Outlook for 2011-15

• The devastating earthquake and tsunami that struck Japan on March 11th will have a profound effect on domestic politics, as it has already silenced speculation about an early general election.
• The disasters have given the prime minister, Naoto Kan of the ruling Democratic Party of Japan (DPJ), a second chance, although a mishandling of the nuclear crisis could cause public confidence in the DPJ to drop sharply.
• The recent disaster has ended the deadlock over the budget for fiscal year 2011/12 (April-March), as well as producing a supplementary budget to cover the costs of rescue and reconstruction operations.
• The Bank of Japan (the central bank) has reacted to the catastrophe by maintaining its near-zero interest rate policy and announcing a slew of emergency measures. Interest rates are unlikely to rise until 2012.
• The loss of consumer and business confidence owing to ongoing nuclear safety concerns has prompted the Economist Intelligence Unit to revise down its GDP growth forecast for 2011 to 1%, from 1.4% previously.
• We have revised up our forecast for consumer price inflation in 2011 to 0.7%, from 0.6% previously, owing to supply-side factors, but this does not imply any fundamental change in Japan's deflationary environment.

Monthly review

• The earthquake and tsunami have benefited Mr Kan in the narrow sense of preserving his premiership from the ignominious fall that had previously seemed imminent.
• Mr Kan has, however, been criticised by some for intervening in a number of small matters in a manner that has retarded the rescue effort relating to both the natural disasters and the nuclear situation.
• The first round of previously scheduled prefectural and municipal elections was staged on April 10th, and the results of the polls revealed considerable dissatisfaction with Mr Kan's recent performance.
• In late March senior members of the DPJ met with their counterparts in the main opposition Liberal Democratic Party and agreed on the broad outlines of the necessary fiscal measures.
• The damage caused by the natural disasters appears to be more profound than most analysts had originally expected. The cost of rebuilding and the loss of output will therefore be greater than initial assumptions suggested.
• The latest Tankan survey (a survey of corporate sentiment, carried out by the central bank) shows that the disasters have damaged business confidence.

The catastrophe that struck Japan on March 11th will have a profound effect on domestic politics, as it has already ended all speculation that there could be either a general election or a change of prime minister within the next six months. Before the earthquake and tsunami and the ensuing nuclear crisis, the political future of the prime minister, Naoto Kan of the ruling Democratic Party of Japan (DPJ), looked bleak. His popularity had crashed, his party was feuding and the government had failed to secure the passage of legislation to implement the budget for fiscal year 2011/12 (April-March). Speculation was rife as to how long Mr Kan could survive as prime minister, but the disaster of March 11th has given him a second chance. Although the crisis-management challenges facing Mr Kan and his government are daunting, this is not a time during which the country may safely hold a general election or even change prime minister.

The authorities' initial reaction to the natural disasters was rapid and competent. In contrast to the lethargic response to the 1995 Kobe earthquake, large-scale relief operations were launched immediately and foreign assistance welcomed. However, Mr Kan took the risky step of assuming personal command of the crisis at the Fukushima Daiichi nuclear plant, which has been seriously damaged by the earthquake and tsunami. There are signs that the move may have backfired on him as the situation at the stricken facility worsened in April. Indeed, the ruling party performed badly in several prefectural and municipal elections that took place in the middle of that month, suggesting dissatisfaction with the prime minister's performance. On balance, however, if the authorities continue to orchestrate a creditable rescue and reconstruction effort, the effect of the catastrophe on the government's standing is likely to be either neutral or positive. Moreover, the government may benefit on the policy front. A sense of emergency and national solidarity led to an end to partisan obstruction of the 2011/12 budget-this was passed in late March, after several months of obstruction by the main opposition Liberal Democratic Party (LDP)-and could even galvanise support for the bold reforms that Mr Kan has proposed to tackle Japan's festering economic problems. At present the DPJ has a large majority in the House of Representative (the lower house of parliament), but it is in a minority in the House of Councillors (the upper house), where the impasse over budget legislation was created.

The next election for the lower house is not due until August 2013, and speculation about the possibility of a poll in the next few months has been silenced by the earthquake and its aftermath. If it is to respond effectively to the earthquake, the ruling DPJ will need to end its internal feuding and forge consensus in the upper house. The LDP, which ran Japan almost without interruption from 1955 until 2009, is unlikely to persist with its strategy of non-cooperation with the DPJ at this time of great national distress, and has already indicated that it is prepared to countenance a rise in taxes to pay for the rescue and reconstruction programme following the earthquake-an idea that has been floated by the government.

If the DPJ is successful in overcoming the multiple crises facing Japan, this will demonstrate that it really is a viable alternative to the LDP and could make two-party politics in Japan a long-term reality. This would be a difficult process, however, as both the DPJ and the LDP consist of ideologically disparate, or even incompatible, factions. The tendency towards factionalism and ideological incoherence within the major parties has remained strong for so long that Japan could still find itself heading for an indefinite period of political uncertainty, and could end up with a sequence of evanescent parties and governments that are incapable of providing effective leadership. It is also possible that, if the DPJ fails to tackle the daunting challenges created by the earthquake and its aftermath, the electorate could return to the LDP. This, in turn, risks reviving the old, LDP model of governance that had so clearly outlasted its usefulness by the 1990s.

Viewed in a larger context, the disaster will have a range of effects on Japan's international position. On a positive note, dozens of countries have extended financial, technological or other forms of assistance. Foremost among them is the US, which has deployed some of its military manpower to assist in rescue and damage-limitation efforts, as well as providing substantial aid. Such co­operation will doubtless deepen Japan's relationship with the US, and may also encourage closer collaboration with South Korea (the latter is also presently providing assistance). To this extent, Japan may emerge from the catastrophe with its security system reinforced.

However, the catastrophe could undermine Japan's national confidence, a fact that will give China an additional geopolitical advantage in East Asia. Also noteworthy is the degree to which the disaster has discredited nuclear power at a time when the rest of the world seemed poised to embrace this technology as an alternative to fossil fuels. Switzerland, France and other countries have announced that they will reconsider their plans for additional nuclear investment, and it seems likely that the balance in Japan will shift in favour of oil, coal and other financially feasible forms of energy. This, in turn, will exacerbate the problem of global warming while also redounding to the geopolitical advantage of countries with abundant hydrocarbon reserves.

The recent disaster has ended the deadlock over the budget for 2011/12, as well as producing a supplementary budget to cover the costs of rescue and reconstruction operations. Various estimates suggest that these costs could amount to 4% of GDP over several years. This raises the question of affordability at a time when Japan's gross public debt is rapidly approaching 200% of annual GDP, by far the highest level in the developed world. Against this backdrop, the additional costs of reconstruction do not fundamentally alter the already bleak outlook for Japan's public finances. Although the government is likely to be able to continue to roll over its obligations relatively easily and cheaply, the country's long-term debt dynamics are unsustainable and getting worse. The Bank of Japan (BOJ, the central bank) has reacted forcefully to the catastrophe, maintaining its near-zero interest rate policy and announcing a slew of emergency measures to pre-empt turmoil in the money markets. Interest rates are unlikely to rise until the second half of 2012.

There are some early indications that the earthquake and its aftermath could induce a greater degree of consensus among Japan's political parties in favour of fiscal consolidation, including tax increases. Clearly, action must be taken to avoid further damage to the country's creditworthiness, following a downgrade in its sovereign rating in January by a credit-rating agency, Standard & Poor's (S&P). Japan is not flirting with sovereign default as some euro zone countries are, but the downgrade to its long-term debt rating by S&P has offered a stark reminder of the country's severe fiscal problems. Unless policymakers grasp the nettle of tax reform, the country is setting itself up for a future sovereign payments crisis. The timing of such an event is highly uncertain and could be far in the future, but the worry is that Japan may already be close to passing the point of no return in terms of its ability to repair its fiscal position.

The catastrophe of March 11th is unlikely to damage the country's ability to continue in a curious sovereign-risk limbo. Japan's public finances have already deteriorated far beyond what would be sustainable for most countries. Yet the government has easily avoided a sovereign-payments crisis, and can finance itself at very low rates of interest. This partly reflects the composition of public debt, roughly 95% of which is domestically held, and the fact that low interest rates and a sluggish economy over the years have limited alternative investment options. Nonetheless, the catastrophe will hurt Japan's fiscal position. Given that the budget deficit (based on OECD definitions) was already high, at 7.7% of GDP in 2010, owing to the after-effects of the 2008-09 global financial crisis, this is a bad time for fiscal policy to be expansionary. Assuming that the crisis at the Fukushima Daiichi nuclear plant is contained, the Economist Intelligence Unit now forecasts the fiscal deficit at 7.9% of GDP in 2011, 7% of GDP in 2012 and around 5.7% in 2013-15.

On March 14th the BOJ declared that it would keep its policy interest rate, the overnight call rate (OCR), at between 0% and 0.1% for the foreseeable future (the policy was retained at its policy meeting on April 28th), pumped ¥12trn (US$145bn) in emergency funds into the money markets, announced plans to purchase ¥2trn in Japanese government bonds (JGBs) and increased the size of its asset-purchase programme from ¥35trn to ¥40trn. The BOJ's asset-purchase programme was introduced in November 2010 in an effort to counter the persistent deflationary pressures affecting the economy, and includes the purchase of risky assets such as exchange-traded funds (ETFs) and real-estate investment trusts (REITs), as well as JGBs. These efforts appear to have been successful in terms of reducing stress in the banking system, although a worsening of the crisis at the Fukushima Daiichi nuclear plant could still wreak havoc in the financial markets. More generally, only when deflation has been beaten and the economy is stronger will the BOJ be in a position to start to raise the OCR; we do not expect it to do so until the second half of 2012. Weak economic growth and persistent deflationary concerns will mean that the OCR will be raised only slowly, to stand at 2% in 2015.

Scenarios for the Fukushima Daiichi nuclear plant

The Fukushima Daiichi nuclear plant has been rocked by a series of explosions and fires following the earthquake and tsunami that struck the eastern side of Japan on March 11th, triggering a major crisis in Japan. Nuclear materials in several of the facility's reactors have been overheating, following the loss of power to their cooling systems. As workers have struggled to restore cooling functions, there have been at least two fires and four hydrogen explosions at the power plant. These incidents have resulted in the partial release of a hazardous amount of radioactive material, according to the plant's operator, Tokyo Electric Power (TEPCO).

In response to the earthquake and tsunami damage and the subsequent damage to the nuclear reactors, the Economist Intelligence Unit has cumulatively downgraded its forecast for Japanese GDP growth in 2011 from 1.6% to 1%. Given that reconstruction should boost growth the following year, we have raised our forecast for 2012, from 1.4% to 2.1%. Whether this forecast remains appropriate will depend on whether the situation at the Fukushima plant improves, remains uncertain or worsens.

Benign scenario: The danger of a more serious nuclear accident dissipates in the next few weeks. So far, the overheating reactors have had a negative impact because of fears that the situation could deteriorate. Worries about further radiation poisoning have triggered panic-buying of supplies, prolonged office closures and resulted in a growing exodus from Japan of expatriate workers. Still, most people have generally displayed a remarkable degree of calm. Although it will take time to restore and reintegrate the sections of the national power grid damaged by the earthquake and tsunami, economic activity in areas of Japan that did not sustain serious physical damage could return to normal in the coming months. In this event, our current forecast is unlikely to change significantly.

Persistent uncertainty scenario: The present state of elevated risk and uncertainty persists for some time. Spent nuclear fuel can take weeks to cool. Even if the latest emergency measures succeed, as yet unforeseen problems could surface in the other reactors. Indeed, aftershocks appear to have inflicted further damage on the Fukushima Daiichi facility and interrupted emergency cooling efforts. If the situation worsens the broader economic impact would depend on how long the crisis simmers without getting markedly worse. With every passing day, the possibility of a catastrophic radiation leak is further fraying the nerves of businessmen and consumers. There are also significant opportunity costs in terms of the broader relief and rebuilding effort; as long as the government continues to focus on the nuclear emergency, reconstruction and infrastructure issues will not receive its full attention. This, in turn, would delay the reconstruction-driven uptick in the rate of economic growth that we currently expect to begin in the second half of 2011.

Worse-case scenario: The outlook would deteriorate dramatically in the worst-case scenario of a nuclear meltdown accompanied by widespread contamination. Most experts in the nuclear industry appear to agree that the superior design of the Fukushima reactors virtually rules out a widespread catastrophe on the scale of the one that occurred in 1986 at the Chernobyl nuclear power plant in Ukraine. Yet the situation could worsen in any number of ways that would significantly magnify the negative impact of the nuclear crisis. Increasingly dangerous radiation leaks or a permanent forced withdrawal from the facility of crisis-management personnel could trigger broader evacuations and create a sense of panic in the capital, Tokyo. The economic costs of the disaster would multiply accordingly.

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Japan's north-east coast will take years to recover from the devastation inflicted by the earthquake and tsunami, as whole towns have been wiped out and infrastructure has been damaged severely. However, the three worst-affected prefectures, Miyagi, Fukushima and Iwate, account for less than 4% of Japan's GDP. Moreover, most natural disasters have a net positive impact on GDP growth as the initial drop in output is offset by the reconstruction boom that follows. Thus, despite the enormous scale of the human tragedy, the earthquake and tsunami have not changed fundamentally our forecast for the Japanese economy. In the short term the natural disasters and a failure to control the nuclear situation will have a negative impact on the economy. Indeed, the loss of consumer and business confidence owing to concerns that the problems at the nuclear reactors could yet worsen has prompted us to revise down our GDP growth forecast for 2011 to 1%, from 1.4% previously. However, once under way, reconstruction efforts will boost the economy, and we have therefore made an upward revision to our 2012 growth forecast, to 2.1%, from 1.4% previously.

Although our GDP growth forecast for 2011-12 on an annual basis has not been greatly affected by the earthquake and tsunami, our quarterly growth profile now looks significantly different. As there were only a few weeks left in the first quarter of 2011 when the disaster struck, the main negative impact will show up in the second quarter, when GDP is expected to fall quarter on quarter. However, this will prove to be a temporary setback, as the positive impact of reconstruction will boost GDP growth in the second half of 2011 beyond what we previously expected. Reconstruction will be driven by higher government expenditure and private residential investment; private consumption growth, by contrast, will remain weak. The earthquake and tsunami will boost imports at the expense of exports, so that net exports will make only a minor contribution to GDP growth in 2011-12.

The most important caveat to this forecast is our assumption that the nuclear crisis unfolding at the Fukushima Daiichi nuclear plant will not lead to widespread radioactive contamination. Such an event would cause grave and lasting damage to large tracts of land in north-eastern Japan, leaving them uninhabitable for many years. Even something more limited in scope-further radiation in soil and water to levels sufficient to discourage people and firms from rebuilding in those areas-could permanently reduce Japanese wealth, productive capacity and growth potential. This would transform the human tragedy that has already occurred into a long-term economic injury that lowers living standards. Already, there are signs that consumer sentiment and business confidence are suffering amid fears relating to the nuclear crisis, and an extended period of uncertainty over the issue represents a major risk to our 2011 growth forecast.

Unfavourable demographic factors, together with Japan's difficult fiscal situation and persistent deflationary pressures, suggest that the economy will be stuck in the slow lane, with real GDP growth averaging only 1.5% a year in 2012­15. Sluggish wage growth and the probability of higher consumption taxes will depress consumer sentiment in 2011-15, with private consumption forecast to increase at an average rate of just 0.9% a year. Growth in government consumption will be boosted in 2011-12 by relief and reconstruction work but will then fall back in 2013-15, averaging 1.1% a year over the next five years. Investment growth will also be boosted in 2012 by reconstruction, but overall excess capacity in the economy will limit investment growth to an average annual rate of 1.6% in 2011-15. Notwithstanding the impact in the second quarter of 2011 on external trade owing to damage to ports and the loss of economic output owing to power and water outages, long-term trends will remain unchanged. On balance, exports will continue to be underpinned by Japanese companies' operations in fast-growing economies, such as China. We expect exports to grow by 5.7% a year on average in 2011-15, while imports will expand at much the same rate.

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The earthquake and tsunami are expected to exert upward pressure on prices in 2011 owing to a number of supply-side problems, but the risk of widespread profiteering (amid the ongoing shortages following the catastrophe) is minimal in Japan's well-ordered society. We have revised up our forecast for consumer price inflation in 2011 to 0.7%, from 0.6% previously, owing to supply-side factors (including a loss of agricultural output amid concerns over nuclear contamination in north-east Japan) but this does not imply any fundamental change in Japan's deflationary environment. The upward pressure on domestic prices in 2011 will be partly counteracted by the continued strength of the yen. In 2012-15 economic growth (albeit modest) and the resultant narrowing of the output gap will cause consumer price inflation to average 0.9% a year.

The yen appreciated sharply in the week following the disaster, climbing from ¥82.9:US$1 on March 10th to ¥80.8:US$1 on March 18th, owing to expectations that funds would be repatriated to Japan to pay for reconstruction. A stronger yen would aggravate the predicament of exporters that are already struggling to cope with damaged infrastructure and broken supply chains. The government has therefore intervened in markets since March to arrest the rise of the yen. We have not altered significantly our forecast for the value of the yen. Despite Japan's weak economic growth prospects in the forecast period, the currency will continue to be supported by the country's current-account surplus and plentiful foreign-exchange reserves. Interest rate differentials between Japan and the US are forecast to remain minuscule in the next 18-24 months, as the Federal Reserve (the US central bank) is expected to keep its funds rates on hold at 0­0.25% until the second half of 2012, while Japan's OCR will remain close to 0%. Japan's low rates will continue to encourage the carry trade (whereby investors borrow in currencies subject to low interest rates and lend in currencies attracting higher ones, profiting from the difference), which should act as a moderating influence on the strength of the yen. We forecast that the yen will strengthen from an average of ¥87.8:US$1 in 2010 to ¥81.2:US$1 in 2012. The currency is expected to weaken slightly against the US dollar in 2013­15 as US interest rates rise more quickly than those in Japan. The yen will be subject to bouts of volatility in the forecast period.

Japan's current-account surplus will be dented by the extra imports that it will need to make up shortages and facilitate reconstruction following the earthquake and tsunami. There will also be a negative impact on Japanese exports, in part owing to the loss of industrial output and problems with supplies of components. Most of these effects will occur in 2011, and we therefore expect the current-account surplus to fall to US$173.9bn (2.9% of GDP) this year, from US$196.1bn (3.6% of GDP) in 2010. In 2011-15 the surplus is forecast to average 3.1% of GDP. Merchandise exports will rise by 6.1% a year in value terms in the forecast period, owing to increases in volumes and also in prices for Japanese goods. The expected expansion in imports will not be rapid enough to prevent the merchandise trade surplus from rising in value terms. The other major factor underpinning the current-account surplus in 2011-15 will be the large surplus on the income account that is a consequence of Japan's substantial stock of overseas direct and portfolio investments. The services balance will remain in the red; this will be mainly the result of outbound tourism, which will keep services debits high.

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Although a tragedy for Japan and its people, the events set in train by the earthquake and tsunami that struck Japan on March 11th have benefited the prime minister, Naoto Kan of the ruling Democratic Party of Japan (DPJ), in the narrow sense of preserving his premiership from the ignominious fall that had previously seemed imminent. A series of scandals and some political mistakes had eviscerated his public approval ratings, and analysts were arguing over whether he would be forced to retire in March, June or perhaps September. Whether his presumed fall would also spell the demise of the DPJ or whether that party would succeed in selecting a new leader who could muster more popular support was unclear. But once the disaster struck, the need for large-scale emergency relief and the containment of the radiation emanating from several damaged nuclear reactors at the Fukushima Daiichi nuclear power plant was so overwhelming that both Mr Kan's rivals within the DPJ and the opposition parties felt compelled to postpone their assault on the prime minister and commit themselves to national unity and reconstruction. This gave Mr Kan a few more months in which to prove himself and his cabinet and, if successful in that regard, perhaps to extend his rule through the autumn and into next year. It even seemed possible that he might retain the premiership through the ruling party's next scheduled presidential election in September 2012. The crisis thus gave him a second, final chance to establish himself as a strong leader.

A "simple" combination of an earthquake and a tsunami would have been ideal from Mr Kan's perspective, at least in political terms, inasmuch as once such events have happened the damage is done and the rebuilding can begin. In such circumstances he might have taken control of the emergency relief operations, shepherded the requisite reconstruction legislation through the Diet (parliament), and then reaped the rewards when after a short interim the rate of economic growth accelerated. However, the nuclear dimension of the March incident makes the assertion of leadership significantly more difficult, as widespread radiation is a problem that cannot be remedied quickly and thus inflicts deeper and more lasting damage to corporate and household sentiment. In the event, the malfunction of the monitoring systems at the nuclear plant and the fact that workers could not access the actual reactors meant that Tokyo Electric Power (TEPCO), the company that owns the plant, and the government were not even aware of what was happening on the ground. This prevented Mr Kan from formulating, let alone conveying to the Japanese people, a clear definition of the problem along with a plan to resolve it. Then came the steady revelations that large doses of radiation had been released into the ocean, compromising the Tohoku region's fishing industry; that water in the capital, Tokyo, was showing slightly elevated levels of contamination; and that agricultural products from the affected area were unhealthily irradiated.

The decision of several other countries to ban temporarily the import of Japanese foodstuffs and of many foreign companies to fly the families of their employees in Tokyo out of the country likewise unsettled the nation and prevented the government from effectuating a bold, rapid recovery scheme. To the contrary, many Japanese wondered if their government was telling them the truth about the nuclear fallout-an impression precisely the opposite of that which Mr Kan wanted to produce.

It would be a mistake to place all the blame for the government's fecklessness on the partial meltdowns at Fukushima, as Mr Kan made matters marginally worse by bungling several political initiatives. One of his early gambits-bringing the competent and widely respected former chief cabinet secretary, Yoshito Sengoku, back into the cabinet as deputy chief secretary, a position from which he could oversee the country's rescue and relief operations-was assuredly a good one. Insiders aver that this appointment clarified the lines of authority and increased the efficacy of the government's operations. But that has not stopped Mr Kan from intervening in a number of minute matters-"micromanaging", the critics have alleged-in a manner that some believe has retarded the rescue effort. He has also been developing a reputation among his underlings for a splenetic attitude that alienates people and renders them less inclined to co-operate. Evidence of these limitations may be seen in the prime minister's unsuccessful attempt to bring the main opposition Liberal Democratic Party (LDP) into a coalition government. This was from the outset a difficult endeavor, for the leaders of that party had long insisted that they would never agree to form a unity government under his leadership. A chance of closer co-operation did, however, emerge in the wake of the disaster. But Mr Kan squandered this valuable opportunity on March 19th when, with no forewarning, he telephoned the LDP chief, Sadakazu Tanigaki, and asked him to join the government as deputy prime minister. The Liberal Democrat predictably rejected this overture. In retrospect it appears obvious that Mr Kan and his colleagues should have broached the topic with Mr Tanigaki's aides, perhaps negotiating an extensive and detailed proposal that the latter could then consider at his leisure. Having failed to perform such groundwork, the prime minister could not reasonably have expected his rival to accede to a coalition arrangement. Mr Tanigaki therefore took his party and retreated into his previous stance of refusing to serve as the DPJ's junior partner in Mr Kan's cabinet.

The DPJ suffers defeat at the polls

Before the earthquake and tsunami struck on March 11th there was considerable speculation that the prime minister, Naoto Kan of the ruling Democratic Party of Japan (DPJ), might call a snap election for the House of Representatives (the lower house of parliament), in the hope of gaining an electoral mandate that would enable him to act more decisively in terms of policymaking. The odds of the electorate rejecting his leadership were of course high, so he probably would only have gone to the polls as a last resort-if, for example, the senior leaders of the ruling DPJ demanded that he do so. Yet even as the earthquake, tsunami and nuclear debacle forced the parliamentary parties to put aside their differences and work together, so too have they precluded the holding of an early poll. Conducting a fair national contest, after all, requires that people everywhere are able to prove their identity, register and go to polling stations to cast their votes. These preconditions cannot be met when around 500,000 refugees are living in high school gymnasiums, civic centers and other makeshift residential facilities. Local elections, however, are another matter. The first round of previously scheduled prefectural and municipal polls was thus staged on April 10th, and their results revealed considerable dissatisfaction with Mr Kan's recent performance. Candidates backed by the main opposition Liberal Democratic Party-itself a relatively unpopular political movement-defeated those preferred by the DPJ in all three gubernatorial contests in which the two parties competed directly, and the ruling party additionally lost some 70 seats in various municipal assemblies. Exit polls reported that the reasons for this electoral repudiation were continuing concern about the government's competence and a general dissatisfaction with the prime minister's failure to bring the nuclear saga to a conclusion. Although it is difficult to see how any other leader could have mastered the events that have unfolded in Tohoku, the outcome of the election has given more ammunition to those who dislike Mr Kan and who are seeking his ouster. No major changes are likely to occur until the nuclear situation in Japan has stabilised somewhat, but the auspices do not appear favorable in terms of a lengthy continuation of the prime minister's tenure in office.

Second only in importance to the need to stabilise the situation at the Fukushima Daiichi nuclear power plant is the initiation of the recovery and reconstruction campaign in the broader Tohoku region. To that end, in late March senior members of the DPJ met with their counterparts in the opposition LDP and agreed on the broad outlines of the necessary fiscal measures. Having thus assured themselves that passage through parliament should not prove problematic, Mr Kan's cabinet then went forward with its own internal discussions and decided that the first supplementary budget-providing capital for the early relief and recovery efforts-should include allocations totaling somewhat more than ¥4trn (US$48.4bn). This includes money for payments to the Self-Defence Force personnel who are providing logistical assistance to the roughly 500,000 displaced people as well as funds for repairs of communications infrastructure, the transport of food and clothing, and other necessary items and services. The proposal was that the scheme would be financed mainly by taking ¥2.5trn from the national pension system and ¥800bn (US$9.8bn) from a previously established emergency fund, while at the same time eliminating several planned tax cuts and subsidies.

The first supplementary budget was submitted as scheduled to the Diet in late April and enacted in early May. The government has now turned its attention to devising a second budget that focuses less on relief and more on reconstruction. In the meantime the DPJ and the LDP have reportedly agreed that the appropriate sum should be approximately ¥15trn. The government has publicly suggested a somewhat smaller price tag of around ¥10trn, but Mr Kan recently, if infelicitously, acknowledged that it will in any case be big. The cabinet has not specified what measures will comprise the second scheme, but major investments in transport infrastructure and subsidies for new housing must inevitably be prominent themes. The government is also likely to spend a significant amount on energy infrastructure, as there have been profound disruptions to the national power grid, with rolling blackouts in Tokyo and other parts of the country that are likely to have a depressive effect on the national economy for many months. The authorities have already started composing plans to force manufacturers to cut their energy consumption by one-quarter over the summer, measured against the level in the year-earlier period, and households to reduce their usage by 15-20%. But these are only short-term initiatives. It will be interesting to see whether the bulk of the second scheme's energy budget is devoted to reopening the several nuclear reactors that have been shut down, or to other forms of power generation.

The Bank of Japan's (BOJ, the central bank) immediate reaction to the events of March 11th was to establish an emergency committee under the governor, Masaaki Shirakawa, to monitor the state of Japan's capital markets and formulate any necessary remedial policies. Almost immediately it announced that it would keep policy interest rates at their very low level for a long time, while also expanding the volume of funds available to the money markets and buying up any risky assets that private institutions shunned owing to the uncertainty generated by the disaster. The BOJ also increased the supply of capital that it offers to commercial banks in order to prevent them from experiencing a shortage of liquidity that might cripple other parts of the economy. Then, when in mid-March the activities of international investors caused the value of the yen to rise in the foreign exchange market owing to their expectations that Japanese companies and financial institutions would repatriate funds in order to pay for the country's reconstruction, the BOJ organised (with the central banks of several other leading economies) an intervention in the foreign exchange market to depress the exchange rate. Since then the bank has offered several additional forms of lending on preferential terms to financial intermediaries and companies situated in the devastated Tohoku region. Subsequently, in mid-April Mr Shirakawa, in an effort to assuage the anxiety of overseas investors, gave a speech in the US, describing the March disaster and the BOJ's countermeasures. However, when responding to questions he suggested that the bank remained concerned about domestic policies that would weaken the yen in international markets. He did not explain how this statement comported with the BOJ's many statements that the stronger yen would harm the Japanese economy or its decision in mid-March to enlist the help of foreign central banks to weaken that currency.

The pace of real GDP growth slowed moderately in the fourth quarter of 2010, measured on a quarter-on-quarter basis, but this seemed understandable after a year of rapid expansion. Going into the 2011, moreover, most gauges of economic conditions were reasonably positive. Industrial production was still rising at 3% in January and February, relative to the year-earlier period, and corporate inventories remained comparatively low-implying that firms would probably keep their plants and employees busy. Leading indicators gave further grounds for comfort. Machinery orders, which lead capital expenditures by about six months, increased by a year-on-year rate of over 30% in both January and February, portending strong corporate spending through late 2011. These expectations of future vigor naturally redounded to workers' advantage, as reflected in an unemployment rate that declined from 5.1% in November to 4.9% in January and then to just 4.6% in February. The overall picture was therefore one in which the economy paused at the turn of the year but appeared poised to continue growing with decent speed through the summer and probably into the autumn.

A crisis as momentous as the earthquake and tsunami would inevitably have caused real GDP growth to decelerate, but the damage appears to be more profound than most analysts had originally expected. The Tohoku region that bore the brunt of the natural disaster represents only 4-5% of the domestic economy, and so the initial calculations suggested that the total damage would not substantially exceed the US$100bn caused by the 1995 Kobe earthquake-a much smaller event in a more industrialised and populated area. But those initial estimates have now proved vastly too sanguine: most estimates now put the damage somewhere between US$200bn and US$300bn. Most of the losses were suffered by homeowners and the operators of local infrastructure, but the operations of a number of manufacturers have also been compromised. To understand the significance of this, it is important to note that the structure of the national economy has evolved significantly in the past two decades or so. One difference is that most manufacturers have become more specialised, eschewing the production of complete products and opting increasingly to make parts that are then transported to facilities elsewhere in Japan or abroad. Now the closure of a relatively small plant in a predominantly rural part of the country could create bottlenecks that constrain output everywhere. Underscoring that possibility is the emergence of the "just-in-time" manufacturing processes that Japan pioneered, whereby firms keep their inventories as small as possible and rely on their suppliers to deliver additional goods almost instantaneously when necessary. In these circumstances the disruptions to the local Tohoku economy have led directly to parts shortages at such domestic car firms as Toyota, Honda and Nissan, and foreign car makers as well. The same pattern is unfolding in the electronics industry, where Apple, a US firm, is running short of parts for its new tablet personal computer, the iPad 2, the debut of which unfortunately coincided almost exactly with the March disaster.

The 1995 earthquake depressed Japanese GDP for one quarter, but by the second quarter the prodigious reconstruction effort had precipitated a commercial boom that ultimately lasted for well over one year. But the Kobe disaster did not compromise the national energy grid in the same way that the Tohoku events have now done. Not only are the six damaged reactors at the Fukushima Daiichi nuclear plant disabled, so too are seven other TEPCO nuclear plants and four of the plants operated by Tohoku Electric Power Company. Some of those facilities are probably safe and could be reopened if it were not for the profound anxieties that Japan now feels about nuclear power in general. Indeed, at least one prefectural governor has announced that he will not approve the reopening of reactors in his region for months or even years. Nor can the two companies easily replace the energy thus lost by expanding operations at their non-nuclear-generating facilities, as a number of their oil, gas and geothermal plants have also suffered considerable harm. Other countries would simply reallocate electricity from other parts of the national grid, but Japan cannot do this because different regions function on different hertz cycles. The upshot is that almost all of the excess capacity in the system that serves the Tokyo metropolis has been eliminated, and a surge in demand during the hot summer months could cause unpredictable blackouts there and in other economically critical areas. Officials have now announced rationing plans, including limits on how much energy manufacturers can employ, but there is no guarantee that such measures will suffice to keep the economy functioning without impedance. The likelihood of widespread power shortages is therefore a real risk looming on the horizon.

Every quarter the BOJ conducts a Tankan survey of sentiment among some 11,000 firms to discover their views on business conditions and economic prospects at present. The last such survey was in process when the earthquake and tsunami occurred, and the central bank has subsequently separated the reports filed before and after that date to divulge what impact the disaster has had on corporate confidence. The results are telling. Companies were becoming more sanguine in the early winter but then grew substantially more pessimistic in the last fortnight of March. The causes of this deterioration were the devastation itself but also the interruption of supply chains, the sudden decline in the availability of electricity, an inability to find the parts necessary to produce goods for export, and a fear that consumers will curtail their spending on goods and services. This last worry has been vindicated by polls of household confidence, which fell off sharply after the disasters. More recent research by media outlets indicates that even the results following the disasters are likely to have been too optimistic. The extent of the damage to the manufacturing sector and the power grid were not fully evident until after the central bank completed its analysis, but with more information available it is likely that the June Tankan will show a much sharper downturn in business sentiment. This is yet another reason to fear that the post-earthquake economic slowdown may last longer than the single quarter that many economists initially reckoned.

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Land area

377,899 sq km

Population

127.3m (2008)

Main towns

Population in millions (August 2009):

Tokyo (capital; 23 central wards): 8.8

Yokohama: 3.7

Osaka: 2.7

Nagoya: 2.3

Sapporo: 1.9

Kobe: 1.5

Kyoto: 1.5

Fukuoka: 1.5

Climate

Temperate, with the monsoon season in June, seasonal winds and typhoons in August-September, and heavy snow in December-February on the Japan Sea side

Weather in Tokyo (altitude 5.3 metres)

Hottest month, August, 29°C; coldest month, January, 7.6°C; driest month, August, 9.5 mm rainfall; wettest month, September, 319.5 mm rainfall

Language

Japanese

Measures

Mainly metric system; local measures include: 1 tsubo = 3.3 sq metres; 1 sun = 3 cm; 1 ri = 4 km; 1 kairi = 1.8 km (used for sea distances)

Currency

Yen (¥); ¥1 = 100 sen. Average exchange rates in 2010: ¥87.8:US$1

Fiscal year

April 1st-March 31st

Time

9 hours ahead of GMT

Public holidays

New Year, January 1st; Coming of Age Day, January 10th; National Foundation Day, February 11th; Vernal Equinox, March 21st; Golden Week holidays, April 29th and May 3rd-5th; Marine Day, July 18th; Respect for the Aged Day, September 19th; Autumnal Equinox, September 23rd; Sports Day, October 10th; Culture Day, November 3rd; Labour Thanksgiving, November 23rd; Emperor's Birthday, December 23rd

Official name

Japan

Form of government

Representative democracy

The executive

The prime minister is chosen by a ballot of the Diet (parliament) and appoints a cabinet, the majority of whose members must also be members of the Diet

Head of state

Emperor Akihito

National legislature

Bicameral Diet, comprising the 480-member House of Representatives (the lower house), elected every four years, and the 242-member House of Councillors (the upper house), elected for six-year terms, one-half of its number being elected every three years. There are 300 single-seat constituencies and 180 seats filled by proportional representation in the lower house

Legal system

A Supreme Court, appointed by the cabinet, presides over a legal system of lesser courts divided into four arms: the High Court, district courts, family courts and summary courts

National elections

An election for the lower house took place in August 2009; the next is due by August 2013. The most recent election for the upper house was held in July 2010; the next is due in July 2013

National government

The Democratic Party of Japan (DPJ) holds 306 seats in the lower house; the DPJ's coalition partner, the People's New Party (PNP), holds four seats; and the largest opposition party, the Liberal Democratic Party (LDP), holds 117 seats

Main political organisations

Government: coalition of the DPJ and the PNP

Opposition: LDP; Komeito; Japan Communist Party; the Social Democratic Party; Your Party; the Sunrise Party of Japan

Main members of the cabinet

Prime minister: Naoto Kan

Chief cabinet secretary: Yukio Edano

Key ministers

Agriculture, forestry & fisheries: Michihiko Kano

Defence: Toshimi Kitazawa

Economy, trade & industry: Banri Kaieda

Education, culture, sports, science & technology: Yoshiaki Takaki

Environment: Ryu Matsumoto

Finance: Yoshihiko Noda

Foreign affairs: Seiji Maehara

Health, labour & welfare: Ritsuo Hosokawa

Internal affairs & communications: Yoshihiro Katayama

Justice: Satsuki Eda

Land, infrastructure & transport: Akihiro Ohata

State ministers

Economic & fiscal policy; reform of social security & tax: Kaoru Yosano

Financial services; postal reform: Shozaburo Jimi

Government revitalisation: Renho

National policy: Koichiro Gemba

Public safety; consumer affairs; civil service reform: Kansei Nakano

Central bank governor

Masaaki Shirakawa