1221 Avenue of the Americas, NYC, NY 10020February
Is Japan’s Economic Recovery in Danger?
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
The Japan External Trade Organization (JETRO) provides the following
information, which examines these issues and other relevant developments
in greater detail.
Investors Dramatically Raised their Exposure to Japan in 2004
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
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
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
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."
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
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:
- Record Profitability: Aggregate pretax profits of listed Japanese
companies is predicted to grow 19.2% to $229 billion for the year
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.
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
keep falling, even as banks continue to clean up their balance
- 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
- 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
- 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
- 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
exchange for granting local governments greater tax collection
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
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
and Japan's leadership within the BOJ has a clear policy goal to
Differentiation Between Winners and Losers is now in Process
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.”
Divergence Makes if Necessary to Look Beyond Macro Data
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.
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.
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.
M&A Leading to Further Restructuring and Rationalization
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
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.
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
||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:
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