Japan: the path of glacial change

I recently visited Japan again. Like a Charlie Chaplin movie, the action in Japan should jerk forward between time-frames. But it doesn’t. Instead, it’s a game of spot-the-difference, so little have the images shifted. Sure, there are more discount stores around. But the cab ride from the airport still costs $260, a club sandwich in the coffee shop of the Four Seasons is $25 and an orange juice $15. None of these prices would hold in a deregulated economy.

Last month’s general election will change little either. The Liberal Democrats have reconsolidated their power. But vital reform of the tax system, the ministry of finance, Bank of Japan and the supply-side of the economy are likely to take at least another two or three elections. Many intelligent Japanese see this as the only way of maintaining stability. I see it as the key to mediocre economic performance.

It’s true that Japan has changed the image it holds of itself. Instead of being the Land of the Rising Sun, it now sees itself as the Sunset Economy of Asia. Everyone talks of decline, of an ageing and disappearing workforce adjusting to lower growth, of becoming an Asian economic underperformer. For a country that could double its potential output simply by stopping discrimination against women, it’s all a bit odd.

Glacial change

But therein lies the conundrum. To change Japan’s new mediocre self-image means altering its culture radically. And Japan’s culture is all about glacial change, except for moments of real crisis, and the moment of crisis has passed. Now the economy is gradually raising itself from recession. Employment is on the up. And the new government will rule out radical reform.

Japan’s model is a top-down one. It’s the only big first-world economy like that. It works like this: employment is a constant. Even during the worst recession since the war employment never fell and neither did real wages. This was achieved at the expense of a stinking return on capital and falling profit-share in national income.

Japan is a corporate welfare state where companies are run to make nice products and employ nice people. Shareholders don’t count. In most Japanese corporations I visited this time, I never got the sense that more than lip service was being paid to corporate governance for shareholders. That is better than a few years ago. Then, there was no lip service at all!

There’s very little sign of radical change. The big companies are rationalizing by natural attrition at a snail’s pace. Sony told me that real wages would have to rise even though they have too many people chasing too few jobs because “the government might be angry if they didn’t”! An old and trusted Japanese friend, who is a senior portfolio manager, told me he won’t invest in smaller, entrepreneurial corporations because talented Japanese only want to work for big prestigious companies.

When an economy recovers after a long recession you expect corporations to make big productivity gains to the benefit of profits. But in Japan, the current recovery is marked by falling productivity growth. So profits in Japan will grow much less than the consensus expects. Return on capital will remain paltry compared with the OECD average.

As corporations look after unemployment on their profit and loss accounts, the Japanese government doesn’t have to take it on its books. So government in Japan is about 15% of GDP smaller than in Europe. However, in return, the government has to keep the economy ticking over by launching massive stimulus packages whenever an overvalued yen and lack of economic reform stops growth in its tracks.

On paper, Japan’s public sector budget deficit looks manageable at 4.5% of GDP for this fiscal year. But, if you exclude the social security surplus (which is needed to pay future unfunded pensions), Japan’s budget deficit is nearer 8% of GDP. That can’t last.

While the new government may announce a supplementary budget this month to provide some fiscal stimulus, Japan’s finance ministry made it clear to me that it wants to balance the budget next fiscal year. To be more exact, the ministry wants to run a deficit no greater than its capital investment expenditure ­ the so-called “golden rule” for public finances. That would ensure that public sector net worth stays a constant, and that current expenditures are matched by revenues. The ministry will do this by implementing measures already passed by the Diet ­ namely, a hike in social security contributions by 85 basis points, an increase in sales tax from 3% to 5% in April 1997 to net ¥4 trillion, and abolishing the income tax rebate introduced at the height of the recession (¥2 trillion). The bureaucrats will have their way, and these measures will not be reversed by the new government. I estimate that this will cut 1.5% off consumer purchasing power next year.

Loose money

The ministry also told me that an even weaker yen was essential to sustained recovery. That’s hardly surprising, as the ministry recognizes the deflationary effect of the fiscal squeeze on domestic demand next year. It will have no hesitation in accelerating the deregulation of foreign exchange markets and forcing interest rates even lower to get capital moving offshore to stop the yen strengthening.

And if I am right, and fiscal policy tightens, the Bank of Japan won’t. So loose money will also keep the yen weak.

Nevertheless, I think the yen will eventually strengthen during 1997. To understand why, you have to look at the Japanese external payments figures. Japan’s current account surplus has shrunk as the merchandise trade surplus has fallen and the deficit on services trade (mainly due to rising tourism) has risen.

But these negative effects have been partly counteracted by the steady rise in income from Japan’s ballooning stock of net external assets. That means any change in the trend on merchandise trade or tourism will quickly stop the fall in the current account surplus. And the weak yen will eventually do that.

Japan’s import growth from Asia, although still very high, is now tapering off, while Japanese export growth to the US is now rising fast. So overall Japanese export growth is picking up. And the Japanese authorities possess a reduced arsenal to hold the exchange rate down. Interest rates can’t fall that much more because they’re already around zero in real terms. The tourism deficit will decline, while the factor income surplus from overseas assets will continue to rise. Thus, the overall services deficit will narrow.

Now the ¥/$ rate is highly correlated with the relative current account balances of the US and Japan. My forecasts for these balances suggest that the yen will strengthen to ¥95-100/$ by the end of next year.

In sum, it would be churlish to say that Japan is not a-changin’. But it’s the sort of movie you’d go and see for plot and character rather than pace and thrill. One consequence is that reform and restructuring don’t throw up any major investment themes. Those who think they do, like advocates of a big shift in corporate governance and super profitability stemming from overseas expansion, are simply mistaken.

So the arguments for investing in Japan are reduced to the cyclical. And they’re not exciting. A cheap yen is already in the price of equities. Money will be made being long the yen, short Japanese government bonds and short equities when the cycle flips. But it could be some time coming.

Japanese current account on a 12-month cumulative basis (¥ billions)

Japanese current account minus US current account, and the ¥/US$ exchange rate

Japan’s financial balances as a percentage of GDP, 1990-1996E

Japan ­ profit share is eroded at the expense of wages (as % of GDP) 1989-1996E

David Roche is president of Independent Strategy, a London-based research firm.