Fighting fit

The global slowdown has stymied Japan\'s economic expansion as demand for exports shrinks and share prices fall. But its strong banking sector prompts some analysts to argue that the country will be the first to recover, writes Jack Mulchand.

The synchronised global recession caused by the aftermath of the subprime crisis that erupted in 2007 ended a period of economic expansion in Japan described as the country’s longest since the second world war. Forecasts for the performance of the world’s second biggest economy have been revised lower for 2009, and the Japanese stockmarket is in the doldrums. Some experts are pessimistic about Japan’s prospects, but others are hopeful that it will be among the first advanced economies to bounce back.

The impact of the subprime crisis is in some ways a cruel irony for Japan. During the 1990s, the country battled with the fallout from its own systemic banking crisis and asset bubble implosion. That 10-year period is often described as Japan’s “lost decade” of deflation and poor economic performance.

Japan finally got back on track in the new millennium. Its GDP expanded annually at a rate of about 1.5% or more for most of the years between 2000 and 2007. Exports boomed, enabling businesses to pick up investment, and unemployment stayed at low levels. Deflation, which encouraged the Japanese to delay purchases in the hope of making them more cheaply, looked to have been licked.

But the Japanese recovery has been derailed by the severity of the subprime crisis, which hobbled banking systems in some advanced economies and ballooned into the worst financial shock since the Great Depression. Japan fell into recession over the second and third quarters of 2008 as exports dried up to destinations such as America and Europe, which are reeling from the financial cataclysm. The International Monetary Fund (IMF) forecasts Japanese economic growth of just 0.5% in 2008, followed by a contraction of 0.2% in 2009.

“Yet again, the Japanese economy appears destined for subdued economic activity,” says Matt Robinson, an economist at Moody’s “This time, given the severity of the global downturn and the country’s reliance on external demand to drive business investment and production, the economy is at risk of a prolonged recession.”

Robinson points out that even during its Lost Decade, Japan managed to eke out “anaemic growth”, whereas business confidence was languishing at its lowest level in more than five years.

Forward-looking indicators, such as core machinery orders, “foreshadowed further declines in business investment, and there is little prospect of a recovery in demand from US or European consumers”, he says, adding that all these factors meant that Japan’s downturn could “easily persist longer than previous recessions”.

Investors are unwinding yen-based carry trades in their droves, pushing up the currency and dimming the outlook for exports still further. Such carry trades involved borrowing in yen, given that Japanese interest rates are close to zero, and investing in higher-.yielding overseas assets. The trade was popular in boom times but rapidly unwound due to the meltdown in financial markets.

The Japanese stockmarket, meanwhile, fell some 38% between the start of the year and November 21. However, its performance is notably better than that of the World index, which is down 51.5%.

Part of the reason for the relative outperformance may lie in the fact that Japan’s banking system has been much less badly hit by the subprime crisis than those of America and Europe. Japanese banks operated more conservatively following their own crisis in the 1990s, and as a result had lower exposure to subprime assets. However, they still have substantial exposure to Japanese stocks, whose slide has hit the banks’ capital base.

“The Japanese financial system remains in relatively good shape,” says Tehmina Khan, an economist at Capital Economics, a consultancy. “Despite the erosion of bank capital due to sliding stockmarkets, a number of factors suggest that there are no major risks to the banking sector.” She says those factors included the fact that subprime losses had been relatively small compared to capital buffers.

Khan says that Japanese stockmarket valuations were starting to “look attractive”, adding that once market sentiment turned, “we expect Japanese equities to outperform other major markets and accordingly for paper losses on Japanese bank stockholdings to reverse.”

Even so, the Japanese government is disquieted by the fall in the stockmarket. In late November, the Japanese finance minister, Shoichi Nakagawa, said the government was looking at ways of addressing the equity market slide.

“We’re seeing declines in global stocks exceeding more than 5% almost every day, which may affect the global economy significantly,” Nakagawa told reporters. “We will study what we can do immediately and would like to respond as soon as possible.”

The government in October had already announced an economic stimulus package worth GBP 5 trillion (GBP billion). The Bank of Japan, meanwhile, cut interest rates in October for the first time in about seven years. It reduced rates from 0.5% by 20 basis points to 0.3%. The low borrowing costs are a legacy of Japan’s battle with deflation during the 1990s, when it not only chopped policy rates but also flooded its financial system with money – a tactic called “quantitative easing” – in a bid to kick-start the economy.

Steve Harker, the manager of the SG Japan CoreAlpha Fund, says the Japanese stockmarket was “clearing” after the shakeout in the global economy and financial markets, which should be viewed as a positive event.

“Japan is having to deal with a “purge and cleanse” episode in the global economy,” he says. “In the West there has been too much debt extended to invest in dubious assets for too long. The West faces a long, hard road back to sanity. Japan is the relative winner as it has a private sector that is liquid and has been operating on the back foot for over a decade. Conservatism wins.”

Harker argues that the collapse in commodity prices would provide “a massive boost to Japan’s private sector without any intervention from government”. He adds that Japan had pledged at a recent G20 summit to provide foreign exchange to the IMF, and accelerate a combined effort with China and South Korea to provide financial aid to other Asian countries.

“The fact that Japan has the foreign exchange reserves to be able to propose this move is not a position to be dismissed lightly,” he says. “Global balances require that deficit countries be matched by surplus countries, but it is those burdened by deficits, and the indebtedness behind those deficits, that face the bigger problems. In terms of support for emerging markets, it is in Japan’s interest to help its neighbours and thereby its own economic activity. In the current climate those that have the money have the power.”

However, some analysts are cautious about Japan’s near-term prospects, eyeing downside risks. For instance, Takehiro Sato, a Tokyo-based economist at Morgan Stanley, says that he anticipates a recovery in the Japanese economy beginning in January to March 2010. But he says there are downside risks to Japan’s economy in 2009 from a regulatory clampdown and liquidity constraints.

“On the regulatory front, we highlight the revised Architect Registration Law due to be enacted next May and the revised Installment Sales Law slated for mid-2009, plus the Housing Defect Liability Law due in October,” he says. “The revised Architect Registration Law risks creating bottlenecks for building approvals as the revised Building Standards Law did in 2007.

“The revised Installment Sales Law brings tougher assessment standards and may well dampen personal consumption, especially automobile sales. The Housing Defect Liability Law threatens to place new burdens on small- and mid-scale businesses.”

Sato says liquidity constraints stems from “a narrower pipeline for direct and indirect financing due to adverse feedback from overseas financial markets”. He adds that it was hard to describe a “convincing” recovery path for Japan’s economy, but points to personal spending nonetheless.

“The determining factors for a consumption recovery will be more settled price conditions as energy pricespeak out, and pent-up demand emerging as consumers tire of economising,” he says, adding that the latter could filter through in the October to December quarter of 2009.

Some economists say the prospect of increased consumer spending in Japan following the fall in commodity prices is among the reasons why the country will arguably be the first among the advanced economies to recover from the synchronised global slowdown.

“First and most crucially, the reason for Japan’s present weakness, like much of Europe ex-Britain, is not ‘home grown’,” says Maya Bhandari, an economist at Lombard Street Research. “Japanese banks have been neither reckless lenders, as in the US, nor reckless borrowers, as in the UK – as evidenced by their unusual role as ‘saviour’ of several US and European financial institutions.

“Households have not borrowed and spent, leaving the current account in healthy surplus. Japan’s downturn is instead almost entirely rooted in the United States: it is commodity-related…cost-push price pressures that have clogged domestic consumption. And this should be unclogged just as quickly, leaving large scope for a consumer-led Japanese recovery – an impossible fix for the UK or US, where any gain in real incomes will be saved, not spent.”

Bhandari also argues that “Japan has the largest business sector financial “buffer” and the biggest scope for fiscal stimulus of the G7 economies. The business sector was in 9.6% financial surplus as a share of GDP at the end of last year, against an average of between 0.7% and 3% for Britain, America and Europe. The general government, meanwhile, having tightened policy with unprecedented gusto – the fiscal deficit shrank from 8% of GDP in 2002 to an estimated 1.4% of GDP this year – now has room for manoeuvre. And this should help Japanese consumption prospects as well.”

Even if Japan succumbs to an extended period of poor economic performance, defying the more optimistic analysts, experts at Credit Suisse recently pointed out that the Japanese stockmarket could still deliver substantial gains in so-called “bear market” rallies. For instance, its research indicated a bear market rally of 12 months’ duration in Japan between June 1995 and June 1996, which involved a rise of 57%.

However, capturing the upside in bear market rallies without being hit by the overall slide in the stockmarket is a difficult task. Overall, the judgement investors have to make is whether tumbling commodity costs open up the possibility of improved domestic household spending in Japan going into 2010. That improved spending, in turn, would boost the economy. Investors would likely discount such a recovery ahead of time, implying increased Japanese stockmarket stability later in 2009.

The other view is that Japan’s fortunes turn more on what happens outside its borders. According to this approach, the overseas struggle against the credit crisis in Europe and America is crucial to Japan’s prospects. Given how hard that battle is, Japan’s recovery could be delayed. Such a position is described, for instance, by Robinson of Moody’s

“Now, more than ever, the fate of the Japanese economy lies with the rest of the world. Japan’s thrifty and ageing population, perpetually weak private consumption, and few domestically oriented growth opportunities mean that the country is reliant on overseas sales and investment opportunities to improve incomes and living standards. Thus, how long it takes for external markets to recover will determine the extent of Japan’s downturn.”

Investors the world over have been wondering for some time whether the steep stockmarket falls this year in Japan and elsewhere open up once-in-a-lifetime buying opportunities. The problem is that the world is experiencing a once-in-a-lifetime financial and economic shock too, leaving the right course of action extremely hard to divine.

Japan’s economic outlook

The Japanese economy officially fell into recession after recording two consecutive quarters of contraction this year, raising fears about its prospects for 2009, including the worrying possibility of worsening deflation.

The Japan Research Institute, a forecaster based in the country, argues that Japan’s real GDP will decline by 0.1% in 2008, before rebounding modestly to expand by 0.4% in 2009.

Despite falls in commodity prices, the institute said that the “still high level of primary product prices such as crude oil and cereals” could continue to hit corporate profits at firms that find it difficult to pass on increased costs in sale prices.

Firms could then retrench and cut back on investment, the think tank says, which would compound the economic slowdown. Resource prices could also take their toll on household income, it adds.

The institute says that global financial turmoil would continue to have a negative impact on the Japanese economy, the biggest in Asia.

“Japan’s exports as a whole would continue to slow down reflecting the deceleration of the world economy. Also, unstable moves in the financial markets could make business sentiment worse,” the economics consultancy says.

Japan’s economic growth during 2008 will “follow a quarterly growth trajectory at a pace considerably below its potential output growth rate”, the institute says.

But the decline in resource prices, while still not so great as to remove all the pressure on corporate profits, is nonetheless set to enable “domestic income [to] recover in the second half of 2008”.

The institute warns, however, that it is “possible that the income shift to overseas could re-accelerate supposing that resource prices start to rise again”.

Looking into next year, the sluggish overall economic situation is likely to continue and “a sense of recovery would hardly be felt even after the start of 2009”, the think tank says.

Weak or recessionary economies in America and Europe will continue to hit Japan’s exports, it adds, although it held out hope that shipments to “emerging and resource-rich countries would keep solid”.

“Business fixed investment would decline and private consumption expenditure would also continue to stagnate” in 2009, the Japan Research Institute says, adding that the “GDP deflator is expected to maintain a declining trend on the year earlier for the time being”. The latter is indicative of disinflationary forces in Japan.

Japan’s lost decade

Japan’s so-called “lost decade” of the 1990s, when its economy succumbed to an extended period of deflationary torpor, provides valuable lessons about how to deal with the impact of the global financial crisis, according to analysts at Deutsche Bank.

The Japanese economy hit problems in the 1990s after huge asset bubbles burst, contributing to a systemic banking crisis, just as many advanced economies experienced banking meltdowns in 2008 in the wake of the subprime crisis.

“Perhaps more than any other banking crisis in the more recent past, the experience of Japan provides useful lessons on which mistakes are to be avoided during the present financial crises,” Deutsche Bank says.

The crucial lessons from Japan’s financial crisis were that “monetary and fiscal policy were initially too timid and too slow to react”, the bank added.

“The failure of measures to rescue the banking system – and address the problem of non-performing loans – to be implemented quickly and aggressively exacerbated the swing from extreme risk appetite to extreme risk aversion. As a result of both the macroeconomic and structural policy mistakes, the Japanese economy suffered a prolonged period of recession and weak growth.”

It is generally accepted that the policy response to the global financial crisis has not been quite so tardy, but Deutsche Bank says there were important differences in the approaches taken by America and Europe.

“In the current global financial crisis monetary policy has been eased very aggressively in the US,” Deutsche Bank says. “In Europe, however, policymakers failed to recognise the severity of the situation early and kept rates high or hiked to counter temporary inflation spikes due to a surge in energy prices.”

Fiscal policy in America had also been eased significantly, Deutsche Bank says, and was likely to loosen more aggressively still.

Indeed, Barack Obama, the American president-elect, during his election campaign promised to push through a fiscal stimulus worth $175 billion (GBP118.5 billion), but lawmakers there are talking about a plan worth as much as $500 billion to $700 billion.

The American Congress enacted a separate $170 billion stimulus package, proposed by President George W Bush, earlier this year.

However, Deutsche Bank says the situation in Europe is somewhat different.

“In the euro area the fiscal stimulus is coming later, is likely to be much smaller, and will probably be less effective,” it says.

Deutsche adds that bank rescue packages had been implemented “quickly and in large sizes”.

Banks were snapping up the support available in America, it said, as they viewed taking part in the government programmes as an “official quality seal” for their balance sheets.

Moreover, optimism caused by Obama’s election victory could lessen any backlash against risk taking in America.

“In Europe, participation in the government programmes has been largely voluntary, but conditions were more comprehensive (and included requirements for bank lending, prohibition of dividends, and limits to compensation of managers),” Deutsche Bank says.

But banks had been slow to take part in the European rescue initiative, it says, adding that it seems as if the backlash against bankers “had been more pronounced in Europe than in the US, probably reinforcing excessive risk aversion and cuts in the supply of risk capital in the former”.

The public discussion over European bank rescues was set to encourage an “excessive swing towards risk aversion”, whereas a lighter regulatory footprint in America, together with the new wave of optimism triggered by Obama, could weaken criticism of risk taking in the world’s biggest economy.