Japan Benefits from Increasing Economic Integration with East Asia

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Japanese Economy Continues to Show Signs of Recovery and Increasing Strength

After reaching a multi-decade low of 7607.88 last April, Japan’s Nikkei 225 index began to rise, reflecting the collective view of investors that the nations economic prospects had improved. Despite a rise of about 50% since that time – far above the approximately 20% advance in the S+P 500 over the same period – many observers continue to doubt a recovery has taken hold. They prefer to believe the nation has been experiencing one of the temporary cyclical upturns that have taken place in Japan over the past ten years.

Given Japan’s anemic performance since the early 1990s, it is understandable that many do not believe it has entered into a recovery mode. Continuing improvements in the economic indicators, however, suggest that Japan has indeed begun to emerge from its long stagnation. It is by no means certain the corner has been turned. Yet it is hard to argue the present environment does not provide a far healthier base than the one marked by despair and a general lack of confidence that existed only a year ago.

Japan’s GDP grew far more than expected during the last quarter of 2003 -- registering a 6.4% annualized growth rate. Additionally, the Bank of Japan's last two tankan surveys of business confidence provide further evidence that business conditions are getting better. The latest results released on April 1st, produced the highest indicators since 1991 – and the first positive reading -- with more non-manufacturing firms saying business was favorable minus those describing it as unfavorable -- since November 1996. Nonmanufacturing firms include service companies and utilities that are dependent on domestic demand. Therefore, as ING Financial Markets economist Richard Jerram noted in the Wall Street Journal “More confidence among these corporations shows you've got a broadening, deepening recovery." The outlook is also starting to improve for small- to medium-sized firms.

In another sign, credit agency Standard & Poors raised its outlook on Japan last month. Peter Morgan, an economist for HSBC in Tokyo commented on this move in the New York Times noting “(S&P is) … responding to the fact that the economic outlook has improved".

Corporate Restructuring Begins to Generate Positive Results

Further dispelling the notion that Japan is simply in the midst of a cyclical recovery is increasing evidence that corporate restructuring is starting to pay off. Japanese firms, particularly the larger ones, are deleveraging debt and strengthening their balance sheets. They have begun to rationalize human resources, to sell off or close unprofitable businesses, and to take advantage of global efficiencies to reduce their cost structures.

According to the Japanese Bankers Association and Asian Banker Research, over the past fiscal year Japan’s seven major banking groups reduced their combined workforce by 20,000 individuals or 14% and closed 545 branches – nearly 20% of their network. These measures were scheduled for completion by the end of March 2005 and achieved about a year ahead of schedule. This may help to explain why Japan's top four banks, including Mizuho Financial Group and UFJ Holdings Inc., are predicting a combined profit of 1.2 trillion yen for the year ending March 31, compared with a 3.6 trillion yen loss the previous year.

In another example, the Nikkei Weekly reports Omron, a manufacturer of industrial automation controls and electronics is now taking steps to move past a comprehensive two-year restructuring. Having achieved a record 55% rise in profitability following a nearly ¥16 billion two year reduction in personnel costs and sale of non-core assets, Omron is now recruiting new staff and initiating an expansion strategy.

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Japanese Economy Strengthened by Internal as Well as External Factors

Many observers think of Japan as being an export-driven economy. But net exports contributed only 0.4 percentage points to Japan’s real GDP growth during the final quarter of 2003. Business and capital investment during the last fiscal year grew at 5.1% in real terms. The Nikkei Weekly notes that sales of semiconductor production machinery in Japan recently surpassed those in North America for the first time in seven years. It is now the highest in the world. Bloomberg reports Sharp Corp., Japan's largest maker of liquid-crystal displays for televisions and cell phones, will double spending on semiconductor equipment in the fiscal year that began on April 1. Manufacturing investment is also turning up, recording a 15% growth rate -- with the automotive sector at 37.4% being the largest contributor. Mazda Motor Corp., Japan's fifth-largest automaker, announced last week it will spend 13.9 billion yen over the next four years on new software and computers to speed up development of new models and cut costs. Mazda spokesperson Mark Schirmer, explains these actions in a recent comment to Bloomberg that “Our factories at home are running at nearly 100 percent capacity and in the near-term we have no plans to reduce that”. The publishing and printing sector saw an even larger increase in percentage terms of 178.8%. The Nikkei further reports capital expenditures by non-manufacturing firms rose by only 1.1%, though the 39% increase of transportation and telecom firms – who invested in facilities for new cell-phone and wireless services – was masked by spending cuts by construction and real estate firms.

There are Also Signs that Japanese Consumer Demand is Rising as Well

The size and importance of Japan’s domestic economy should not be underestimated. Consumer spending accounts for about 60% of Japan’s GDP, and domestic demand provided the bulk of the growth that was achieved. Portfolio managers are starting to recognize this trend and adjusting their portfolios accordingly. For example Jeremy Hall of Henderson Global Investors, which manages $3.5 billion in Japanese equities, recently commented to Reuters “We think the Japanese economy is going from a cyclical … to a broad-based domestic recovery.”

Recent data indicates Japanese consumers are finally beginning to spend. Bloomberg reports that sales at Takashimaya Co., Japan's largest department store operator, and Isetan Co. are benefiting from improved consumer sentiment. The Japanese government reported last month that household spending had risen for the fourth straight month. Average spending by households of wage earners, a closely watched consumption measure, increased nearly 7% in February. Integrated retail sales data reported by the Bank of Japan also jumped by .9% in February and real household expenditures by 1.3%, both on a year over year basis. One media account quoted Ryo Hino, an economist at J.P. Morgan in Tokyo who noted “This was clearly stronger than expected. The trend, for the first quarter at least, is looking pretty good."

Demand for digital products and appliances have been leading Japanese consumption and show the potential to continue to expand over time. The Nikkei Weekly cited a report by the Nippon Electric Big-Stores Association that sales of DVD players and related devices since August 2003 have been rising 60% over the previous year. In addition, cable TV charges paid by households headed by consumers over 70 years old rose by 33% over the same period.

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Japanese Economy Enhanced Through Stronger Economic Relations with East Asia

One might rightly ask whether the rise in business and capital investment we are now seeing in Japan is entirely positive – especially if consumer demand proves to be unsustainable. When evaluated within the context of the nation’s traditional reliance on export growth to the United States and Europe, this might be seen as problematic. That is because the utilization of this capacity would ordinarily be dependent upon an expansion of growth and consumption either domestically or in these relatively mature markets – which are also struggling with their own economic problems.

While the potential for complications arising from over investment should not be minimized, it can be pointed out the current expansion in Japanese exports is taking place as a result of increased activity in East Asia. China alone is serving as an amazing source of growth. In 2002 its GDP grew by 9.1% and even though it only accounts for 1/30 of the world’s total GDP, last year it consumed 25% of the world’s total steel production, 30% of coal, 50% of cement and 13% of electricity.

In 2003, East Asia accounted for nearly 50% of total Japanese exports. According to the Japanese Ministry of Finance, dollar-denominated exports fell below 50% for the first time since it began collecting this data in 2000. Since July 2001, Japanese exports to China have risen by 117%, and to Association of Southeast Asian Countries (ASEAN) by 34%. Furthermore, the Financial Times reported that the value of Japanese exports to China rose 33.8% in January compared to a year ago, while shipments to the U.S. fell 5.4%. And in February, Japan registered its first trade surplus with China in more than a decade.

A recent JETRO survey of 1,743 Japanese firms operating in 12 Asian countries and regions, indicated these Japanese executives were positive on the prospects for expansion within almost all parts of China as well as Hong Kong, Taiwan, Thailand, Malaysia, Indonesia and the Philippines. This optimism is also reflected in Japanese direct investment trends in the region. In Thailand, for example, during the January-October 2003 period, fixed Japanese investments into Thailand rose in value terms by 62%, many of which were focused on the automobile, electronics, petrochemical and telecommunications sectors.

Japanese Firms Are Moving to Embrace the Challenges of Globalization and Asian Competition

Japan is also exporting substantial amount of consumer products to the region. The Nikkei reports “Chinese demand for color TV’s surpassed that of Japan in the early 1990s, with demand for steel and petroleum following suit in the mid-1990s and 2002, respectively”. Chinese demand for automobiles may also exceed that of Japan by next year. Additionally, anime, music, fashion and other cultural exports are increasingly popular throughout the region.

While many believe products sold in the U.S. and other developed economies need to be altered in China to adjust to lower per capita incomes, this is not necessarily the case. The Nikkei Weekly recently quoted Hironori Uchibori, Senior Economist, Mizuho Research Institute as stating “China is no longer a mere manufacturing base …. but has turned into an active arena for R&D and marketing operations”. He reports Honda, for example, is now “marketing its latest model Accord into China, the same vehicle sold in the U.S. and slightly larger than the version available in Japan. The car, … is marketed to wealthy individuals, and it is said that many buyers have to wait as long as six months before … delivery”.

Regional growth is reflected in another JETRO survey of Japanese-affiliated manufacturers operating in six ASEAN countries and India. It was conducted in January 2004. Companies in which exports account for more than 70% of sales declined to 51.1%. This is down from 58.8% in the previous 2003 survey. This declining importance of exports reflects that companies are responding to increasing domestic demand due to the rising importance and strength of private consumption throughout the region.

Japanese transportation and service firms have begun to position themselves for this activity. All Nippon Airlines (ANA) will be increasing its flights within Asia by approximately 30%. This includes new routes to Hangzhou and Shenyang and code-sharing arrangements with Air China. Sagawa Express operates 70 vehicles in Shanghai, which handle approximately 1,700 packages a day for 2,500 clients. Moreover, recent media accounts have covered efforts by Tokio Marine and Fire Insurance to expand into China. The firm recently received approval to sell life and nonlife insurance products. It invested about $43 million into a wholly-owned unit, and also plans to establish a national branch network through its Sino Life Insurance joint venture. By raising its network of sales agents from 120 to 36,000 individuals, Sino Life hopes to generate annual premium revenues of $1.2 billion by 2008.

The rise of Japanese exports to Asia reflects expanding economic cooperation within East Asia. Direct investment by Japanese companies has been growing rapidly, leading to increased crossborder activity among affiliated companies. For example, from 1990 to 1998, general machinery part exports from Japan to China and ASEAN increased from $0.4 to $2.4 billion and $2.4 to 3.7 billion respectively. Likewise, electrical machinery part exports increased from $0.5 to $3.5 billion and $2.9 to 9.8 billion as well.

It is interesting to view the shift in Japan toward a greater emphasis on economic and production activity in Asia within the context of current U.S. concern over “outsourcing” and the loss of jobs to lower cost offshore producers. Several years ago Japan went through a similar period of anxiety as it struggled to come to terms with the potential threat these competitors represented.

Japanese firms, however, along with their government have come to understand the inevitability of change and are moving to embrace this challenge. Capital equipment and machinery constitute an important part of this trend. One example is the performance of Komatsu .By 2005 it expects to more than double the approximately $400 million in Chinese sales it achieved in 2002. It already has three manufacturing plants in the country and is considering further expansion. Nippon Steel is also operating close to capacity and recently invested ¥45 billion in a joint venture with China’s leading steel producer.

The Nikkei Weekly also reports that Matsushita now has 59 business units in China, including 45 manufacturing facilities. The company has a strong presence in the Chinese appliance market and is now restructuring to enhance operating and financial efficiencies, as well as the ability of affiliated companies to carry out product development, production and marketing in an integrated manner. Matsushita is seeking to raise China-related sales (excluding exports from Japan) to $9.1 billion in fiscal 2006, up from the estimated $3 billion it will achieve during the current fiscal year.

Matsushita has also been active in other Asian locations such as Vietnam. Since it formed its first manufacturing and sales company in Ho Chi Minh City in 1996, Matsushita has been developing its presence. Last year it signed a signed a memorandum of understanding with the Vietnamese Ministry of Planning and Investment and recently established a Hanoi-based home appliances manufacturing and sales company in Thang Long Industrial Park in a joint venture with Sumitomo Corporation. Canon has also ventured into Vietnam through a US$76.7 million ink jet printer plant in Hanoi that was established in 2001 to make Canon products more accessible to customers in Vietnam.

Indonesia has also been attracting the attention of large and small Japanese firms. According to one article by Indonesian Investment Agency BKBM smaller Japanese firms “… are establishing their businesses to be the suppliers of automotive and electronic component, as sub contractors of sogososha like Toyota, Honda, Epson, and Panasonic. However, some of them are self-business, running a small and medium company in consultant sectors, restaurants, karaoke, hotel, furniture, and industrial estates.“

Japanese investment in Thailand has also been growing. Honda, for example, and May 2003 marked cumulative production of 10 million motorcycles within its Thai facilities. Since 1962, when Honda began manufacturing motorcycles in Taiwan, it has since extended its production network to factories in Pakistan, Thailand, Indonesia, the Philippines, India and Vietnam. Currently they produce some 6.4 million motorcycles per year at 10 locations in eight Asian countries.

To expand corporate and investment activity by Japanese firms throughout Asia, government entities, including JETRO and Japan’s Ministry of Economy, Trade and Industry (METI) are moving to strengthen regional relationships and to work toward the development of an East Asia Free Trade Agreement. The leaders of Japan and ASEAN countries decided that the implementation of measures for the realization of this emerging partnership, including free trade agreements, should be completed as soon as possible. As a result, Japan signed its first free trade agreement (FTA) with Singapore in 2002 and is now in enthusiastic and serious talks with the Philippines, South Korea, Malaysia and Thailand.

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Despite Substantial Progress, Japan Still Must Address a Range of Serious Problems

The progress Japan has achieved over the past year is causing fund managers such as David Linehan of Excelsior International, to note in Barrons “I don’t think this is another false dawn” and to stress that evidence the Japanese consumer is spending more as being “the third leg of the stool” in the countries recovery. That said, while the future looks far brighter than only a year ago, Japan needs to maintain its focus on a range of issues that could threaten its achievements. These include:

• Non-performing Loans: The injection of public funds into Resona Bank last year marked a major turning point in efforts to clean up the Japanese banking system. Much more needs to be done, yet the situation today appears far better and more stable than a year ago -- when there was real fear whether a major bank failure might destabilize the Japanese, and even the global, financial system. Today, however, this anxiety has subsided. The question moving forward, however, is with the imminent danger having passed whether Japanese banks will retain the same sense of urgency and dedication to resolving their problems. This is necessary to achieve the 50% reduction that has been targeted by Japan’s Financial Supervisory Service by March 2005. Dow Jones recently quoted several leading Japanese bankers who testified on this issue at Japanese Diet proceedings. For example, Shigemitsu Miki, president of Mitsubishi Tokyo Financial Group Inc. commented "We're in sight of the goal of halving the bad loan ratio as set by the financial revitalization program". Dow Jones notes the bad loans of Japan's seven major banking groups totaled ¥18 trillion ($165.5 billion) as of Sept. 30, down 13% from ¥20.8 trillion six months earlier. Restructuring efforts by these major banks also gives further credence to efforts to rationalize their financial structure and competitiveness.
  
  
• Consumption: Spending by Japanese households rose for a fourth consecutive month in February. Sales of stores in Tokyo rose .3% in February over the previous year and most major retailers are more confident about their prospects. In Barrons, David Linehan of the Excelsior funds noted he is moving to act on this trend highlighting the reversal of the "long and arduous decline in (Japanese) retail sales” and that “this is a very significant turn for the psychology of the Japanese market." While it is hoped these trends will continue -- it is too early to make definitive forecasts. Many people remain nervous about the future and economists debate whether the deflationary forces that have been impinging upon consumption will continue to ease. Furthermore, per capita salary levels in Japan have been declining for eight months in a row. This means that households are tapping into their savings rather than relying upon increases in income to fund the expansion in consumer spending we are now seeing. As Mamoru Yamazaki, chief economist at Barclays Capital Japan Ltd noted to Bloomberg News “It's still a bit too early to say that domestic demand has recovered, but we're definitely starting to see signs that it has”. In another hopeful sign, however, Japanese listed real estate investment trusts – which might be seen as indicators of consumer and economic confidence, have begun to outperform the broader Nikkei Index. From last October until late February, the QUICK REIT index has risen by 8.5% and the Nikkei by 2.9%. As one financial manager commented in a Nikkei Weekly story “This only makes sense if a rise in the value of the (underlying) real estate holdings – fueled by higher land prices – is being factored in.”
  
  
• Unemployment: Last December’s .3% dip in the unemployment rate to 4.9% marked the first improvement in 13 years and hopefully points to a trend that can be sustained. This is critical if Japan is to achieve a sustainable recovery. Nevertheless, job prospects, especially for younger workers, continue to remain problematic. As Akira Yamashita, an economist at Dai-Ichi Life Research Institute stated in a Bloomberg report “It's hard to be too positive about consumer spending when companies are still cautious about their labor plans''. Unemployment among men under 24 years old rose during 2003 and stood at about 10% in December. The number of university students who have received informal employment offers is also falling. As in the U.S., job creation continues to lag, especially for those who lack transferable, or who do not possess the, skills, that will enable them to compete with competitors based in countries with lower cost structures. To help ease these people into the workforce and to help transition displaced workers into new positions, METI, the Ministry of Health, Labor and Welfare and other government entities are working to expand training programs and to offer a range of other incentives, particularly in areas outside of major population centers.
  
  
• Globalization: While larger and world-class firms and major metropolitan areas are as a whole benefiting from the added scale and cost benefits that can be achieved through a more global corporate structure, small to mid-sized companies and rural areas have found it far more difficult to make the necessary transition. This move toward rationalization and efficiency in both the private and well as public sectors is causing social dislocations and a divergence of personal incomes. In the U.S. this adjustment process has also been painful and politically sensitive, however, in Japan it is even more so given that the nation has not experienced the levels of income disparities that are common in the U.S. Unfortunately, there are no easy answers to this dilemma and the only apparent solution is to make every attempt to facilitate this inevitable transition through education and targeted training programs and to offer a competitive business and social environment that will attract foreign investors and help to prepare Japanese workers and municipalities to compete in the increasingly competitive global economy that is emerging.
  

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Investor Interest in Japan is Likely to Continue to Expand over Time

According to emergingportfolio.com, Japan Equity Funds recorded their 18th consecutive week of inflows on March 27th and have pulled in $1.74 billion over the past four weeks, bringing the year to date total inflows to $3.11 billion. This 19% gain in 2004 is the highest among all fund categories. Indeed, the last week in which Japan funds saw outflows was November 20, 2003, the only week of net redemptions since the beginning of last August.

This rising interest should not be surprising given that many Japanese firms are a comparative bargain compared to their counterparts in the United States and Europe. As Jeremy Hall of Henderson Global Investors commented recently to Reuters, “You can buy some of Japan’s best companies – Toyota at 14 times (earnings) – (and) … smaller companies … at 20-21 times.” While accounting differences might make direct comparisons unfair, as of Mid-February companies listed on the S&P 500 had an average valuation of 23.4.

Furthermore having endured many years of hardship, many investors remain extremely underweight Japanese capital markets – which at the height of the bubble had a market capitalization larger than the U.S. While it is unrealistic to think Japan will rise to the heights seen at that time within the foreseeable future, it is important to realize that despite the substantial appreciation seen over the past year, we remain far below levels seen only three or four years ago.

Investors might also take a look at Japan within the context of the rapid growth now taking place in China and other emerging Asian markets. While it is true that Japan is a relatively mature economy, it has also proved to be a major beneficiary of the accelerated business and financial activity that has been taking place in the region. With established infrastructure, deep and liquid markets, lower volatility, an economy that is increasingly showing an ability to realize the benefits of restructuring and reform, Japan represents an opportunity that every internationally-focused investor – both financial and corporate -- should consider as part of their agenda.

Data, statistics and the reference materials presented within this newsletter have been compiled by JETRO from publicly-released media and research accounts. Although these statements are believed to be reliable, JETRO does not guarantee their accuracy, and any such information should be checked independently by the reader before they are used to make any business or investment decision.

Focus: Gross National Cool
Focus: Regional Development
Focus: New Policy Challenges
Focus: Investment Japan IV
Focus: Investment Japan III
Focus: Biotechnology
Focus: Investment Japan II
Focus: Investment Japan
Focus: Foreign Direct Investment
Focus: Mergers & Acquisitions
Focus: Entrepeneurship
Focus: Economic Revitalization 
Focus: Industrial Revitalization 
Focus: Foreign Investment 
Focus: Bush Visit
Focus: Koizumi Visit
Focus: Economic Rebirth
Focus: Hiranuma Plan
Focus: Foreign Direct Investment
Focus: Emergency Economic Package
Focus: Action Plan
Focus: Economic Reform
Focus: Okinawa Summit
Focus: Small Business Development
Focus: New Enterprise Development
Focus: Industrial Revitalization
Focus: Economic Recovery 4
Focus: Steel
Focus: Economic Recovery 3
Focus: Economic Recovery 2
Focus: Economic Recovery

Focus is published and disseminated by JETRO New York in coordination with KWR International, Inc. JETRO New York is registered as an agent of the Japan External Trade Organization, Tokyo, Japan and KWR International, Inc. is registered on behalf of JETRO New York. This material is filed with the Department of Justice where the required registration statement is available for public viewing.