Special Review: Impact of Middle East Turmoil on Japan's Economy

◆Middle East turmoil rattling global financial markets: Turmoil in Middle Eastern markets is rattling global financial markets. In our main scenario, we believe Japan’s economy will see an end to consolidation in Jan-Mar 2011 and then enjoy steady growth into FY12. In this report, with the view of examining our risk scenarios, we analyze the adverse impact that Middle East turmoil will have on Japan’s economy. While we believe that the adverse effect of (1) a fall in exports to the Middle East will be limited, we are greatly concerned about the adverse effects of (2) surging crude oil prices and (3) re-emergence of upside pressure on the yen.

◆Fall in exports to the Middle East: Although having an impact on Japan’s economy, the effect of a fall in exports to the Middle East will be limited. Certain industries, centering on transport equipment, will receive a blow, but the impact on Japan’s economy will not be of an order that could be called significant.

◆Surging crude oil prices risk mini-stagflation in Japan: The second adverse effect is a surge in crude oil prices. We believe that the current level of commodity prices can be explained by real global demand and does not represent a major problem. However, heightening geopolitical risk or inflow of speculative funds could lead to bubbles in commodity markets, worsening the terms of trade of Japanese companies, with Japan perhaps experiencing mini-stagflation.

◆Re-emergence of upside pressure on the yen: The third risk is re-emergence of upside pressure on the yen. According to our macroeconomic forecasting model, should the yen appreciate Y10 above its predicted exchange rate of Y82/$, the growth rate of real GDP would contract 0.1 point in FY11 and 0.6 points in FY12. Also, should the yen appreciate Y10 above rates of Y80/$ and Y112/euro, recurring profit would decrease 9.6% in FY11 (-7.5 points from depreciation against the dollar and -2.1 points from depreciation against the euro) and 8.4% in FY12 (-6.5 points from depreciation against the dollar and -1.9 points from depreciation against the euro).

◆Developments in Bahrain bear watching: A matter of interest is what will happen in Bahrain. The rulers of Bahrain are mainly Sunni while the citizens are mainly Shiite. Many analysts see Bahrain as being in the midst of a proxy war between Saudi Arabia and the US who support the former and Iran which sympathizes with the latter. Developments related to the Fifth Fleet of the US Navy stationed in Bahrain are also of great interest. Depending on how things develop, turmoil in the Middle East may gain momentum, and the adverse impact on global financial markets may increase. While our bullish scenario for Japan’s economy still holds central place in our forecast, we intend to carefully monitor the effect on Japan’s economy of such risk factors as surging resource prices and the re-emergence of upside pressure on the yen ensuing from geopolitical risk.