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After months of bad feelings over the economy, it looks as though things are improving – to a point. The Bank of Japan’s most recent quarterly Tankan report showed that business sentiment has almost made it to positive territory. On the day of the announcement, the Nikkei 225 stock index rose 2.2% to 9,278, a nine month high and things have continued to improve, with it now approaching 10,000. The improvement in business sentiment comes as disruptions from SARS and the war in Iraq fade, while oil prices are gradually falling and stock prices have enjoyed a two-month rally. The U.S. economy is also gradually getting better, which helps the outlook for exporters such as Toyota, Honda Motor, and Matsushita Electric. Reflecting the Tankan, a number of manufacturers have raised their pre-tax profit forecasts for the fiscal year that began in April.

Part of Corporate Japan’s cautiously improving sentiment comes from the fact that companies have been active cutting costs. Yet, there are also indications that sales will be up in the second half of the year, part of which will come from overseas. This, in turn, is helping to push an increase in capital spending.

Although the Japanese economy is showing a stronger staying power than earlier thought, the “recovery” is far from dynamic and the banking sector remains a concern. Exports remain the hope of achieving 1% GDP growth for the year, especially as domestic sales remain sluggish. The job market is hardly reassuring, with unemployment hovering above 5%. The Japanese consumer also faces falling incomes hurt by ongoing deflationary pressures and higher taxes. On top of this government finances are in bad shape – the fiscal deficit will easily top 7% of GDP this year and public sector debt to GDP is the highest among G-7 economies. Yet, the situation is perhaps not as dire as initially thought. Revised figures for GDP in Q1 2003 show that it grew at an annual rate of 0.6%, rather than stagnating. And Japan still maintains a massive current account surplus. It actually widened by 2% in April, to $111.7 billion, equal to 2% of GDP. This compares favorably to the U.S. which is expected to run a 5% deficit.

One consequence of the uptick in business sentiment is the recent decline in the Japanese Government Bond (JGB). With hopes of a better economy and less deflation, many Japanese investors have opted to put their funds into equity markets, fueling an upward swing in the Nikkei. The recent volatility in JGBs has also helped make U.S. and European bonds more attractive. The top four Japanese life insurance companies increased their holdings of foreign bonds by more than Y2 trillion to Y10 trillion at the end of March over the same period a year earlier. Does all of this portend a major crisis for JGBs? Although it is easy to point to the Nikkei and say that good times are here – considerable deflationary pressures remain that will drive investors back to JGBs. Moreover, 95% of the $4.7 trillion in JGBs are held by Japanese investors – many of who will maintain a position, unlike more fickle foreign investors.

All of this has important political consequences for Prime Minister Koizumi. He has an upcoming LDP party leadership convention in September, in which his more conservative rivals will seek to either displace him – which is not likely -- or to cut into his influence by attacking Economy Minister/chief financial regulator Heizo Takenaka, whose tough decisions on Resona Bank angered party conservatives. With the recent Tankan report and indications that industrial production and exports grew over the last two months, Koizumi goes to the LDP convention in September with a much stronger hand than he has had in months. This gives us hope about reform. If nothing else, it helps Koizumi keep Takenaka in the driver’s seat on the economy and bank reform.