Japan's promise - and problems
By John Berthelsen
There is very little but euphoria today over the performance of Japan's benchmark Nikkei index of 225 stocks, which rocketed upward by 45 percent over the past four months, making it one of the world's best-performing equity markets. That the market has fallen back over the past week on yen fears hardly tempers the excitement.
There is added euphoria over the re-election last week of Liberal Democratic Party president and Prime Minister Junichiro Koizumi with 61 percent of the vote in his party. Now, according to a wide variety of commentators, Koizumi will be able to take the action that has eluded him for the past three years in restarting Japan's economy. Already, he has replaced the finance minister with a strong ally and placed other allies in strategic ministries.
But the fact is that Japan's financial system is a chamber of horrors and its long-term fiscal outlook, though growing slightly better, is staggeringly bad and appears to be based in large part on exports to recovering Western markets. If the US were to stumble, Japan faces yet another setback, Koizumi or no. There is plenty that can go wrong before Japan regains its turbo economy.
The Japanese themselves seem to know this and appear to have been staying out of their own market, while foreign institutional ownership of Japanese stocks is skyrocketing. Fujio Mitarai, president and chief executive of Canon, the office-equipment maker, was quoted last week as saying that, although the market is largely driven by foreign investors, this is creating the psychological boost essential to the recovery. The gaijin think they have found a gold mine.
This is not the first time that equity markets have come unhooked from reality; witness the recent US experience from 1995-2000, when the Dow Jones Industrial Average roughly quadrupled in value. Nor will it be the last, and it is a continuing lesson that markets have little to do with present real economic performance as they look forward to future possibilities. They run on sentiment and fear, Adam Smith to the contrary, and they inevitably overshoot. But in the meantime, lots of people make lots of money on the greater-fool theory, which holds that you can always find a sucker to sell to in order to get out in time.
Although the market has been reacting to reports that Japan had been growing faster than the United States for the first time since 1991, newly revised second-quarter gross domestic product (GDP) figures indicate that real growth was almost certainly much lower than the annualized 3.9 percent announced early this month, and actually was probably somewhere in the neighborhood of 2 percent. The Bank of Japan (BOJ) said on Tuesday that a record 51 percent of households have taken money from savings so far this year, and that 22 percent of Japanese - traditionally the world's most thrifty savers - have no savings at all.
That shows that Japan's sustained recovery may not be as fast as some skyrocketing stocks indicate, after the equity markets had been at dismal levels for more than a decade. The GDP deflator has been negative since 1995 and, as a result, the economy is smaller today than it was in 1997.
"The capital position and profitability of the banks and life insurers are weak, and non-performing loans, while declining, remain high," the International Monetary Fund (IMF) said in a wide-ranging report issued this month. "In addition, the financial institutions are exposed to significant market and credit risks. As a result, financial sector weakness has held back prospects for a sustained [economic] recovery."
While Japan's financial system is fragile and a systemic crisis now seems unlikely, the report continues, "expeditious and forceful action is required to avoid further deterioration". And, while Koizumi has started his new tenure with dramatic action, it remains to be seen whether he can sustain it in the face of widespread opposition on the part not only of the dinosaurs in his Liberal Democratic Party but of lots of other vested interests in Japanese society. Other than having extraordinarily unconventional hair for a Japanese politician, his previous reform policies have largely been abandoned either voluntarily or in the face of concerted opposition within his own party.
Will the market continue to soar in the face of this bleak assessment? If Asia's equity analysts have anything to say about it, it probably will. The equities strategists and economists covering Japan sharply increased the consensus forecast after second-half GDP statistics were released. The TOPIX index promptly hit three-year highs before profit-taking set in, nonetheless still managing to record a very healthy 2.7 percent gain over the week.
"Given the consensus view, there is more scope for expectations about Japan to be exceeded than is left for the US or Europe," said a recent report by CLSA in Hong Kong.
JP Morgan Fleming Asset Management agrees. A July research note pointed out: "We continue to believe that there will be further upgrades to profit forecasts in September and October, as previous forecasts were quite conservative, while recent economic data [have] shown signs of a further acceleration in industrial activity. News flow remains supportive and new ideas keep appearing, but the strength of the yen may be a short-term risk."
However, for instance, the market was brought up short this week by the currency markets, which increasingly believe that the BOJ, which so far this year is believed to have spent at least US$75 billion on US treasuries to intervene to stem the yen's rise against the dollar, may slack off buying, at least temporarily. The dollar immediately dived to a two-and-a-half-year low against the Japanese currency, trading as low as 110.5 yen briefly.
There is a growing danger that if the BOJ doesn't act before September 30, the fiscal half-year point next week, currency traders could go after the yen in a big way, forcing the Bank of Japan to intervene decisively. For instance, HSBC believes that the rising domestic economy and firm asset prices will preclude yen intervention. HSBC's year-end target for the yen is 107 to the US dollar.
It is questionable how far the yen might rise before it begins to threaten the fragile export-led recovery. With short-dollar, long-yen positions growing, according to the Financial Times, there is the possibility of a massive wave of BOJ-sponsored yen selling to catch the market off guard and force the dollar sharply higher.
While the Japanese authorities have taken important regulatory and legal steps to strengthen the financial sector, and banks have attempted to improve their capital adequacy, raise provisioning and accelerate the disposal of non-performing loans (NPLs), "it has become clear that financial institutions have not been able to solve the problems on their own", the IMF says, noting:
The banking system's capital cushion has been run down to minimal levels, and most new capital has been in the form of interest-bearing paper that is not the basis for stronger balance sheets.
Life-insurance companies are under considerable stress as a result of the declines in investment income and stock prices, which have weakened their capital base.
The corporate sector is highly leveraged and deflation has increased the real burden of debt.
On a macroeconomic basis, land values remain weak, reflecting the sluggish economy and overhang in the real-estate market. Despite the broad run-up over the last seven months, the Nikkei index of 225 stocks is hovering near 11,000, hardly more than a third of the 38,000-plus where it closed in 1989.
Although Japanese banks have disposed of more than 90 trillion yen worth of non-performing loans amounting to 16 percent of GDP since 1992, official NPLs still account for more than 8 percent of outstanding loans as new problem loans continue to emerge.
Return on assets (ROA) on an operating-income basis in the corporate sector has remained flat since 1993. To compare this with other Group of Seven countries, ROA in Japan is about half to a quarter that of Canada, the United Kingdom and the United States.
In another IMF report issued this month on selected issues facing the health and vulnerability of the Japanese economy overall beyond the financial sector, a team of five economists wrote that "we find that weak companies account for a significant portion of total debt and continue to make losses".
In 2002, despite record negative real interest rates, companies with non-performing debt accounted for 16 percent of Japan's total debt, while those with losing money on operations accounted for 10 percent of total debt. A quarter of those weak companies had reported negative operating profit for two years or more. While debt-to-equity ratios in the corporate sector have fallen from a peak of 287 percent in 1975 to 155 percent in 2002, debt leverage is still breathtaking. That 155 percent compares with an average of 80 percent in Germany, 70 percent in the US, and 45 percent in the UK.
The fund managers are investing in individual companies, for which they have research reports of fast growth prospects, but the overall scenario is thus hardly encouraging for the time being. The financial sector is still weak, land prices have not recovered much and several companies are still in need of restructuring to make themselves profitable.
As Jamie Miyazaki wrote for Asia Times Online on September 23 (Barbarians at the gate, vultures overhead), the Industrial Revitalization Corp of Japan (IRCJ), established in May as a kind of answer to the Resolution Trust Co that cleaned up the debris of the United States' savings-and-loan scandal, so far looks ineffective.
The announcement this month of the first batch of firms that the IRJC intends to help restructure may indicate a new willingness by Japan to tackle failing firms, or it may not. Its initial five candidates for cleanup and their relatively small size, with the exception of Mitsui Mining, may signal that the IRCJ will function as a hospital for zombie companies instead of a graveyard. No firms from Japan's TMT manufacturing sector, which probably stand the best long-term chance of revitalization, appear on the IRCJ's initial candidate list.
There have been some tough decisions made, particularly in allowing Resona Bank, Japan's fifth-largest, in effect to go to the wall in April, resulting in its de facto nationalization. The markets seem to believe that this kind of reform will continue, that privatization will pick up speed and that business deregulation will move forward as well.
But it would be wise to remember just how far Japan has to travel through some considerable thickets before it gets where it has to go. Annualized 2 percent GDP growth, in a fragile economy whose population is aging inexorably with little chance of immigration to revitalize it, does not translate into sustained 45 percent annual performance for the markets.
(Copyright 2003 Asia Times Online Co, Ltd. |
