By Scott B. MacDonald

Although there has been considerable discussion about the “beating” that Prime Minister Koizumi’s Liberal Democratic Party (LDP) took in the July 11th upper house of the Diet elections, the economy is in about the best shape it has been since the 1980s. The restructuring of the banking sector (as reflected by the UFJ and Bank of Tokyo-Mitsubishi merger) is moving ahead. Economic growth looks sustainable. This was reflected by the government’s upgrading its real GDP growth forecast to 3.5% from its previous estimate of 1.8% for the year to March 31, 2005. Moreover, Japan’s economy expanded at an annualized rate of 6.1% in the first three months of the year, the strongest among major industrial countries.

We think the current growth pattern is sustainable – at least through next year. Beyond that our outlook is more cautious. The Japanese economy initially gained momentum from exports. It then benefited from corporate capital investment, with personal spending providing the last stimulus for growth. Ongoing strength in world trade and steady increases in domestic demand as well as some improvements in the labor market should provide the foundation for next year’s expansion. It will also help bring deflation to an end.

Yet, Japan still faces substantial challenges. These include the fall in land prices (still going on outside of Tokyo), weak bank lending, the ongoing challenged nature of many regional banks, and the potential for the Chinese economy to hit a hard landing. The last is important considering that China is a major factor in the strong expansion of exports, accounting for two-thirds of the rise in 2003. There is also the problematic nature of government’s finances – the fiscal deficit was 8% of GDP in 2003 and is expected to decline to 7.1% in 2004. Public sector debt reached a massive 144% of GDP in early 2004.

Considering the pluses and negatives of the Japanese economy, it can be said the short-term is positive, but the long-term is harder to forecast. Government finance is a major concern. According to the Organization for Economic Development and Cooperation (OECD), public sector debt is projected to surpass 160 percent of GDP this year. Related to this is the ability of the Koizumi government to continue its economic reforms. There remains considerable work – deregulation of agriculture, medical services and education, reform of the postal bank system and restructuring regional banks.

Ongoing and broadening economic growth means an eventual return of inflationary pressures. In turn, the Bank of Japan will at some point have to abandon its zero interest rate policy and raise rates. If done too quickly, a number of large companies that are struggling would be plunged into having serious problems. If so, that could once again cause problems in the banking sector.

Koizumi (and the return of global growth) have helped put the Japanese economy on the right track, but much more work is required. That requires strong political will. Along these lines, we fully agree with the OECD’s assessment: “Over the longer term, failure to press ahead with structural reforms would limit Japan’s growth potential.” More significantly, failure will limit Japan’s future, holding the door open to a possible major economic crisis linked to massive public sector debt. Having survived the July 2004 elections, Koizumi has a window of opportunity to push ahead over the next two years, which should be free of any new electoral challenges. The stakes of making further reforms could not be higher. We wish Prime Minister Koizumi well.