October 4, 2005

Now Japan comes to the party

Optimism is again rising that Japan’s economy is coming out of a protracted slump. If this is more than just another false dawn, it will add even more muscle to an already strong global economy, says Ruchir Sharma.

   ACAT may or may not have nine lives, but the Japanese equity market certainly does. The mega bull market in Japanese equities culminated in 1989, and the benchmark Nikkei average is still 70% off the 1989 peak. But through the 15-year secular downtrend, the Japanese market has staged eight meaningful rallies and a ninth one is now underway. In fact, in the just ended third quarter, the Nikkei was the best performing major benchmark index in the world — rising 15%.
   Foreign investors have led the rally again as the view gains ground that Japan’s economy is finally coming out of a protracted slump. There have been many false dawns before, which have made for the eight bear market rallies in the past 15 years. If the current rally turns out to be merely another headfake in that series the budding enthusiasm among investors will be terribly dampened. However, several analysts believe the Japanese economy is at last on terra firma after years of much-needed restructuring.
   Following the boom of the ’80s, the Japanese economy was weighed down by excessive debt and overcapacity in many industries. Those structural problems were exacerbated by policy mistakes, inaction on the part of politicians and a long period of denial by corporate Japan. Although the bubble of the 1980s started to deflate in 1990, Japanese companies kept accumulating debt until 1997, the labour force grew to a new high of 66 million that year and real wages continued rising at levels far higher than optimal. Sharply slowing growth combined with higher debt and wage bills was disastrous for Japanese companies, which were once the engine of economic growth. Policymakers made the mess worse by either coming out with inefficient spending packages for pet projects to apparently stimulate the economy, or dithering on any major reform steps to revive the economy. But the thinking is that all the stars are now aligned the right way.
   Japanese companies are generating record cash flows, property prices are turning around and, what’s probably the most crucial factor, there’s a strong political leadership guiding the country.
   In fact, Prime Minister Junichirio Koizumi’s electoral success last month has been the catalyst for the latest wave of optimism. Koizumi took a bold gamble in calling for early elections, making the privatisation of Japan’s gargantuan postal system a centrepiece of his electoral campaign. His landslide victory is seen as a strong mandate for a smaller government and fiscal change. The privatisation of Japan’s post office — the world’s biggest financial institution with over $3.2 trillion of savings deposits and insurance policies — will further change the country’s economic structure toward a less capital-destroying and more free-market oriented system.
   Japanese companies have already been moving in that direction: becoming leaner by cannibalising excess capacity and cutting debt. The banking system, too, is in better shape after writing off bad loans.
   Sclerosis in the banking sector was one of the main contributors to deflationary impulses in the Japanese economy. Now, there are signs that the transmission mechanisms in the monetary economy are getting back into gear, leading to a gradual change in deflationary expectations. Consumer price indices, which have been falling since the late ’90s, are expected to move into positive territory by the end of the year.
   FOR Japan to truly have a reflation cycle though, it’s important for the 15-year secular process of land price deflation to reverse. Over the past year, pockets of Tokyo have witnessed the first increase in residential prices since 1989. While prices are still falling in most other parts of the country, the rate of decline is slowing and showing signs of bottoming out.
   All these factors have contributed to a relatively strong Japanese economy in 2005. GDP growth came in at 5.8% and 3.3% respectively in the first two quarters, accompanied by healthy employment and wage growth. The economy is expected to expand around 2.5% over the coming year, which is quite impressive for a country experiencing little growth in its labour force growth due to an ageing population problem.
   A sustained revival in Japan’s economic fortunes will add more muscle to an already strong global economy and be particularly positive for Asia. After China, Japan is the second most important driver of exports for the region.
   A Japanese comeback would leave euroland as the only weak link in the global economic recovery chain. Growth in the euro area remains stuck in the 1%-1.5% region and, unlike Japan, prospects for reform don’t look encouraging. The recent election result in Germany showed that Europe is far from willing to embrace path-breaking free-market policies.
   The main risk with the Japan story is that structural problems — ranging from adverse demographics to a still high level of indebtedness — prevent the economy from gaining traction. Furthermore, pressure to fix the high budget deficit could lead to a policy mistake — akin to the infamous consumption tax increase in 1997 that stalled a nascent economic recovery. Japan has to let the fiscal and monetary policy stance remain supportive for growth.
   If the Japanese economy does indeed move into a zone of sustainable recovery, foreign investors will, for a change, be vindicated in their often ebullient view of the country. Otherwise, the tale of past eight bear market rallies will once again repeat itself: overseas investors get excited by some data wiggles that turn out to be head-fakes, but better-informed domestic institutions see through the data mirage and sell into the spikes. While the foreign investor community is now again leading the charge, at least this time domestic investors are showing some — albeit still modest — faith in the uptrend. May be it will be ninth-time lucky for the Japanese equity market and investors can finally say sayonara to one of the longest bear markets in investment history.

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