Author: Mark Lehane
After more than a decade in the doldrums, Japan’s economy is set for a robust recovery.

coverstory_01 Cherry blossom time is always a festive time in Japan as salarymen and students alike gather to drink alfresco while admiring the beauty of the trees. This year, however, the mood was even more upbeat than usual. The economy is growing: GDP in the first quarter posted a 1.9% uptick—the fifth straight increase. Exports are booming. And in key cities more jobs are on offer than there are workers to take them. The country is finally hauling itself out of nearly one-and-a-half decades of gloom.

Sadakazu Tanigaki, Japan’s finance minister, puts it succinctly: “Japan is back,” he says.

Faced with that prospect, the Bank of Japan is preparing to signal the death of deflation by returning interest rates into positive territory, ending a policy of flooding the economy with money that was called “quantitative easing.” That’s a process that has gone remarkably smoothly so far, says Ben Eldred, a senior economist at Daiwa Securities SMBC in London, but it’s not without its attendant controversy. In 2000 the central bank judged deflation over, started to turn off the liquidity tap and in doing so stifled—and eventually killed off—a nascent recovery. That disastrous misstep has not been forgotten, and governor Toshihiko Fukui has had to battle vocal politicians—and elements of the Ministry of Finance—reluctant to wean the country off cheap money. The market is signaling two rate rises this year, the first as early as June, but Daiwa’s Eldred says softer activity data might make rate rises later and slower than that.


Looking at the various indexes, including CPI and the GDP deflator, it is possible to question whether Japan has finally shed deflation or not, agrees Cameron Umetsu, head of economic research at Nomura International in London. But the signs are clear: “Whichever way you tap it, the trends are positive,” he says. Banks are lending again: In April non-adjusted outstanding lending rose by 1.2 % on an annualized basis, a 10-year high.


“The most noticeable element of this recovery is that it is led by private sector demand,” says Tanigaki. That stretches across the economy, he says: “Japan’s financial system has overcome its problems and is healthy again, Japanese companies have become much leaner and healthier, and this recovery is trickling down to the private individual.”

Reversing the Second Great Defeat
Hajime Takata, chief strategist in the fixed-income department of Mizuho Securities, says it is important to realize just how deep a hole it is that Japan is climbing out of. He calls 1990, when the recession began to bite, “the second great defeat.” “The losses we suffered after 1990 in asset terms were greater than the loss we suffered after World War II relative to GDP,” he says.

Rebuilding bank and company balance sheets, previously laden with loans that turned toxic during the recession, has been the platform for renewed growth.

“Excess capacity, excess employment and excess debt have been dealt with,” says Kohei Yuki, managing director and head of global banking at Deutsche Securities in Tokyo.
That has allowed Japanese companies to do what they do best—export (see box, right). And it’s that export drive and an accompanying boom in domestic capital investment that is in turn powering the Japanese recovery. But the feel-good factor threatens to obscure the fact that substantial challenges remain if Japan is ever to soar above the 1% per annum GDP growth that the International Monetary Fund says is the economy’s natural cruising speed.
Structurally, according to finance minister Tanigaki, Japan faces two key challenges: emerging market competitors and demographics. The country’s population began to decline in 2005. “We must draw in goods, people, money and information from around the world,” asserts Tanigaki. Racially homogenous, Japan has tended to frown on immigration. That needs to change. “Many people think Japan is a closed society,” says Tanigaki. “It is imperative for us to become an open society.” At the very least, that means encouraging selective immigration from workers whose skills are in short supply, he says.

“One of the major reasons for pessimism in Japan is the demographic situation,” says strategist Takata at Mizuho. “We must put out the welcome mat for engineers.”

coverstory_02 More than in any other country except, perhaps, Germany, Japan relies on engineers to power its economy. The typical Japanese champion continues to employ ever more automated processes to manufacture high-end products at home, eschewing the chase after the cheapest labor that forms conventional CEO wisdom elsewhere. If that system has allowed Toyota to bear down on General Motors as the world’s leading automaker, it also has allowed erstwhile champions as Sony to grow flabby and to lose their touch.
But even though much of Japanese industry has gotten leaner and fitter in recent years, argues Deutsche’s Yuki, the changes need to go deeper still. “There are two fundamental problems,” says Yuki. “Japan still has too many companies in each sector, and each company still does too many things.” He points out that Japan is home to 13 car and truck companies, each making roughly the same product. “There is no Porsche or Ferrari,” he adds.
Yuki points outs that Japan now has just three megabanks, compared to the more than 20 that it boasted just a few years ago. “That consolidation now needs to happen in each sector— chemicals, pharmaceuticals, steel, engineering and so forth.”

There are signs of that happening. Hostile takeovers, while still rare in Japan, are now not unknown. Boards are beginning to pay more attention to shareholders. But the challenge stretches beyond the production line.
“Japan is the only one of the G10 countries where manufacturing as a share of GDP has not actually gone down in recent years,” says Grant Lewis, head of fixed-income research at Daiwa Securities SMBC Europe.
Lewis argues that there are two separate economies in Japan: “a fantastic manufacturing economy—the best in the world—and a service sector that is frankly awful.”
The result is a per capita GDP figure some 20% less than in the US. “It’s not that the Japanese don’t work hard—they do—it’s that they tend to work less smartly.”
The challenge is to raise productivity in the services sector, particularly in a society where workers are set to become a scarce commodity.


Japan’s premier, Junichiro Koizumi

When US Treasury secretary John Snow visited Japan in October last year, the consensus was already growing that the country’s economy had finally hauled itself out of recession. Secretary Snow was clear as to the reasons for the turnaround: the clean-up of the banking sector, deregulation and the overhaul of key parts of the corporate sector. “The lesson is that steadfast commitment to good policy, and political leadership that takes the risks to put good policies in place, pays some dividends,” he said, referring to other hidebound economies in the eurozone.
The subtext of his remarks: Japan got better because it got more like the US.

And it’s true that much of the medicine administered in recent years had a free-market label on the bottle. Japanese companies have shed jobs over the past five years. Corporate cross-holdings have begun to unwind: Around one in five Japanese shares are now held by “friendly” investors, compared to almost one in two in the late 1980s. And, of course, Prime Minister Junichiro Koizumi used the privatization of the Post Office as a totem for wider changes in the country and the ruling LDP party in his wildly successful September 2005 election campaign.

Little wonder, then, that outsiders view Japan’s rebound through an Anglo-Saxon prism.

But look again, and this recent recovery looks, well, a lot more Japanese. Pick apart the components of the rebound. Sure, consumers have been opening up their pocketbooks a little more, but at close to 30% of GDP, household savings rates are the highest in the developed world. This is anything other than a US-style economy powered by individuals using houses as cash machines. And, yes, companies are meaner, leaner. Almost one in three workers are part-time now, a shift that has spurred the growth of two-income households—as well as a flood of books bemoaning the accompanying insecurity. But in an important sense Japanese companies had already written the textbook on lean production. Star performers such as Toyota are world leaders in the use of advanced robotics. Investment by Japanese companies accounts for around 40% more of the country’s GDP than in the US or Germany.
That gap is widening further: According to the Bank of Japan, manufacturing capital expenditure grew by 12.9% in 2004 and 15.5% in 2005. The spur for that spending splurge: an export drive erected on the back of a swooning exchange rate and ballooning world demand. Some 30% of GDP growth over the past four years came from exports, a figure only Germany could come close to in the developed world.

Sure, this party must come to a close sometime. The currency is already sharply up and is likely to go further. “Once this appreciation has started, it is hard to stop,” says Takatoshi Ito, a professor at the University of Tokyo and a former deputy finance minister. “¥100 [against the dollar] is no barrier.” And, yes, important questions remain about the long-term viability of the Japanese economic model (see main story). But for the moment at least, this recovery is about Japan doing what it has traditionally done best: making high-end products at home to sell abroad.

Japan may have just pulled itself out of a deep hole, but now it has a mountain to climb. At around 160% of GDP its debt burden is the highest ratio of any industrialized country. Decades of pork barrel politics and economic pump priming have left the country with a fiscal deficit at around 6.5% of GDP. And to cap it all, the country is running against a demographic timeclock. The country’s population began to decline in 2005, and Japan is set to get older and emptier fasted than any of its rivals.

“Faced with a declining trend in population, we have to grapple squarely with the fiscal deficit,” says Japan’s finance minister, Sadakazu Tanigaki. “We aim to move into a primary surplus by the early 2010s, by the time the baby boomers start claiming their pensions.”

But don’t expect radical moves on the fiscal front any time soon. “For the time being, the plan is to give the economy room to grow and to achieve nominal GDP growth,” says Cameron Umetsu, head of economic research at Nomura Securities in London. That’s unlikely to change fast, whoever replaces the current prime minister in September.

“Koizumi’s successors don’t look like hawks,” says Grant Lewis, head of fixed-income research at Daiwa Securities.
A growing economy will, of course, help swell government coffers; set against that is the effect of rising interest rates. The Ministry of Finance calculates that every 1% increase in long bond rates adds ¥1 trillion ($13.5 billion) to Japan’s debt service burden.

Hiroshi Okawa, director in the government debt policy planning and legal division of the Ministry of Finance, points out that Japan government IOUs account for 37% of the world’s outstanding government debt and 40% of new issuance. Until recently the Ministry of Finance has been able to rely on stable sources of demand for its bonds; those sources are likely to be eroded in coming years, however. The Post Office has been a huge buyer of JGBs to match its saver base. Once privatized, the postal system may reduce its holdings of what are low-yielding instruments.
Likewise, the banking sector used to mop up the liquidity arising from the gap between the amount of money it took in from depositors and the amount it lent. With lending picking up, there will be less cash to park in bonds: According to the Bank of Japan, banks turned net sellers of JGBs in late 2005.

The Bank of Japan is also set to reduce its bond buying as it moves into normal monetary policy. “It’s pretty clear we are going to have a deterioration in the balance of supply and demand for JGBs,” says Ben Eldred, senior economist at Daiwa Securities.

That’s something that is already exercising the minds of the Ministry of Finance. “We have been lucky that we didn’t have to look beyond our borders to sell our debt because of our strong domestic savings base,” says Hiroshi Okawa, a director in the government debt policy division of the ministry, “but now we are trying to internationalize our bonds.”
The ministry has already taken a couple of steps to expand the buyer base for its bonds: It has scrapped the withholding tax for overseas buyers and issued new types of bonds that were more attractive for Japanese mom-and-pop savers.
And in move steeped in irony, in 2004 the Ministry of Finance issued its 10-year bond linked to inflation.

Mark Lehane