The 11 March 2011 Great East Japan Earthquake was the strongest ever recorded in Japan and triggered the country’s worst disaster of the post-war era. The earthquake and accompanying tsunami resulted in an enormous loss of human life, as well as massive economic damage. A preliminary report by the government estimated the damage to social infrastructure, housing and private firms’ fixed capital at between 3.3% and 5.2% of 2010 GDP.

In addition to the usual risks related to the strength of world trade, exchange rates and commodity prices, there is great uncertainty about developments in Japan, including the duration of electricity shortages, the problems at the Fukushima nuclear plant and the size and timetable of government reconstruction spending. Consequently, the timing and strength of an economic rebound is exceptionally difficult to forecast.

The earthquake hit when Japan’s expansion appeared to be back on track following the economic slowdown in the latter part of 2010. The immediate impact of the horrendous disaster is likely to be large, extending beyond the areas devastated by the earthquake and tsunami. Indeed, damage to factories in the Tohoku region has disrupted the supply chains of key industrial products even beyond Japan, notably in the automobile sector. Consequently, the Bank of Japan’s April report downgraded its assessment of seven of Japan’s nine regional economies. However, the experience of past disasters in Japan and other developed countries suggests that the negative short-term impact on economic output will be followed by a rebound as reconstruction spending picks up. Such a pattern is projected to slow real GDP growth to 0.8% in 2011, followed by a pick-up to 2.3% growth in 2012.

The damage to the capital stock, electricity shortages and the disruption of supply chains is projected to significantly reduce output in the second quarter of 2011 (see chart below), although it is likely to be relatively mild compared to the 20% drop (seasonally-adjusted annual rate) following the 2008 Lehman shock. Output is expected to rebound sharply from the third quarter of 2011, driven by reconstruction-related fixed investment:

- The downward trend in public investment will be reversed by government reconstruction efforts, which are assumed to amount to 5.6 trillion yen (1.1% of GDP) by the end of 2012. One-half of this spending takes place in CY 2011 (see the box below on the fiscal assumptions).

- Business investment is expected to increase sharply beginning in the third quarter as firms replace or repair equipment damaged in the earthquake and tsunami.

- Residential investment also picks up rapidly to rehabilitate or replace the housing damaged or destroyed in the March disaster.

In contrast to fixed investment, private consumption is projected to remain relatively subdued during 2011, reflecting weaker household confidence, as occurred following the Kobe earthquake, and the impact of measures to finance reconstruction spending without increasing government borrowing. In addition, with electricity shortages likely to continue through the summer, the electric utilities have asked consumers to conserve energy and some stores have shortened their opening hours. Consumers may also scale back conspicuous consumption. As reconstruction spending and residential investment gain momentum, private consumption, particularly for consumer durables, is likely to strengthen in 2012.

An extended downturn is thus unlikely. On the external side, there have been signs of a pick-up in trade in the Asian region, which accounts for 56% of Japanese exports. In addition, several domestic factors that were apparent in early 2011 prior to the earthquake will continue to have a positive impact on activity. First, the fiscal stimulus packages launched in the autumn of 2010 will support the economy in the first half of 2011. Second, the labour market had improved markedly by early 2011, as shown by the rise in the job-offer-to-applicant ratio from its trough of 0.43 in 2009 to 0.62 in February 2011.