PLANT

Japan’s aftershocks ripple through global economy

The earthquake that devastated the northeastern region of Japan on March 11 is also a harsh reminder to manufacturers of the risks they face in global markets.


May 25, 2011
by KARL SCHAMOTT

The earthquake registering 8.9 on the Richter scale that struck the northeastern coast of Japan on March 11 has caused untold human suffering and unprecedented economic destruction. It was also a harsh reminder to manufacturers of the risks they face, as the impact travelled outward from the Japanese economy, and the foreign exchange markets went through yet another period of wrenching adjustment. This points to the need for effective currency risk management practices.

Given the evolving nature of the situation on the ground, the true cost of the calamity is unknowable. It’s already clear that this was one of the most expensive natural disasters in history, and the aftershocks will be felt across the global economy in complex and varied ways.

Japan will unquestionably bear the brunt of the catastrophe. The tsunami wiped out many coastal towns and villages while destroying production facilities and transportation infrastructure across the northeastern part of the country. Rebuilding will likely continue for years at an enormous cost but Japan’s vast savings pool should be more than sufficient to pay for it.

As the Japanese will effectively be drawing down on long term investments and spending the largest portion of the funds domestically, economists expect the economy will experience a short-term growth surge. However, the long-term effect is less certain. Given Japan’s poor performance over the past two decades, many experts believe the disaster may have been just what was needed to snap the economy out of its slumber.

For the rest of the world, the impact will be more nuanced.

In the immediate aftermath of the disaster, global financial markets dropped precipitously, with most major stock indexes falling sharply for almost a week as panic-stricken investors assessed the likelihood of detrimental effects outside of Japan. The overall trend was quickly reversed, however, as the panic gave way to a calmer approach. At the time of writing, most indexes are sitting near their pre-earthquake highs.

The tsunami caused extensive damage to oil refineries clustered along the coastline, meaning that total Japanese oil demand fell by almost the same amount as the production that was knocked offline by unrest in Libya. This meant that the net effect on the oil price was negligible. However, traders anticipate an eventual uptick in demand as Japan recovers, and long-dated futures contracts have risen in value accordingly.

The quake also broke a vital link in the global supply chain. With many complex and specialized components manufactured in northern Japan, there have been production delays for items such as advanced computer chips and chemicals. While these will unquestionably be detrimental for global economic growth, it will be interesting to see just how severe the effect ultimately is. The traditional supply chain has evolved over time, and might now be more accurately described as a network. Producers are spread across the globe, and many major companies have relationships with a variety of them. Of course, lines may have to be retooled and products redesigned, but the global economy may experience more of a glitch than a crash.

In contrast, global capital flows saw the most dramatic impact. Japan may have lost much of her economic dominance over the past two decades, but her external investment balances remain the world’s largest. The possibility that Japanese investors might change their behavior had a profound impact on exchange rates – the Japanese yen surged to a postwar high against the US dollar before coordinated action by the G7 central banks sapped its strength and sent speculators scurrying for cover. Elsewhere, exchange rates saw extreme swings as traders reacted to news headlines and sentiment shifted dramatically from minute to minute. The Canadian dollar moved by 300 basis points over one trading cycle.

Clearly, manufacturers are facing a new world of risk. This disaster, along with recent crises in Europe and the Middle East should underline the fact that the global currency markets are now more integrated than at any other time in history. Events in distant areas of the world can cause ripples to spread, adjusting exchange rates and directly impacting bottom lines across Canada.

In this environment, the value of a strong hedging framework shouldn’t be underestimated. Many of the largest and most successful manufacturers in Canada have built robust currency risk management practices directly into their cultures, allowing them to focus on maintaining growth and increasing profits in the real economy: something to consider before the next economic tsunami hits.

Karl Schamotta is a Calgary-based senior market strategist for Western Union Business Solutions (business.westernunion.ca) who has designed and implemented risk management and trading strategies for businesses of all sizes. E-mail Karl.Schamotta@business.westernunion.com or call (403) 827-9741.