If Japan Is Back In Gear, Fasten Your Seatbelt

For months, policymakers, investors, and executives have hesitated to label the good economic news coming out of Japan as proof of a sustainable revival. But on May 18, Japan blew away market expectations by reporting annualized economic growth of 5.6% in the first quarter of 2004 -- and 3.2% growth for the fiscal year ended in March, the highest jump since 1996. After more than a decade of growth averaging 1% a year, the $4.7 trillion economy seems increasingly on solid footing, with huge implications for the region and for the global economy. "For 12 years, Japan was putting a brake on world [economic] growth. [Now it] is making a positive contribution," says David Malpass, chief global economist at Bear, Stearns & Co. (BSC ) in New York. Forecasters say Japan's economy should clock anywhere from 3% to 3.4% growth for the full year, and maintain that rate for several years out.

Soaring Demand

Why are these numbers so encouraging? In the 1990s, Japan relied on two factors to keep going: Massive government spending and exports. Now, faced with huge budget deficits, pump-priming isn't an option for Prime Minister Junichiro Koizumi. Japan's government debt is 160% of gross domestic product. Exports are still a big engine of growth, especially to China. But the recovery is now being powered by domestic consumption, which means it could have more staying power than earlier suspected. Consumer spending, housing, and business investment represented about two-thirds of the first-quarter output. Not only are corporate net earnings expected to grow 24% this year but the jobless rate of 4.7% is a three-year low. After enduring years of stagnation and restructuring, Japan-style, shoppers are shrugging off the gloom. Domestic demand for high-tech gadgets is soaring. Housing construction is up, as were auto sales in the first quarter.

If the recovery takes hold, policymakers worldwide will have to adjust their view of Japan's role in the world. Asia will have a source of growth to rely on besides China. It's easy to forget that Japan's economy is 13.5% of the global whole, vs. China's 4%. Sustained growth in Japan could also start to wipe out the last vestiges of deflation in the world economy. The Corporate Good Price Index, which reflects commodity, wholesale, and shipping costs for Japanese manufacturers, rose in March by 0.2% for the first time in nearly four years. That reflects stronger demand for Japanese exports and domestically produced goods, and could eventually feed into consumer prices.

The experts disagree on when Japan's deflation will peter out. The Bank of Japan thinks consumer prices will stop falling in the middle of 2005. Bear Stearns' Malpass predicts consumer prices will start rising later this year -- putting pressure on the BOJ to raise interest rates modestly next year. Japanese savers who park their wealth in bank deposits would get a better rate on their savings, increasing their disposable income.

Could Japan's turnaround get derailed? An unexpected recession in the U.S. would be a major setback. A crash landing in China would also hurt, but it might not kick Japan back into recession if the U.S. keeps growing. And if a virtuous circle of rising consumer spending, corporate investment, and growth gets going in Japan, it will be easier for the government to tackle long-term problems such as its still-massive debt load. A robust Japan? It could be the economic shock of the year.

By Brian Bremner in Tokyo

Edited by Rose Brady

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