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Just Another Day Under Rising Sun

Marc Chandler

Japan is emerging from an economic period that is largely comparable with the U.S.' Great Depression. The Bank of Japan has signaled an end to its quantitative easing strategy under which it provided something on the magnitude of 5 to 6 times the amount of liquidity Japanese banks required. It has slowly begun reducing that excess liquidity.

The gradual normalization of monetary policy, the robust economic performance (5.5% GDP growth in the fourth quarter of 2005) and the stabilization of real estate prices have given rise to speculation that Japan is back. But the real situation is more complicated, and in many ways, rather than the return of the Rising Sun, it is just another day in Japan.

Changing Relationships

In fairness, though, one must acknowledge that in many important respects the Japanese economy now is not the same one that entered economic malaise more than 15 years ago. Most importantly, several key relationships have been fundamentally altered.

The relationship between Japanese companies has generally been weakened. This is evident in the reduction of cross-shareholdings. Some studies suggest that cross-shareholdings fell from 46% of the total outstanding shares in the early 1990s to 27% in 2002 and now are believed to stand closer to 20%.

Another important relationship that has changed is between Japanese companies and their main banks. This seems especially true for manufacturing companies. Many, though clearly not all, have reduced their dependence on their banks. The process that economists call disintermediation has taken root in Japan. Many large manufacturing companies use their own cash flow and their record profits to finance investment rather than relying on bank loans. More than previously, Japanese companies are going directly to the capital markets to raise funds by issuing stocks and bonds.

The relationship between employees and employers has been altered as well. Although lifetime employment still is offered by some firms, reports suggest it is not as widely practiced as in the past. More importantly, there has been a significant increase in the use of contract workers. Some reports suggest that contract workers now account for almost one-third of the workforce, when previously that figure was closer to one-fifth.

One would be remiss not to recognize the role that accounting changes have played in Japan's business renaissance. Japan belatedly has introduced mark-to-market accounting, and the consolidating reporting makes for more transparent corporate activity. Also, Japanese companies must more rigorously account for pension liabilities, and this is particularly important, given the country's aging population.

Last, the role of foreign investors has changed. According to data from the Tokyo Stock Exchange, foreign investors held fewer than 5% of the outstanding shares in the early 1990s. Last year, foreign ownership was closer to a quarter.

Old Wine, New Skin

In two critical ways, however, Japan 2006 is the same Japan of a decade ago. First, the main drivers of the economy haven't changed. The economy continues to stand on three legs: exports, investment and government spending. Martin Wolf, economics columnist for the Financial Times, noted recently that during the last deep trough, from the fourth quarter of 2001 to the fourth quarter of 2005, the Japanese economy grew by 10% in real terms.

Of that growth, exports accounted for almost a third. The strong export showing is a function of a significant decline in the Japanese yen. In real trade-weighted terms, the yen depreciated by 30% between December 1999 and February 2006. On the demand side, the booming Chinese economy accounts for a third of the increase of Japanese's total exports (2001-2005).

Investment accounted for almost a fifth of the Japanese growth during this period. Japanese investment exceeds that of other major industrialized countries. It is roughly 40% higher than in the U.S. and Germany. What befuddles many observers by contradicting established economy theory is that such high investment has not generated strong growth. The International Monetary Fund estimates potential growth for Japan to be around 1.5%. By comparison, U.S. potential growth is estimated near 3%.

Essentially, the problem is that Japan is a terribly inefficient user of capital. It still requires roughly 70% more capital to produce a given unit of GDP compared with the US. Such wastage is often associated with excess. And this appears to be the case in Japan.

The second critical way Japan hasn't changed all that much is that it does not enjoy excess savings, it suffers from it. Japan's private sector saves between 25% and 30% of GDP. Although household savings have slipped a bit lately, the increase in corporate savings offset this. On top of that, Japan has been running a current account surplus of 3% of GDP. This combination of high private savings and a slow-growing economy is a large practical and theoretical challenge that has not been addressed.

Between the fourth quarter of 2001 and the fourth quarter of 2005, government spending accounted for almost 15% of Japan's growth. Even this year, when there is a general acceptance of the fact that the Japanese economic recovery has broadened and deepened, the budget deficit is likely to be in excess of 6% of GDP. The persistent budget deficits have accumulated into a significant level of debt. An Organisation for Economic Co-operation and Development estimate from the end of last year puts Japan's national debt at more than 160% of GDP, more than any other member (Italy stands second, near 128%). Because of various intra-government loans, Japan's net debt may be closer to 82% (the comparable figure for Italy is 103.5%).

Global Imbalances

The U.S. and Western Europe emerged from the Great Depression because of a combination of socialism, the creation of the modern welfare state and nationalism, which is to be understood not only in militaristic terms. Japan has also introduced a mixture of socialism and nationalism, and it too is emerging from its Great Depression.

However, Japan is still plagued by excess savings. The challenge is not accumulating capital. Japan does that just fine, thank you; the problem lies in absorbing it. Japan's inability to do so is one of the sources of the global imbalances that are so worrisome for so many policymakers.

U.S. Federal Reserve Chairman Ben Bernanke confirmed in a speech last month that the G7's strategy for addressing the global imbalances was a three-pronged approach. The U.S. should boost its savings. Europe and Japan should implement structural reforms. Asia should develop more flexible capital markets. Hardly revealing a state secret, Bernanke acknowledged that the strategy has been only modestly implemented.

This does not mean, however, that the G7 is about to change strategies and call for a dollar decline directly or indirectly. This is no substitute for structural reforms.

Japan is enjoying an export- and investment-led economic recovery, with a budget deficit almost double that of the other G7 members. Corporate Japan is posting record profits. Japan's stock market looks like it has legs. But do not confuse the cyclical recovery with a solution to the problem of excess savings. Resolving this would, in turn, go a long way toward easing the global imbalance.