Japan, the public versus the private

Throughout the 1990s, the Japanese economy was like a jellyfish. It rose and fell with the deep-sea swell of the world economy, but ultimately went nowhere. But now things are beginning to change. For Japan's government and private sector are like two of the country's famous bullet trains on the same track, but heading full tilt in opposite directions.

The government keeps pumping in huge fiscal injections to revive the economy. But if fiscal packages could save Japan, the job would have been done long ago. Every unsustainable increase in government spending produces an offsetting jump in household savings. That's because Mr and Mrs Suzuki are much more intelligent than their rulers. As Japan's public sector debt hits 150% of GDP and government pension liabilities remain seriously underfunded - making Japan's government twice as bust as Italy's ever was - the population knows it will have to finance its own old age and pay through the nose in higher taxes.

In contrast, Japan's corporate sector is on the move. In the past, whenever profits started to rise, the first thing Japanese corporations did was recruit more people. That was their social duty. Now that's ending. The historic tie between profit performance and employment growth in Japan has broken down as globalization forces Japanese companies to operate for profit maximization.

The traditional interpretation is that corporate restructuring will eventually raise the rate of return on Japanese industry's assets. But, in the short term, say the economists, it will unleash a deflationary tidal wave, as jobs grow scarce, earnings remain low and household savings stay high. And that's why Japan is slipping back into recession. Eventually, this crisis will force the Bank of Japan to loosen monetary policy by printing money rather than just keeping interest rates near zero. Then the yen will weaken sharply.

But I reckon the traditional view is wrong in one important way - restructuring need not be bad for growth. The Japanese stock of IT investment (and output of IT services) stands at less than 40% of the US's. But Japan's supply-side revolution will boost corporate profitability dramatically over the next few years. And it will create a dynamic service sector in Japan based on efficiency rather than ritual. Japan's IT paradigm could look like that of the US within five to seven years. The capital investment that this would need in equipment and software could add 0.3-0.6% to annual GDP growth.

And that's before counting the derivative effects that the availability of better services would have on demand. Here, the dynamic gains of supply-side reform will more than outweigh the depressing impact of job losses. That's because reducing a corporate workforce makes the majority of workers much more productive and even a little better paid. That implicit reduction in unit labor costs and the increase in real wages can raise the purchasing power of both consumers and companies.

Reducing government's economic role has a similar effect. It is amply proven by the example of EMU's impact upon Europe's erstwhile most profligate governments, like Italy. These were forced to limit (not eliminate) wastage of taxpayer's money. And lo and behold, instead of shrinking aggregate demand, this resulted in the same buck being spent more efficiently by the private, instead of the public, sector. Economic growth picked up.

So I'm convinced that, even if Japan did slip into a technical recession at the end of 1999, it won't continue in 2000. And even if real GDP growth did stay flat like the surface of a lake, it is becoming increasingly irrelevant in determining the fate of equity investment in Japan. That depends on all the agony of corporate birth and death unfolding underneath.

Japanese equities will continue to outperform in a low-growth domestic environment because globalization and corporate restructuring is destroying the old Japan and raising the new. The successful equity investor will short the former and be long the latter. And, on balance, there will be more success stories than failures.

What about the yen? That's a harder call. If I'm right about Japan Inc starting to operate for the benefit of shareholders, an awful lot of money will pour into Japan to go overweight Japanese equities. That should be good for the yen too.

But I still think the yen will be weaker by the end of this year. The first and most obvious reason is that, prior to kicking the bucket at the elections this year, the ruling Liberal Democrats under PM Obuchi will spend every yen they can to try and avoid their own funeral. As I argued in this column last November, the government's launch of yet another fiscal package worth Y6 trillion, or 1.3% of GDP, in real spending at the end of last year will not generate any sustained economic recovery. So, if Japan's economy still looks weak by the summer another package prior to elections is in the cards.

That would cause the issuance of government paper to soar, exacerbating fears of public sector insolvency. Already, Moody's has signaled a warning that it might downgrade the credit rating for Japan's sovereign debt. None of that is good news for the currency. No wonder it has weakened to Y111/$ now. After all, who would want to own the bonds of a bankrupt state yielding less than 2% when the US offers a shrinking stock of the world's safest government bonds yielding over 6%?

But most important for the yen in the longer term is that Japan's corporate sector will act differently than in the past. More services and fewer things will be produced at home. So the outflow of capital to finance foreign production of tradable goods for the Japanese market will expand and so weaken the yen.

A rapidly declining trade account surplus will result from a bigger slice of domestic demand being supplied by Japan Inc abroad. And rising profits from foreign investments will not necessarily flow back to buoy the current account. More likely, foreign profits will be reinvested overseas. America's are, so why not Japan's?

So the prospects for Japan in 2000 are an eventual pick-up in growth and the end of deflation, but at the expense of a weaker yen and rising bond yields. And behind the economic cycle is Japan's supply-side revolution, driven by globalization and the e-commerce revolution. That will sound the death-knell of Japan's political elite, starting with the election this year

Debt and pension liabilities (% of GDP)

David Roche is president of Independent Strategy, a research firm based in London. www.instrategy.com