Matt Sherwood, Perpetual’s Head of Investment Market Research looks at how recent events in Japan will impact its economy and global sharemarkets.

• The Japanese earthquake is likely to be the most expensive natural disaster in history.
• Concerns about nuclear power may increase the construction of coal-based facilities.

For the land of the rising sun, these are dark days indeed. Not only did Japan experience the fourth largest earthquake in recorded history, but the tsunami that followed sparked a partial meltdown in the Fukushima nuclear power plant. While Japan sits on a fault line and earthquakes are regular events, the combination of back-to-back disasters is unique and prompted a sharp market reaction.

In the last 16 years, the worst earthquake experienced in Japan (in terms of damage) was in Kobe in 1995. According to the Guinness Book of World Records, this has the distinction of being the most expensive natural disaster in history with an estimated $US103 billion in damage (or around 3% of Japanese economic output).

Nonetheless, while Kobe’s manufacturing activity recovered back to normal levels within 15 months, the recent earthquake is likely to attract a higher reconstruction cost and over a longer time period.

The best case scenario - minimal radioactive leaks

Putting the enormous human cost to one side, the economic damage is still being assessed. The potential meltdown of the Fukushima facilities is the biggest difference between the 1995 and 2011 disasters. In the best case scenario, where minimal radioactive leaks and lives are lost, there will still be sizable short-term and long-term costs to the Japanese economy. There would be an immediate shock to industrial production which would likely decline in the March and June quarters. However, the eventual rebuilding of the economy’s capital stock (such as housing, commercial buildings and infrastructure) could increase economic activity in the second half of 2011 and beyond.

If this is the case, the impact of any economic loss from the earthquake on global gross domestic product (GDP) is likely to be modest. This is because Japan’s contribution to global economic production has halved over the last 20 years and is now dwarfed by the total productive capacity of other parts of Asia (see Chart 1).

Given the cost of the Kobe earthquake was 3% (in terms of GDP), Japan is unlikely to experience any trouble raising the funding for their reconstruction as interest on their entire debt is only 4% of government revenue (representing an interest cover of 25 times).

Japan is carrying a debt burden equivalent to roughly 200% of its economic output, which is the worst among any industrialised country. However, this disaster will add only marginally to this mounting number, and Japan’s domestic savings pool is very large.

On the other hand, in a worse case scenario, more economic damage would be sustained if the radiation spread south west and led to an evacuation of Tokyo or if it spread into North or South Korea and China.

The long-term effect could lead to more oil and coal-facility investment

There are likely to be significant power shutdowns in many nuclear facilities in Japan over the medium to long term for repairs and safety checks, which could significantly impact growth. In the 1995 quake, some nuclear facilities were shut down for several years, but growth remained positive.

There is also the growing risk that safety concerns of nuclear power, in general, will prompt a decline in global construction of these facilities and accelerate the use and development of more coal-based facilities (which produce cheaper energy, but with higher carbon dioxide emissions, than nuclear power). Accordingly, the long-term impact on commodities could be mixed, with Japan's need for more oil and thermal coal to produce electricity (to replace its damaged nuclear plants) possibly offsetting reductions in other commodity markets. This may add more pressure on some global energy prices through time.

Impact on global sharemarkets

While the earthquake and tsunami have caused widespread damage, it appears that the impact on the Japanese economy and its trading partners is becoming increasingly dislocated from trends in global sharemarkets.

The recent events in Japan have interrupted a nine month upward trend in global sharemarkets. The sudden decline is most likely the result of investors taking the worst case scenario into account – that being that the radioactive threat could spread further to major economic hubs such as Tokyo.

The clear risk is that the market volatility we have recently seen results in reduced liquidity. If volatility continues, the downward trend could spread to other markets.

While it seems to have stabilised at this stage, if the radioactive threat moves to Tokyo and prompts evacuation, this could trigger a more serious downturn in markets.

What’s next?

Events in Japan appear increasingly serious and not just because of the wide-scale loss of life, but also because of the risks that damaged nuclear facilities pose. The best we all can hope for is minimal radioactive damage in a localised area. Should things deteriorate further, the current uncertainties in the market and economy are likely to continue and intensify the risks. 

This article has been prepared by Perpetual Investment Management Limited (PIML), ABN 18 000 866 535, AFSL 234426, and contains information contributed by third parties. It is general information only and is not intended to provide advice to particular investors, or take into account an individual's objectives, financial situation or needs. The views expressed in the article are the opinions of the author at the time of writing and do not constitute a recommendation to act. You should consider, with a financial adviser, whether the information is suitable for your circumstances. Any information referenced in the article is believed to be accurate at the time of compilation and is provided by Perpetual in good faith. No company in the Perpetual Group ABN 86 000 431 827 (Perpetual Group means Perpetual Limited and its subsidiaries) guarantees the performance of any fund, stock or the return of an investor's capital. Past performance is not indicative of future performance.