In Japan's darkest hour, signs that the worst may be over

Hamish McRae On the bull case for a battered economy
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The moment when things look truly dreadful usually proves to be the turning point - just as the moment when the future looks most rosy is the moment to sell. Since everyone at the moment is so convinced that the Japanese bear market has further to run, dedicated contrarians ought at least to be considering that this is the moment to plunge back in. Absurd? Maybe. At least, too early? Quite possibly. But let's look at the bull case.

It is easier to start by thinking in terms of the economy rather than the share market, for two reasons. First, the particular characteristics of the Japanese equity market, with its large cross-holdings and hence relatively small proportion of stock that can be traded mean that it is particularly vulnerable to mood swings. And second, because the market has been so manipulated by the authorities during the first half of the 1990s - being artificially propped by the so-called "price keeping operation" - it might be some time before an economic recovery is reflected in share prices.

Start with the bad news. If you look at the economy, the second quarter of this year was catastrophe-ville. It is not often that the GDP of a developed economy declines at an annual rate of 11.2 per cent, but the Japanese one managed that in the second quarter. The culprit was a collapse in private consumption, down at annual rate of 21 per cent, in response to the rise in the sales tax. You can catch a feel for the scale of the disaster by looking at the first graph, showing registrations of new cars. These had been slowly recovering from the recession in 1994 and surged at the end of last year in anticipation of the rise in the tax. Then they fell off the cliff.

Inevitably this collapse in consumer demand has hit industrial production. We tend to forget that the Japanese manufacturers are much more dependent on the home market than ours: only 9 per cent of GDP is exported, against 28 per cent here. Until the beginning of this year manufacturing has been recovering nicely (middle graph). True, it was still below the peak of 1990, and if anyone had suggested in 1990 that industrial production seven years later would be no higher, it would have been dismissed as absurd. Still, cover the left-hand side of the graph with your hand and it doesn't look bad at all. But now it is starting to nudge back down again, largely in response to domestic weakness.

So why, after this build-up, is there a case that the worst is over? Here are four reasons. First and most important, the period of price destruction - that expression which describes the process where Japanese companies were having to sell their products at ever-lower prices - may be over. The graph on the right, from the Bank of England's latest Quarterly Bulletin, shows how both consumer and producer prices have quite suddenly pulled from negative to positive territory. If you are worried about inflation, fears of higher interest rates and all that, the move from falling to rising prices might seem bad news. But if you are worried about the dead- weight of debt on the books of both companies and banks, a little inflation is a very helpful thing, for it reduces the real size of the debt. Provided nominal rates do not rise in response, it also reduces real interest rates. A little inflation therefore is exactly what Japan needs.

Second, the collapse of demand in the second quarter ought to be a one- off affair. Deutsche Bank is now forecasting consumption rising at an annual rate of between 2 and 3 per cent through next year; nothing special but at least the sign is positive rather than negative.

Third, it looks as though the yen will continue to weaken. Do not expect this to have a material impact on the volume of exports, which will in any case be depressed by the chaos in East Asia. But it will help export profitability, and the sight of more profitable companies will boost corporate confidence, and in turn market confidence.

For nearly two decades Japanese companies have sold investors the line that profits are unimportant and growth is what matters. Capital was too cheap, and investment was frequently wasted. Low returns on capital distinguished Japanese business from the rest of the world. Now the returns available on Japanese securities are becoming more "normal" as prices fall, but the usual argument is that further falls are necessary. That is right: you can make a case on those grounds for a Nikkei-Dow at 10,000 or below. But a rise in profitability, and more important, a shift in the corporate culture towards recognising the need for profits, means that present levels look more reasonable.

Finally, there is the mood of reform. Effective reform has largely been stalled by political opposition. One small sign that the impossible is becoming possible came with the bank collapse and subsequent intervention by the government. The events yesterday do not in themselves support the sharp rise in the stock market, but I think the market is trying to tell us something more. I think it is trying to tell us that the political consensus in Tokyo is shifting towards reform: not just window-dressing reforms designed to appeal to foreigners, but a deep-seated culture of reform, which recognises past failure.

It is very difficult, if you have an apparently successful economic model, to recognise that its run of success has come to an end. But until you do, all reforms are going to be half-hearted, dealing with symptoms rather than the underlying weakness. Back in the 1950s Japan experienced a period of dreadful labour unrest, similar to the trouble in Britain in the 1970s. This resulted in the co-operative model which drove Japan's commercial renaissance, just as the (very different) response to the British disease set in train the economic recovery in this country. I don't think that Japan Inc is quite ready yet to confront its failure, but many people within Tokyo are certainly ready to do so. Eventually they will win the argument.

This may all be too early. Conventional wisdom is that there is worse to come. But the darkest hour is just before dawn, and it is pretty dark at the moment.

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