Richard Katz
02/01/2005
In March 2003, confidence in the Japanese economy reached such a low ebb that the prices of Japanese stocks and bonds behaved as if a calamitous crash, complete with bank runs, was just around the corner. But the sky did not fall, and investors took the reprieve as a signal to turn bullish. Some declared that after 15 years of stifling economic malaise, the Japanese economy had finally turned the corner.
That exuberance fueled a 60 percent rise in Japanese stock prices over the following year, making the Tokyo Stock Exchange’s performance one of the best of any major bourse. However, while other macroeconomic indicators were also encouraging, the fine print cast doubt on the long-term viability of Japan’s renaissance. Yes, industrial production soared from its 2001 nadir, but only to a level slightly higher than the country achieved in 1991. GDP began growing at a brisk pace, registering 2.5 percent in 2003 and perhaps as much as 4.5 percent in 2004. However, the Organization for Economic Cooperation and Development forecast that Japan’s growth rate would decline to a dismal 0.9 percent average from 2006 to 2009.
Many find the successive waves of exuberance and despair that characterize the Japanese economy perplexing. The simplest explanation for these gyrations is that Japan is transitioning from one economic structure to another. Such a fundamental change, which will take several more years to complete, is inherently bumpy, and expectations will shift more than the underlying realities. Even so, the rebirth of an economy that was, only a few years ago, the envy of the world will ultimately come to pass. Japan’s numerous inefficient industries, long sheltered from competition, will eventually catch up to world productivity benchmarks. When they do, sustained growth of 3 to 4 percent will be within the country’s reach.
The old Japanese economic system was indeed a miracle. Created out of the wreckage of military defeat, this model took a country with more farmers than factory workers and a 1950 per capita GDP only slightly higher than that of Pakistan today, and transformed it into an industrial superpower. True, it was a top-heavy system with too much statist direction of industry and finance and too little competition, both domestically and from imports. Nonetheless, for two decades, the benefits of Japan’s industrial policy of subsidies and market protection outweighed its costs. Once the Japanese economy matured in the mid-1970s, however, the country needed to give the market more sway. Its failure to do so produced a deformed dual economy—a dysfunctional hybrid of superstrong exporting industries and superweak domestic sectors.
OLD JAPAN FALTERS
In 1990, the system came crashing down with the collapse of the stock market. An economy that had grown 4 percent a year from 1975 through 1990 proceeded to labor along at 1.5 percent. Of course, any economy running far below capacity can temporarily grow above its long-term potential if it gets a temporary spurt in demand. Japan proved this in 1995–1996 and in 1999–2000; it is doing so again today. However, only a productivity revolution borne of structural reform can bring about 3 to 4 percent growth on a sustained basis.
| Japan’s long financial crisis and deflation are the financial mirrors of structural defects. |
SCLEROTIC POLITICS
Japan remains a one-party democracy—the only one remaining in the advanced industrial world. The ruling Liberal-Democratic Party (and its precursor organizations) has ruled Japan for almost 60 years with only two brief one-year interruptions. One-party states are inherently more rigid. Today, the LDP is divided and weak. While some parts of its base would benefit from reform, others would be hurt. These factors make political decisiveness a rare commodity.
Prime Minister Junichiro Koizumi has made significant changes on a few fronts. Koizumi built a consensus that economic recovery requires reform, even if there remains much disagreement on the substance of that reform. He has diminished antireform factions within the LDP. The government, under his leadership, has also taken firm steps to stabilize the nation’s large, scandal-plagued banks.
While financial stabilization is an indispensable first step toward more level economic performance, it will not, by itself, lead to a revolution in productivity. That requires much deeper change. Productivity grows fastest when new firms can easily enter an industry and supplant older, inferior firms. On this score, Japan’s performance is the worst among the major industrial nations; improvement under Koizumi has been minimal.
One of the most common measures of corporate efficiency is return on assets. For the 5,000 biggest Japanese firms, the ratio of operating profits to total assets has risen from an average of 3 percent in the 1990s to around 4 percent today. However, that is still below the 5 percent level of the 1980s and still only half of U.S. levels. Worse yet, most of the improvement is limited to those big firms of interest to investors, which employ only 10 percent of Japan’s workers and produce only 17 to 18 percent of its GDP. At the smaller firms, return on assets still lingers at its low 1990s average.
Japanese companies have failed to shed wasteful assets; instead, they prop up profits by squeezing wages. Companies are shedding full-time workers who get health and pension benefits, not to mention substantial twice-yearly bonuses, and are rapidly replacing them with part-time and temporary workers who are not entitled to benefits. As part-timers rose to 25 percent of the workforce, company expenses per worker fell by almost 10 percent. As a result, half of the entire increase in corporate operating profits from the 2002 trough came from wage cuts rather than increases in genuine efficiency.
With so many firms cutting wages, household income is fairly flat, as is consumer spending. Consequently, the economy is heavily dependent on exports. While exports account for only 12 percent of GDP, these exports—particularly exports to China—have provided almost half of all GDP growth since early 2002. Business investments oriented toward exports provide much of the rest. That lopsided pattern cannot last indefinitely.
RISING SUN
Though many of Japan’s most troubled sectors do show hopeful signs of change, improvements may be slow in coming. For example, retail firms have reduced their debt load by 10 percent; old, inefficient “mom and pop” stores have been dropping out in droves, and some of the largest zombie retailers have either gone bankrupt, been radically downsized or have been absorbed by other firms. Nonetheless, efficiency keeps falling. Sales per employee have tumbled 16 percent since 1997, but payrolls have barely budged. Even worse, sales per square meter have plunged 25 percent since 1991—and, still, retailers keep expanding floor space. In each year from 1999 to 2002, retailers added 5 percent to total floor space. This sector is clearly not yet subject to the kind of financial discipline needed to ensure efficiency.
A more positive example comes in one of the traditionally most inefficient sectors: retail apparel. Between 1995 and 2001, output per textile employee grew 40 percent, or 5.5 percent a year. This improvement was due in part to competition forced by trade. As Japanese retailers and manufacturers began outsourcing production to China, imports of textiles and apparel doubled as a share of household consumption, to 37 percent. In response, the weakest firms dropped out. The industry shed half its labor force and eliminated 30 percent of its capacity. Meanwhile, plunging apparel prices liberated consumers’ purchasing power, allowing them to acquire cell phones and other new products.
| NIKKEI JASDAQ INDEX Japanese stocks' bumby ride since their March 2003 nadir. |
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Imports and FDI remain very low by international standards, but investments are increasingly welcomed by much of Japan’s elite, which was once suspicious, if not downright hostile, to them. Imports remain a tougher sell, but the efforts of Koizumi and the Ministry of Economy, Trade and Industry to promote Free Trade Agreements (FTAs) are partly motivated by the desire to rid Japan of its excess dependence on a horribly inefficient farming sector. The recently signed FTA with Mexico is the camel’s nose in the tent on this front. Progress will be slow because the LDP caucus in the Diet is still disproportionately dependent on the rural vote.
Some of the most dramatic changes have occurred in finance. As recently as 1985, foreign brokers were unable to buy seats on the Tokyo Stock Exchange, and foreigners owned only 5 percent of all corporate shares. Today, foreign-affiliated brokers handle one-third of all trades, foreign investment bankers are leaders in stock underwriting and foreign investors own more than 20 percent of all shares. Foreign life insurers now have a 20 percent market share, making them a force in institutional investment. In many areas, foreign investors are a leading force for corporate governance reform. The demand for more shareholder power—from both foreign investors and domestic pension funds—is growing and will eventually become irresistible.
Though the Japanese economic ship is certainly not turning on a dime, it does continue its slow transformational veer. Moments of market exuberance will be interspersed with despair as Japan confronts the inefficiencies of the old economy. While hopeful trends have not yet reached critical mass, ultimately they will prevail, and the old will give way to a new, successful model, one made in Japan with foreign components.
Richard Katz is editor of the Oriental Economist Report, a monthly newsletter on Japan, and author of Japanese Phoenix: The Long Road to Economic Revival.