For Japan, Will Exports Cure All?

Facing economic woes, Tokyo may let its trade surplus surge

Earlier this year, Prime Minister Ryutaro Hashimoto was pulling off some nifty footwork. He had pushed through a fiscal austerity program of tax hikes and tighter government spending. The economy was holding up. And while a weak yen had pushed up the Japanese trade surplus, Washington seemed willing to buy Hashimoto's assurances that serious deregulation was around the corner.

But Hashimoto and his policymakers seem to have stumbled. On Sept. 11, Tokyo reported that the economy had contracted 11% on an annual basis--almost double the forecast and the worst performance since 1974. The stock market is reeling, and a string of gloomy indicators suggest Japan will be lucky to avert a recession this year. What's more, its global trade surplus, which jumped 113% in August, is inching up, and there are signs that much needed deregulation may take longer than expected.

The U.S. wants Tokyo to do more to correct these staggering numbers. And at the International Monetary Fund and Group of Seven's annual meetings in Hong Kong on Sept. 20, U.S. officials will have this message for Tokyo: Don't worry so much about budget deficits, and move more quickly on deregulation. The concern is that Japan may just let its currency slide further past 120 yen, allow its trade surplus to surge off the charts, and try to export its way out of a recession. With Treasury Secretary Robert E. Rubin and his deputy, Lawrence H. Summers, already under pressure from Detroit auto makers feeling the flood of Japanese car imports, the trade implications are getting tougher to ignore.

STOCK SLUMP. How did Hashimoto miscalculate so badly? In April, he gambled that a recovering Japanese economy could withstand a 2% increase in the national sales tax, a repeal of income tax breaks started in 1993, and tighter public-works spending. But auto and housing sales started heading south, and with consumer spending 60% of Japan's economic output, the effects compounded. Now, the Nikkei is off 14% from this year's June high.

To placate Washington, says Vice-Minister for International Finance Eisuke Sakakibara, Hashimoto's government is weighing a corporate tax cut and other measures to pull Japan's bombed-out real estate and stock markets from their prolonged slumps. The Ministry of Finance might also tolerate an easing of Japan's stock transaction tax and other levies on land transactions to bring these markets back to life. Yet any big government pump-priming, such as big public-works projects or personal income tax cuts that would get the average Japanese spending again and boost import demand, isn't likely. "One thing that's almost impossible for Hashimoto's government is to end the fiscal restructuring," says Sakakibara.

The latest round of belt tightening has done little more than correct past policy blunders. Some $500 billion in government spending packages dating back to 1992 have driven Japan's budget deficit to about 5.4% of gross domestic product, one of the highest levels in the industrial world. Worse, the spending has given the Japanese economy little in the way of a lift. Meanwhile, for the past two years, the Bank of Japan has kept interest rates at near-zero levels. "There are very few policy tools left," figures Katsuhiro Fujiwara, a managing director at the Japan Federation of Economic Organizations, or Keidanren.

One option does remain open: A serious deregulation push. Japan's most cosseted sectors, such as retailing, construction, distribution, and transportation, have kept consumer prices artificially high. That has all but snuffed out consumption and forced Japan to rely on export-led growth.

But the ruling Liberal Democratic Party (LDP) has less incentive than ever to do anything. It has regained a majority in the powerful lower house of the Diet, thanks to opposition party defections. So it feels free to take its time to tackle those areas of deregulation that are the most politically painful since they damage the party's business allies.

Worse yet, with its power base more secure, the LDP leadership is back to its old habits of packing key posts with cronies. That could further undercut any efforts to deregulate. One worrisome sign is that Hashimoto has tapped Koko Sato, a politician convicted of bribery in the Lockheed scandal of the late '70s, for a ministerial post in charge of streamlining Japan's bloated bureaucracy. That will blunt efforts to reduce the power of the MOF and the Ministry of Industry & Trade, both of which have resisted efforts to open the economy.

The U.S. has been willing to cut Japan some slack as it maps out deregulation. Yet so far, the limited market opening that has taken place hasn't been able to offset the tsunami of Japanese autos, fax machines, and video games washing over into U.S. markets. Japan's current account surplus has soared about 40% in the first half of this year and now is the equivalent of 2.6% of GDP. U.S. officials have said that 2.5% is a critical threshold.

There has been some progress in financial reform. Last December, the MOF agreed to U.S. demands to liberalize the pricing of auto and commercial fire insurance. In addition, Hashimoto's Big Bang package to tear down the walls between banks and brokerages, free up stock commissions, and open more of Japan's pension fund market to foreign managers has won some praise.

"OUTSPOKEN." The question now is what will Japan's policy gurus try next. With a decelerating Japanese economy ever more tied to export growth, Sakakibara certainly has much less wiggle room on currency matters. Earlier this year, he successfully talked up the yen to 117 to the dollar, from a low of 127 to the dollar in May. He did so to placate Washington and by arguing that the Japanese economy was on the mend and interest rates might head up. He also sent currency trading pits buzzing by suggesting the yen could rise back to 103, a stunning statement in the subtle world of currency diplomacy. Yet with the yen weakening again, Sakakibara has been unusually reticent of late. "When it's necessary to be outspoken, I will be outspoken," he says.

But words may no longer be enough in the risky game Japan is playing. It may yet be able to muddle through with a devalued yen fueling just enough export growth to keep its economy above water without drawing the ire of Washington. Yet if Japan stokes up its export machine too high and stonewalls on reform, there's another script: The U.S. caves in to political pressure from angry U.S. exporters, talks down the strong dollar, and turns up the heat on trade. Japan loses its export prop, and its economy reels. Unless Hashimoto makes good on his pledges for widespread reform, this high-wire balancing act will be very difficult to maintain.

Before it's here, it's on the Bloomberg Terminal.