Is This the Real Deal for Japan?

Its economic rebound may be a mirage

In Tokyo, the scent of quick money is in the air again. The Nikkei is up 11% this year, more than any other major stock index. Corporate Japan forecasts a 51% jump in profits for the year ending next March. And on June 7, the government was expected to announce that the economy blasted out of the recession in the first quarter and grew at a 7.7% annual clip.

The good news is that Japan has freed itself from the grip of a nasty nine-month contraction. The dire predictions of a cascade of major bank failures didn't materialize. Exports to the U.S. and elsewhere in Asia--everything from cars to steel to laptops--have rebounded, with stalwarts such as Toyota Motor Corp. and Sony Corp. leading the way. Inventories have been worked down to manageable levels. Household spending in April increased for the first time in three months. In addition, Japan is benefiting from a big shift in capital flows away from the U.S. During a two-week period in mid-May, overseas investors steered $8 billion into the Tokyo Stock Exchange. "We are seeing a big bounce back," says Ian Burden, chief investment officer at Invesco Asset Management Ltd., which manages $2.5 billion. He thinks the market could rise another 10% this year.

But is this the real deal--that is, the start of a lasting recovery and the rebirth of a Japanese stock market that creates, rather than destroys, wealth? No, that's about as likely as Japan winning the World Cup. To begin with, Japan's unreliable economic statistics probably overstated first-quarter growth. Second, the downturn in the dollar could deep-six the modest recovery that actually is happening. In any event, Japan's long-running bank mess will keep a lid on the economy until it finally gets resolved. That's why economists are betting that for the full year, Japan will be lucky to grow even 1%.

In fact, it's easy to argue that the Japanese are getting just what they don't need: enough growth to forestall a financial collapse but ease the pressure for reform--and nowhere near enough to restore optimism, kill off deflation, and reduce Japan's debt to manageable levels. For that reason, Moody's Investors Service downgraded Japan's debt on May 30 to the level of Israel's and South Africa's, drawing howls of protest from Tokyo.

Of course, as an investment destination, Japan benefits from the woes of the U.S., which has sucked in $1 billion of foreign capital a day for years. While the Nikkei has risen by double-digits this year, the Standard & Poor's 500-stock index is off 9%. The steady drumbeat of accounting scandals and terrorism threats in the U.S. makes even Japan look good in comparison. At Mellon Global Investments Japan Co., which sells offshore financial products to wealthy investors in Tokyo, country representative Haruo Sawada says that ever since the Enron Corp. meltdown, Japanese investors have shifted away from U.S. stocks and toward highly rated Japanese corporate bonds. "Japanese investors are very cautious now," he says. "It has to be corporate paper with an AA or AAA rating."

But investors chasing Buy Japan advice are likely to be disappointed. Exhibit No. 1 for the be-cautious crowd is those squishy economic numbers, particularly the preliminary data on gross domestic product. Barclay's Capital Chief Economist Mamoru Yamazaki recalls that a 1999 first-quarter annualized spurt of 7.9%, which electrified the markets, turned out to be a 3.9% contraction when the numbers were finalized. Others don't buy the talk from Prime Minister Junichiro Koizumi's economic team that the deflationary pattern of falling prices--and thus profits and wages--is subsiding. HSBC Securities Economist Peter Morgan says Japan's consumer price index, which fell at an annual rate of 1.1% in April, the smallest decline in six months, "still underestimates the degree of deflation by about 0.7%." Reason: It excludes many of the discounts regularly offered by department and other stores.

What's more, the earnings recovery looks pretty suspect, according to Goldman, Sachs & Co. economist Kathy Matsui. First, she says, Japanese companies, and particularly the banks, are notorious for overestimating expected profits. Second, about half the expected 51% jump in pretax profits is clustered in the electronics sector, so the earnings recovery won't be broad-based. Matsui also worries about a continued decline in the dollar, which could take the yen from 124 per dollar now to the 115 that is the breakeven point for most exporters. "This year's earnings recovery," she says, "is enormously dependent on export earnings." Small wonder that the Bank of Japan on May 31 spent about $10 billion to cool off the yen's recent surge, in one of the biggest currency interventions ever.

The central bank has also been printing money like crazy this year in an effort to end deflation and get people borrowing and spending again. Japan's monetary base is growing at a blistering 36% annualized rate, a pace not seen since Japan's first oil shock in 1973. Usually, such money-supply jumps presage inflation and also a sharp upturn in economic growth.

But Japan's very big and very ailing banks are just not lending the money that's being pumped into the system. New loans dropped 5% in April, for example, from a year earlier. The banks are weighed down more than ever with bad debts. In May they reported their nonperforming loans rose by $48 billion, to $217 billion, in the fiscal year ended Mar. 31, despite $62 billion in write-offs. One reason was tougher government audits that reclassified more loans as nonperforming. The bad debt equals almost 11% of their loan portfolios, far exceeding the 2% or so common in the U.S. and Western Europe. And they haven't set aside enough reserves against some $144 billion of those dud loans, says Nikko Salomon Smith Barney economist Jeffrey Young. He thinks dealing with the debt will "absorb many years of [bank] profits."

For a sustained recovery, the Gordian knot between the banks and the troubled borrowers they keep afloat must be cut. But that's unlikely to happen because it's certain to inflict huge pain on Japan's workforce, where unemployment has been steadily rising. The worst indebted companies are small and midsize retailers, service companies, and construction outfits, which employ 80% of the workforce, points out Bank of Japan Governor Masaru Hayami.

Meanwhile, the Koizumi government is pointing to the fragile signs of recovery as proof that its policies are working. Most Japanese are not fooled. "The government is not dealing with the debt problem," says Hiromasa Yonekura, president of Sumitomo Chemical Co. "People are not satisfied." Yonekura advocates a quick bank cleanup and deep tax cuts. Sounds reasonable. What the Japanese will probably get, though, is a botched recovery and more pain down the road.

By Brian Bremner in Tokyo

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