ETF Investment News & Articles
Is
Japan Back?
June 14, 2004
International Cover Story
After a disastrous decade, markets, household spending,
and once-struggling sectors are soaring. Here's the story behind
the numbers
One of the big surprises of the global economy is Japan's remarkable
turnaround. It has grown faster than the U.S. over the past six months,
and its 3.2% expansion for the fiscal year ended in March is the
best showing the country has managed since 1996. The stock market
is up 45% over the past 13 months, and the economy is generating
jobs again, pushing unemployment to a three-year low of 4.7%. Exports
-- always a strong driver of Japan's economy -- are soaring, particularly
to China. "Japan has not been this strong in the past decade," says
General Electric Co. (GE ) Chairman Jeffrey R. Immelt.
The surprise is that more and more of the recovery is being powered
by demand at home, both from business investment and consumer spending.
On May 28, Japan reported that household spending shot up 7.2% in
April from the year-earlier period as shoppers flocked to department
stores and discounters, stocking up on everything from suits to stereos.
You have to go back to the heady days of 1982 to see that kind of
consumer splurge in Japan.
This Japanese surge wasn't supposed to happen. After all, over the
past decade a historic plunge in stock and land prices, three recessions,
and stagnant growth have wiped out as much wealth as World War II
did. Much of that was the wealth of a bubble economy -- unrealistic
valuations doomed to fall. The problem is that the authorities opted
for a slow workout to avoid bankruptcies and massive unemployment.
That approach preserved social stability but cost trillions -- money
that could have been spent resurrecting the country more quickly
-- and helped push Japan into troublesome deflation. Even today the
nation continues to experience major structural problems: a still-fragile
banking system, a central-government debt burden equal to 160% of
gross domestic product, and a sovereign credit rating more suited
to a banana republic than to the world's second-biggest economy.
Nonetheless, Japan clearly is moving forward. Here's why:
Japan was written off as hopeless as recently as 18 months
ago, but the numbers are finally looking good. What's going on?
To understand the answer, you have to remember Japan in its heyday: Ever-higher
exports to the U.S. built up the strength of the keiretsu, those vast networks
of corporations that supported all members, no matter how weak. Meanwhile,
high prices at home propped up domestic industries and robbed the Japanese
consumer of buying power. The system worked -- until the keiretsu banks fueled
a huge property bubble and gigantic overcapacity in the manufacturing sector.
The banks refused to cut off deadbeat borrowers, and recession set in. Not
even continued U.S. demand for Japanese products could end the downturn that
started in 1993 and staggered on for nearly a decade.
Today, though, Japan is a beneficiary of global trends that did
not exist when it slid into trouble. First, there's the rise of intra-Asian
trade. A half-decade ago few understood how much Japan would gain
from China's boom. Chinese manufacturers and consumers have been
eager buyers of the machine tools, chipmaking equipment, cars, and
consumer products that Japan excels at making. Last year two-way
trade with China shot up 30.4%, to $132.4 billion, for the first
time eclipsing import and export volumes with the U.S. And it's not
just China: Southeast Asia has also bounced back from the Asian financial
crisis of 1997-98. Last year, Japanese exports to Southeast Asia
rose 10%, to $60 billion.
Japan is also raking in money from the growing global demand for
must-have gadgets such as digital cameras, flat-screen televisions,
and DVD recorders -- products where it still has an edge. Fujitsu
Hitachi Plasma Display Ltd. and Matsushita Electric Industrial Co.
(MI ) together control 42% of the global market for plasma-display
screens and are spending nearly $1 billion each to build new factories
in Japan. Meanwhile, Sony, Canon, and Olympus have a lock on half
the global market for digital cameras. The digital-appliance boom
has in turn created business for Japanese machine-tool companies
that make specialized machinery needed to crank out microchips used
in these products. Machine-tool orders surged 25% in 2003, to $8.3
billion, government data show. Sure, Japan faces competition from
Korea, Taiwan, and China, but it leads in key technologies such as
tiny hard drives and specialized chips used in digital gizmos.
Tech isn't Japan's sole salvation. Something else happened, too,
with little help from the government of Prime Minister Junichiro
Koizumi or any other politician: The mighty keiretsu started to lose
their iron grip on the economy. Constant deflation, heavy debt loads,
and stagnant demand at home chipped away at corporate profits, forcing
the weakest into bankruptcy. The tight relationships among banks
and borrowers, manufacturers and suppliers started to fray. To survive,
the strongest companies went offshore to produce their goods and
ship them back to Japan at ever-lower prices.
At the same time, Japan's consumer psychology started to change,
and deflation, ruinous as it was, proved to have a hidden payoff.
Shoppers demanded lower prices and got them -- from entirely new
retail categories such as "100 yen" shops, discount grocers,
and warehouse-style department stores offering more and cheaper imported
goods. So Japan's hard-pressed consumers finally could stretch their
spending power, even on scantier wages. With employment picking up
and strong economic growth, many now have the best of both worlds:
steady incomes and still-decent prices.
Global investors are starting to amplify these trends. Until the
mid-1990s about half of equities in Japan were held by banks, a legacy
of the keiretsu cross-shareholding networks. That figure is now about
25%, according to fund manager Sparx Asset Management. The banks
sold off their shares in 2001 and 2002 to meet new capital requirements
imposed by regulators. Those sales sent the Nikkei 225 stock index
to 20-year lows 13 months ago. But the sell-off sparked interest
in Japanese stocks among foreign investors, who poured $77 billion
into Japanese equities last year and now control 30% of the shares
traded on the Tokyo bourse.
Those foreign shareholders are demanding better corporate governance,
profitability, and transparency. In December, for instance, private
equity fund Steel Partners Japan Strategies LP launched a hostile
takeover of Yushiro Chemical Industry Co. Why? Steel Partners, which
owned 8.9% of the cash-rich machine-oil maker, was tired of the company's
low stock price and paltry dividend. Yushiro fended off the attack,
but not before a panicked management agreed to raise its dividend
fourteen-fold. Meanwhile, dealmaker Wilbur L. Ross Jr. has established
a $200 million fund with the California Public Employees' Retirement
System pension fund that will buy japanese shares and agitate for
better governance. American private equity players are at work, too.
Carlyle Group and Lone Star are on the prowl for turnaround opportunities
after seeing the success Ripplewood Holdings had with its investments
in Japan Telecom and the near-bankrupt long term credit bank, now
called Shinsei.
Isn't too much of Japan's recovery linked to the volatile,
overheated China trade?
That's a legitimate worry. "Japan's reflation is just
the mirror image of China's investment cycle overshooting," says
Hong Kong-based Morgan Stanley (MWD ) economist Andy Xie. Regarded
as a China bear, Xie thinks the good times will be short-lived. The
bubble in China has sparked a capital-expenditure turnaround in Japan,
he says, and that has fed into the rebound in consumer spending.
Once China collapses, Xie says, Japan's economy will suffer heavy
collateral damage.
The argument, though, may be overblown. Few think the long-term
outlook for China is anything but rosy, and there are some signs
that the country is headed for a soft landing. Unless the U.S. were
to crash at the same time, it's hard to imagine Japan falling back
into recession. Moreover, such reasoning ignores the fact that, while
Japanese companies have rushed to build up Chinese plant capacity
to sell goods to consumers there, they're also using China as a cheap
production base to sell products back home and around the world.
Imports from China shot up 21.9%, to $75 billion, in 2003. About
15% of that, says the Japan External Trade Organization, was "reverse
imports" -- subsidiaries of Japanese companies sending Chinese-made
PCs, printers, and DVD players back home. China may see boom-and-bust
periods that crimp Japanese export growth, but Corporate Japan still
benefits from having a vast production base on the mainland.
It's also hard to argue that China has much to do with the rapacious
domestic demand for digital appliances. The boom started inside Japan
about two years ago; today roughly half of all Japanese households
have digital cameras, and one-third own DVD players. If you have
ever visited a space-starved Japanese home, you can quickly grasp
why sleek flat-screen TVs are all the rage. In March, Japanese consumers
bought 216,000 of them, up 72% year-on-year. Now that these products
have been successfully marketed at home, companies are boosting capacity
to sell more overseas. Matsushita just announced plans for a new
factory to crank out 3 million plasma-display panels a year. When
it comes to digital TVs, says Fumio Ohtsubo, a senior managing director
with Matsushita, "we can't be beaten."
Has Japan Inc. really restructured enough to regain its
global stature?
It depends on which part of Japan Inc. you're talking about. There has been
a true revival in the competitiveness of the biggest multinationals, particularly
in electronics, steel, and autos. Nissan Motor Co. (NSANY ), for instance,
had a near-death experience but was revived by foreign capital and world-class
managers such as CEO Carlos Ghosn. Today, Nissan is enjoying record profits.
Ghosn sees enormous potential in Japan given its educated and diligent workforce,
engineering smarts, and manufacturing prowess. "Every problem has a solution," he
says. "The key is getting people thrilled about what's going on in the
company."
Other Japanese outfits have relied on homegrown managerial talent
to pull out of the rut. At Matsushita, CEO Kunio Nakamura has closed
or streamlined dozens of plants, cut the workforce by 20% since 2000,
and last year poured some $5.5 billion into research and development
on products such as camera phones and flat-screen TVs. Even Old-Economy
mainstays are getting into the act. Toray Industries Inc., a manufacturer
of synthetic fibers, now produces materials needed for making LCD
panels. And steelmaker JFE Holdings Inc. has stormed back to profitability
with decisive downsizing and a shift to higher-margin products such
as sheet metal for carmakers. All in all, the average return on equity
of Japan's 400 top nonfinancial companies has jumped fourfold, to
7%, since 1998. Goldman, Sachs & Co. (GS ) thinks it could hit
10% by 2006. Another new trend is part-time employment, which adds
to companies' operating flexibility. Last year the number of temps
soared 21.8%, to 2.13 million workers -- 2 1/2 times as many as five
years ago, or 3.5% of the workforce.
That said, there are still plenty of backward-looking companies.
While labor productivity increased about 2% overall in 2003, the
biggest gains came from giants such as Toyota and Canon. Companies
in services, retail, construction, and food processing -- which represent
some 60% of total employment -- lag far behind, says Nikko Citigroup
Ltd. (C ) economist Jeffrey Young. "In some cases, productivity
is falling outright," he points out. That lack of productivity
translates to scarce profits. In the past fiscal year the five most
profitable enterprises represented some 25% of the pretax earnings
of Japan's 300 biggest companies, Young says. So while Japan has
made progress, its restructuring drive still needs to go deeper.
The banking sector seems to be bouncing back. Will that
make much of a difference?
This is one area where Koizumi deserves credit for getting the job done. His
appointment of Heizo Takenaka as Japan's economics czar and top bank regulator
was smart. Takenaka and his staff at the Financial Services Agency have forced
Japanese bankers to reclassify marginal loans as the duds that they really
are and made them drop accounting gimmicks that hide problems. For instance,
in March, FSA auditors discovered that banking group UFJ Holdings Inc. had
underreported loans by some $9.1 billion and needed to shore up reserves by
$8.4 billion. UFJ reported a $3.6 billion loss last year -- a shock, but a
refreshing change after years of book-doctoring with tacit government permission.
The other side of the bank problem is that many companies that were
going to go under have already gone bankrupt, while borderline cases
have returned to health as the economy improved. Last year, the number
of corporate bankruptcies fell by 16.6%. The banks have written off
much of the debt owed by those companies or sold it to a government
loan-workout corporation. So the level of nonperforming loans at
major Japanese banks has dropped by about half over the past two
years, to $124 billion, or about 5% of their loan books. This development
could prove a tremendous boost for the economy. With the banking
sector in a funk, total outstanding loans have been declining for
the past six years, hobbling the ability of enterprises to raise
capital for expansion. True, the rebound in the Nikkei has reopened
a key source of financing, and the best-run companies have no problem
raising money in global markets. Still, Japan needs a vibrant banking
sector to fund new ideas.
What are the challenges for Japan now?
Japan still suffers from deflation, which took root in 1998. Consumer prices
have been dropping at about 1% annually, and land prices have fallen since
1992. Most economists, though, think prices are hitting bottom and will start
rising modestly late next year.
The government also faces a Godzilla-sized debt problem. Its national
pension scheme is such a mess that most workers -- and even some
politicians -- don't even bother to pay into it. These troubles are
fixable provided Japan keeps growing and Koizumi can push through
higher pension premiums and rein in government spending. But it will
take years, if not decades.
Then there's the question of when the Bank of Japan will boost its
benchmark interest rate from the near-zero level it has maintained
since 1999. BOJ Governor Toshihiko Fukui probably won't move until
consumer prices start to rise next year, and even then will only
raise rates modestly. That shouldn't hurt. But if inflation sets
in, he may have to be more aggressive. Then the government's debt
costs would rise, which in turn could make it harder to reduce the
deficit and cut spending.
For now, though, ordinary Japanese finally have a reason for cautious
optimism. Kimiko Hasegawa, 50, recently spent an afternoon looking
through designer dresses at the upscale Mitsukoshi department store
in the Ginza, for the first time in ages. "For the past two
years, I only shopped at discounters," she says. If Japan can
keep growing and get its competitive groove back, more and more Japanese
might feel confident enough about their economic future to splurge.
For the world economy, that could be a very good thing.
By Brian Bremner, with Hiroko Tashiro, in Tokyo
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