Japan is all too coupled with global economy: James Saft

-- James Saft is a Reuters columnist. The opinions expressed are his own --

By James Saft

LONDON (Reuters) - Far from being "decoupled," Japan is proving to be on a very bad date with the global economy.

The hope for Japan had been that its deepening economic ties with China, which is still growing quickly, would shelter it from a downturn in the United States and elsewhere.

The only problem is that Japan's exports to China are tied closely to China's exports to the west; as Europe joins the United States as a source of weakness, Japan's economy is looking decidedly frail.

And while years of recession, deflation and struggle have deadened investors to the importance of Japan, it is still the world's second largest economy in nominal terms and is a significant consumer of everything from oil to Treasuries to U.S. mortgage bonds.

Japan's economy shrank by six tenths of a percent in the second quarter, while exports fell by 3.3 percent in inflation adjusted terms.

And don't count on domestic demand: wages are not keeping pace as surging prices for food and energy drive inflation to a decade high. The Japanese government last week unveiled a package worth more than $100 billion aimed at helping individuals and businesses withstand rising prices, a plan that is now caught up in political uncertainty after the resignation of Prime Minister Yasuo Fukuda.

But the real action for Japan is overseas. While Japan's exports to most of its trading partners were growing in inflation-adjusted terms through last year and the beginning of 2008, in the second quarter only sales to China increased.

"Japan has not been able to decouple fundamentally, the only question is how long their short term decoupling can persist," said Kyohei Morita, the Tokyo-based Japan chief economist for Barclays.

"It's coming to an end."

Morita isn't calling for a recession in Japan, though many economists are, expecting instead a period of stagnation. As for China as a savior, its manufacturing sector actually shrank in August, according to surveys of companies. This may simply have been an Olympics-related pause, but looking at the tea leaves in Europe and the United States it's easy to see it as part of a trend.

China is said to be readying its own stimulus package, one that has been reported to be at least $29 billion and including measures to prop up both the domestic stock and property markets.

The slowdown in Europe and the United States is having an effect globally and Japan will increasingly feel the chill as even China finds growth tougher to produce.

BRINGING HOME THE MONEY

To be clear, Japan's situation is nowhere near as parlous as it was in past recessions. While it was not uncommon in previous downturns to see industrial production contracting by as much as 10 percent, it actually rose by 0.9 percent in July, though it had been negative in the first two quarters of the year.

But as demand sags and prices for commodities rise, Japan's firms are unable to pass on their higher costs. Current profits, a broad measure of profitability for non-financial firms, fell 17.5 percent year on year in the first quarter.

This in turn puts Japanese workers in a weak position, both in terms of getting new jobs and winning higher real wages. Japanese wages rose 0.4 percent in the year to June, as compared with a core consumer price inflation rate of 1.9 percent for the same period.

And as we know, when Japanese households feel the pinch, they are far less likely than their British or American peers to merrily spend their way into debt.

Ultimately, Japan will probably find it is unable to stage anything like a recovery and a return to reasonable growth until the situation improves in the United States and Europe.

That doesn't mean necessarily that Japan is simply acted upon, a weak partner which will feel pain but not cause a lot of its own for others.

Japan has been a bit of an unloved step child in the eyes of economists and investors, struggling with its own demons while being outshone by its brash and rapidly growing neighbor China.

But it is also hugely integrated into global financial markets, with large overseas holdings of debt and equity, including bonds issued by Fannie Mae and Freddie Mac. A major downturn in Japan could see some of that repatriated. This would be particularly difficult for the United States, which needs not just to recapitalize its financial system but also a steady source for its debt-heavy consumer economy.

"If Japan were to go into recession it would be a significant drag for the rest of the world," said Albert Edwards, global strategist at Societe Generale in London. "It would matter for commodities, it would matter for financial markets."

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund --

(Editing by Ruth Pitchford)