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“Here we are folks, days away from the next round of the mega-fight between Japan and the ‘dreaded recession’…”

Let’s take a look at the rankings – for a long time, Japan economy’s was ranked as the 2nd largest economy in the world. Last year, Japan had a total output of about $4.3 trillion while in 2007, Japan contributed about 6.6% of the WORLD’s total gross output.

Despite Japan’s “premier” status, the global recession is really weighing down on the nation. For one, its GDP was reported to have narrowed by an annual pace of 15.2% during the second quarter of the year. Secondly, Japan’s exports slumped 40.9% year-on-year in May. In addition, the ‘pearl of the orient’s’ debt/GDP ratio is expected to reach 170% by year-end!

Apparently, Japan’s shipments to China did little to offset the downturn in exports to the US. Economists say that with Japan’s heavy dependence in US consumer demand, Japan has to wait for the US to emerge from the ruins before seeing an uptick in exports. Also, to keep in line with the downturn in exports, industrial production took a couple of steps back as it failed to meet expectations of a 7.1% increase in May. Business outlook is clouded with pessimism as the Tankan manufacturing index lingers in the negative zone.

Furthermore, Japan’s retail sales also slid by 2.8% from the prior year in May – the 9th consecutive monthly decline. Worsening labor market conditions aren’t helping the situation either. The nation’s unemployment rate has risen to 5.2% in June from a low of 3.8% in November 2008. Job security is being put at risk. It is therefore understandable that consumers save their money than spend it on new gadgets and fashionable clothing.

It seems like a vicious cycle is at play here. When unemployment rises, people start saving, which causes consumer demand to fall. In turn, firms are forced to cut its production and, therefore, its labor force as a result. This leaves the Japanese economy to keep taking hits to the head and the body.

Furthermore, the Organization for Economic Co-operation and Development (OECD) sees Japan’s GDP to fall steeper by 6%. Here, tax revenues would fall to only ¥30 trillion, thus, the need for further debt issuance which will amount to at least ¥60 trillion to help fund the government’s projected spending of ¥90 trillion. Japan’s debt would now be taller than Mt. Fuji! Even if the government decides to use all of the country’s output in a year to pay for its debt, it would still fall short by 70%!

What does the Bank of Japan (BoJ) say in the face of all this? Curiously, in its last statement, the bank upgraded its view on the Japanese economy for the second month. There has been some good news, as exports and factory production increased in March and April due to revived demand in China. Consumer confidence likewise rose to a 10-month high in April. Was the BoJ trying to work the crowd by jumping for joy on “not-as-bad” data?

Given all these economic factors, the upcoming BoJ economic forecast would probably keep its upbeat tone. The thing with Japan is that their currency is under heavy political influence. Bank officials and the Japan’s Ministry of Finance (MoF) have the tendency to talk down the yen whenever it gets too strong compared to other currencies. Verbal intervention, as traders call it. A weak currency makes a nation’s exports more affordable to foreigners… And, given Japan’s robust export industry (more than 40% of their economic activity), it’s easy to understand why they do this.

So what’s been happening to the yen during this fight? From March to May, we saw stocks and higher yielding currencies rise strongly on sentiment that a recovery was at hand. The euro and pound rose steadily, while the com-dolls also experience a nice boost. What happened to the yen? It fell… which was probably what the BOJ wanted.

Lately, despite the poor state of the economy, the yen has appreciated as risk aversion is driving traders towards safe haven currencies like the US dollar and the yen. Will the BoJ try to stop its momentum? Are the BoJ and the MoF trying to take advantage of today’s risk driven foreign exchange market? Will an upgrade of their economic forecast drive the yen lower versus higher yielding currencies? We’ll never know for sure but it’s certainly an angle to consider…. especially given the Japan’s colorful history of verbal currency manipulation.

With the BoJ having kept rates at an all time low, it is difficult to see what surprises the BOJ has in store. Watch out for the BoJ to switch to a southpaw stance and find creative ways to help stop the bleeding. For the mean time, let’s see whether the BoJ can escape the trap in the corner and stall till the end of the fight before it gets knocked out for good.