Will Japan's economy ever recover?

Related topics: economy, investing strategy, funds, shorting, Anthony Mirhaydari

All eyes are on Japan after the powerful Tohoku Pacific earthquake spawned a tsunami that flooded the Fukushima Daiichi nuclear plant -- one of the largest in the world -- setting the stage for a multiple reactor meltdown. It's like the Kobe earthquake of 1995, the Indonesia tsunami of 2004 and Three Mile Island in 1979 all rolled into one. The human toll is almost incalculable, with the number of people killed now expected to exceed 10,000.

Investors are focused on the economic costs, which are large. It's no surprise that Japan's Nikkei stock index has fallen to levels not seen since early 2009 -- the levels of the early days of the post-recession bull market. Three years of gains were wiped out in three days of trading, in the worst performance since 1987.

After all, Japan is both the world's third-largest economy and its weakest. Power disruptions and damage to infrastructure in the affected prefectures of Iwate, Miyagi and Fukushima will surely weigh on factory output and economic growth. Consumer confidence, which fell for the sixth straight month in February, will continue to drop. Shoppers will stay home. Businesses will close. Japan's deflationary nightmare, and an economic mess dating back more than two decades, will continue for the foreseeable future.

Contemplate how Japan can begin to recover, and the picture looks even worse.

How much more debt?

Japan is the most heavily indebted country in the developed world, with a government debt-to-GDP ratio of around 200%. Only Zimbabwe carries a larger load. (America's ratio stands at 95%.) As a result, in the immediate aftermath of the quake and with the nuclear disaster still unfolding, experts began to question whether the government would be able to finance a massive reconstruction effort.

After all, for the third year in a row, the Japanese government is expected to raise more cash from borrowing than from tax collections in the fiscal year that starts next month -- $547 billion vs. $506 billion. And even with ultra-low borrowing rates, annual debt service payments are ballooning and now total $266 billion compared with the $355 billion spent on social security.

Many have begun to wonder whether this will finally catalyze the crash in Japanese government bonds they have anticipated for decades -- pushing ultra-low borrowing costs higher as concerns about credit risk overpower the waning strength of Japan's army of domestic savers. This would create a self-feeding debt spiral as higher interest costs force additional borrowing, in turn forcing borrowing costs even higher.

On Monday, Moody's lead analyst Tom Byrne said the quake "may have shifted such a potential tipping point a bit forward."

He is understating things. Make no mistake, this disaster has brought the next phase of the sovereign debt crisis to the shores of Japan. What started in November 2009 in Dubai and spread to Greece, Ireland and Portugal last year has now moved to one of the world's wealthiest nations. The fallout -- fiscal, not nuclear -- could be devastating far beyond Japan.

The solution, if Japan's leaders are brave enough to embrace it, would be social and immigration reforms on a scale not seen since Commodore Perry's "Black Ships" sailed into Tokyo Bay in 1853 and forced an end to more than 200 years of extreme isolationism known as sakoku. Japan needs a younger, more dynamic workforce. And it needs to import it.

Right now, Japanese 10-year bond yields stand at just 1.2%. Moody's credit analysts, who downgraded Japan's sovereign credit rating in January, don't expect the government to get around to fixing its debt problem until the mid-2020s. The problem is a fiscal deficit that amounts to 9.1% of GDP and is driven by hard-to-cut welfare payments. The outlook is grim: Deflation keeps Japan's economy from growing, increasing the real burden of its debt. A rapidly aging workforce suggests the dynamic will continue as the dependent-to-worker ratio swells. Only an influx of workers will solve that problem.

Clearly, we don't know the extent of the damage in Japan just yet. But in the words of Julian Jessop at Capital Economics: "The greater the social and economic damage, the larger the threat to the government's ability and willingness to ward off a fiscal crisis." At the end of the day, Japan's politicians will be pressured into easing the human toll, no matter the hit to the country's credit rating or borrowing costs.

For the global economy, the timing of the disaster "could not have been much worse," adds Jessop, since it increases the chances of another global debt crisis at a time when investors are already contending with a litany of concerns. From budget fights in Washington, D.C., and Wisconsin, to the Libyan civil war, and now a massive natural disaster, all types of fresh negative catalysts are hitting the newswires.

And they are all coming at a time of particular vulnerability, since rising inflationary pressures are forcing central banks around the world to tighten their policy stance and force interest rates higher.

Staggering costs, lingering trouble

Teams of Wall Street economists have been busily trying to calculate the cost of the disaster. The numbers aren't pretty.

Credit Suisse economist Hiromichi Shirakawa estimates that total economic losses in the disaster zone may amount to just over 6% of Japan's GDP, or around $370 billion. Nearly 23,000 houses could be destroyed -- triple that of the Great Hanshin earthquake in Kobe. Including those moved because of the nuclear power incident, there are upward of 300,000 evacuees. More than 2 million households have had their electrical power interrupted.

For perspective, government officials put the cost of the devastating 2005 Hurricanes Katrina and Rita, in 2011 dollars, at $102 billion -- less than 1% of U.S. GDP.

Still, overall losses amount to just under 40% of that seen in the Kobe earthquake, since the area affected by the Tohoku quake is dominated by industries like fishing, forestry and agriculture that don't require big factories or other infrastructure that a quake or typhoon can take down.

But the impact could be long-lasting. Strategist Shun Maruyama, also of Credit Suisse, notes that the Kobe earthquake's damage was confined to a comparatively small area, which allowed manufacturing to be switched to areas not impacted while export and imports were rerouted to other ports. As a result, there "was only a limited decline in overall economic activity, as consumers in areas not affected by the earthquake only cut back on consumption for about a month."

The Tohoku quake has affected a much larger area -- so manufacturing may not be quickly relocated, and production delays are likely since Japanese factories operate lean, with minimal inventory. Maruyama also expects consumers to cut back for a long period across "a wide swath of the country" including Tokyo, which is being hit with strong aftershocks.

As a result, manufacturing, spending and overall economic activity will likely suffer a multi-month growth slowdown.