Greek crisis and China's stock market turmoil could have a significant impact on Japan's economic situation

The Greek crisis and the turmoil in China's stock markets could have a significant impact on Japan's economic and inflation situation, depending on how things develop. However, there is a good chance that QE from the ECB (and an increase in that QE is necessary) will largely prevent the crisis from affecting other countries in the euro zone. In addition, there has been considerable improvement in the US and Japanese economies. In light of the above, the most likely scenario is that the impact on the Japanese economy will be relatively limited. 

"We had previously simulated the impact of the European debt crisis on the Japanese economy under three different scenarios. We believe the current conditions are likely to be closest to the scenario showing a limited impact. If the impact from the Greek crisis is limited largely to the EURJPY rate, we expect roughly a 0.1ppt downward impact on Japan's growth rate. But even if there is some impact via indirect channels, such as the USDJPY and capital outflows from emerging markets, we expect a downward revision to growth of about 0.3ppt," says BofA Merrill Lynch.

The potential effects on the economy are greater in the event that financial market disruptions cause the Chinese economy to slow significantly. A 2ppt slowing of the Chinese economic growth would have a 0.4ppt negative impact on Japan's growth rate via a worsening of exports, and if risk-off moves cause roughly a 5% appreciation of the yen at the same time, it would add another 0.3ppt of negative impact. Weaker China growth is also likely to lead to a decline in oil and other commodity prices. A decline in commodity prices would be a positive for Japan's growth because it would improve its terms of trade, but it could have the effect of delaying the point at which the inflation rate approaches 2%. 

Because it looks like China's government and central bank still have the ability to implement policies to deal with these problems, a continued worsening of the Chinese economy is a risk scenario. Nevertheless, for now, the BOJ is likely to keep a close eye on how much longer China's financial markets remain unstable and the extent to which that causes the yen to rebound and commodity prices to decline.