Japan's Deflation Disaster

Plunging prices are clobbering the country's economy

To see what havoc deflation is wreaking on Japan's economy, swing by a model-home complex in the upscale Tokyo suburb of Sakura Jyosui. There, big homebuilders such as Mitsui & Co. (MITSY ) and Misawa Homes Co. show off their latest homes, which boast elegant tatami rooms, wine cellars, and saunas. But there aren't many takers these days. This despite the fact that Misawa and rival homebuilder S x L Corp. last year triggered a price war that has crunched prices for a new home by as much as 28%. "Times are awful," says a Mitsui salesman. "And the competition is ferocious."

Life is hell for such foot soldiers of the Japanese economy. Why splurge on a big-ticket purchase like a new home now, consumers figure, when it will likely cost less next year? And buyers aren't likely to change their tune any time soon. While some observers hope the early March jump in Japan's stock market signals a recovery that will put a floor under falling prices, such hopes are misplaced. That spike in the Nikkei could well prove temporary.

Deflation, on the other hand, seems frighteningly permanent. All kinds of consumer and wholesale prices, from compact discs to three-piece suits, have been dropping for two years now--and show no sign of stopping. Nor should anyone have much confidence in Prime Minister Junichiro Koizumi's just-released anti-deflation package, which fails to address Japan's big problems, including extra capacity. Says Yuichi Ezawa, Japan representative and vice-chairman of UBS Group: "There is no easy escape from deflation."

Indeed, it is deflation--and not the hoped-for shot in the arm from a rising stock market--that will have the biggest impact on Japan's economy this year. A number of structural factors are responsible for the continuing drop in prices. Frightened consumers don't want to buy, overbuilt industries are pricing their products to move, and cheap imports from China and the rest of Asia are flooding the markets. The result is that sectors such as food, clothing, consumer electronics, and housing are getting hammered. As corporate failures keep mounting--20,000 companies went under last year--consumers are wondering when they will get hit, too. Megumi Yamamoto, a young Tokyoite, loves the fact that she can now buy Sony CDs of Japanese artists for $3.75 less than last year. But, she adds, "I am very worried about my future."

So are plenty of executives. Deflation has forced consumer-product companies to make wrenching shifts in planning and marketing, with mixed results. During the 1980s, when incomes were rising, pricing a product amounted to slapping a fat margin on top of the cost of production. Brand-loyal consumers, whose living standards were improving, went along for the ride. Today, retailers are fighting for a dwindling share of the household budget. "The profit margin is now what the consumers let you keep," quips Jerry Black, a managing director with Kurt Salmon Associates, a retail management consultant.

Companies need to take a machete to distribution costs, shift production offshore, and get creative to pry yen from Japanese wallets. Sometimes this works. Frozen-food outfit Katokichi Co. can make its chicken skewers and octopus balls 15% cheaper in China, so it does. Since it started importing meat, fast-food king Yoshinoya D&C Co. has been able to cut prices by 30% and open new stores. It still expects to turn a $137 million profit this fiscal year.

But not every industry can chop fixed costs so easily--especially in Japan, where costs are the highest anywhere. Consider distribution. Japanese trucking companies pay five times more in road levies than their counterparts in the U.S., while shipping costs are twice as high, largely because unions control the docks. Such high operating expenses are forcing the likes of Matsushita Electric Industrial Co. (MC ) and NEC Corp. (NIPNY ) to move more production to China and other low-cost centers.

Consumers, meanwhile, can't afford to indulge in brand loyalty, which is hard to justify when so many cheaper products are available from abroad. "Nobody used to take South Korean electronics very seriously," notes Iain White, J. Walter Thompson (Japan) executive director for strategy. They sure do now.

Deflation has also created, or at least popularized, entire product segments. Low-malt beers, or happoshu, which cost 40% less than regular brews, are hot in drinks. The $7,000 to $9,000 subcompact car is the fastest-growing product category for Toyota (TOY ), Nissan (NSANY ), and Honda (HMC ), while sales of family sedans are anemic. And no retail category is more emblematic of the shift in consumer psychology than the "100 yen" (75 cents) discount shops that are now all the rage.

Some innovative banks are even designing loan products to take advantage of one of the stepchildren of deflation: ultralow interest rates. With mortgage rates around 3%, many homeowners are eager to pay their balance early before rates head north. In an effort to pick up new business, Shinsei Bank has introduced a mortgage scheme that allows consumers to pay off big chunks of their balance ahead of time without incurring penalties. "You're looking at a more effective way to finance your home," says K. Sajeeve Thomas, Shinsei's corporate executive officer and chief of staff.

Some of these innovations are welcome, of course: Japanese consumers deserve a break. But at some point, deflation's destructive power could become too great for Japan to handle. Companies laboring under huge debts, for example, can't raise prices to service their loans. Maybe a lift in exports will help a few companies. But this year, most managers will remain as miserable as those house salesmen in Sakura Jyosui.

By Brian Bremner in Tokyo

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