recording a current account surplus since late 1960s with only a number of exceptions. However, the rise in imports have led the current account to turn into deficit in December 2021 and January 2022. With elevated import prices and the slowdown in global economy affecting exports, current account deficit could stay for a longer period than before.
There are signs that the market has started to expect a change in the trend of Japan’s current account. The exchange rate of the yen that used to show strength when such an increase in uncertainty in the global economy emerged is no longer observed. Yen was seen as a safe haven currency when the currency had a possibility of appreciating while funds were parked temporarily to weather the storm. If, to the contrary, current account deficit increases the possibility of a depreciation, it is natural that other currencies are chosen to be purchased.
Supply constraint of imported goods
Third is the possibility of a supply constraint of goods that had traditionary been imported from Russia.
The share of Japan’s imports from Russia is limited. In CY2021, the share of imports from Russia in total imports was only 1.8 percent. The shares of Russian imports in the imports of individual item have also been generally low. The only exceptions are fish (9.1 percent), wood (13.1 percent), liquidated natural gas (8.7 percent), coal (10.2 percent), and non-ferrous metal (16.0 percent).
Since the payment for the imports may be disturbed by the exclusion of Russian banks from the SWIFT (Society for Worldwide Interbank Financial Telecommunications), imports themselves may become difficult. However, most of the goods that had been imported from Russia would probably be able to find alternative suppliers.
However, that kind of an optimism may not be allowed to some of the non-ferrous metal that is imported from Russia. In this category, some important rare-metals such as palladium, antimony, platinum, and cobalt are included. They are used as catalyst for exhaust gas purification catalyst, or materials for batteries used in electric vehicles and smartphones. They are rare in the sense that there are only limited number of suppliers, and for these metals, Russia is one of the few suppliers. It means that production of some of the strategically important goods may face a constraint because of the difficulty in securing supply of some essential rare metals.
Negative financial impact
Fourth is its negative impact through the financial market.
Financial impact is coming through a number of channels. Stock prices have fallen because of the more cautious attitude of the investors and the decline in the growth prospects of those firms that have decided to suspend business in or withdraw business from Russia. The fall in stock prices may have a considerable impact on the balance sheets of firms whose financial year ends at the end-March. Nikkei stock average (Nikkei 225) closed on March 31, 2021 at 29178.8 yen while the index at the closing of the market on March 11 this year was 25162.78 yen (a decline by 13.8 percent).
The possibility of a default of Russian government bonds is also considered to have become realistic as bond prices decline and CDS rises significantly. Foreign holders of funds with the bonds in the portfolio may be affected: about 25 percent of the Russian government bonds is said to be held by foreign investors.
Consideration in designing policy responses
The negative impact as mentioned above will worsen the prospects of the Japanese economy in the short to medium term. It would require responses by the government to alleviate the negative impact. In this respect, a number of points may be worth mentioning.
First, the government’s response to oil price hike needs to be designed carefully.
The government has introduced subsidies to be provided to the oil companies to put a ceiling to the prices of gasoline and kerosene. This policy is intended to support the households and the small business that have to pay more bills for the energy.
However, it prevented the market mechanism to play: there would be no increase in prices above the ceiling that would lead to less consumption of these energy. Less consumption of energy would have contributed in making an advance to addressing climate change issues as well as containing import bills so that wider current account deficit would be prevented. If the government considers helping the household necessary, it should be done by a direct transfer of funds to the households in need rather than interfering with the market mechanism.
Second, avoiding the current account to stay in deficit is important. That is because a deficit in the current account means a net borrowing is made in the financial account. Japanese economy would need to depend more on foreign investors.
In an ordinary situation, there will not be a problem in depending on foreign investors. However, when there is a huge government debt as Japan has at the moment, foreign investors may require higher risk premium to hold the debt. It may be a challenge for the Bank of Japan, which is committed to quantitative and qualitative monetary easing with QQE with yield curve control (YCC), in controlling the long-term interest rate to stay at around zero.
Third, supply chain may need a further review from a geopolitical aspect.
Japan has experienced a number of disruptions of supply chains in the recent years: for example, at the time of the Great East-Japan Earthquake and when the COVID-19 pandemic broke out. The current warfare is another reason why we should review the structure of the supply chain so that it would be more resilient to unexpected halts in the supply of essential parts and materials.
Many countries, who are engaged in a similar review of supply chains, are considering “reshoring” as a solution. However, in the case of Japan, it may need a careful consideration because Japan is also subject to the risk of experiencing major earthquakes and tsunamis. Simply reshoring supply sources to within the border may not work in the case of Japan.
Finally, in order to support the financial sector, clear vision of where the Japanese economy is heading to needs to be provided.
Dealing with COVID-19 and addressing climate change issue were already suggesting the need for a major transformation of the Japanese economy. With a heightened uncertainty and a new structure of the global economy in sight as a result of the war in Ukraine, outlining the government’s policy direction in the medium to long-term has become all the more important in helping the private sector to plan business in a long horizon. If they are able to identify new business opportunities, it should lead to better financial market developments.
Additional task for the government
These tasks may be too much for a government which already has a handful of things to deal with under the COVID-19. However, since we cannot choose which and when the crisis will take place, the best thing that the government can do is to make the most of opportunities provided by the crises and make an steady advance towards a better future.