Authors: Uri Dadush, Bennett Stancil
Originally published by the Carnegie Endowment for International Peace
The Japanese earthquake is, first and foremost, an enormous human tragedy. Japan’s earthquake precautions are among the most elaborate in the world, but the enormity of the suffering should prompt deep introspection in Japan and in exposed regions across the world about what more can be done to mitigate the effects of such disasters in the future.
Occurring in a geographic area that accounts for about 4 percent of the GDP of Japan (a very rich country), the earthquake destroyed an enormous amount of wealth in a matter of minutes. Available estimates are obviously preliminary and should be taken with a pinch of salt, but, based on the effects of previous earthquakes in populated regions, they range from $125 to $200 billion, equal to 2.5 to 4 percent of Japan’s GDP and less than 1 percent of Japan’s national wealth. While the earthquake is unlikely to spell disaster for the Japanese or world economy, a number of unknowns and risks, beginning with the still-uncontrolled situation at the Fukushima nuclear facility, could worsen the outcome considerably.
The scale of the disaster and its effect on wealth
Both the earthquake and the tsunami that hit Japan were of almost unprecedented magnitude.
Estimates of total economic damage from the disaster are in line with those of previous disasters in rich countries. After adjusting for inflation and exchange rate changes, the cost of the 1995 Kobe earthquake, which occurred in a geographic region of approximately the same economic size and left about 310,000 people homeless, is estimated to be around $100 billion. Hurricane Katrina, which displaced 800,000 people, is estimated to have cost about $140 billion. Based on estimates of 434,000 people being displaced from Japan’s northeast, total damages are likely between $125-200 billion. Natural disasters tend to hit poorer countries hardest. For example much less violent earthquakes than occurred in Japan killed 223,000 in Haiti and 69,000 in Sichuan, China, while a similarly-sized tsunami killed 228,000 on the coasts of the Indian Ocean. The disaster in Haiti, one of the world’s poorest countries, is estimated to have cost between 100 and 200 percent of the country’s $8 billion GDP—at least fifty times more proportionately than the Japan earthquake.
Systematic examinations have found that poor countries are much less able to contain the effect of natural disasters than rich countries: the cost of natural disasters relative to GDP is highest for countries with low literacy rates, large numbers of vulnerable people (as measured by income inequality), weak government institutions, inadequate foreign exchange reserves, and undeveloped credit markets. Japan scores very highly on all these dimensions—for example, its income distribution equality is second only to Denmark and domestic credit to the private sector represents 160 percent of GDP, over three times the global average. It helps that Japan’s buildings are sturdier and built to withstand seismic shocks, its safety regulations are stricter, the government is more accountable, and the country’s financial resources can be quickly mobilized.
What about public finances? Although gross public debt represents 226 percent of GDP, and net debt (accounting for foreign exchange reserves and debt held by other public agencies) is 121 percent of GDP, the Japanese government is still able to borrow at some of the world’s lowest interest rates: its 10-year bonds yield just 1.2 percent in inflation-adjusted terms. This reflects, in part, the fact that nearly all of Japan’s government debt is held domestically and Japan’s public and pension funds appear disinterested in shifting away from Japanese government bonds.
Additionally, rich populations insure more and insurance companies, including international reinsures, will help defray a large part of the cost. Currently, insurance losses are estimated to be between $10 and $60 billion dollars, but the actual figure could turn out to be even higher. Following Katrina, for example, insurers paid out $55 billion (adjusted for inflation), or about 40 percent of the total damages.
The cost of government relief and reconstruction efforts will be large, but even if it amounts to half of the total damage and the sum is deficit-financed, it will increase gross government debt by less than 1 percent—hardly be enough to catalyze a debt crisis, unless one believes that Japan is very near a tipping point. In our view, it is not. Moreover, Japan has over $1 trillion in foreign exchange reserves, which can help fund relief efforts if necessary. If foreign exchange sales are used to pay for reconstruction, however, they may put upward pressure on the yen—which has already appreciated by about 25 percent since 2007—affecting Japan’s competitiveness more broadly.
Effect on growth
Based on these estimates and the anticipated official response, the earthquake’s effect on GDP growth will probably be small. Japan’s growth will be slower for a quarter or two, especially if power is not quickly restored to the affected areas (approximately 8 percent of Japan’s power generating capacity has been lost). But reconstruction efforts should stimulate both demand and output by the end of 2011 and into 2012. A year from now, the change in GDP level from its pre-earthquake path will likely be minimal. Recent empirical evidence supports this conclusion: following a massive earthquake in February 2010, Chile grew by 5 percent in 2010—equal to its 20-year average—and is expected to grow by 6 percent in 2011. Studies have found that natural disasters have little lasting impact on output.
The outlook for the worst-affected communities is less sanguine. While manufacturing had returned to 98 percent of its pre-quake trend eighteen months after the Kobe earthquake in the affected area, only 78 percent of shops had reopened and department store sales were still at only three-quarters of their original level. Other instances present a direr picture. Following a 1992 hurricane in Hawaii, per capita incomes took seven years to return to pre-quake levels.
Risks and global implications
Over the course of the three trading days after the quake, the Nikkei 225 fell by 18 percent, representing a destruction of $600 billion in investor wealth—many times the estimated cost of the earthquake. The global stock market reaction has been less severe, shedding 2 to 4 percent in major markets. Nevertheless, this represents a global loss of nearly $1.6 trillion, though there has been some recovery recently.
If the economic effects of the disaster appear manageable, why are markets so nervous? Partly the gyrations reflect a tendency to overshoot, but they also reflect important unknowns and specific risks that could make matters worse.
In particular, if the authorities fail to bring the Fukushima nuclear incident under control, costs could increase dramatically. It is estimated, for example, that the total cost of the Chernobyl disaster, which occurred in a much poorer region, was a staggering $235 billion; the less-severe partial meltdown at Three Mile Island, however, cost just under $1 billion. According to Carnegie’s James Acton, a nuclear expert, the outcome in Fukushima remains highly uncertain, and therefore it is too early to estimate the final costs.
With the affected region responsible for less than one-third of one percent of global output, the effect of the disaster on the global economy is expected to be tiny. Several effects of the disaster, however, could have more important consequences for specific countries and sectors.
First, in order to support the economy and stabilize markets, the Bank of Japan has injected nearly $700 billion into Japanese banks. These funds—if not quickly absorbed—could contribute to the existing massive liquidity overhang in world markets, with undesirable effects on risk-taking, especially in some overheated emerging markets and in a number of other speculative trades.
Second, the earthquake could disrupt global supply chains in key industries. For example, Japan plays a central role in the production of electronic components, providing over 50 percent of the global supply of silicon wafers, which are vital for computer manufacturing. Although the region affected by the earthquake is a significant producer of manufactures, it is not known whether it is an important source of such critical components.
Finally, with oil markets reeling from the uncertainty in the Middle East, the nuclear incident, which has already prompted a suspension of reactor construction and permits around the world, could further destabilize global oil markets both in the short-term and the longer term. Though oil prices are down—worries that the disaster could slow global growth appear so far to outweigh concerns about energy shortages—sentiment could change quickly. Equities of major nuclear power producers are already down by around 20 percent, while stocks of solar energy providers are up by roughly the same amount.
In sum, although the human impact has been devastating, provided the nuclear incident at Fukushima is controlled, the economic effects of this disaster on the broader Japanese and global economies are likely to be confined and short-lived.
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