Outlook: Japanese economy stands at the crossroads of reform

Britain and America have been keeping their economies going through the business downturn by applying a policy of exceptionally low interest rates and easy credit. It seems to be working, but by encouraging the arguably undesirable side effect of a consumer credit and mortgage boom, the policy is still best characterised as an experiment in economic manipulation. No one yet knows what the long-term consequences might be. Yet set against the zero interest rate policy being applied by Japan, the British and American "experiment" seems positively tame and unadventurous.

I've been in Tokyo for the past week with a group of British journalists as the guests of the Keizai Koho Center, an offshoot of the Japanese equivalent of the CBI, the Keidanren. Through the KKC, we were able to gain unparalleled access to a wide range of front-ranking economy policy makers, business leaders and politicians. What I can report is that after years of economic malaise, there is a real sense of optimism and renewed confidence in the air. The world's second-largest economy is growing again, albeit only marginally in nominal terms, business investment is picking up, exports are booming, and even Japan's 12-year-long banking crisis shows signs of abating.

Is Japan finally emerging from the economic quagmire, or is this just another of the short-lived cyclical recoveries we have seen so many of since the bursting of Tokyo's stock market and property bubbles 12 years ago?

The first thing to observe is that Japan at long last seems to be getting macroeconomic policy right again, both at the fiscal and monetary level. After years of blaming each other for economic calamity, Japan's two most important policy-making organisations, the Ministry of Finance (MoF) and the Bank of Japan (BoJ), seem to have settled their differences to pursue a co-ordinated, pro-growth approach to policy.

The key element is zero interest rates, a concept which, despite historically low interest rates the world over, most of us still struggle fully to grasp. The markets remain sceptical, both about the sustainability of the policy and the Bank of Japan's willingness to maintain it. I can report that the BoJ is in deadly earnest. It intends to maintain the policy for as long as it takes to inject a bit of inflation back into the Japanese economy.

The BoJ has committed itself to keeping short-term rates at zero until the ghost of price deflation is finally exorcised - that is until the statistics show several consecutive months of year-on-year growth in consumer prices with no anticipation of a resumption of deflation. My own impression on talking to BoJ officials is that the Bank might be prepared to sustain the policy even after the conditions for lifting it are met, such is the degree to which the scales have fallen from the BoJ's eyes on the dangers of too early or pre-emptive a tightening. The BoJ made that mistake during the last cyclical recovery, raising rates from zero in August 2000, and helping halt the recovery in its tracks.

Zero interest rates are supported by massive injections of liquidity into the system. This is achieved not just through overnight money market instruments, but also through the purchase of government bonds at the rate of 1.2 trillion yen a month, or 14 trillion a year. This amounts to approximately a third of the expected budget deficit of about 8 per cent of GDP for this fiscal year. Bizarrely but necessarily, Japan's central bank has become the largest single purchaser of government bonds. In essence the BoJ is bankrolling government spending by printing money. Even with interest rates at zero and the printing presses running overtime, deflation remains doggedly entrenched. That the situation would be even worse without these policies is not as obvious as it might seem.

Not everyone agrees that the BoJ is doing the right thing. There is a perfectly respectable school of thought that argues that zero interest rates are the worst possible response. Instead, the BoJ should be allowing rates to rise, so as to strip out the overhang of inefficient, uneconomic enterprise in the economy, which in turn would allow profits in more efficient companies to rise and for growth in private investment to resume. Householders would also start earning income again from their savings, supporting demand.

This is not a mainstream view, and it is certainly not one I would share, but it does highlight a fundamental issue for the Japanese economy. Is Japan capable of recovery without resort to shock therapy? Is the present, slow pace of incremental structural change in the Japanese economy likely to deliver the goods, or does a sledgehammer need to be taken to the problem, rather in the way Margaret Thatcher brutally restructured the British economy in the 1980s.

The present approach is one of slow change, and support for the economy through zero interest rates. To ease the pain further, the Koizumi government has pledged itself not to raising taxes for at least three years, despite the fact that the budget deficit is at crisis levels. The government needs the zero interest rate policy as desperately as Japanese enterprises. Government debt has reached 120 per cent of GDP, which rather puts our own debate in Europe about excessive government borrowing into perspective. In any case, the government couldn't finance itself but for the zero interest rate policy.

As can readily be seen, the short-term consequences of allowing interest rates to rise would be utterly miserable. The government would go bust along with great swathes of the Japanese economy, throwing millions out of work. The political arguments against shock therapy are too persuasive to allow it to happen. Whether the right approach or not, Japan is stuck with a programme of incremental reform. The big bang approach is just too painful to contemplate.

Fortunately, THE present cyclical upturn in the economy gives the ruling Liberal Democratic Party (LDP) a god-sent window of opportunity to begin that programme from a position of relative economic strength. Asked why it was that the structural economic reform promised by Junichi Koizumi when he first became prime minister appeared to have run into the sand, Shinzo Abe, Secretary General of the LDP, puts it like this.

Japan is a country where it is difficult for change to take place. Mr Koizumi doesn't have as much power as a British prime minister. He must consult on everything he does and the factions and interest groups in the party are still strong. Working on reform when the economy is in such a poor state is difficult. To impose cuts in government spending at such a moment, or raise taxes, would only cause the economy to stall. With the economy now recovering, such excuses may soon look hollow.

The other key feature of macro-economic policy in Japan is currency intervention. The Ministry of Finance is spending trillions of yen buying dollar assets. That in turn depresses the value of the yen against the dollar, which has helped support the Japanese recovery story by enabling Japanese exporters to exploit the explosive economic growth going on in China.

The other encouraging feature of the Japanese economy is that the banking crisis is plainly easing. Significant progress has been made by the big four city banks in reducing their portfolios of underperforming loans. Even among the regional banks, the problem is being gripped with growing vigour. Last week the government nationalised Ashikaga Bank without compensation to shareholders, the first time it has dared take such harsh action. Yet despite balance sheets which in many cases can now support a resumption of lending, borrowing continues to fall. It is lack of demand for credit which seems to be the primary problem in Japan, not the banks' inability to provide it.

If Japan is to resume sustained growth, then, structural reform remains the key priority. Getting macro-economic policy right is not enough. The recovery in the world economy, together with the Chinese development story, has given Mr Koizumi the chance he needs to grip the problem of Japan's hinterland of uneconomic activity and lay the basis for a return to economic vitality. But will Japan allow him to take it?