Focus: Japan’s Domestic Economy

JETRO, 1221 Avenue of the Americas, NYC, NY 10020September 9, 2005

Japan Enters New Phase of Its Economy Recovery

Encouraged by positive reports, foreign observers are becoming far more positive about Japan’s economic prospects. The latest data, includes noteworthy improvements in employment, land prices, consumer and industrial confidence as well as spending, indicating that Japan’s economy is gaining speed and may be entering a new phase of sustained recovery. Regulatory changes have played an important part in laying a foundation for these developments as well.

A move by Prime Minister Koizumi to call for new elections on September 11th in the face of resistance to his efforts to privatize Japan’s $3 trillion Postal Savings System (PSS) has led some analysts to suggest that heightened political uncertainty will undermine further economic progress. Investors, however, have been accelerating their allocation of funds into Japan-related investments. Many believe this is because the Prime Minister’s actions have served to focus a spotlight on those who have been resisting reform. They suggest that regardless of the outcome on September 11th, the entry of non-traditional pro-reform candidates into the political arena, is likely to have major consequences -- not only in terms of economic reform – but also in respect to political, social and cultural practices

There are certainly risks to investing in Japan, and improvement is not likely to be linear in nature. Nevertheless, improving fundamentals, favorable valuations, and ongoing corporate rationalization suggests both portfolio and corporate investors would be wise to pay more attention to Japanese business and financial markets.

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

Japan Making Significant Progress in Initiating Sustainable Domestic Recovery

The Japanese economy continued to yield positive economic news on multiple fronts during the second quarter of calendar year 2005. Bankruptcies decreased 9 % year-on-year and unemployment fell as well. Japanese companies also sustained their efforts to upgrade plant and equipment, boosting investment spending by 2.2 % over the April-June quarter.

Although Japan’s real GDP rose only by a modest 0.3 % in the April-June quarter (a 1.1 % annual rate), a look at the broader numbers led BNP Paribas economist Yoshimasa Maruyama to state, “… the numbers are very strong. The headline may not look that good, but the reality is far more positive.” Supporting this assessment, government statistics reported that Japanese economic output rose a seasonally adjusted 1.5 % in June. Electronic components represented an important component of this increase and suggest, in the view of Credit Suisse First Boston (CSFB), that Japan’s IT sector was making progress in reducing its inventories. Machinery orders were also a standout, surging by 11 % in June from a month earlier.

June’s Tankan survey also showed a significant rise in business confidence. Commenting on the survey, CSFB economist Yukari Sato opined in a Financial Times article that the survey results were “an economic turning point for Japan.” There was more behind this optimism, however, than the Tankan survey. Japanese exports in June, for example, rose for the first time in three months, reaching a record high of $48 billion.

This news was complemented by a rise in Japanese employment and retail sales figures, which are now at their highest levels since 1997-1998. As a result, Jesper Koll, chief economist at Merrill Lynch Japan asserted in the aforementioned Financial Times article that, “the conditions for a self-sustaining domestic demand-led non-inflationary growth path are better than ever. It’s never been as good as this.”

On the employment front, Japan’s jobless rate fell by almost 300,000, to its lowest level in seven years.

Source: Government of Japan, Labor Force Survey, etc.

Other statistics hint that Japan’s improving labor situation is fueling growth and a rise in full-time positions as well as wage increases. Data shows average earnings in June increasing 1.1 % over the previous year. Positive trends in land prices in certain areas of Japan, also indicate a trend toward greater confidence on the part of Japanese consumers. Equally important, there are also signs that Japanese citizens are beginning to draw money from their bank accounts to invest in the stock market. This suggests Japanese households are becoming less risk adverse.

Domestic consumption, which many view as the “missing link” to a sustainable recovery in Japan, also appears to be on more certain footing. Progress, however, has not been linear. For example, after a 2.7 % year-on-year rise in May -- following even stronger April results, private consumption consolidated to a more modest year-on-year rise of 0.1 % in June. Nevertheless, Takuji Aida, an economist at Barclays Capital, took the position that “Japanese domestic demand is much stronger than the markets expects.”

Another factor troubling Japan in recent years is the phenomenon of deflation. Deflation limits domestic spending as it reinforces a reluctance to consume. While signs of deflation continue to exist in Japan, current data shows it has begun to ease or even reverse itself in certain areas. Barclay’s Capital, for instance, argued that data showing a rise in clothing prices “where deflationary pressure had previously been strongest, is symbolic of the easing deflation in the Japanese economy.” Other commentators have pointed to the decline of 100 Yen stores as evidence of the moderation of deflation. Indeed, in the business sector, prices are actually increasing.

Source: Government of Japan


Japanese Government Accentuates Commitment to Restructuring & Reform

Another factor that bodes well for Japan is continuing efforts by its government to create a positive environment for restructuring, reform, and foreign investment. Measures initiated since the adoption of the Action Plan for Economic and Structural Reform almost ten years ago include tax reforms, changes to the Anti-Monopoly Act, and the development of new policies vis-à-vis hostile takeovers. Japan’s nascent policies with respect to takeovers are summarized in the following chart:

Source: Japanese Ministry of Economy, Trade and Industry

These steps have been well received by foreign governments, industry associations and investors and are reflective of Japan’s continuing desire to encourage increases in foreign investment through mergers, joint ventures, and even hostile takeovers – a practice considered virtually impossible in Japan even a year ago. Initiatives to support FDI are also likely to derive additional energy in the future as Japanese and foreign shareholders are increasingly willing, and empowered, to exert their influence on management to gain maximum efficiencies and value.

Corporations Now Moving to Enhance Efficiencies and Shareholder Value

The corporate sector in Japan has not been idle in the face of numerous government-led policy and reform initiatives. Changes in competition and tax laws, coupled with market pressures, have induced consolidation in the steel, paper/pulp, and distribution sectors. Furthermore, Japanese firms have begun to unwind cross-shareholdings. As the Japanese corporate model has changed, firms have become more willing and eager to embrace foreign investment.

Source: Japanese Ministry of Economy, Trade and Industry

These changes have led to a surge in M & A activity. Japanese firms are now utilizing M&A techniques to restructure and enhance the competitiveness of their operations. At the same time, M&A activity between Japanese and foreign firms has also risen significantly since the early 1990s, when it was virtually nonexistent -- yet still accounts for only a relatively small amount of total activity. As foreign entities increase their commitment to Japan, and Japanese managers and employees become increasingly comfortable operating under foreign ownership, cross border M&A is likely to represent a progressively larger share of total activity.

Individual Japanese firms are also introducing other measures to achieve efficiencies and to control costs. Sanyo, for example, a major electronics firm, recently announced plans to initiate a comprehensive restructuring, involving a 15% workforce reduction. Sanyo’s new CEO, Tomoyo Nonaka, the first woman ever to head a leading Japanese electronics group, noted in a Financial Times article titled “Sanyo wields axe to achieve turnaround” that “there will be no taboos” in the restructuring program. For its part, Sony appointed a foreigner, Howard Stringer, as Chief Executive, in an effort to restore the firm’s role as an innovative global powerhouse. Restructurings and consolidations are a hard reality of business, even where so-called “new economy companies” are concerned. For instance, in the game software sector, Sega has merged with Sammy, Bandai with Namco, and Takara with Tomy.

Japanese businesses continue to invest, to enhance their competitiveness and to prepare them for new opportunities. During the first quarter of 2005, Japanese manufacturers increased their investment by approximately 8 % while other Japanese firms boosted their investment by roughly 7 %. According to GaveKal Research, what may be most noteworthy about this data is that Japanese firms are investing to “churn out profits;” that is, “without lowering the returns on invested capital.”

Higher levels of corporate investment are attributable, to a large extent, to the double-digit increases in profitability experienced across both the manufacturing and non-manufacturing industries. This is particularly true among SMEs. Indeed, Japanese manufacturing SMEs recorded a dramatic 42 % increase in profits in the first quarter of 2005 -- compared to the first quarter of 2004.

A third area where there are positive developments are actions taken by Japanese managers to focus on shareholder value. This is manifest in the rising number of dividend payout increases and share buybacks announced in recent years. Japanese companies are also according more importance to communicating with outside investors, sometimes hiring investor relations firms to connect with shareholders.

Source: Nomura Securities

Many analysts believe Japan’s changing corporate environment, coupled with supportive policy moves, is opening up a range of new opportunities. U.K.-based Hermes, for example, has partnered with Nissay Asset Management of Japan (Namco) to create one of many new funds seeking to foster change on under-performing companies. Wataru Tanaka, the president of Namco, told the Financial Times “the time is right to introduce a new investment philosophy based on encouraging shareholder friendly management.”

Aside from market forces, already-enacted government policies as well as policies now being developed, will serve to sustain and enhance the transformations now taking hold. More specifically, changes in disclosure requirements, accounting standards, and the tax code will continue to generate incentives for Japanese firms to pursue efficiencies, to embrace domestic and foreign partners, and to invest at home and abroad.

Investors Significantly Increasing their Involvement in the Japanese Economy

Japanese stock market indexes hit four year highs in late August, with both the Nikkei-225 and Topix reaching levels not seen since April 2001. This strength had much to due with inflows of foreign funds, which had been positive for five consecutive weeks, and totaled nearly $450 million in the week ending August 17 alone. The strengthening case for investing in Japan is linked to numerous factors, including improvements in consumer demand and corporate spending, corporate profitability, and a newfound emphasis on stockholders, and supportive government policies. In addition, rising confidence in, and coverage of, Japanese economic trends, is helping to attract a wider group of investors, who are now coming to recognize the potential for diversification and the fact that many Japanese firms possess more favorable stock market valuations than their competitors in European and U.S. markets.

Despite the surge into Japanese equities that has been seen, Hideki Takayama, chief investment officer at State Street Global Advisors, stated in remarks to the Wall Street Journal, “It is not too late” to invest. For his part, Youssef Affany, head of investment counseling at Citigroup Private Bank observed, “Japan is about to realize its longer-term growth possibilities”. Technically-oriented investors also saw positive signs in the surge of Japanese indexes through resistance levels. As reported in Barron’s, even Japan bears seem to be embracing the view that the country has reached a turning point with Dr. Carl Weinberg of High Frequency Economics, a long-time pessimist, expressing hope about Japan’s economic prospects.

Corporate and other direct investors also seem to be more optimistic about the prospects of Japan and Japanese corporations. According to government data released in June, foreign direct investment over the twelve-month fiscal year ending last March was approximately $36 billion, double the previous twelve-month period. Incoming FDI was substantial enough to outweigh outgoing FDI for the first time since Japan started keeping records in 1950.

Japanese Fundamentals Likely to Improve Despite Any Present Uncertainty

While fund managers such as Hans Goetti, of Citigroup Private Bank in Singapore, maintains a thoroughly optimistic outlook, stating in a recent Bloomberg interview that “Japan’s story is one of the most compelling you can find globally”, it should be noted that all investments are not without risk and uncertainty. For one thing, the rush by many financial investors to redress their underweight allocation of funds to Japan may lead to some consolidation in coming months. This should not be surprising given the Nikkei 225 index rose over 5% in the first 12 trading days since lower house elections were called on August 9th. Another potentially salient risk is the impact of increasing oil prices as well as the potential for economic weakness in China, Europe or the United States. Despite increasing signs of domestic strength, these markets absorb large quantities of Japanese exports. Therefore, weakness in these markets could have major implications in terms of economic activity in Japan.

On the bright side, Asian integration and Japan’s increasing ties with India and Southeast Asia, both detailed in the last JETRO Focus, will make it somewhat less vulnerable to the vagaries of the American and European economies. On the other hand, should U.S. economic growth remain stable, this is likely to create additional opportunities and remove, in the words of Richard Jerram, economist at Macquarie Research, “one risk that could disrupt the domestic recovery” in Japan.

While analysts and investors need to incorporate risk and volatility into their investment plans, they also need to be cognizant of the continuing improvement in Japan’s underlying fundamentals. Rising output growth, consumer spending, increasing capital investment, as well as major changes in Japanese corporate strategies are all leading to greater interest and opportunities for business and investors. Finally, it should be emphasized that many Japanese companies are now valued at what Goldman Sachs recently termed “… historical lows”. This allows for substantial appreciation both within selected Japanese equities as well as fixed investment into companies, real estate, greenfield projects and many other areas and sectors.

Momentum Likely to be Sustained Regardless of September Election

WOn August 9, Japanese Prime Minister Koizumi dissolved the lower house of parliament after the upper house refused to back his plan for the privatization of Japan’s Postal Savings System (PSS), the largest financial institution in the world. As detailed in a previous JETRO Focus, the PSS controls a third of Japanese household deposits and a major share of Japan’s life insurance market. It is also a major purchaser of Japanese government bonds.

Certain commentators have interpreted the dissolution of the Lower House of Parliament as signaling the end of Prime Minister Koizumi, the LDP, and the PSS reform agenda. Investors, however, appear to be unconcerned, and in fact have moved to accelerate their fund allocations into Japan. Indeed, the Nikkei 225 and Topix finished incrementally higher the day that Koizumi called snap elections and ended the week with its largest weekly advance in more than 18 months. Paralleling this, the Japanese yen, which initially fell after the defeat of the PSS reform bill, ended unchanged and rose to its highest level since July 21. Standard & Poor’s, the credit rating agency, affirmed its sovereign ratings for Japan.

In fact, some analysts have noted the primary implication of the Prime Minister’s actions has been to focus a spotlight on those legislators who have been opposing reform. As a result, many stories are now being written about the 37 pro-reform “assassins” who are now campaigning with the support of the Prime Minister. One candidate recently commented in the Mainichi Daily News on the role of these new players stating, "I think they're trying to stimulate the world of politics by bringing in more people with different backgrounds". As a result, it can be imagined the entry of more women and other non-traditional candidates into the political arena, is likely to have major consequences regardless of the outcome on September 11th – not only in terms of economic reform – but also in respect to political, social and cultural practices. It would be fair to say this is likely to further open up Japan to foreign involvement and lead to many exciting new business and investment opportunities.

Perhaps, the most important factor behind rising investor optimism, is the belief that Japan has already reached the level of momentum needed to sustain its economic recovery efforts. For example, the movement to clean up Japan’s financial system is eliminating overcapacity and debt. This is one of many factors leading to powerful political, market, and attitudinal shifts that are likely to sustain Japan’s economic transformation and recovery regardless of any short-term political uncertainty. This can be seen in comments by Jan Lambregts, head of Asia-Pacific research for Rabobank, who told the Financial Times, “medium-to-long term, the positive backdrop for Japan is mostly an improving economic story and one we don’t think the same or different political leadership could easily mess up,” Tetsufumi Yamakawa, co-director of Asian economic research at Goldman Sachs echoed these sentiments in the same article stating that, “reversal to the ongoing structural reform policies laid down by Koizumi so far, is difficult to imagine.”



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: 

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