Is JapanÆs resurgence already over?

The prime ministerÆs resignation and disappointing economic figures are dulling JapanÆs recent lustre.
Two days after prime minister Shinzo Abe stunned the nation by quitting, market watchers are debating the implications for Japan's economic future.

One banker has likened the news of AbeÆs resignation as like a kick to the head for the country. ôJapan is looking very bleak at the moment,ö he said of the shock move, which came less than a year after Abe took the job.

But others say that the departure of the profoundly unpopular prime minister, who has been associated with revisionist foreign policy more than economics, might not be a bad thing.

In any case, says one Japanese banker, Japan is not like Western countries. The economy works pretty much on auto-pilot with scant exposure to politics. Still, the political elite must grapple with a situation which seems to belie the promise that Japan held until very recently.

Japan has been experiencing its longest phase of growth since 1945, marked by six years of economic expansion. But disappointing second quarter GDP numbers were reported last week. These suggested the economy had contracted by 1.2% in the second quarter of this year, substantially worse than predicted. In the last quarter of last year, the economy was storming along, growing at a rate of 5.4%.

The yen, currently at 114 to the dollar from 122 in mid-June, may also be facing a period of sustained strengthening as a result of the unwinding of the carry trade. This is not helpful to Japanese exporters.

Kathy Matsui, Goldman SachsÆ Japan strategist, writes in an August 10 report that recent circumstances are a æperfect stormÆ of foreigners (the biggest buyers of Japanese stocks year-to-date) offloading their stakes, a rising yen and tighter credit conditions on the back of the subprime debacle. Foreigners turned net sellers of the stockmarket in July, after over a year of being net buyers.

ôThe subprime debacle in the US is having a huge negative effect on Japanese stocks,ö confirms one Japanese banker. ôItÆs far more of a factor than Abe resigning.ö But the ongoing political debacle has added a dose of uncertainty to an already gloomy situation.

The immediate effect on the bond and equity markets might be muted, however. ôThe Japanese bond market is pretty much self-sufficient. There is a lot of demand from life insurance companies. Just 7% to 8% of Japanese government bonds are held by foreigners,ö notes one banker at a US bank. ôThat means we will not see bonds being dumped by panicking investors.ö

From an equity point of view, Japanese retail participation is surprisingly small, with the most active investors being foreign over the past few years. ôJapanese investors have preferred playing with foreign currency. They are not terribly exposed to the stockmarket,ö he says.

ThatÆs fortunate, since the Nikkei 225 has been through a disastrous run over the past few months, losing 2,000 points since July. It is now down 8% year-to-date. On Wednesday, the day the news of AbeÆs resignation broke, the Nikkei closed at 15,821 points, fractionally down.

ôOverall, that just means the index has given up a fraction of the gains over the past few years,ö notes one banker, pointing out that the Nikkei has put on some 30% in recent times. In fact, since hitting its lowest point of the decade in 2003, the Nikkei has almost tripled.

Nikko CitigroupÆs strategist, Tsutomu Fujita, estimates that the departure of Abe ôwas only a matter of timeö and also expects ôthe near term impact on share prices to be limitedö. In the longer term, however, Fujita fears that JapanÆs æreform premiumÆ û fuelled by former premier KoizumiÆs free-market rhetoric û may be whittled away.

ôAt end-April 2006, Japan was on a price-to-earnings (P/E) ratio of 21.7x, versus a global P/E ratio of 15.9. We think a structural reform premium was being awarded to Japanese stocks,ö he writes. But the Japan P/E ratio had dropped to 15.5x by mid-August.

Equity issuance has slowed to a trickle, with Japan slumping to the position of 11th largest issuer in the world. Last year it was in second place, according to Dealogic.

On the debt front, $156 billion has been raised so far this year, compared to $113 billion for the same period last year.

While the trickle of bad news is not inspiring, observers point out that Japan is saddled with problems that appear unsolvable in the short run. ôDomestic demand is basically massively held back by JapanÆs ageing and shrinking population. You are never going to get that boost to GDP from consumption you get in the US,ö says one. The only solution would be massive immigration, but Japan is unlikely to countenance that.

There appear to be two schools of thought in Japan at the moment. One school is interested in pushing for economic growth, and the other school is pushing for fiscal reform. Both aim to improve government revenues and repair the countryÆs strained balance sheet û at 130%, the highest level in the developed world.

The debt has been incurred over the past 15 years as a result of vast government expenditure to boost rural Japan. Tokyo is increasingly becoming the only centre of economic dynamism in the archipelago, and has been blamed for sucking the vitality out of the rest of the country.

Fiscal reform and tax hikes are the favoured strategies of AbeÆs probable replacement, Taro Aso, according to some sources. But fiscal reform has taken a step back as a result of the decision not to raise the sales tax after the LDP was thrashed in the upper house elections in July.

Interest rates are also unlikely to be raised following the resignation û meaning they will stay at rock-bottom levels. There have been calls to ænormalizeÆ interest rates by raising them. Higher deposit rates would benefit the older generation of Japanese living off their savings. ôIn effect, the low interest rates are a way of transferring money away from the retiree generation to other parts of the economy,ö points out one banker.

Former prime minister Koizumi was the inspiration behind the idea that the government become smaller and subject to æmarket discipline rather than government discipline,Æ as one banker puts it.

That put privatisation on the agenda, of which the test piece is the privatisation of the post office û not yet carried through.

But ôthe structural reform programme carried over from the Koizumi administration looks to have reached an end,ö writes Deutsche Bank senior economist, Seiji Adachi, on the news of AbeÆs resignation.

Whether JapanÆs much-touted and very welcome renaissance survives such a turnaround will be the issue most bankers will be pondering over the next few months.
¬ Haymarket Media Limited. All rights reserved.
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