Japan's Leaders Powerless as Economy Plunges

A slurring, muddled performance by Japanese Finance Minister Shoichi Nakagawa at the Group of Seven meeting in Rome over the weekend is attracting plenty of attention in Japan. At a news conference on Feb. 14, the minister, an ally of Prime Minister Taro Aso, appeared to be drunk: He misunderstood questions, his speech was unclear, and at one point he even appeared to almost drift off to sleep. A day later, back in Tokyo, Nakagawa explained that he had been suffering from a cold and reacted badly to medicine. "I wouldn't drink before a G7 meeting," he told reporters outside his home, sniffling. (Update: On Feb. 17, Nakagawa nevertheless announced he would resign.)

Explaining away Japan's dreadful economic performance is likely to prove rather more challenging. Stung by collapsing exports, a surging Japanese yen, and ineffective government, Japan's Cabinet Office today announced that Japan's gross domestic product slumped at an astonishing annualized rate of 12.7% between October and December. The fall is more than most Tokyo economists expected and marked the biggest quarterly slump since 1974. "There's no doubt that the economy is in its worst state in the postwar period," Economic and Fiscal Policy Minister Kaoru Yosano said in Tokyo.

For the quarter ended Dec. 31, Japan's economy declined 3.3% compared to the previous three months. That's worse than U.S. and Europe, which posted declines of 1% and 1.5% respectively. The outlook for the current quarter is only marginally better. Barclays Capital projects Japan's GDP will slip at annualized rate of 9.6% between January and March, although the pace of decline will at least slow after that as government stimulus packages, especially in the U.S. and China, boost demand for Japanese goods.

Exports in a Free Fall

As the government says, external events are having a massive impact on Japan's economy, which until November 2007 was experiencing its longest period of expansion since World War II. In particular, as the slump in demand for Japanese autos and electronics products has spread from the U.S. and Europe to China and other previously fast-growing markets, exports have collapsed at a unprecedented pace, falling 13.6% compared to the previous quarter in the three months through December. Making matters worse is that the Japanese yen has soared against rival currencies. In 2008, the yen gained 20% against the dollar and even more against the euro and other currencies, further gnawing into exporter competitiveness.

That's causing Japanese companies to take drastic action. Last week, Pioneer and Nissan (NSANY) said they would cut 10,000 and 20,000 employees, respectively. Toyota (TM), like many Japanese companies, is shedding thousands of contract workers and said on Feb. 6 it would show its first loss since 1950. "We're facing a once-in-a-hundred-years crisis," Akio Toyoda, who will take over as the company's president in June, said last month. Toyota is also trimming U.S. labor costs.

But why should Japan's economy be plunging at twice or more the pace of the U.S. or the euro zone? After all, a year ago there was still confidence that Japan's economy was relatively well-positioned to weather the economic crisis that started with the onset of the subprime crisis in the U.S. Even today, one oft-cited reason for the yen's surge is that Japanese financial institutions were relatively unexposed to subprime and other toxic assets. Despite today's dreadful figures, Japan is seen as a safe haven for parking cash.

Bureaucrats Out of Touch

Critics and the Japanese public (who have given Prime Minister Aso approval ratings of just 10%, according to one recent TV poll) say Japanese government must take its share of the blame. Even by Japan's low standards, the political response to the current crisis is disappointing. The biggest criticism is that Japan's politicians and bureaucrats, shielded from the worsening realities of everyday life, appear unable or unwilling to do anything address the country's spiraling problems. "It's as if after Keynesianism and monetarism, we are now trying a new paradigm: fatalism—whatever the world does to Japan, there's almost no attempt to do anything about it," says Richard Jerram, chief economist at Macquarie Securities in Tokyo.

Aso's difficulty in passing a fiscal stimulus bill is one example of Japan's political deadlock. While the U.S., China, and European countries have agreed to large expenditures to bolster slumping economies, parliamentary gridlock in Tokyo means that the $111 billion economic stimulus plan proposed by the ruling Liberal Democratic Party late last year is still on hold. Even if it passes, critics point out it is small compared to President Obama's $789 billion plan and China's $560 billion plan. That's despite a surge in unemployment, which Barclays Capital estimates will reach 5.7%—more than the 5.4% peak following the collapse of Japan's bubble economy in the early 1990s. "In terms of job creation, the government isn't doing what it is supposed to do," says Kyohei Morita, Barclays' chief economist.

Monetary policy options are more limited. Having been slow to raise interest rates from near-zero when the economy boomed, the Bank of Japan has had little leg room to make big interest rate cuts. As the economy has slowed, Japan's base rates have fallen from a recent peak of 0.75% to 0.1%. That's far less than the steep cuts undertaken in the U.S. and Europe and another factor in the yen's surge. Nevertheless, economists say additional measures being undertaken by the Bank of Japan, such as plans to buy corporate stock holdings from banks and special credit measures for business, aren't enough to halt Japan's slide.

Missed Opportunity on Yen

Japan's authorities have also failed to curtail the yen's rise. In late October, the Group of Seven issued a statement, which some interpreted as implicit backing for Japan to step in and attempt to stem the yen's rise. Japan's Ministry of Finance, however, chose not to intervene and the yen strengthened further, reaching 13-year-highs against the dollar in December. Notably, a G-7 statement following this weekend's meeting in Rome, attended by Finance Minister Nakagawa, made no mention of the yen, suggesting Japan's window of opportunity had closed. With the global economy worsening, attempts by Japan to go it alone and sell yen are unlikely to be welcomed. In any case, with seemingly little leverage over rival powers, the success of an intervention seems unlikely.

One idea, mooted recently, is that Japan and the U.S. could do a deal with Japan using surpluses to help the U.S. fund bailout and stimulus costs in return for a combined effort to reduce the yen. Economists, though, aren't convinced. A problem is that the U.S. has little to gain from such a deal. One reason is that U.S. is unlikely to need Japan's help to buy treasuries, particularly as the Federal Reserve chief Ben Bernanke has said it may make purchases and, despite some tough talking by new Treasury Secretary Tim Geithner, China is another option. "As far as I can see a deal on the yen is against the interests of the U.S.," says Macquarie's Jerram. "Effectively it would be a donation of U.S. growth to Japan."

Consumers Cutting Back

Critics also contend that policies by Japan's ruling LDP taken several years earlier are now coming back to haunt them. Under former Prime Minister Junichiro Koizumi, Japan scaled back public investment and paid scant attention to dwindling domestic demand, relying on exports to grow the economy. Now, with exports in decline, Japan cannot rely on the the domestic economy act as a buffer.

What's more, with unemployment rising, long-suffering consumers are understandably reining in spending. (On Feb. 11, Koizumi delivered another blow to Aso, giving him a public dressing down for expressing criticism of Koizumi's plan to privatize Japan's post office.

For all that, Richard Koo, chief economist at Nomura Research Institute in Tokyo says positives can emerge from the current crisis. First, he says Japan and other Asian economies are learning that they cannot rely on uninterrupted export-based growth and begin to take necessary, but difficult, steps accordingly. "For 60 years, Asia has had a single model of keeping currencies low, making good products, selling them to Americans and getting rich," he says. "We have to reinvent ourselves."

Infrastructure Projects Could Help

In the nearer term, Koo notes that while Japan has been slow to enact stimulus plans, the impact of its measures may at least take effect faster than in other countries. One reason: Many infrastructure projects delayed as the Koizumi government cut back on spending can be undertaken relatively easily. "There are a lot of projects at regional government level that were put on hold even though all the environmental studies and usual procedures had been completed," he says. "They are ready to go." For Japan Inc., anything that slows the economic free fall cannot come quickly enough.

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