"You can't build a car with 97% of the parts"

The title statement summarises the challenge for the global manufacturing sector with Japan's industry and logistics disrupted for an unknown span of time.

Power shortages threaten global supply chain

Ford Motor Co., Samsung and The Boeing Co. are waiting for suppliers in quake-stricken Japan to increase one key export: information.

A top supplier of high-end components for the global technology and auto industries, Japan may need weeks to recover output lost as a result of the country's strongest earthquake on record, according to a forecast by Barclays Capital. . . .

“Our production won't be affected this week, but then we'll see,” Volvo spokesman Per-Ake Froberg said.

Supply of batteries, Blu-ray compact discs and magnetic heads used in hard drives also may be affected by the quake and power shortages, according to a report by Taipei research company TrendForce Corp.

“The reality is, the companies don't know the full extent of what's happened,” said economist Kim Hill at the Center for Automotive Research. “You can't build a car with 97% of the parts.”

Damage to ports, railroads, and factories in northern Japan has yet to be fully assessed - not least because engineers, corporate management and insurance claims adjusters have been kept at bay by radiation leaks from the Fukushima crisis-hit nuclear complex. Fuel shortages, power blackouts and disrupted land and mobile communications further stymie any effort to document damage or predict reopening schedules for stalled manufacturing plants. Rolling blackouts occasioned by damage to power generation and electricity grids mean even undamaged industries across the nation are producing less than expected. The scale of human tragedy - with half a million displaced refugees and 21,000 lives lost - mean many workers will be unable to report to work, or too concerned with rebuilding their homes and comforting their families to work more than regular shifts.

We have a highly interdependent, global manufacturing sector for modern goods, particularly high end electronics and automobiles. Japan may only account for 3 percent of the modern product, but it is usually the high value components that will be very difficult to source elsewhere. And as the title suggests, a failure to supply the 3 percent might result in halting production for the rest of the supply chain.

As this week rolls on, and the scale of disruption becomes better understood, I expect a lot of companies worldwide will start evaluating the implications for their operations of a disrupted supply chain. Without more precise information from Japanese suppliers on the expected scale of the disruption, few businesses elsewhere have been able to issue statements on the implications. As the information begins to flow, we can expect more than a few negative shocks about Q2 and Q3 earnings as inventories of parts run down globally.

So far as the media has noticed the issue, concern has been limited to supplies of the iPad 2. We may find that the implications are more serious for our economies than delayed gratification of Apple fans.

Intererestingly, the Japanese companies most directly affected are the only ones likely to be able to claim insurance for business interruption. Companies elsewhere reliant on Japanese-sourced components might have comparable losses, or even greater losses, but have no recourse except their reserves and such corporate finance as might be available in already tight markets.

Magnitude of insurance claims still almost impossible to measure

While analysts and risk modellers are daily raising their estimates of the economic damage, with the latest Barclays Capital estimate coming in at $US185 billion, many insurance experts believe it will be well over $US200 billion.

In terms of insured losses, risk modeller AIR Worldwide estimates it at $US15 billion to $US35 billion.

But some big-name brokers are quietly suggesting it could be $US70 billion, making it one of the biggest losses to the insurance and reinsurance industry.

Claims adjusters have poured into Japan in the past few days trying to grapple with the size of the damages and their clients' exposure, but cannot get near the radiation-affected area. Japanese insurance companies are also being hampered by power cuts in Tokyo that make it virtually impossible for them to appraise the damage.

A growing concern is how the tsunami is covered by general insurance policies. For example, AIR's estimates for insured losses do not factor in tsunami-related damage, business interruption costs or potential losses from nuclear damage.

Adding to the uncertainty of losses and disruption is the likelihood that insurers may contest coverage for some damage or disruption. After Katrina, many hurricane insurers asserted that their policies did not cover flood damage to properties. Similar disputes may arise in Japan where a trifecta of catastrophe has complicated claims assessment. The longer companies are kept from rebuilding and restarting production, the longer and deeper will be the losses for the industries dependent on them for their own operations, production lines and profits.

Inflation and Deflation revisited

In December 2008 I came off the fence and plumped for deflation as inevitable. Mostly I reasoned that debasement of accounting practice, mismanagement of financial intermediaries, captured regulators that collaborated in perpetuating failure, and extremely poor market pricing of risks and fundamentals meant that there was litte incentive to save and no place safe to invest. I predicted that when the last great bubble in sovereign debt popped, deflation would work its cleansing power to restore fundamentals.

It is now clear to me that policy makers in the West are determined to apply every available resource to underpinning failure, misallocation and executive excess. As this discourages the honest saver from parting with cash, policy makers are ensuring that deflation will wreak its havoc on the financial and real economies of the world. Only when that deflation has played out and rational policies that reward market-based management and returns are restored will it be worthwhile to invest again.

The Fed permitting dividend hikes at bailed out banks only deepens my cynicism about the poor quality of regulation and the inadequacy of management controls.

Obviously, I was premature about deflation as events in 2009 and 2010 proved, but I am not convinced I was wrong in the longer term. Events this week in Japan, and political upheavals this year elsewhere, have me thinking that we are at a turning point in many ways. When the numbness that follows such a mammoth series of tragedies wears off, the public in Japan is going to be very angry. They have suffered three great catastrophes in one week: the 8.9 earthquake, the tsunami that swiftly followed, and the failure of safety controls at six nuclear reactors. We still don't know the scale of the final disaster, or what it will mean for the country or the world.

The Japanese state is to be congratulated that strict building codes preserved much of the physical infrastructure from the earthquake, and regular tsunami drills doubtless saved tens of thousands of lives during the tsunami. The most serious failure was in management, risk assessment and regulation of the nuclear industry. The anger will be that an industry critical to the economy, with powerful lobbyists close to government, was able to capture its regulators and erode safety standards until a crisis revealed the tragic short-termism. The anger will increase when the Japanese come to appreciate that the serial depredations of the banking industry have left them over-exposed with few fiscal policy options to meet the financial challenge of rebuilding and resettlement of refugees.

If the government and institutions of Japan are forced to liquidate and repatriate foreign assets, then fears of rising Yen and destabilisation of G7 economies are well founded. I believe it was the collective self-interest in preserving stability that motivated today's central bank interventions. The Yen appreciated 20 percent in the three months following the Kobi earthquake, and the scale of the current disaster - particularly with the risk of nuclear contamination of some part of the country - is likely to dwarf the Kobi effect.

As radiation reaches California from Fukushima today, we might all consider that regulatory capture places us all at some degree of risk. The crisis in California sub-prime real estate was borne by the currents of international finance to the pension funds of Norway and the savings banks of Germany. Both the nuclear energy industry and the banking industry had parallel patterns of political influence leading to regulatory capture and debasement of best practice, and ultimately ruination for a suffering public. It will be interesting to see how much accountability is demanded of management and regulators in the nuclear industry in Japan, and compare this with the lack of accountabiity for serial financial failures and bailouts.

Japan has 20 years more experience of financial sector accounting abuse and bailouts than the rest of us. And the result has been almost continuous deflation - even in the face of mounting deficits, ZIRP and quantitative easing.

Another factor that leads me to fear deflation over inflation is the risk of popping of the great China bubble. My view is that the Chinese economy slowed markedly in Q4 2010 as monetary tightening and administrative regulation of bank lending began to bite, and that the slowing has accelerated in 2011. This view has been confirmed by Gavyn Davies on his FT blog. With another rate rise today by the PBOC, and the supply chain shock of Japan's industrial disruption and power shortages, we could be in for a sharp, deflationary global contraction in the next few months.

UPDATE 20/03/11: Days before quake, plant operator admitted oversight

Days before Japan plunged into an atomic crisis after a giant earthquake and tsunami knocked out power at the ageing Fukushima nuclear plant, its operator had admitted faking repair records.

The revelation raises fresh questions about both Tokyo Electric Power Co (TEPCO)'s scandal-tainted past and the government's perceived soft regulation of a key industry.

The operator of the Fukushima No. 1 plant submitted a report to the country's nuclear watchdog ten days before the quake hit on March 11, admitting it had failed to inspect 33 pieces of equipment in its six reactors there.

A power board distributing electricity to a reactor's temperature control valves was not examined for 11 years, and inspectors faked records, pretending to make thorough inspections when in fact they were only cursory, TEPCO said.

It also said that inspections, which are voluntary, did not cover other devices related to cooling systems including water pump motors and diesel generators.

The report was submitted after the regulator ordered operators to examine whether inspections were suitably thorough.