Recognizing the Long-Term Nature of Japan’s Economic Recovery

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Portfolio Inflows into Japan Have Increased Dramatically Over the Past Year

The increased confidence of foreign investors in Japan’s ability to achieve a sustainable economic recovery has resulted in substantial inflows into Japan-oriented investments over the past year. For example, emergingportfolio.com estimates as of October 13, 2004 investments into the 205 Japan-related equity funds it tracks totaled almost $9 billion so far this year.

That is the largest percentage increase of all fund categories – over 50% above their beginning of year total assets. In comparison, investments into Western European funds declined over $250 million and the 2,150 U.S. funds -- with almost twenty times more assets than those dedicated to Japan -- declined approximately $242 million over the same time period.



Nevertheless, despite these large inflows, investors looking at Japan have in recent weeks shown signs they are troubled by growing uncertainty over higher energy prices, China’s ability to maintain its rapid expansion, the sustainability of Japan’s recovery efforts, the strength of global consumption and a range of other factors. Along with the general need for consolidation after a period of such strong performance, flows into these funds – while remaining positive at about $315 million since the beginning of September – have been negative in four of the past six weeks. In addition, the Nikkei 225 Index has declined slightly over the past few months as well – though remains well over the lows seen a year and a half ago.

Performance of Nikkei 225 Index

While upward momentum has slowed, institutional investors do appear to be maintaining their confidence in Japan. For example, recent Tokyo Stock Exchange and Ministry of Finance data revealed that foreigners had been net buyers of Japanese equities for the three weeks ending October 8th. Over $3.2 billion of net purchases took place during the week of October 4-8th alone. This is the highest level of activity since the Nikkei reached a high last April.

Undoubtedly, there will be periods of volatility moving forward in both directions, however, in examining this phenomenon, the rise of investor inflows into Japan in recent years should be taken in context. One telling indicator is the weight accorded Japan in the Morgan Stanley Capital International (MSCI) World Index. At the height of the bubble Japan had a weighting of about 60% of world market capitalization. Today it is just over 10%. That is slightly less than the United Kingdom, a far smaller economy. In comparison the U.S. – an economy about 2.1 times larger than Japan, has an MSCI weighting of over 55%. While it is highly doubtful Japan will regain the high relative level of capitalization it enjoyed during the bubble era, even minor movement back toward a higher weighting could have major implications.

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Japan’s Stability and Recovery Potential Represents a Real Strength in Uncertain Times

Rising confidence in Japan can at least partially be attributed to a desire for stability and predictability in uncertain times. The nations commitment to democratic rule, the maturity of its institutions, large, well-educated and affluent population, size and diversity of its economy, relative transparency, and even ironically the homogenous and conservative nature of its society – which in many ways has held Japan back as it sought to revitalize its business environment -- have all helped to make Japan one of the more attractive investment venues in the world today.

Important policy reforms have helped to introduce change into the troubled banking and real estate sectors. In 2002, the FSA obliged major banks to cut their nonperforming loans to 4% from 8.4% of total loans by the end of FY 2004. This target appears achievable as at the end of FY 2003, nonperforming loans within the portfolios of the 11 major banks had already declined almost ¥7 trillion to 5.2%. Key changes in the property sector include reductions in the real estate transaction tax as well as the introduction of a new system to adjust gift taxes to promote the transfer of assets from between parents and children and other beneficiaries.

At the same time it is true that a continuing dependence on exports does underscore Japan’s ongoing reliance on demand from, and the business environment within, the U.S. and other trading partners. However, the combined effects of corporate restructuring, cleanup of Japan’s financial system and gradual restoration of consumer confidence and spending, all promise to help relieve many of the problems that have been troubling Japan for more than a decade.

Corporate profitability in Japan is on the rise, and a recent Nihon Keizai Shimbun survey of 760 public companies noted an average 57% average year-on-year rise in combined group profits in the second quarter. This was matched by expectations that FY2004 as a whole would represent the second consecutive year of record profits. Investors should not, however, be under the impression this trend is peaking. While progress can be made, as seen in the chart below, Japanese firms by and large continue to lag their counterparts in other countries in terms of their overall profitability. As a result, far more can be done to achieve further gains moving forward.

Ratios of operating income and current profits to sales

Source: Ministry of Finance's Financial Statements Statistics of Corporations

In addition to benefits that can be realized through further restructuring efforts, the potential for earnings and revenue growth will be especially dramatic if Japanese consumers continue to regain their confidence. While it is too early to declare victory, there are definite signs the nation is now moving past the troubling deflation it endured over the past decade. For example, one recent media account concerning middle-aged Japanese consumers quoted Takayuki Hara, marketing research and planning manager of Louis Vuitton Japan Co., who stated “People in their 40s experienced the go-go years of the bubble environment in their 20s, and are less hesitant to buy expensive goods than … any other generation … Now that their busiest childcare years are behind them, they are starting to spend money on themselves again.”

Part of the confidence now being seen is reflective in signs of a gradual recovery in urban Japanese real estate markets. With over 18,500 new condos placed on the market in Tokyo during the first half of this year, increases can also be seen in spending for household interiors. Recent government statistics note spending by working households on household goods increased over 10% in the second quarter on a year-on-year basis. Increases in luxury spending are even more dramatic. For example, an importer of Christian Dior housing products from France reports sales have been 30% above expectations.

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Major Japanese Firms Continue to Transform Themselves to Compete in a New Japan

Despite substantial evidence that illustrates the strength of the change now underway in Japan, many observers remain skeptical -- questioning whether Japanese companies are willing, and possess the capabilities necessary, to become efficient, shareholder-friendly, profit-seeking enterprises. Others question the sustainability of the reform process.

The simple fact, however, is that many of the reforms and deregulation measures envisioned within the “Action Plan for Economic and Structural Reform” adopted in 1996/7 have already been initiated. As a result, Japanese firms are now moving to adapt themselves to a more market-oriented economy. This process can be expected to accelerate over time. That is true not because these firms necessarily welcome and endorse these changes, but because they are coming to understand they are essential to maintain their competitiveness and survival.

A notable recent development is the initiation of a U.S.-style M&A battle over the acquisition of UFJ Holdings, Inc., Japan’s fourth largest banking institution. This transaction was perhaps unprecedented in Japanese corporate history, where dealings of this kind have generally been resolved behind closed doors. In this case a Supreme Court decision proved necessary after Sumitomo Mitsui Financial Group moved to initiate a competing offer to one that had already been accepted from the Mitsubishi Tokyo Financial Group. In addition to litigation, Sumitomo Mitsui issued a direct appeal to UFJ shareholders and publicly released key details of its proposal even before UFJ agreed to consider their offer. This is expected to have major implications, prompting further consolidation and efficiencies in the Japanese banking sector. Looking at this development in a broader context, it prompted one senior banking official to state in a recent news article that in the future “legal ambiguity in merger talks and contracts will no longer be tolerated [in Japan].”

Even beyond the M&A arena, Japanese firms are now recognizing the need to pay more attention to shareholders. Many Japanese firms have traditionally held brief, highly choreographed annual meetings. The Nikkei Weekly, for example, reports that to facilitate the involvement of shareholders, gaming company Namco Ltd., has held its shareholders meeting on Saturdays for seven years. This year it held a social event featuring a dance show by Namco characters as well as a cake sampling by an affiliate and other family-oriented services. 581 shareholders attended, an increase of 19%. In its coverage, Namco President Kyushiro Takagi stated “Shareholders are our customers”. In another Nikkei piece, Masahiko Ishizuka, counselor of the Foreign Press Center/Japan after explaining the reasons why this has not been the case in the past, notes in an opinion piece “….for the time being, shareholders are coming in the limelight, presumably in reaction to their past neglect.”

Japan’s corporate services infrastructure is also moving to adapt itself to this transformation. One change, almost unimaginable even a few years ago was the recent announcement by Linklaters, a major UK-based international law firm that it was planning to merge its Japanese law practice with the Japanese firm Mitsui Yasuda Wani & Maeda. This is first international merger in the history of Japan’s legal services industry. In an Economist article, Robert Grondine, a partner at White & Case in Tokyo commented “…you have medium-sized firms deciding to affiliate themselves with international firms”, because of the pressures from clients whose needs have changed because of globalization.

This improving environment is also motivating foreign financial institutions to boost their Japanese presence. Morgan Stanley Japan Ltd. Chairman Kensuke Hotta noted in a recent newspaper interview his belief the environment for M&A activity in Japan was flourishing and that “Japan’s profile is heightening within Morgan….[and it now]… accounts for about 10% of Morgan’s total earnings from the corporate business, or a quarter of the business the division earns outside of the U.S.” In another development, Lone Star, a U.S. investment group announced plans to invest ¥1.3 trillion in corporate buyout activities in Japan over the next three years.

Additionally, in an effort to better service foreign investors – who now account for approximately 30% of total trading on Tokyo Stock Exchange (TSE) – the TSE plans to being providing daily English-language investment information based on same-day announcements in Japan starting this December. This information is expected to contain data on dividends, share splits, mergers and other investment –related issues -- not only for TSE-listed companies, but also for the those listed on emerging company and regional exchanges, about 3,700 companies in total.

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Economic Fundamentals in Japan Likely to Continue to Improve Over the Long Term

While the Japanese economy remains highly influenced by global trends and demand from major trading partners, it should be noted that economic fundamentals are continuing to improve. After a long period where it could be said that the nation was lagging behind other major economies, one can now safely say the Japanese locomotive has begun to move again.

Corporate bankruptcies declined nearly 18% during the first half of the current fiscal year – their third consecutive biannual decrease. In addition, Japanese exports – largely propelled by increased sales to other Asian markets – rose 12.5% in 2003 to approximately $51 billion. This is the highest level achieved since the government began monitoring this data in 1947.

Within Japan’s domestic economy, unemployment fell to 4.8% in August from 4.9% in July. Additionally, while spending by wage earner households declined in August by a real .2% over the same month last year, consumer sentiment is becoming more positive. For example, data recently released by the Japanese Cabinet office shows that consumer confidence for the three months through Sept. 30 rose to an eight-year high. Furthermore, a Bank of Japan survey released on October 19th notes that Japanese consumers are feeling positive about economic conditions over the next 12 months for the first time in four years. The central bank's quarterly consumer index measuring the outlook of consumers over a one year time frame rose to 1.2 in September from zero in June. This is the first positive reading since March 2000.

Additionally, the September Bank of Japan Tankan survey released this month was more positive than it has been in over a decade. The central bank survey's headline index of sentiment among big manufacturers rose four points to 26 -- the highest level since 1991 – more than double the reading of 12 last March. The index for small manufacturers also rose three points to plus 5 from minus 3 over the same period. This is significant, as it was only in June that this reading became positive for the first time since November 1991.

While the Tankan reading was over 10% stronger than the number that had been expected, the DI -- derived by subtracting the percentage of companies downbeat about their business conditions from those that are upbeat – forecast for December declined to plus 21. This has caused some to ask whether sentiment may be peaking.

One recent Reuters report quoted Hiroyuki Nakai, chief strategist at Tokai Tokyo Securities, who commented on the September Tankan numbers stating "Weakening sentiment is certainly reflected in a slowdown in companies' capital spending plans (in the October-March period from the previous six months), Together with the U.S. and China both putting a brake on their economies (by maintaining tight credit policies), there's little chance that the export-led economy here will see a strong expansion in the next six months," he said.

This change in corporate sentiment is to some extent due to caution after the nations second quarter real GDP growth slowed down to an annualized rate of 1.7%. That was the lowest increase since early 2003, and substantially less than the annualized 6.1 percent registered in the first quarter of 2004 and 7.3 percent seen in the final quarter of 2003.

While this decline is disappointing, it should be understood the torrid growth seen earlier this year -- the strongest in 13 years -- was not likely to prove sustainable. A more measured pace will allow for a period of consolidation, present less of a need to alter macroeconomic policy and in general help to facilitate a more stable and sustainable recovery over time.

Wachovia Global Economist Jay Bryson in a report last summer commented on these new GDP figures noting “While growth in Japan is slowing, we do not believe that another recession is imminent … capital good orders were very strong in Q2 …. In addition, consumer spending should remain relatively solid given decent levels of consumer confidence. While export growth may slow going forward, we do not look for outright declines unless the rest of the world goes into recession … In short, our view is that the Japanese economy is transitioning from very strong growth that occurs in the first year or so of recovery to something closer to trend.”

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Economic Recovery in Japan Should Be Viewed as a Long Term Investment Story

Every investment story, Japan’s included, will have its corrective phases. However, it is the job of every asset manager to attempt to distinguish those sectors or national markets whose performance constitutes manic, or measured upward, volatility within long term downward trends, from those enduring the normal ebb and flow that is part of every secular bull market.

While every corporate and portfolio investor needs to ascertain for themselves whether Japan is indeed within the early stages of a long term economic recovery, it is important to recognize the long-term nature of the changes that are now taking place as well as the numerous structural and cyclical factors that provide evidence of continuing progress moving forward.

Earlier this month, Japanese Central-bank Governor Toshihiko Fukui spoke of developments in Japan in an address to the 11th International Conference of the Bank of Japan's Institute for Monetary and Economic Studies. He noted the Japanese economy is near to ending its adjustment following the asset-price bubble of the early 1990s, and that the momentum of its recovery is increasing.

According to a newswire report, Mr. Fukui stated "… the Japanese economy is finally reaching the end of the long and painful path of post-bubble adjustment … Our economy has achieved significant progress .... It is gradually gaining momentum for the restoration of sustained growth, and is showing more signs of recovery, spreading from manufacturing to non-manufacturing industries, from large to small firms and from metropolitan to regional areas."

Mr. Fukui went on to caution, that he could not predict whether Japan’s economic recovery will lead to sustainable economic growth and noted "We should ask here what makes the current economic upswing different from the past two recoveries, and whether such differences are sufficient for the economy to reach a sustained growth path."

While the normal need for caution and intensive due diligence must prevail, international corporate and portfolio investors – who have only just begun to address the severely underweight position they have maintained in Japan for many years – are advised to pay closer attention to these and other recent developments in order to determine how they can benefit from, and plan their optimal exposure to, the Japanese market moving forward.

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: Entrepreneurship
Focus: Consumer Demand
Focus: Asia
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.