JETRO, 1221 Avenue of the Americas, NYC, NY 10020August 23, 2003

Over the past decade many observers have doubted whether Japanese government and business leaders were ready to introduce the dramatic and painful actions necessary to achieve a sustainable economic recovery in Japan.

Investors are now, however, aware of the changing dynamics taking root in Japan. They are also more cognizant of the determination of Japanese leaders to restore sustainable economic growth. This shift in sentiment is a positive change and marks an important evolution in thinking.

In light of the rise in Japanese equity indices seen in recent months, investors now seek to determine whether this appreciation reflects improving fundamentals or is simply the result of a cyclical upturn. The answer requires a better understanding of the scope of, and Japan’s ability to deal with, its underlying problems.

This includes the ability to deal with non-performing loans, improving corporate governance and the environment for corporate reorganization and overcoming deflationary pressures through stronger consumer and industrial demand.

To help investors and executives to better understand these issues and the barriers that need to be addressed, The Japan External Trade Organization (JETRO) provides the following information examining these issues in greater detail.

It remains to be seen whether the rising interest and appreciation in Japanese equities over recent months reflects a sustainable improvement in Japan’s fundamentals or a temporary cyclical upturn. This question at least partially reflects the indecisiveness seen in Japan’s benchmark Nikkei 225 Index over the past month. After reaching intra-day highs of 10,000 in July – a 30%+ move off its April low – the Nikkei entered a period of consolidation. It then began to rise and at the time of this writing closed over 10,000 – for the first time since August 2002.

While the direction and pace of future movement in the Nikkei is not yet clear, investor concerns and their view toward Japan is changing. This includes an evolution from a paradigm based on doubts whether Japan is willing to commit itself to reform, to one that concerns itself with Japan’s ability to overcome the obstacles necessary to restore sustainable growth

• Can Japan Resolve its Serious Non-Performing Loan Problem?
  
  One of the most critical problems facing Japan is its non-performing loan (NPL) problem. This is a truly daunting obstacle. While the Bank of Japan (BOJ) estimates the cumulative NPL disposal of all banks from FY1992-2001 stood at about 90 trillion yen, with an additional 11.17 trillion yen disposed in FY 2002, it is officially estimated that about $369 billion in bad loans remained as of March 31, 2003. This is equivalent to about 8% of Japan’s GDP, far surpassing the U.S. savings and loan crisis in the early 1990s and some fear these official estimates understate this problem.
  
  Compounded by Japan’s greater reliance on commercial loans in comparison to the U.S., which has more developed capital markets, the process of financial intermediation has been impaired. Major banks and small financial institutions have become risk-adverse, facing the need to strengthen balance sheets and reserves, rather than to make new loans. Finally, Japanese banks have traditionally held large equity shareholdings in their portfolios. This makes them reluctant to take actions that might result in bankruptcies, as it would force them to write down their holdings – further expanding this serious problem.
  
  This has resulted in a tendency to provide these "zombie companies" with sufficient funding to keep them alive to service debt, but without the means or pressure needed to restore their competitiveness or to redistribute their assets to those who can use them more efficiently.
  
  Unlike the U.S., however, which relies on foreign inflows to service ever-rising debt loads, Japanese NPL's are almost totally self-financed. Japan remains the world’s largest creditor, holding over ¥175 trillion in net foreign assets. Its current account balance totaled almost $110 billion at the end of March 2003 -- compared to a U.S. deficit of approximately $510 billon. Therefore, this problem can be resolved domestically. It will not require the protracted negotiations with foreign creditors that have often hampered other countries who face this problem.
  
  Resona Recapitalization Marks Major Advance in Resolving Japan’s NPL Problems
  
  One major development this year was the government’s move to inject approximately $17 billion of public capital into the Resona Bank – the fifth largest by asset size in Japan. In addition to raising Resona's capital adequacy ratio to more than 12% -- far above the 4% required -- stricter conditions were imposed than in the past. Senior managers were changed and shareholders forced to suffer a dilution of their equity stakes.
  
  U.S. Ambassador to Japan Howard H. Baker, Jr., commented on the Resona recapitalization in an August 6th article in The Daily Yomuri, stating “Enforcing the principles of management and shareholder responsibility will improve operational incentives at Resona and at other banks.” He further noted “The government's action on Resona increases my confidence that Japan can look beyond the narrow special interest ... It is also a sign that Japan is starting to harness the enormous resources at its disposal to forge a brighter future.”
  
  IRCJ Sets Off Moves by Banks & Buyout Firms that Accelerate Restructuring Process
  
  Another positive development was the launch of the new Industrial Revitalization Corporation of Japan (IRCJ) this May. The IRCJ has been tasked with purchasing the nonperforming debt of, and providing support to, struggling companies that demonstrate an ability to reorganize themselves in three years. While critics charge the IRCJ has been slow to embark on its mission, it is now conducting due diligence, with hopes of announcing its earliest targets as early as the end of this month.
  
  The implicit threat of IRCJ involvement, however, is already giving rise to a renewed impetus by banks and firms to begin redoubling efforts to resolve their financial difficulties. Sumitomo Mitsui Bank’s announcement that it is planning to transfer NPLs to a turnaround firm established with Goldman Sachs might be seen in this regard.
  
  Many analysts believe the combination of a more positive forecast for the Japanese economy, along with moves by the IRCJ and banks to dispose of NPLs will also lead to a rapid acceleration in M&A and other corporate financing activities.
  
  For example, U.S. buyout firm Ripplewood Holdings announced Japan’s first major leveraged buyout on August 21st - a $2.2 billion acquisition of the fixed-line business of Japan Telecom Holdings, Co. In their coverage of this anticipated transaction, the Wall Street Journal noted “For bankers in Tokyo, this is a watershed deal ….generating nearly as much excitement here as Kohlberg Kravis Roberts & Co. in New York… when it took over RJR Nabisco … a … transaction that woke the world up to the immense potential of LBOs.”
  
  Eric Lucas, who runs the Tokyo-based office of buyout firm Babcock & Brown LLP, commented in the Wall Street Journal on the implications of this transaction noting “I'm hopeful Japanese equity will follow this example. …. If this spurs the acceleration of … similar deals, it will be good for the economy.”
  
  Japan’s FSA Requires Troubled Banks to Submit Business Improvement Plans
  
  Finally, Japan’s ongoing effort to accord top priority to resolving NPL’s is reflected in the August 1st announcement by Japan’s Financial Services Agency (FSA) that it will require 15 banks and other financial institutions who have received public funds to submit business improvement plans by August 29, 2003. If these banks do not show a clear improvement by the end of March 2004, the FSA is prepared to seek the resignation of senior management and to initiate strong actions that will effectively nationalize these institutions. The business improvement plans required by the FSA will contain projections of gross and net profit, as well as measures to repay the public infusions that have been made.
  
  
• Can Japan Allow Bankruptcies & Continue to Enhance Corporate Governance?
  
  While an efficient and facilitated bankruptcy and reorganization process is vital to developing a vibrant and dynamic business environment, the need to maintain a social and institutional consensus is also essential. As seen in the growing concern over the “jobless recovery” currently taking place in the U.S. this is not an easy task.
  
  In spite of the pain that is an essential part of the reform process and a once unthinkable unemployment rate that has exceeded 5% since 2001 -- and which averaged 9.3% in 2002 among 20-24 year olds entering the work force -- Japan continues to introduce regulatory reforms that facilitate this unfortunate, but necessary, transition.
  
  One of the most important developments in this regard were the dramatic changes made to Japan’s commercial code last year. These include measures to strengthen boards of directors, and to otherwise empower the ability of shareholders to exercise their rights.
  
  Corporate change has been further facilitated by a shift in the shareholder base of listed Japanese companies. Japanese businesses and financial institutions excluding trust banks once held approximately 60% of shareholder equity. Today, approximately 40% is held by retail and foreign investors, 40% by businesses and financial institutions and 20% by pension funds and investment trusts.
  
  Investors are also helped by recent changes in disclosure requirements. Companies listed on the Tokyo Stock Exchange and some other domestic exchanges were formerly required to release earnings every six months. Now they must do so on a quarterly basis.
  
  Japanese Firms and Investors are Still Adjusting to the Latest Regulatory Developments
  
  Regulatory change in Japan over the past few years has indeed been far-reaching. New infrastructure has and continues to be put into place, yet it is fair to say Japanese firms, shareholders and other parties need to adjust themselves to this new corporate dynamic. One case that illustrates the paradox between the “old” and “new” Japan is the effort last year by M&A Consulting, Inc., the largest shareholder of apparel maker Tokyo Style, to initiate a proxy fight to require a stock buy-back and larger dividend payment.
  
  This effort ultimately proved unsuccessful, yet Japan is likely to see many similar efforts in the future. M&A Consulting president Yoshiaki Murakami commented on this need in a recent Nikkei Business Daily interview stating “If shareholders who ‘speak out’ such as foreign investors and corporate pension funds, increase their presence, Japanese companies will be forced to change their management policies.”
  
  Executive Managing Director Tomomi Yano, of the Japanese Pension Fund Association, also stressed the need for more shareholder activism in another Nikkei interview. He noted “Management at a company which … failed to pay a dividend for the third straight year, or which posted a loss for the fifth year in a row should see themselves disqualified … We will vote against a reelection of such executives ... and demand payment of their compensation be cut or suspended.
  
  This type of thinking is very new in Japan and promises to increase over time. One can already see far more attention being paid to the development of risk ratings services and in the growth of Japanese and foreign legal and accounting firms who are positioning themselves to provide the sophisticated services needed to operate in this changing environment.
  
  Corporate Bankruptcies in Japan Declined Over the First Half of 2003
  
  Corporate bankruptcies in Japan declined during the first half of 2003. There were 8,984 cases during the January-June period -- the first time in four years that bankruptcies came in below 9,000. Significantly, job losses associated with bad loan write-offs have been estimated at between 50,000-70,000. This is far less than the 1.7 million workers anticipated two years ago by Japan’s Cabinet Office.
  
  A recent Teikoku Databank report noted bankruptcies in July dropped 23.7% from a year earlier to 1,384 cases. The debt of bankrupt firms also continued to fall, totaling approximately $5.9 billion -- a 41.8% drop from FY 2002 and 14.1% below June's total. This was the fourth straight month under one trillion yen. Sectors including manufacturing, retail and services saw their lowest monthly failures of the year. Teikoku attributed the fall to restructuring efforts by struggling firms, as well as an expansion of lending to small and medium-sized enterprises by government-affiliated financial institutions.
  
  Some analysts criticize this data claiming Japan continues to rescue troubled borrowers rather than let them fail. Teikoku Database wondered about this phenomenon stating "We still think it is difficult to say ... Japan has entered a sustainable recovery...and … still do not see strong impetus coming from … capital spending and private consumption". Teikoku further noted Japan needed to prepare itself for increasing numbers of bankruptcies noting their belief "The current drop in bankruptcies is not due to an elimination of a potential crisis, but rather to a postponement of that crisis."
  
  Other analysts credit improvements in the Japanese economy. For example, Lehman Brothers economist Matthew Poggi was recently quoted stating "It probably does have quite a good deal to do with the pace of growth we're seeing … It's a bit of a lagging indicator, but we are now six quarters into this upswing, so it makes sense that starting this year we would begin to see a decline in bankruptcies.”
  
  It is too early to tell whether this fall in bankruptcies will prove sustainable. Japan continues, however, to recognize that further restructuring and reorganization is both desirable and essential. That is why it is taking care to prepare itself with the regulatory tools needed to facilitate this process. This includes retraining programs and a stronger social safety net. Attention is also being paid to educate the public. This can be seen in the ever-expanding constituency in Japan that acknowledges and supports reform.
  
  It is too early to tell whether this fall in bankruptcies will prove sustainable. Japan continues, however, to recognize that further restructuring and reorganization is both desirable and essential.  That is why it is taking care to prepare itself with the regulatory tools needed to facilitate this process.  This includes retraining programs and a stronger social safety net.  Attention is also being paid to educate the public.  This can be seen in the ever-expanding constituency in Japan that acknowledges and supports reform.
  
  
• Can Japan Restore Domestic Consumer and Corporate Demand?
  
  Consumer optimism eroded sharply with the collapse of Japan’s “bubble economy" in the early 1990s. Combined with its traditional higher propensity to save, Japan lacked the strong consumption orientation that fueled the 1990s boom in the U.S., and over the past decade endured a series of recessions from which it has not fully recovered to this day.
  
  The rise of economic growth to an annualized 2.3% in the second quarter, the higher consumer confidence reported in Tokyo this summer and over the past seven quarters, and the 14.1% surge in reported job vacancies in June over a year ago -- hopefully marks the beginning of a reversal of this trend. Similar sentiment is reflected in growing capital investment over five consecutive quarters. As seen in the U.S., however, lower prices and greater competition are an inevitable byproduct of globalization. They also serve as a force that must be endured by every nation that seeks to maintain an open economy,
  
  Ongoing deregulation, restructuring and reform on both the national and firm level will help Japan to meet this challenge and over time to enhance its overall competitiveness. This is certain to further alter the face of the Japanese economy and to create a whole new range of winners and losers, who will respond with consumption and investment patterns in accordance with their achievements.
  
  It will also serve to reconstitute demand in Japan to a level that befits the world's second largest economy, and to hopefully over time restore its place as an engine of growth in a global economy that has been too reliant on consumption in the United States.
  
  The divergences that will be created constitute attractive business and investment opportunities and foreign investors and companies, who have more experience dealing with this type of environment, are in an ideal position to profit as a result.
  
  

While it is too early to suggest a sustainable economic recovery has taken hold in Japan, it is fair to note Japan’s prospects look far better than what has been seen in many years.

As the world's second largest economy, Japan represents one of the few markets in the world with the size, depth and liquidity needed to provide investors with a credible source of diversification and potential growth in an uncertain global environment.

The recent influx of investment funds into Japan and the resulting appreciation of its indices provide two indicators that investor perceptions are changing. This includes a growing acceptance that Japan is actively moving to promote economic recovery and that its attractiveness as a venue for direct and portfolio investment is dramatically improving.

To sustain this progress, however, Japan needs to continue to address its underlying problems. This includes the resolution of non-performing loans, facilitating stronger corporate governance, reorganization and the bankruptcy process and restoring consumer and domestic demand.

By facing these issues directly and moving forward carefully in a manner that will maintain the social and institutional consensus necessary to manage a credible solution, Japan hopes to maintain the movement that will lead to an ongoing recovery.

To date, the outlook appears quite promising and investors who increased their exposure to the Japanese market in recent months have been handsomely rewarded. While continuing monitoring, investigation and evaluation is clearly warranted, investors are advised to begin paying more attention to Japan and the many attractive opportunities that are emerging.