The Jonathan Davis Column
SO THE news out of Japan is official at last. The miracle economy that only 10 years ago was the scourge of Western car makers and the darling of our investment com- munity has officially gone into recession. At the same time the Japanese government has come out of denial about the real scale of the economic crisis facing the country.

This is role reversal with a vengeance and some, no doubt, will take malign pleasure from it. It would be foolish, however, to ignore the fact that the crisis affects all of us in one way or another.

The worry now in Japan is not just that the economy will continue to contract for a few more months - which seems inevitable - but that the deepening crisis will eventually plunge Japan into an enduring economic slump.

The threat that Japan is facing is one of debt deflation, in which the heavy hand of the debt that financed the reckless expansion of the 1980s slowly squeezes the life out of the economy in the 1990s. This so-called credit crunch is in essence the same syndrome that produced the 1930s slump in Europe and the United States.

The economic situation in Japan has been deteriorating since the early 1990s, when the flood of money into inflated assets such as shares and property reached its peak. There was a partial recovery in the mid-1990s, but that has since been brought to a juddering halt with the financial crisis in the rest of Asia. According to the economic analysts at HSBC Markets, the only word to describe the recent statistical evidence on the performance of the Japanese economy is "dire". It is hard to disagree.

Industrial production, retail sales and investment have all fallen this year. Unemployment has hit a post-war record and the yen - a crucial barometer of the health of the economy - has been falling like a stone. Meanwhile many of the country's leading banks are sitting on huge amounts of bad loans, a throwback to the day when they lent heavily to finance speculative share and property deals, as well as what by Western standards are huge amounts of industrial investment.

Japan regularly spends 50 per cent more on capital investment as a proportion of GDP than most other developed economies, which is fine when that money has a profitable home to go to, but disastrous if it merely ends up as idle capacity. Company profits (shown in the chart) are meanwhile set to fall this year by between 5 per cent and 20 per cent, depending on whose estimate you believe.

This week the weakness of the yen finally prompted the US government to intervene in the foreign exchange markets in an effort to reverse the relentless slide in the Japanese currency. The one continuing bright spot in the Japanese economy is the continued strength of its trade balance, so the fall of the yen can only make its exports even more attractive in the short term.

This is one reason why the Americans (who are still running a large trade deficit) and the other Asian exporting countries are so worried by the yen's decline and would like to see it halted.

All in all, therefore, with the government still seemingly unable to push the economy back into a growth path, the economic situation in Japan could hardly be less promising. The odds therefore are on a long, grim summer, with plenty more bleak headlines and gloomy economic data. The government faces the classic problem identified by Keynes: that with consumers scared to spend, and interest rates already down to 0.5 per cent, any fresh efforts to stimulate the economy will be like "pushing on a string" - forceful but ineffective.

It is still too early to say whether the operation launched by the US and Japanese authorities to prop up the yen will stop the rot. (There appears to be an element of public relations about the US involvement, just a week ahead of President Clinton's visit to Japan.) Past experience suggests that currency intervention only really works for long if the economic fundamentals are already starting to pull in the same direction as the currency is being pushed.

So does this alter my view that it is time to start thinking about the Japanese stock market as a potential home for a portion of your long-term equity savings? Not a bit of it. As I have observed before, the time to find the best bargains in the markets is often when the news flow is at its worst.

The value-minded investor always bears in mind the timeless adage that the darkest hour is just before the dawn. The key point to remember is that the issue for a long-term investor is not so much when - but whether - recovery will eventually take place. In Japan's case, that is not a serious issue.

It is true that the stock market may yet have further to fall. The Japanese authorities have invested a huge amount of time and effort in trying to stop the Japanese stock market falling below the 14,000-15,000 range, so far with some success. From a purely investment point of view, it would probably be better if the market was to breach this psychological barrier and find its real bottom. However, there are genuine concerns that such a market fall would trigger a wave of destabilising bankruptcies among banks and insurance companies, whose solvency ratios depend on the value of their equity holdings.

This is certainly not a trivial matter, since the last thing any Western potential investor wants is a full-scale financial crisis in Japan, which could rapidly spread to the Western banking system.(The more news that seeps out of Asia, incidentally, the more remarkable it is that Western stock markets have so far virtually ignored the developing crisis.) My assessment, however, is that the gloomy headlines coming out of Japan are poor omens for European and London markets, but still positive for Japanese equities on a long-term view.

It is true, as one of the City strategists I follow remarked this week, that the Japanese market is something of a casino and definitely not for conservative investors. But the odds that it will produce some significant gains in the next five to ten years are improving, and it will be a big surprise if a prudent monthly investment in, say, a Far East or Japanese investment trust trading at a 15-20 per cent discount does not produce some handsome gains in due course. Provided, of course, that you can discipline yourself to ignore all the gloomy headlines in the meantime.

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