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Tuesday, October 07, 2003

Japan: Thrice Fooled?

Why do you blog. Sometimes for the simple comfort of knowing you are not alone. This time the case in point is Japan. I can't remember when I last saw anyone come out and say it straight as Richard Katz is doing here. His reasoning is fairly sound, the NPL problem is still there, structural reform has not gone as far as some claim, and the banking situation only seems sounder because all the speculation about recovery has seen the value of equities rise, and this of course has boosted the value of bank reserves. But I am convinced for another reason which Katz doesn't mention (in fact in the course of two books he manages to mention that Japan has a demographic problem about twice). This is why I'm convinced even his ten year horizon could be way too optimistic. Without a change in mentality towards immigration Japan is unlikely to go anywhere particularly attractive, and this change is the one I definitey don't see coming.

Fool me once, shame on you. Fool me twice, shame on me. How about three times? Japan is now experiencing its third cyclical upturn in the last decade. Once again, we hear that "Japan is back". Once again, investors are betting tens of billions of dollars that this recovery will last. Doubtless a skilled market player can get rich in a stock market that doubles and halves every few years. But unfortunately, this time is not different. One reason we know this is that the arguments being handed out today are the same premature declarations of victory handed out in the previous false dawns: that the non-performing loan (NPL) problem is being solved and that companies are rapidly restructuring. One new rationale is that Junichiro Koizumi, the current prime minister, is a reformer.

But Mr Koizumi was at the helm when, not so long ago, alarmists insisted that Japan was about to crash. Indeed, some of today's born-again bulls are yesterday's doom-sayers. There is also a more fundamental reason for scepticism: Japan cannot recover without structural reform. Japan's long-term potential growth is still about 1.25 per cent. This rate cannot be raised without a productivity revolution born of structural reform. Meanwhile, structural defects that depress household income continue, causing a chronic shortfall in private demand. Certainly, some reforms have been made but not enough to restore vibrancy in the near term.

Bulls point out that NPLs declined in the 2002 fiscal year for the first time in six years. Nonetheless, NPLs still remain higher than in any year except one. More importantly, Japan has done little to weed out the non-performing borrowers behind the debt crisis. Bankruptcies are not rising, but falling. Japan continues to keep zombie companies going via government loan guarantees, sub-market interest rates and debt waivers. Among publicly listed companies, 16 per cent of the debt is held by companies that do not earn enough to pay even today's ultra-low interest rates. Another 14 per cent is held by companies that earn just a tiny bit more. To keep these companies afloat, 10 per cent of all loans charge less than 0.5 per cent, up from 5 per cent a few years back.

As for corporate restructuring, there is less than meets the eye. Most of the improvement in financial indicators is due to cost-cutting measures such as wage cuts - which hurt consumer demand - not genuine increases in efficiency. The average return on assets halved in the 1990s to just 3 per cent. The data to June 2003 show no trend recovery in returns, just another cyclical bounce.Company inefficiency is, in turn, the product of weak competitive pressures. Here some trends are moving backwards. Business start-ups and closures are both down. In most industries, the market share of the top three companies is increasing, partly because of the merger and acquisition activity that some mistakenly hail as reform.

Worse yet, most of the good news is limited to Japan's biggest companies. In the 2002 fiscal year, which ended in March, the 1,200 biggest publicly listed companies enjoyed a 38 per cent increase in operating profits. But they produce less than 10 per cent of Japan's economic output. By contrast, the small and medium-sized companies that produce most of Japan's output suffered a 12 per cent drop in both sales and operating profits. Mr Koizumi does seek reform. However, his priority is not the economy. It is destroying the corrupt nexus linking party bosses in the ruling Liberal Democratic party (LDP), state enterprises in construction and elsewhere, and their bureaucratic protectors. He has split anti-reform factions of the LDP and is now ousting Haruho Fujii, the Highway Corporation president, for allegedly cooking the books.

Time will tell whether Mr Koizumi can go on to privatise some of the main state enterprises, such as the Highways Corporation and postal savings. Some of the new allies he made to secure his re-election as party leader oppose these reforms. Even if he succeeds, privatisation alone will have a marginal impact on growth so long as the resulting entities remain virtual monopolies, as when Nippon Telegraph and Telephone (NTT) was privatised in the 1980s. Markets must be open to new competitors. Reform will eventually return Japan to sustained growth of 3 per cent or so. But that will probably take another decade. As for this year, it takes more than a few swallows to make a spring.
Source: Richard Katz, Financial Times

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