FROM THE ECONOMIST INTELLIGENCE UNIT

Japan is still reeling from the effects of the massive earthquake and tsunami
that devastated the north-east of the country on March 11th. The offshore
earthquake, measuring 9.0 in magnitude, was one of the largest ever recorded.
The tsunami flattened towns and villages, resulting in massive destruction of
property and the displacement of hundreds of thousands of people. With
thousands still unaccounted for, the death toll is likely to rise rapidly. The
disaster has also damaged a nuclear-power plant, resulting in several
explosions and prompting the evacuation of the surrounding population. The
Economist Intelligence Unit outlines below the main implications of the
disaster. Overall, so long as there is no nuclear catastrophe, the impact on
national GDP growth is likely to be modest compared with the scale of the
human trauma.

ECONOMIC GROWTH

On the initial news of the earthquake and tsunami damage, we lowered slightly our
forecast for economic growth in 2011, from 1.6% to 1.4%. In the worst-affected areas,
economic activity has virtually halted, and private consumption and investment will
remain weak until the second half of the year. However, reconstruction should provide a
boost in the following year, so we have raised our growth forecast for 2012 from 1.4%
to 1.5%.

Our current forecast assumes that the national impact of the disaster will be limited so
long as major economic centres such as Tokyo avoid prolonged disruption. For example,
we expect that power supplies will be fully restored in key economic areas by May.
Whether this assumption will hold up depends, in turn, on how long the crisis at the
Fukushima Daiichi nuclear plant continues. If the current state of elevated risk and
uncertainty persists, this could delay the reconstruction-driven uptick in growth we
currently expect to begin in the second half of 2011. In that case, our growth
expectations for 2011 would be reduced but our forecast for 2012 would rise.

POLITICS

Prime Minister Naoto Kan and the ruling Democratic Party of Japan are facing a major
test. A dramatic deterioration in the government's standing is ruled out by the fact that
it was already dismally unpopular before the disaster struck. Public dissatisfaction with
relief and rebuilding efforts is a risk, but on balance the authorities' reaction has been
rapid and competent. Unlike the lethargic response to the 1995 Kobe earthquake, large-
scale relief operations have been launched immediately and foreign assistance
welcomed. Mr Kan has taken the risky step of assuming personal command of the crisis
at the Fukushima plant—a move that could backfire if the situation at the stricken facility
worsens. However, public ire is more likely to focus on the firm that operates the plant,
TEPCO, which is notorious for being economical with the truth about nuclear mishaps.

Overall, if the Kan administration can avoid sharing in the blame from further radiation
leaks, and if the authorities continue to orchestrate a creditable rescue and
reconstruction effort, the effect of the disaster on the government's standing is likely to
range from neutral to positive. Moreover, the administration may benefit on the policy
front. A sense of emergency and national solidarity could mitigate partisan obstruction of
the budget for the upcoming fiscal year—or even galvanise support for the bold reforms
Mr Kan has proposed to tackle Japan's festering economic problems.

FISCAL POSITION
The disaster has inevitably invited comparison with the 1995 Kobe quake, but one major
difference between now and then is that Japan's fiscal position was much healthier in the
mid-1990s. In 1994 public debt averaged 79% of GDP, but by 2010 that share had risen
to 198% of GDP. In theory, the government is now not only less able to afford
emergency relief and reconstruction, but also more vulnerable to a loss of confidence in
its creditworthiness.

Does this mean that the earthquake and tsunami will prove disastrous for the public
finances? The answer is unclear, but the most likely outcome is that the country will
continue—as before—in a curious sovereign-risk limbo. Japan's public finances have
already deteriorated way beyond what would be sustainable in most other 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, we do
expect the disaster to hurt Japan's fiscal position. We are likely to revise our budget
forecasts to incorporate larger deficits than previously expected. As Japan's budget
deficit was already almost 8% of GDP in 2010 owing to the after-effects of the global
financial crisis, it is a bad time for fiscal policy to be expansionary.

BUSINESS

Business operations in Japan's north-east have suffered severe damage, especially in the
automotive, electronics and other manufacturing sectors. Japanese corporate
powerhouses including Canon, Sony and Toshiba have shut down multiple factories in
the affected region. Several carmakers, including Toyota, the world's largest, have
suspended all production in Japan. At the other end of the scale, countless small
businesses have been literally wiped out.

The indirect effects on businesses as a result of infrastructure damage have also been
severe. Electricity rationing and water shortages have forced factories to scale back
production, and offices across the country remain closed amid a state of emergency and
fears of aftershocks. Train services have been cut, airports shut down and major
highways closed to public traffic. In the short term, these factors will wreak havoc on
Japanese industries, many of which use just-in-time production methods that rely on
seamless logistics. This, in turn, is having a knock-on effect on global supply chains, as
Japanese firms supply crucial components for many high-technology goods ranging from
semi-conductors to iPhones. However, the impact on global production is unlikely to be
severe unless Japanese production of vital components is significantly impaired for a
matter of weeks or months rather than days. In many cases, inventories of the affected
products are ample and a number of factories were reopening as of March 17th.

FINANCIAL MARKETS

The earthquake has produced significant aftershocks in the markets for Japanese stocks,
government bonds and the currency. Between March 11th and March 15th, the Nikkei
225 slumped by 11.3% and the broader Topix index plummeted by 10.7%, although
both indices regained some ground on March 16th. The government has tried to limit the
financial damage by pouring in a record amount of liquidity. Among other measures, the
Bank of Japan (BOJ) has injected trillions of yen into money markets and doubled its
asset-purchase programme. Yields on ten-year Japanese government bonds have fallen
accordingly, despite the fact that the disaster will exacerbate the government's already
severe fiscal burden. Meanwhile, the yen has appreciated sharply, climbing from
¥82.9:US$1 on March 10th to ¥78.1:US$1 on March 16th, on expectations that funds
will be repatriated to Japan to pay for reconstruction. A stronger yen will worsen the
predicament of exporters already struggling to cope with damaged infrastructure and
broken supply chains. The government may try to intervene to stop the rise of the yen,
but such measures are rarely effective. Several weeks of volatility lie ahead for the
foreign-exchange, bond and equity markets.

Unsurprisingly, the insurance sector is also set for turmoil. Preliminary estimates of the
insured losses as a result of the quake are beginning to emerge. AIR Worldwide, a
disaster-modelling firm, put the potential insured loss at between US$14.5bn and
US$34.6bn. Domestic insurers account for more than 90% of the non-life insurance
market in Japan, so they will be hit hard. However, most have passed risks on to global
reinsurers, so the disaster will be felt all over the world. Coming so soon after the floods
and cyclone in Australia, and the earthquakes in New Zealand, the Japanese earthquake
and tsunami have prompted talk that global insurance prices, which have fallen for
years, will begin to rise again. 

COMMODITY MARKETS

International commodity markets are still digesting a variety of potentially conflicting

implications of the disaster in Japan. In soft commodities, for example, weaker economic
growth may reduce import demand in the short term, but market participants may also
anticipate a pick-up in demand as stockpiles are rebuilt. Similarly, metal markets are
likely to benefit once reconstruction begins in earnest but will suffer in the near term
because of factory closures and lower economic activity. In oil markets, the disruption to
transport networks suggests lower consumption, but there may be a switch to oil to
meet immediate power needs. The oil market has initially focused on lower consumption
in the world's third-largest consumer, with the price of Brent crude falling to about
US$110/barrel on March 15th. However, prices have subsequently risen slightly on
Middle East unrest. Japan has few natural resources and is heavily reliant on imports, so
reconstruction is subsequently likely to boost commodity demand in international
markets.

ENERGY

The earthquake and tsunami have severely interrupted Japan's supply of nuclear power,
which amounts to nearly 30% of total electricity production. Information remains patchy
and contradictory, but at least ten reactors automatically shut down in response to the
earthquake, meaning that Japan faces a potential loss of around 15-20% of total nuclear
capacity. Multiple thermal plants are also reported to be down. TEPCO has said that half
of the thermal capacity knocked out by last Friday's events will be back in service within
around a week, but the outlook for the affected nuclear equipment at its Fukushima
plant is less sanguine. Seawater has been pumped into several reactors in order to
control temperatures at their cores, making their repair impossible.

How will Japan attempt to make up for the shortfall in electricity supply? Historical
precedent suggests that increased reliance on natural gas is likely to be the fallback
position. In the wake of the 2007 earthquake-triggered shutdown of the Kashiwazaki-
Kariwa nuclear plant, the world's largest, Japanese demand for liquid natural gas spiked.
However, the fragmented nature of Japan's gas industry and underdeveloped gas
infrastructure will complicate a switch to gas. Larger shipments of crude oil, fuel oil and
coal are also likely.