Reprinted with permission of AsiaTimes

Japan: The light at the end of the tunnel?

By John Berthelsen

For 13 years, as Japan has struggled from one economic calamity to the next, financial analysts, bankers and investors have been waiting to hear five words: "The economy is turning around." Like the light at the end of the tunnel, which periodically used to appear to the Americans in Vietnam only to go dim again thereafter, however, there have been plenty of false starts.

Now the Japan External Trade Organization New York (JETRO NY) is hearing those sweet words again and has produced a study saying that "Businesses and Investors Perceive a Change in Japan's Economic Prospects".

The study seems surprisingly even-handed for being produced by a government organization, but it may not be even-handed enough. Japan has enormous structural difficulties that are not going to be solved by the rise in the Nikkei, Japan's benchmark stock index, or by a pickup in exports as the US economy starts to recover and US consumers again seek Japanese consumer goods.

Nonetheless, for the first time in years, JETRO NY says, Japanese companies and the government have not met the end of the fiscal year in March by artificially ramping stocks to protect banks and investors from having to write down the value of their portfolios. After an initial fall, the Nikkei has risen more than 20 percent, which is faster than the Dow Jones index over the past 10 months.

" Whether this performance will prove sustainable or accurately reflects current fundamentals remains to be seen," JETRO says. "While Japan has achieved real progress in implementing structural reform and other measures that are helping to improve efficiency and the overall competitiveness of the Japanese economy, much remains to be done and markets rarely move in linear fashion.

" What is clear, however, is that businesses and investors are beginning to recognize the inherent value that lies within the Japanese economy and they are starting to take steps to position themselves accordingly."

For example, the study quotes Credit Suisse First Boston (CSFB) global equity strategist Andrew Garthwaite as recently advising investors to change the amount of Japanese equities in their portfolios from a 12 percent underweight to a 2 percent overweight position. Taking a similar but slightly more cautious view, Merrill Lynch Japan has upgraded Japan in a global portfolio to "neutral" from "underweight" as a hedge on the world economic recovery. Portfolio investment funds into Japanese equities have been positive for five of the last six weeks.

In addition, the Bank of Japan's Tankan survey of major companies, released last month, showed that large Japanese companies have become less negative over the past few months. The Tankan measures the percentage of companies saying business conditions are better, minus the percentage saying things are worse. The headline index has been in negative territory since March 2001.

Changing investor and corporate sentiment toward Japan can be viewed as a net positive, JETRO says. "However, this optimism should by no means be interpreted as a sign the nation has overcome the many difficulties and risk factors that must be addressed to achieve a sustainable recovery."

Indeed. For one thing, deficit spending has pushed Japan's national debt to truly frightening levels. According to the Ministry of Finance, gross debt stood at 143 percent of gross domestic product (GDP) at the end of fiscal year 2002, not including sizable amounts of off-budget, non-government bond debt, as opposed to 58.9 percent in the United States. The only government that came even close in the industrialized world is notoriously spendthrift Italy, at 106 percent.

According to the Organization of Economic Cooperation and Development (OECD) Economic Outlook issued in June 2002, the fiscal deficit in Japan in calendar 2002 was 8.0 percent of GDP on a general government basis, and 8.4 percent excluding social security funds, by far the worst deficit among major advanced countries. Prime Minister Junichiro Koizumi has been unable to make much headway in reducing either.

Japan's Ministry of Finance, which sometimes seems to bear a pathological antipathy to inflation, is also threatening again to charge higher interest to government-affiliated institutions. Higher interest rates would place a greater strain on the debt loads of Japan's already strapped borrowers and would threaten any nascent recovery unless they are carefully managed. But, while many believe higher interest rates may serve as a constraint on Japan's economic prospects, the sentiment is mixed, JETRO says.

This can be seen in the July 10 comments of Morgan Stanley chief investment officer John Alkire in the Financial Times, who noted his belief that higher rates could boost the Japanese economy, stating: "Consumption will rise because savvy individuals will stop hoarding money and lock in ultra-low fixed rates for large-ticket items such as mortgages and real estate."

Japan's seemingly endless round of deflation, compounded by weak economic growth since 1990 when Japan's stock-market bubble collapsed, has restrained consumer spending, leading businesses to cut back their spending. While the Tankan survey suggests this may be about to change, it is not clear whether consumer and business demand will expand sufficiently in the foreseeable future to constitute a source of sustainable growth.

Nonetheless, as JETRO points out, Japan's consumers are not particularly parsimonious, as can be seen in most of the high-end shopping malls of Southeast Asia, where Japanese tourists continue to sample the Louis Vuitton and Gucchi. Per capita consumer expenditures in Japan are the same as in the United States. And Japan remains the world's second-largest economy, which accounts for 15 percent of the world's total GDP - about four times the size of China, which gets all the ink.

Optimism is also reflected in the Japanese cabinet's "Economy Watchers" survey, an index measuring sentiment among restaurant owners, taxi drivers, and other small business and service workers who are in a sense leading indicators of consumption trends, JETRO says. The index rose 3.7 points to 42.1 in June from the previous month. As with the Tankan results, one must maintain caution when evaluating this statistic, as while representing a real improvement, a reading below 50 still means more people say they are worse off now than three months ago.

One of the biggest questions remains whether Japanese companies, so nimble in developing consumer electronics and other goods for international markets, are ever going to be able to alter their traditional business practices. JETRO says there are signs that companies have begun to recognize the need for change. Some US and other foreign companies believe a transition is taking place, partly engendered by the fact that multinationals are increasingly buying into Japanese companies and changing their corporate architecture.

Citigroup now has more than US$8 billion in equity capital invested in Japan. WL Ross recently purchased Osaka-based Kansai Sawayaka Bank. Nissan has been revitalized by Renault of France. Kenwood, the audio-equipment maker, is restructuring on its own and recently posted its first consolidated profit in four years after having spun off money-losing divisions, as did NEC Corp, one of Japan's biggest semiconductor companies.

The question is whether Japan can sustain the budding movement toward economic reform. Many difficult issues remain to be resolved, JETRO says, including the ability to clean up bad loans and restore the health of Japan's financial system, to promote the dynamism of new businesses, start-ups and technology development as well as labor flexibility and the issues presented by an aging population.

In addition, Japan launched the Industrial Revitalization Corp of Japan in May to begin finally to purchase non-performing debt and transform Japan's so-called zombie companies, as the United States did promptly by creating the Resolution Trust Co during its savings-and-loan crisis of the mid-1980s to buy up dud assets, convert them to equity and sell them off. The IRCJ, as it is called, has a five-year mandate before it is to be dissolved. It expects to use public funds and technical assistance to nurse at least 100 companies back to health and reorganize them.

However, other observers point out that the IRCJ - which has gotten under way a full decade after the magnitude of Japan's problems became apparent - has yet to find a single company to rescue and many think it probably won't, because of the magnitude of debt and inability of the system.

The government's injection of 2 trillion yen ($16.8 billion) in public funds into Resona Holdings, Japan's fifth-largest bank, was an unprecedented move that shocked Japan's banking community and was the country's first effective nationalization of a banking institution. JETRO says the move was handled professionally and expeditiously and managed to avoid a deposit run. Nonetheless, the scale of Japan's banking problems virtually defies solution. Japan's banks have an estimated $3 trillion in non-performing loans and possibly much more on their books.

The government has also set up 117 special zones for structural reform, JETRO says, which provides local governments with the ability to obtain waivers from national regulations to aid in their own economic development, with such examples as establishment of a more diverse educational curriculum, around-the-clock customs clearance for importers and exporters, accepting credentials for foreign medical professionals in target industries such as biochemistry.

Nonetheless, JETRO itself recently conducted a survey of 449 foreign-affiliated companies in Japan on the country's inherent strengths and potential. The results were disheartening to say the least. Some 41 percent expect that it will take yet another three to five years for the economy to recover and an astonishing 27 percent think it never will. Some 43 percent do think opportunities are arising in their own businesses, however.

It is tempting to go with the 27 percent. Japan's politicians are completely in the thrall of the construction industry and have responded to the economic downturn with wildly inappropriate pump-priming projects that have virtually destroyed the country's environment. Hardly a streambed in Japan remains unpaved. There are roads and bridges to nowhere, airports where no airplanes land.

Japan got rich by manufacturing high-quality consumer goods cheaply and selling them primarily to the Americans. With the Plaza Accord of 1983, which engineered a dramatic downward drop in the US dollar, the country had too much of its manufacturing plant offshore to cheaper sites. Free-trade zones across the planet pop up in ever-cheaper countries as one after another seeks to beggar its neighbor.

Japan's inability to restructure its industries and its banking system has left it at the mercy of the tiger economies and, after the tiger economies, even less-expensive ones. In addition, it is beset with serious demographic problems from a rapidly aging population and a lack of young people to revitalize its society.

Nonetheless, JETRO says, continuing movement toward restructuring, reform, business revitalization and deregulation promises over time to provide increasing ongoing evidence of Japan's progress, and commitment, to achieving a full economic recovery. "With this in mind, corporate and portfolio investors would be wise to devote more attention to current trends in Japan, to determine how they effect, and potentially benefit, their own investment and business development decisions."

Piece of cake.

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