Japan will be left struggling with a broken economy, swelling debts and surging prices as it recovers from the devastation of the worst natural disaster in its history, further fuelling uncertainty about the impact on the fragile global recovery.
Its infrastructure in shambles and its manufacturing base hampered for now by major supply chain disruptions, the Japanese government will have to come up with an aggressive new spending package certain to dwarf the ¥2.7-trillion spent after the Kobe earthquake of 1995.
Estimates of the reconstruction costs range from ¥10-trillion ($122.1-billion) to ¥20-trillion - between 2.1 and 4.2 per cent of the entire economy. But this number could rise substantially, as more detailed assessments pour in.
As Tokyo's benchmark Nikkei plunged a further 11 per cent yesterday - bringing the two-day drop to 16 per cent, the worst since the 1987 market crash - fears spread to other markets around the world. Investors rushed into the traditional safe haven of U.S. Treasuries and other governments' bonds, while fleeing riskier equities and commodities, including gold.
Some analysts have already predicted a marked slowdown in the global economy this year, stemming from the efforts of China and other emerging Asian countries to curb inflation, the end of massive stimulus spending in the U.S. and continuing debt woes and austerity in Europe. Now the fear is that the spillover from Japan's disaster could be enough to derail the recovery.
Japan is the world's third-largest economy, a major manufacturer and big importer of oil and other raw materials like iron ore. So a pronounced slowdown in the economy would cut demand for key commodities, in turn hurting major exporters. Japan is also a huge player in global finance, buying a lot of sovereign debt. Any move by the Japanese to repatriate significant amounts of capital held in other currencies would have a big impact on bond markets, and could even impinge on the ability of some governments to finance their rising deficits.
The S&P/TSX composite index fell more than 72 points, the Dow Jones industrial average declined 137.74 and the S&P 500 shed another 14.52, its fourth drop in five days. Recent high-flying commodities such as oil, gold, silver and copper also nosedived.
Japan was struggling to get back on a growth track even before the tragic earthquake and tsunami. Now the country could be looking at another two quarters of economic contraction, economy watchers warn. And the government, which already faces the highest debt in the developed world, at 200 per cent of gross domestic product, will have to pile on more debt.
"We expect the Japanese government to produce a ¥5- to ¥10-trillion-sized fiscal stimulus, but with some offsetting reduction in spending or tax increase," Takuji Okubo, the Tokyo-based chief Japan watcher with Société Générale, said in a research note. "We do not think the disaster would materially change the sustainability of public finance, but an occurrence of capital flight is a … risk Japanese policy makers should watch out for."
Mohamed El-Erian, the chief executive officer of Pacific Investment Management Co., also painted a bleak picture, though he believes Japan can navigate the crisis.
"We know that inflation will spike because of shortages and because of supply chain disruptions, and we know that the deficit and public debt are going to increase significantly," Mr. El-Erian told Bloomberg. "Fortunately, Japan is a rich economy, and the private sector has saved a lot."
The Bank of Japan pumped another ¥5-trillion into the financial system Tuesday. This followed a record ¥15-trillion infusion into money markets the previous day and a doubling of the bank's asset purchase program to ¥10-trillion. The moves are designed to stabilize financial markets and ensure that banks, brokerages, insurers and borrowers have access to enough capital to weather the crisis.
The money is particularly essential for banks to continue operating in the devastated northeast region, where severe financial dislocations are likely to remain for months, if not years, analysts say.
"A million people in Sendai will not be paying their mortgages, car payments or credit card bills any time soon," Carl Weinberg, chief economist with High Frequency Economics in Valhalla, N.Y., said in a note to clients. "Companies will not be paying their suppliers or servicing their bank debt. Companies that do not get paid will not be able to pay the people they owe money to."
This is bound to affect Japanese banks' solvency, Mr. Weinberg said, adding that "the extent of the risk is yet to be realized."