You can see it in the faces of dispirited traders streaming out of the Tokyo Stock Exchange or sense it in the mood of homebound commuters transfixed by the neon-lit market numbers flashing on a giant electronic display at the Tokyo central train station. After seven straight years of distress, the Nikkei stock average is melting down again.
What started as a modest decline last fall (chart) and accelerated in recent weeks has cast a pall over Kabuto-cho, Tokyo's Wall Street. The Nikkei has tumbled 20% from its 1996 high, extending a bear market that has eliminated $2 trillion worth of value from the Tokyo Stock Exchange's blue chips since their 1989 peak. With the Nikkei now down 50% from its record high and with some pundits predicting it may have an additional 25% or more to fall, "we haven't seen the worst day yet," figures Toshimitsu Aonuma, a trader with Okasan Securities Co.
Traders mouthed the same grim sentiments when the market lost its footing back in 1992 and 1995, only to see stock prices recover some ground. But this rout feels different. To many observers in and out of Japan, the market is sending a powerful message that the global economy is finally closing in on the country's protected, overregulated domestic economy. The decline is now provoking a serious rethinking of how far Japan should experiment with liberalization and edge closer to a profound transformation that will get its economy moving again after five straight years of fits and starts (charts).
What has set the rethinking in action is the emergence of the two-tier economy (tables). Look closely at the Nikkei's latest sell-off, and you'll see a reordering of Japan's $5 trillion economy into divergent camps--cosseted, uncompetitive domestic industries vs. a core of highly competitive multinationals.
Behind both lie thousands of midsize and small businesses that depend on the health of large companies for their livelihood. These second-tier businesses, along with huge protected industries, employ about 70% of Japan's private workforce. As nameplate companies like Toyota and Toshiba accelerate the shift of their business to Asia and America, many of their suppliers are being left out in the cold. At the same time, thousands of service-company employees who work for big regulated industries may now also see their future threatened. It's the early stage of what could be a long and painful struggle to bring protected domestic industries up to world standards of efficiency. "Japan cannot develop further if it does not become the world's economic front-runner," says Nikko Research Center Ltd. Chairman Masao Yokomizo.
Over time, this quest to remain ahead of the global pack will force Japan to refashion its vaunted system of close mutual dependence among government, industry, and all classes of workers. And it will have to promote deregulation and administrative reforms to lessen the intrusion of the government into Japan's daily economic life.
LEAN AND MEAN. This will mean sweeping change--and that realization is shaking up the stock market. Led by banks groaning under $260 billion in bad debts, companies in protected sectors have seen their shares tumble some 10% since the start of the year. Some companies' shares are now trading at a small fraction of their highs at the Tokyo market's peak in 1989. Since two-thirds of the market is controlled by large companies investing in each other, the message is doubly clear. Corporate Japan is turning on itself, with the strong dumping the weak.
While the domestic companies suffer, Japan's world-class multinationals have stormed back since 1995's soaring yen forced executives from Tokyo to Osaka to slash costs and expand abroad. Investors certainly recognize this: Even after the Nikkei's big drop as January began, many multinationals still are trading near record highs. Indeed, these global companies have reemerged lean and insulated against the next round of gyrations on the world's currency markets.
Thanks to $515 billion worth of investment since 1970 in production, research, and marketing outside Japan, the multinationals have moved closer to their customers and become less dependent on exports than ever. But they are not content with that. With precious few investment opportunities inside Japan's slow-growth economy, auto makers and high-tech manufacturers are embarking on another round of global diversification.
After dropping off in the first half of the 1990s, Japan's overseas business investment is expected to jump 20% annually through the end of the decade, analysts say, until it approaches the $70 billion-a-year record of 1989. "We have no other choice but to globalize and market worldwide," says Toshiba President Taizo Nishimuro.
BUDGET BUSTERS. Many of these companies will benefit mightily if Prime Minister Ryutaro Hashimoto's plans to deregulate big parts of the economy become reality. Indeed, the market's collapse comes as Hashimoto is entering the most trying period of his meteoric political career. His margin of error is razor-thin. Since 1992, Japan has pumped out $560 billion worth of emergency spending packages and billions more into Ministry of Finance-led "price-keeping operations" to prop up stocks. The spending pulled the equity market back from the brink several times and built plenty of concert halls in farm communities and fishing ports along Japan's coastline. However, all the cash did precious little for the overall economy, which averaged growth rates just above 1% from 1992 to 1995. The measures also turned budget surpluses into deficits of Italian proportions.
Now, everybody is wondering how far Hashimoto will go--and whether his shakeup will push Japan back into a recession. "The argument is no longer about direction but speed," says Ian Burden, Asian portfolio chief at HSBC Asset Management Asia Pacific Ltd.
To bring Japan's finances back into line, Hashimoto is proposing flat government spending--albeit with a fair number of pork-barrel construction projects for political allies. But he also wants to hike the national sales tax from 3% to 5% and repeal an income-tax break enacted in 1995. On top of a coming increase in social security payments, the moves will hold GDP growth to 0.7% in the fiscal year ending in March, 1998, estimates Salomon Brothers Inc. economist Robert Alan Feldman.
If the stagnant economy actually goes into recession and the stock market continues to plunge, Hashimoto will face pressures to ease up on his fiscal reforms, soft-pedal deregulation, push down the yen, and sanction another price-keeping operation to bolster equities and the economy.
Many observers doubt that's the case, however. Hashimoto may moderate some of his austerity plan if the economy goes into shock. But right now, he is resisting widespread calls to revive the moribund property market by easing capital-gains taxes on some real estate transactions. And Ministry of Finance insiders suggest that high-level bureaucrats have reached a quiet consensus that they must start tinkering with the Japanese economic model to ensure the country's future success. Indeed, officials believe there is no turning back. Bureaucrats now concede their recent efforts to spur the economy and stock market lack credibility in the outside world. Their fear is that traders will view any new pump-priming moves with even greater disdain, sell stocks with abandon, and leave the country in an even worse pickle than before.
Hashimoto and the bureaucrats have any number of reasons to want to avoid this fate. Chief among them is the urgent need to improve the productivity of domestic industry as a way to improve Japan's growth prospects. With a looming demographic bombshell, Japan must renew its domestic sector as it starts to divert greater portions of its economic output to social security and medical payments. By the year 2025, one out of four Japanese will be over 65, nearly double the proportion today. And Salomon figures that supporting the seniors' needs will eat up a shocking 26% of GDP.
In some ways, Japan's domestic economy is finally feeling the global shock waves that have disrupted other industrial societies. Indeed, in the new two-tiered economy, 30% of Japan's workers are lucky enough to be hitched to the global corporate winners. But the losers are far more numerous. They include tiny low-tech suppliers that just can't compete and the bigger domestic companies that have lived under state protection--industries ranging from airlines to insurance.
JITTERS. As the ranks of losers grow, opinion surveys now show ordinary Japanese are deeply anxious, worried about their jobs, and yearning for change. Unofficial unemployment is at least twice as high as the official 3% rate, and millions more are underemployed in going-nowhere jobs. Polls also show a dramatic loss of faith in Japan's social compact as mandarins at the MOF and the Ministry of International Trade & Industry have proven unable to manage the economy to ever higher levels of prosperity. "There needs to be deregulation of the economy," says Hiroshi Ono, a 60-year-old manager with Tsukasa Sangyo, a small steel wholesaler. "People can't live the same as they have before."
To be sure, Japan is very rich. It has an impressive $10.3 trillion in household savings to fall back on. But that nest egg could be eaten away in an economy that's going nowhere and where 25% of its 124 million citizens will be living off their personal assets. Sensing this, Hashimoto is pushing liberalization on several fronts. Last November, he kicked things off by unveiling his "Big Bang" package of reforms to make over Tokyo's financial market by 2001. It calls for deregulation of stock commissions; lifting barriers that separate banks, brokerages, and life insurers; and loosening rules that govern asset allocations by pension funds.
If the plan succeeds, one-third of Japan's financial players will likely vanish or be merged out of existence, says J.P. Morgan & Co. economist Jesper Koll. Even without the plan fully in effect, that is already happening. Last fall, the Ministry of Finance shut down Hanwa Bank, a midsize lender based in western Japan that was sinking under the weight of $700 million in bad property loans. This was the first time the MOF had closed a bank since the end of World War II, and the move sent a clear signal to the industry that save for the collapse of a giant money-center lender, bureaucrats would no longer support smaller players that can't find merger partners.
FREE-FOR-ALL. Banking is not the only financial industry facing a lighter government hand. Not long after Hashimoto announced the Big Bang, the government concluded a far-reaching deal with Washington to open up the tightly segmented and rigidly protected insurance industry to competition. The deal has already pushed down premiums by as much as 20% on large corporate fire-insurance policies. It has also set into motion a free-for-all among U.S. and Japanese companies for new business. Six foreign insurers have already won licenses to sell auto policies by direct mail, for example. And life-insurance companies have suddenly jumped into the medical insurance business.
Moves to open up the economy to more competition are showing up on many other fronts. Take transportation. Faced with Transport Ministry-sanctioned competition from a discount carrier that vows to cut fares 50% on its high-volume Tokyo-Sapporo route, Japan Air Lines Co. has been looking for ways to reduce costs wherever it can. One answer is to rely more and more on cheaper foreign cabin crews to staff its charter subsidiary. By next year, some 17% of JAL's overseas traffic will be handled by the unit, which is already flying from Japan to Hawaii, Bangkok, Guam, and Saipan.
Retailing is also in for shock therapy. A recent easing of rules limiting gasoline imports has lowered Japan's pump prices but is also crushing profit margins and could push 50,000 service stations into the red, figures Todd Guild, a partner with McKinsey & Co. Mom-and-pop retailers face similar pressures if a push to lift restrictions limiting stores' floor space goes through. Any such move would invite new competition from "category killer" outlets and superstores, triggering a bruising shakeout that would affect a third of Japan's labor force, figures James Vestal, an analyst with BZW Research Ltd.
Workers for multinationals may have equally dire prospects. With the recent decision to split Nippon Telegraph & Telephone Corp. into two local companies and one long-distance carrier owned by a holding company, the Diet is now expected to lift a ban on such combines dating to the U.S. occupation. Large companies would reap big savings by spinning off laggard divisions and pegging pay levels to performance. Even layoffs could become a reality, threatening lifetime employment that has secured worker loyalty in bigger companies.
Already caught in the squeeze are many of the midsize suppliers. It's no longer an act of economic treason to look beyond long-standing keiretsu suppliers. Toshiba has set up a home page on the Internet to solicit bids from overseas suppliers. It hopes to double its foreign procurement, to $5 billion, by 1999. The story is the same at Sony, NEC, Casio, and Minolta, which all have reached out to lower-cost Asian and American suppliers to provide key components. Nowadays, General Motors Corp.'s sprawling Delphi Automotive Systems parts division not only supplies Toyota Motor Corp. in the U.S. but also sells catalytic converters to Toyota plants in Malaysia and Thailand. Delphi executives in Tokyo even sit in on strategy sessions with the auto giant's Japanese suppliers.
Of course, big suppliers such as Denso Corp., a leading maker of automotive electronics components, have the kind of cash to follow the big manufacturers abroad. But plenty of others can't. That's why foreign subsidiaries of Japanese companies now get only 38% of their parts from home, down from 56% a few years ago. This reflects the multinationals' efforts to regain ground lost to the U.S. in global markets as the yen spiraled to a record high in 1995. The 40% depreciation of the yen against the dollar is helping the comeback. But the multinationals are gaining even more advantages from their production bases that have sprung up around the world.
In America, Japanese auto makers are grappling back by trimming prices on new models, revamping existing ones, and expanding their plants to regain ground. "U.S. producers haven't been able to keep up with demand, and the Japanese are making up the difference," says Toyota President Hiroshi Okuda. Since mid-1995, the Big Three's cost advantage over Japanese models has shrunk from $1,400 to $1,000. Toyota's American-made Camry, launched last fall, and Honda's U.S.-made Accord, due out later this year, even have a shot at overtaking Ford's Taurus as the top seller this year.
NEW GIZMOS. Toyota and Honda also are racing ahead to set up regional manufacturing and parts supply networks in Southeast Asia. Honda partially developed the City sedan it sells in Thailand at a Thai design center set up two years ago. Thai designers also helped Toyota modify its Soluna passenger car to make it rugged enough for Bangkok's steamy climate and tortuous road conditions. With 70% of its parts locally sourced, the Soluna is due out in Thailand on Jan. 31. It also may be exported to Singapore and Brunei later this year.
The moves by Toyota to buy local components are part of a broader trend by many manufacturers to dump longtime keiretsu suppliers in favor of the cheapest vendors around. Bridgestone Corp., for one, has mushroomed in the U.S. and Canada since buying Firestone Tire & Rubber Co. in 1989, doubling its production to 23 million tires a year. Bridgestone recently opened a $400 million plant in Warren County, Tenn., to produce 4,600 bus and truck tires daily.
Once written off as digital slackers, Japanese consumer-electronics giants such as Sony, Toshiba, and Hitachi have been every bit as aggressive as the auto makers in fighting for global market share. Each has launched new notebook or desktop offerings lately, and Sony's hot-selling PlayStation video-game machine has come from nowhere to become a $3 billion global business. Toshiba's high-end Infinia PCs are also heading for success. Decked out with radio, TV, and answering-machine functions, they are a splashy example of Japan's broader strategy to push its consumer-electronics knowhow into new digital realms. "This is a declaration that we're not confining ourselves to small, laptop computers," explains Toshiba President Nishimuro.
More important, though, is that this push is being led mostly from California, by American managers steeped in the entrepreneurial culture of Silicon Valley. And maybe a bit of that culture is rubbing off on high-tech executives: Fujitsu Ltd. recently unveiled a performance-based stock-option plan at its California affiliate. Such plans are almost nonexistent in Japan, where pay is still largely tied to seniority.
"OPPORTUNITIES." To a great extent, multinationals always have been on the outer perimeter of the Japanese economy. But increasingly, the flexibility and keen sense of competitiveness they offer are exactly the practices the economy needs so dearly right now. Hashimoto realizes this, but the chance of costly mistakes looms large. A big policy misstep--say, deregulating banking without first resolving the industry's bad-loan mess--could plunge already thinly capitalized banks and life insurers into a vicious circle of selling.
Fearing lenders would see their capital dip below internationally agreed-upon standards as the value of their equity portfolios erodes, investors might dump bank stocks with abandon. That would make banks even more reluctant to lend money than they are today, threaten to send the economy into a tailspin, and spark even more selling in the stock market.
To ward off such a calamity, Hashimoto now must articulate his vision of reform, build a consensus among powerful ministries to see it through, and gain public support for the short-term pain it will bring. Japan already has lost trillions of dollars in national wealth in the bear market of the 1990s. Hashimoto's challenge now is to guide the country along a path that lets it profit best from the globalization of business. As the Nikkei's latest nightmare suggests, making the transition to an economy in which government intrudes less and the market counts for more will not be fun. But "this decline is throwing up opportunities," says Merrill Lynch & Co. Japan strategist Jeff Bahrenburg. Unless Japan now takes advantage of them, its vast domestic economy could be consigned to stagnation even as the country's multinationals continue to make hay.