Focus: Economic Recovery

JETRO, 1221 Avenue of the Americas, NYC, NY 10020February 28, 2005

Is Japan’s Economic Recovery in Danger?

Japan has enjoyed a healthy GDP growth rate over the past two years, however, economic weakness over the last three quarters has caused some analysts to question whether this progress marks a sustainable improvement or simply reflects a cyclical upturn that has now passed.

The simple answer is there is no reason to worry about Japan’s underlying fundamentals. This conclusion can be reached through increasing evidence of ongoing structural change, with key developments, including: 1) dramatic increase of foreign direct and portfolio investment, 2) strong aggregate GDP growth in 2003-2004 after more than five years of anemic growth, 3) improving corporate and financial efficiency and encouraging policy reforms, 4) increasing social acceptance of differentiation between winners and losers and an entrepreneurial career path, 5) accelerated economic divergence between companies and sectors and use of M&A as a corporate finance tool, and 6) rising interest in real estate and gradual movement toward greater consumer demand.

The Japan External Trade Organization (JETRO) provides the following information, which examines these issues and other relevant developments in greater detail.

Foreign Investors Dramatically Raised their Exposure to Japan in 2004

Many foreign direct and portfolio investors bypassed Japan during the 1990s and early 2000s believing other markets offered better returns. Their reluctance was based on perceived barriers of entry, as well as Japan’s high cost structure, burdensome regulatory infrastructure and a business and social orientation that emphasized market share over profitability, seniority over achievement, and exports over domestic consumption.

Recognizing the need for change, Japanese policymakers adopted an Action Plan for Economic and Structural Reform in 1996. This has helped to introduce market forces and trends that are dramatically transforming Japanese lifestyles and the way business is conducted in Japan.

Value Investors Began Recognizing the Potential of Japan in the late 1990s

In the late 1990s, value and distressed investors, effected by the strained valuations that came to characterize the dotcom era, began to look for alternatives. Finding little in the U.S. that made sense in their investment models, they sensed that Japan offered a more attractive environment.

As a result, several unprecedented transactions, in which foreign investors such as Renault, Ripplewood Holdings and Cerberus took control of major Japanese firms including Nissan, the Long Term Credit Bank (LTCB) and Nippon Credit, were realized. Along with smaller transactions such as WL Ross’ acquisition of a local bank in Osaka, the possibilities that awaited those that were willing to make the commitment needed to enter the Japanese market became more evident. The high profitability of many of these transactions, as well as the bursting of the dotcom bubble and emergence of Enron and other scandals in the U.S. further encouraged investors to seek opportunities beyond U.S. shores.

Foreign Direct Investment into Japan Rose by 144% During First Half of FY 2004

In recent years this trend has gained serious momentum as both direct and portfolio investors significantly raised their exposure to Japan. Japanese government data, for example, reveals during the first six months of FY2004, foreign direct investment into Japan reached approximately $20.32 billion. This 144% increase – was more than was generated over the entire 2003 fiscal year.

Of this total, approximately 98% consisted of investments in service industries. Accounting for almost $19.9 billion – this was a rise of 219% over the first half of FY 2003. It included approximately $15 billion in finance and insurance investments, $3.8 in telecommunications, $510 million in general services and $128 million in real estate. Conversely, foreign investment into manufacturing declined almost 79%, accounting for only 2% or $442 million of the total.

U.S. direct investment into Japan rose more than 760% over this period -- consisting of almost 69% of total foreign direct investment into Japan during FY2004. Investors from the European Union accounted for slightly over 15%.

Portfolio Investment Into Japan Also Rose Significantly

Net purchases of Japanese equities and bonds by foreign investors totaled ¥15.26 trillion in 2004. This is the highest level since the Ministry of Finance began compiling these statistics in 1981. Net equity purchases by foreigners accounted for ¥10.46 trillion – a 7% increase over 2003. Net foreign purchases of bonds totaled ¥4.8 trillion. This was the first time purchases exceeded sales in three years.

In addition, as of September 30, 2004, 82 major publicly-traded companies in Japan were at least 30% owned by overseas investors – compared to 47 a year earlier.

GDP Growth in 2004 Weakened After Blistering 5.8% in First Quarter

Government data released on February 16th indicated Japan's real GDP contracted by 0.5% in annualized terms during the final quarter of 2004. Dragged down by weaker than expected consumer spending and external demand, this fall marked the third consecutive quarterly contraction, following revised falls of 0.3% in July-September and 0.2% in April-June.

For the full year, however, strong 5.8% growth during the first quarter, helped push up real GDP by 2.6% over the course of 2004. This marked a second straight year of growth, and reflects Japan’s best performance since the economy grew by 3.4% in 1996.

The fourth quarter data was worse than expected by economists surveyed by the Dow Jones and Nikkei news service, who predicted an annualized quarterly rise of 0.5%. Domestic demand remained positive, though added only 0.1% to overall growth. This was not enough to make up for weaker external demand, which declined for two consecutive quarters. This was not due to weak exports, which rose by 1.3%, but an even larger 3.1% rise in imports – which were affected by rising prices and demand global for steel, energy and other raw materials.

Private consumption, accounting for approximately 55% of Japan’s GDP, also came in lower than expected, registering an anemic 0.3% decrease during Q4. Many analysts attribute this weakness to a relatively warm winter, which hurt demand for clothing, and the impact of typhoons and earthquakes that impinged on consumer spending.

Corporate optimism, however, is reflected in the 0.7% rise of capital spending in Q4 – a further improvement over the 0.4% registered in Q3. Corporate expenditures are expected to stay strong, with February data revealing Japanese core machinery orders -- a leading indicator of capital spending -- rose 6.0% during October- December over the same period the prior quarter.

Many investors are also expressing optimism despite the current data. Sabrina Jacobs, for example, a currency strategist at Dresdner Kleinwort Wasserstein, recently stated in one media account that "Investors are increasingly realizing that the second-half recession in 2004 was the low point in Japan and that it's most likely getting better."

This sentiment was also reflected in comments by Japanese Finance Minister Sadakazu Tanigaki, who noted on February 20th Japan's economy will "improve in the latter half of this year."

Current Consolidation Encourages Corporate Efficiency and Change

One of the most important objectives of Japan’s ongoing transition has been the need to remove structural barriers. This includes cross-shareholdings, relationship-based main bank lending and an overly cumbersome regulatory environment. While these practices helped Japan to industrialize, they now lead to a misallocation of resources and to protect marginal companies and other entities at the expense of the nation’s overall efficiency and competitiveness.

As a result, the current slowdown, while unfortunate, may represent a blessing in disguise. It can be seen as a long term positive – exerting additional pressure on companies and individuals to maintain the pace of change now taking place in Japan. This sentiment can be seen in the comments of Nobuyuki Koga, president & CEO of Nomura Holdings Inc., who noted in a recent media interview “It has become clear that there is no future for businesses that are protected only by corporate laws and restrictions."

Substantial change -- in government policies, corporate actions as well as the orientation of Japanese companies and the lifestyles of Japanese citizens have been reported in past Focus Newsletters and other sources. Indeed this movement is expected to continue and there are few analysts – even among those that are not presently optimistic -- who maintain economic growth in Japan over the past few years was achieved strictly on the basis of cyclical factors.

Moving forward, Japan will need to redouble its efforts to maintain the pace of corporate and regulatory reform. While much needs to be done, there are many signs of encouragement from the private and public sectors, with several illustrative examples including:

Private Sector:

  • Record Profitability: Aggregate pretax profits of listed Japanese companies is predicted to grow 19.2% to $229 billion for the year ending March 31, 2005, according to data compiled by the Nihon Keizai Shimbun. This is the second consecutive year of record profitability.

  • Non-Performing Loans: The bad-loan ratio of major banking groups fell .6% in the six months preceding Sept. 30, 2004. This is only .4% away from the 50% reduction goal that has been scheduled for March 31,2005.

  • Employment: Japan’s unemployment rate fell to a six year low of 4.4% in December, as companies moved to hire more workers. The ratio of job openings to applicants is also at its highest since 1992. Bankruptcies keep falling, even as banks continue to clean up their balance sheets.

  • Real Estate: Listed rents for newly-built office space in Tokyo rose sharply in 2004 and overall commercial vacancy rates have fallen. This is significant given the large amount of construction that has taken place in Tokyo over the past few years. Vacancy rates are reported to have declined in Osaka as well, and supply-demand in areas such as Nagoya are improving. It has also been reported assets in private real estate funds have soared 120% over 2004 – to a total of ¥2.2 trillion.

Public Sector:

  • Stock Swaps: Japan’s Legislative Council has recommended additional changes to it’s Commercial Code. This includes allowing foreign investors to purchase Japanese companies through using stock swaps in 2006.

  • Merger Accounting: The Accounting Standards Board of Japan plans to increase the transparency of M&A within corporate groups, by requiring that all unrealized losses be included within their income statements.

  • Local Autonomy: To make local governments more independent, Japan’s central government and ruling coalition approved a fiscal reform plan last November. This will slash subsidies over the next two years in exchange for granting local governments greater tax collection authority.

These and many other achievements are dramatically changing the Japanese economy. The progress can be seen in the words of Chief Economist at Merrill Lynch Japan Securities Jesper Koll, who in a presentation before the American Chamber of Commerce in Japan (ACCJ) noted “cross-share holding is down, accounting transparency has improved, household propensity to save is dropping, the cost of labor by unit has dropped since 1994, and Japan's leadership within the BOJ has a clear policy goal to end deflation."

The Differentiation Between Winners and Losers is now in Process

Over the years, Japan has faced significant criticism over its perceived inability to differentiate between winners and losers. Reforms passed in the late 1990s, however, as well as the success of early investors have helped to dramatically change the way business is conducted in Japan. It is true many Japanese firms resist these changes. However, the entry of companies such as Toys ‘R Us, Wal-Mart, Cisco and Starbucks as well as firms such as GE -- which has more than tripled the number of employees dedicated, and more than doubled the revenues generated from, Japan over the past ten years – and Pfizer, Citibank and AIG have created a competitive need to adjust to these pressures. This is true not only for individual firms and domestic financial institutions, sectors and regions, but also employees and students who are just beginning to plan their careers.

At the same time, current changes in Japan are also helping to ease the pain of business failure so that entrepreneurs and employees are able to start again and assets can be put back into productive use. In fact, Ministry of Economy, Trade and Industry (METI) data released in 2003 reveals that nearly 14% of entrepreneurs who had filed for bankruptcy had gone on to start new enterprises.”

Economic Divergence Makes if Necessary to Look Beyond Macro Data

As Japan continues to introduce a more flexible business environment, greater efficiencies will be achieved and winners and losers identified. Therefore, while it was always a mistake to view Japan as a nation where everyone worked together to pursue common goals, in the future it will be increasingly necessary to look beyond the macro data. The resulting differentiation will help to improve Japan’s underlying competitiveness. It will also create firm- and sectoral-level opportunities for investors who devote the commitment and attention necessary to discerning the trends, companies, individuals and opportunities that are best positioned to succeed moving forward.

For example, exporters have traditionally done well in Japan and their performance also helped to drive the recovery seen in 2003-2004. Unlike past recoveries, however, today about 80 percent of Japanese exports are going to China, rather than the U.S. In addition, the variety of goods exported are much wider, so this activity benefits a greater number of industries. This is positive and signifies the underlying competitiveness of Japanese companies and products.

Speaking of technology exports in particular, Jesper Koll, in his ACCJ presentation noted his belief that Japan continues to "upgrade the quality of its capital stock," and by doing so will stay a technology leader. Koll stated while "this year's sexy machine, the iPod," with about "10 million units sold," comes from a U.S. company, "approximately 40% of the components are made in Japan" and at this time "can only be made in Japan."

That said, many consumer electronics companies, who had been doing very well early in the year given strong demand for flat panel displays, DVD recorders and other devices are now showing slower growth. Data for December reveals the Ministry of Economy, Trade and Industry’s index for electronic devices and parts posted a 1.7% decline and one for IT and communications equipment dropped 4.9%. Some firms, however, such as Mitsubishi Electric Corp. and TDK are still experiencing strong profitability (29% and 10% growth respectively during current fiscal year). Nidec, which possesses an approximate 90% share of the ultra-small hard-drive motor market, rose an even more impressive 120%. On the other hand, Pioneer saw its operating profit decline by 95%.

Higher energy and resource prices are also affecting the Japanese economy, however, many major trading houses and other firms who focus on this sector are benefiting from rising commodities prices. Mitsubishi Chemical and other major chemical companies, for example, all reported record profits for the first half of FY2004. Similarly, Komatsu forecast an 85% rise in profits, due to strong demand for its mining equipment.

Emerging Japanese venture companies are also worthy of attention. While their small size and illiquidity, place these firms beyond the reach of most foreign investors, many show strong promise. The JASDAQ index, for example, the oldest market for young companies in Japan, has more than doubled in little more than two years. There are currently 944 companies listed on JASDAQ, including 175 initial public offerings in 2004, the highest level since the dot-com bubble of 1999-2000. The Mothers Market, run by the Tokyo Stock Exchange, lists 122 additional companies, and the Hercules market, run by the Osaka Securities Exchange, lists 110.

The combined market capitalization of these exchanges is approximately $176 billion. That does not come close to the Tokyo exchange, which possess almost 20x the market capitalization, however, these firms represent a powerful force. Their growing presence is helping to reshape Japan's institutional equity culture, the ability of Japanese citizens to pursue an entrepreneurial career path. It is also affecting the overall business culture in Japan.

Despite Current Weakness, Japanese Consumers Shows Tremendous Promise

Given the realization that a sustainable recovery must be based upon improving domestic demand, analysts have been closely watching the Japanese consumer. As the latest data shows that households lowered their consumption by 1.3% during the fourth quarter of 2004, many have expressed concern as to whether Japan is making any progress in stimulating consumer demand.

This is understandable, however, a report from Japan’s Cabinet Office noted Japanese consumers grew less pessimistic in January, as the outlook for incomes and employment improved. Confidence among households with two or more people rose to 47.4 from 44 in December. A reading below 50 indicates pessimists outnumbered optimists. In Tokyo confidence rose to 47 from 43.5.

Foreign companies including GE Capital and Citigroup are moving to take advantage of forecasted growth by expanding their consumer finance operations in Japan. Their optimism is based upon recognition of the underlying fundamentals and the fact there is so much potential to be realized, especially considering the consumer debt-loads and extended consumption patterns seen in the U.S. and other markets.

Japanese firms are also moving to offer a broader range of services to consumers. Orix Corp., for example, holds a dominant position in the auto-leasing market. This generates 10%+ of the company’s consolidated pretax profit. It also benefits from strong growth in real estate-related financial services. Orix’s annual return on equity exceeds 14% -- a number that compares favorably with GE Capital itself. In another case, Nissin Co., a smaller firm that engages in unsecured lending to individuals, including consumers and small business owners recently purchased the YAMAGEN Securities Co., Ltd. This will help it to expand its offerings to include services such as investment, leasing/installment credit, real estate financing, and insurance.

Domestic M&A Leading to Further Restructuring and Rationalization

Close relationships and cross-shareholdings between business partners and financial institutions have traditionally protected Japanese firms from unwanted suitors and activist shareholders. As a result, many public firms, despite possessing attractive assets and business models at attractive valuations, have attracted little attention from outside investors -- given that there was little chance that any transformation could be realized.

Changing regulations and lending practices, along with a generational transfer of assets and a changing business orientation are creating a need for a wider range of corporate finance techniques. This includes management buyouts, M&A transactions and asset securitization, such as the rising use of REIT’s in the real estate market.

Through this process many corporate subsidiaries are being forced to support themselves. A recent Nikkei account highlighted a management buyout by Omron Amakusa Corp. following original plans to liquidate and to dismiss its workforce several years ago. The shared adjustment to life as an independent company, and sense of ownership within the firm has allowed it to become profitable once again. Fifteen people have been hired over the past two years and 13 graduates will join the company this April.

As foreign and Japanese institutional investors, hedge funds, and corporations involve themselves in these transactions, several activist-oriented firms, such as Tokyo-based M&A Consulting or New York-based Steel Partners, are moving to initiate U.S.-style takeover battles. Many of these efforts have not been successful. On the other hand, last December, Steel Partners Japan Strategies, a U.S. private equity fund, decided it wasn't getting enough return on its investment in Yushiro Chemical Industry Co., a mid-sized firm. Trading well below its book value, Steel Partners, with an 8.9% stake, launched a hostile takeover bid. Steel was not successful, yet to fend off this offer, Yushiro management increased the company's dividend 14x, to $1.80 a share. They also moved to supplement their investor relations capabilities. Yushiro's stock has since risen over 50% in less than two months. Businessweek reported on this story and quoted a top Steel executive who commented "the environment in Japan is changing". Some of the impact of this and similar efforts can be seen in a recent Nikkei Weekly article which lists seven additional Japanese firms who have moved to enhance their investor relations capabilities – many for the first time – in response to equity purchases by Steel Partners alone.

As more corporate and institutional investors see the potential that can be realized in Japan, this type of activity is likely to be more prevalent. Shareholder relations will become more important and senior managers who do not realize their objectives and profitability targets will be required to justify their efforts.

This forecast would probably not surprise many Japanese corporate insiders. In a recent Nikkei news survey almost 73% of the Japanese corporate presidents surveyed noted their belief that there would be an increase in the number of M&A transactions between domestic companies over the course of 2005.

U.S. and other foreign direct and portfolio investors are advised to pay closer attention so that they might benefit from these trends and the many opportunities that are emerging.



Data, statistics and the reference materials presented within this newsletter have been compiled by JETRO from publicly-released media and research accounts. Although these statements are believed to be reliable, JETRO does not guarantee their accuracy, and any such information should be checked independently by the reader before they are used to make any business or investment decision.

  For additional information on economic and financial trends in Japan, please contact Akihiro Tada, Executive Director of JETRO NY at Tel: 212-997-0416, Fax: 212-997-0464, E-mail: 

Focus: Privatization
Focus: Economic Recovery
Focus: Entrepreneurship
Focus: Consumer Demand

Focus: Asia
Focus: Gross National Cool
Focus: Regional Development
Focus: New Policy Challenges
Focus: Investment Japan IV
Focus: Investment Japan III
Focus: Biotechnology
Focus: Investment Japan II
Focus: Investment Japan
Focus: Foreign Direct Investment
Focus: Mergers & Acquisitions
Focus: Entrepeneurship
Focus: Economic Revitalization 
Focus: Industrial Revitalization 
Focus: Foreign Investment
Focus: Bush Visit
Focus: Koizumi Visit
Focus: Economic Rebirth
Focus: Hiranuma Plan
Focus: Foreign Direct Investment
Focus: Emergency Economic Package
Focus: Action Plan

Focus: Economic Reform
Focus: Okinawa Summit
Focus: Small Business Development
Focus: New Enterprise Development
Focus: Industrial Revitalization
Focus: Economic Recovery 4

Focus: Steel

Focus: Economic Recovery 3

Focus: Economic Recovery 2
Focus: Economic Recovery

Focus is published and disseminated by JETRO New York in coordination with KWR International, Inc. JETRO New York is registered as an agent of the Japan External Trade Organization, Tokyo, Japan and KWR International, Inc. is registered on behalf of JETRO New York. This material is filed with the Department of Justice where the required registration statement is available for public viewing.