The Drought Won't Lift

The latest data suggest that Japan's economy contracted further in the second quarter, after almost no growth in the first. The recessionary clouds overhead mean higher unemployment, shrinking profits, and more problems for Japan's frail banking system.

The most recent bad news: Production fell 0.5% in May, as new factory orders, excluding ships and electricity, sank 8.1% from April. Inventories of finished goods rose for the fifth straight month in May, to stand at their highest level in 11/2 years. And the jobless rate remains above 3%. That's why it came as no surprise when the Economic Planning Agency's July 14 economic report admitted: "The recovery has stalled." It added: "There's an increasing risk that [the economy] will deteriorate."

The only source of strength has been trade. Japan's trade surplus grew in June, to $11.57 billion, up 2.1% from a year ago. But the trade surplus with the U.S. slipped 11.5% from a year ago. And because of the yen and a slowing U.S. economy, the surplus shows signs of shrinking (chart).

The U.S. trade turnaround is one reason for the recent weakening in the yen. The yen began to slip after the June 28 U.S.-Japan trade agreement. Then the Bank of Japan followed the Federal Reserve interest-rate cut on July 6. The BOJ cut the official discount rate a half-point, to a record low of 0.75%. As a result, the U.S. dollar has traded above 87 yen so far in July--a more tolerable exchange rate for Japanese exporters.

But the yen must weaken further to offer any relief for Japan's banking system. Banks hold more than 40 trillion yen in bad loans. And economists at Hitachi Research Institute calculate that an additional 2 million to 5 trillion yen of loans go awry every year--a worrisome trend given the sinking value of such collateral as real estate and stocks.

The ruling coalition has hinted only at an added 10 trillion yen in fiscal stimulus for this year. But that's little help. Tokyo will have to initiate structural changes to lift the economy's direction.

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