In spite of the economy’s positive moves early last year, however, a significant slowdown in growth occurred in the second half of 2004. According to the Japan Center for Economic Research, annualised GDP growth was only 0.3% in the third quarter. This has led many to believe that the Japanese economy will remain flat in 2005.The International Monetary Fund predicts Japan’s GDP growth will fall to 2.3% in 2005, well down from the forecast of 4.4% for 2004, largely because of a decrease in demand for exports. Economists, fund managers and analysts alike have forecast Japanese growth to be anywhere from zero to 3% next year. In spite of this slight difference of opinion, there is a consensus that this year’s slowdown should be only a small obstacle on Japan’s road to economic sustainability, and further recovery will be seen in 2006. Exports remain the main concern for Japan’s economy, although they arguably led growth last year. Surging demand from China has helped boost exports by 20-30% a year over the past two years. But Edward Lincoln, senior fellow at the Council on Foreign Relations in Washington DC, says several factors look set to curb exports in 2005. Falling demand for Japanese products as China slows down to avoid overheating is the main problem. Andrew Rose, head of Japanese equities at Schroders in Tokyo, says: “Exports have played a very important role, as the recovery Japan has had was almost entirely driven by them.” However, the impact on Japan of the slowing Chinese and American economies is a subject of debate. Some experts argue that external economies may not have much of an effect on the Japanese economy in 2005, largely because of increased consumer spending as well as a rise in domestic demand. “China will slow down this year and this will be of importance to Japan, but to a lesser extent than it was last year,” says Rose. Hisae Toews, a senior analyst with Fidelity in Tokyo, acknowledges that export growth may have been driven by Chinese demand. But she argues that an underlying weakness in the Chinese economy will not necessarily have a direct impact on Japanese exports. Demand from within Japan may be enough to bolster the economy. Noriko Hama, an economist at the Mitsubishi Research Institute in Tokyo, disagrees. “It will be a difficult year ahead. The Japanese economy is hinging on China. Japanese business cycles tend to be made in China these days,” she says. Hama adds that exports will continue to be the driving force for the Japanese economy this year, but as they have lost velocity, they will act as a downward force on economic momentum. The strength of the yen against the dollar is also likely to be a deterrent for Japanese exports to America in 2005, as well as a threat to economic sustainability, says Lincoln. “If the yen continues to rise against the dollar, it will have a dampening effect and exports to the US may go down,” he adds. He says the Japanese government is unlikely to intervene massively in 2005, as it did last year, to prevent a rise in the yen against the dollar. The main argument for the sustainability of Japan’s recovery in the face of lower exports lies in the restructuring efforts that have been made by the corporations since the Asian crisis of 1997/98. Lincoln adds that the Japanese economy is in better shape than it was four to six years ago, as it is now finally dealing with problems such as bad loans within the banking system, as well as corporate governance. Toews agrees, saying the structural changes made recently by Japanese companies are likely to limit the downturn in the economy, leaving the likelihood of recession low in 2005. The Organisation for Economic Co-operation and Development takes a similar view, saying that the profitability of the corporate sector should help drive growth this year and next. It will be these restructuring efforts, rather than exports, that will help to sustain the economy, in the form of capital spending. Hideo Shiozumi, manager of the Legg Mason Japan Equity fund, says the economy will be given a boost by companies’ healthy balance sheets as well as an increase in cash, which companies are likely to spend on new equipment. The latest quarterly tankan survey, the Bank of Japan’s survey of business sentiment, showed that business investment is the factor most likely to drive economic growth in 2005. Firms are investing profits “strategically”, according to Lombard Street Research, which will help to ease the effects of a slowdown in exports. While several economists and fund managers agree that inflation may return to Japan in late 2005, the Japanese government will probably not see the steady inflation it is seeking until 2006. “Prices have been declining and the disparity between the GDP deflator and the CPI [consumer price index] is not as big. Inflation at the end of the year will be 0.1-0.2%, but not a significant level,” says Lincoln. Schroders’ Rose adds that the final remnants of deflation are taking time to work out of the system. Because of this, it is likely the Japanese government will not be tightening monetary policy in 2005. Before it considers that idea, inflation will have to return in sustainable fashion, but that will not happen this year, he says. The Japanese stockmarket will also be driven by capital spending throughout 2005. Although the Nikkei 225 is widely expected to trade in a narrow range this year, restructuring efforts and low valuations should keep the market stable and relatively positive. Shiozumi says the best investment will be in domestic Japanese companies. “Companies that were growing fast last year should continue to do well this year,” he says. Fidelity’s Toews agrees, saying stocks related to domestic demand are the ones to watch this year, including the financial and retail sectors.