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Japan shows signs of revival

14 Nov 2003

Government data has been indicating the worst might be over for the Japanese economy. That could mean the long bond market rally is over and the recent stock market rally is actually the start of a recovery. There is at last genuine cause for optimism.

It was back in March 2001 when the Bank of Japan said it would maintain its zero interest rate policy until consumer prices rose again. Since that time, core CPI has trended around minus 1% year on year.

But in recent months, things have begun to improve. The CPI fell by only 0.2% in July from a year ago. Capital expenditure also rose, as did consumer confidence.

Improving Japanese economic indicators and the rallying stock market have resulted in a widespread, although some would say premature, view that the preconditions for a tightening in Japanese monetary policy are falling into place.

In preparation, investors have been shortening the duration of their debt holdings. Ten year Japanese government bond (JGB) yields have more than tripled from the all-time low of 43bp on June 11.

Nikko Citigroup's well regarded equity strategist Alexander Kinmont noted in a research report back in August that if there are signs that deflation is abating in Japan, under normal circumstances this might imply JGB yields of 2% or so. But Kinmont also said allowance should be made for the Bank of Japan's effectively unlimited ability to sit on the long end of the yield curve.

Higher rates not a fait accompli
While no government can claim to have full control over bond yields, especially one with ¥535tr ($4.7tr) of marketable debt, the Bank has plenty of tools at its disposal to slow a rise in rates.

In his monthly press conference during the week of September 14, BoJ governor Toshihiko Fukui reiterated that the Bank's zero rate policy would hold fast "until we can be sure prices won't easily slip back to minus".

Joanne Collins, senior fixed income economist at Daiwa SMBC Europe, believes that the conditions for monetary tightening will not be in place until mid to late 2005 at the earliest.

In a September 19 report, she concluded: "Financial markets... need to pay greater heed to the very clear signals from the BoJ that its zero rate policy is likely to remain in place for the foreseeable future."

Irrespective of this, there has been a sharp sell-off of Japanese bonds since August, although in the first two weeks of September bonds rallied marginally before and after Fukui's comments.

The 10 year bond's yield touched a record low of 43bp on June 11, and yields then surged to more than 1.6% at one point before the benchmark 10 year JGB yield settled back to trade around 1.4% in mid to late September.

The trend line is clear - investors believe the decline should signal the end of a near decade-long rally in government debt.

Japan has in fact been growing faster than the US for the first time since 1991, according to revised second quarter GDP figures released in September.

The data showed that the economy grew by a real 1% between April and June and 3.9% on an annualised basis, largely thanks to higher than forecast capital spending. That compared with an annualised second quarter growth in the US of 3.1%.

However, the key here is the word 'real', meaning that the nominal GDP growth is boosted by the deflation factor.

Japan's lacklustre real growth had until recently been wiped out by deflation. As a result, the economy is smaller today than it was in 1997. The GDP deflator, the most reliable measurement of deflation, has been negative since 1995 and is now standing at about minus 2.5%.

Some economists nevertheless argue that Japan's economy has finally turned a crucial corner as the current upturn, unlike previous ones, appears to be supported by domestic demand, while government-led and private sector restructuring have reassured investors in the capital markets.

Other economists warn that Japan's recovery will be fleeting so long as structural problems of oversupply, inefficiency and deflation remain.

In a strongly worded article, written in September in the Japan Times, Noriko Hama, an economist and professor at Doshisha University School of Management, said: "Now that deflation - not inflation - has become the fact of economic life here, it is anachronistic at best, and deceitful at worst, to boast about a better than expected real growth figure while the reality of the nominal economy remains one of declining general price levels."

The International Monetary Fund warned in a September paper that economic growth could not be sustained unless weakness at Japan's banks and rising public debt are tackled.

An onerous debt burden
As a result of rising bond yields, the Ministry of Finance's funding cost is rising when finances are already weak. Evidence of that can be heard in the market noise that Japan may increase new bond sales by 10% to a record ¥40tr in the fiscal year beginning April 1, 2004.

That would exceed the record ¥37.5tr of new bonds sold in the fiscal year ended March 2000 and is far above the commitment the government made at one stage to limit annual sales to ¥30tr.

Japan has more sovereign debt than any other country. But at roughly 1.4%, the 10 year bond yield is less than one-third of the 4.4% the government pays on 10 year notes that it sold a decade ago which are now maturing and due for refinancing.

Moreover, Japan's interest payments are less than half the $170bn paid by the US in the year ended September 2002, even though Japan's total debt is 38% higher that that of the US, the second largest sovereign borrower with $3.4tr of securities outstanding.

Although 10 year yields are more than triple the lows reached in June, by some estimates they would have to rise to nearly 3% before the average interest rate the government pays on its debt securities starts to rise.

Yet the rating agencies remain concerned. Japan's headline debt is rising and as a percentage of GDP is the largest of all OECD member countries.

The organisation estimates Japan's ratio will be 156% at the end of 2003, more than double the roughly 75% of 10 years ago. The next largest debtor is Italy, at 120%.

Moreover, Japan's income is falling. Tax revenue this fiscal year will drop to ¥41.8tr, the lowest since 1985. That will cover only 51.1% of total state spending, the lowest on record, according to government estimates.

Rating agency Fitch therefore remains cautious about the outlook for Japan's finances. It rates Japan's domestic debt AA- with a negative outlook, which suggests the rating might fall.

Moody's slashed Japan's rating on yen denominated debt to A2 in May 2002, saying the government's economic policies will not stem the rising national debt.

Relying on external demand
Another worry is that Japan also appears once again to be relying mostly on external factors to achieve its own growth targets, counting largely on the US to generate an export-led recovery.

The BoJ announced on September 16 that while economic activity continues to be virtually flat, exports have improved.

Kinmont notes that export expansion brings with it the risk of yen appreciation, as has been happening of late. To stave off that eventuality, the BoJ has this year been intervening aggressively. "Japan is trying to turn itself back into an Asian exporter with a de facto dollar peg, in our view," says Kinmont.

Obviously under some pressure from its peers, the BoJ stepped off the throttle before the G7 meeting in mid-September and afterwards seemed to indicate it could tolerate a stronger yen. By late September, ¥110 to the dollar appeared to be the BoJ's new line in the sand. For much of the year the rate has hovered around ¥117/$.

But what the risk economists and market watchers see is that if rates in Japan rise further, that would in turn theoretically further strengthen the yen and threaten to undermine the export growth and capital spending which are together driving the incipient recovery.

If Japan is really to pull out of its 12 year slump and end five years of falling prices, its own economy must create more jobs and ignite consumer spending. The jobless rate held at 5.3% in July, just below the record high of 5.5%.

If the average worker or salaryman can be given better expectations of the future, which they have not had for more than a decade, it could accelerate a recovery in consumer spending, which accounts for 55% of the economy.

Hoping for spending
There is at least some good news on this front. The key index of consumer confidence in Tokyo rose to 43.7 in August, up 1.8% from the previous month for the second straight month of increase, the government said on September 8.

For this upward trend to continue, the nascent rise in capital expenditure must also be sustained. Government statistics showed in September that there was also a 4.7% increase in capital spending in the last quarter.

If growth accelerates, with Japanese companies continuing to restructure, the leverage effect on corporate profits could be hard hitting. If the economy does indeed accelerate, there is a view in some quarters that there is an almost desperate need for rapid capital expenditure, which has been throttled by pessimism for more than five years.

The rising capital expenditure is also linked to the declining number of corporate bankruptcies, which fell 15.4% in August from a year earlier. That was the eighth consecutive monthly decline, according to Teikoku Databank, a credit research firm.

The improving capital expenditure, coupled with declining corporate failures and the possible end of the long bond rally might combine to encourage banks to start lending more to the real economy.

Banks, which hold about 16% of outstanding government debt, according to official figures, may shift funds to higher yielding corporate lending as the economic recovery boosts company profits and trims bankruptcies.

Encouraging this trend, Japan's corporate elite is getting stronger. For example, Moody's upgraded Toyota's credit rating to Aaa in late July, making the world's third-largest car manufacturer the only Japanese company to carry the highest ranking available.

No Japanese company has had a triple-A rating from Moody's since September 1999, when Nippon Telegraph -amp; Telephone, the former state telecoms monopoly, was downgraded from the top notch.

Cashflows are certainly improving. As just one example, NTT DoCoMo, Japan's largest company by market value, said in September it would enhance a two-fold increase in dividend it proposed in May by also returning cash to shareholders through buybacks.

The political will
Government stability is also likely to persist, further underpinning the incipient recovery. Prime Minister Junichiro Koizumi won the LDP leadership election on September 20.

Heizo Takenaka was re-appointed to his position in charge of the FSA by Koizumi, and immediately said he would accelerate efforts to cut Japan's roughly $384bn of bad loans. Takenaka, a 52 year old former economics professor, was first drafted in by Koizumi in September 2002 and since then has been responsible for regulating more than 700 banks and credit unions.

Meanwhile, Koizumi also named Sadakazu Tanigaki, a 58 year old lawyer, to replace the octogenarian Masajuro Shiokawa as finance minister. The move was seen as bolstering the adminstration's structural reform efforts.

The challenge facing Japan's policy makers is to ensure that the opportunity to build this nascent recovery into something more sustainable is not squandered.

Previous periods of growth have too often been snuffed out by bad policy. In 2000, when things were looking better, the Bank of Japan became worried about the prospect of inflation and raised interest rates prematurely, throttling any recovery.

The stock market at least is anticipating a surge in profitability, rising yields and stronger cashflows, but probably not a strong economy - at least not yet.

Denis Clough, a fund manager of Japanese equities at Schroder Investment Management, has this year become increasingly confident in the restructuring story. He sees a growing weight of evidence that corporate Japan is grasping the nettle of business and balance sheet reform.

Clough reports that "the risk/reward equation in Japan is very good and the market should be re-rated upwards." He notes the rally this year has been driven by both fundamentals and liquidity. "Global investors have bought strongly into this rally because it is underpinned by rising profits," he says. "If the Japanese consumer suddenly decides to spend more and save less, then the fundamentals will be stacked even more in the favour of Japanese equities."

According to Schroder estimates, the Japanese market was in early August valued at slightly under 16 times forward profits to the end of June 2004. At that time, Clough reckoned the market could rally another 15%-20% over the next year through a revaluation of the underlying profit streams. "If there is another jump forward in profits, or if the economy improves, there could be room for greater outperformance," he concluded.

Underlying all this is a growing fundamental investor pool. Explains Kinmont: "External investors are engaged in the long battle to assert their shareholder rights and to pressure boards of directors for enhanced corporate governance and returns."

Individuals nibbling again
There is deep liquidity at home and Japanese investors will likely increasingly switch some of their assets into equities as confidence in the market grows.

In a late July report, Nikko Citigroup's Kinmont concurs with Clough's view that the rise in the market by that date was supported by valuations, writing that earnings prospects were acceptable without being wonderful, and sentiment, though better, still not at disturbing levels of bullishness.

In an earlier report, Kinmont reported the improvement in breadth and volume indicators as akin to canaries singing in a coal mine. He wrote: "So long as speculators can find oxygen, so, we suspect, will the broader market. The sound of the canaries is currently deafening."

The market had at that time just traded over 1bn shares per day for 21 days in a row, surpassing the previous record of 20 consecutive days, set back in the boom times of February 1989.

All in all, he said that the market was beginning to feel like 1985, with volume, breadth, and rotation all seeming to hint at an important turning point.

Even the misery of the commercial property market could be nearing an end. Analyst Toshihiko Okino in late August upgraded UBS's ratings for Japan's three major real estate firms. "We are doing so at this stage because the vacancy rate in the Tokyo office market dropped in July for the first time in 21 months," Okino said.

Okino believes the capital's office market, which has long deteriorated, has hit bottom at last and should now improve gradually.

Nevertheless, there is caution about what the stock rally means. Throughout its 13 years of pain, the market has staged four such rallies, each time promising much, but with indices then crashing back to ever new post-bubble lows.

That helps explain why Japanese individuals remain cautious and the domestic fund manager is sitting on the sidelines.

At the end of March 2003, out of the ¥1,378tr ($12.3tr) financial assets of Japanese households, 85% was in cash, savings, insurance, and pension reserve funds, and only 10% in securities, including investment funds. The ratio is quite different in the US, where the split is 43% and 53% for those two categories.

"The explanation is the cultural differences between the two nations," explains Jun Kigoshi, general manager, global capital markets division at Mitsubishi Securities. "Japanese people prefer to save and avoid risk. According to a survey on investment by the government in May last year, roughly 83% of people still hesitate over securities, but we expect that this situation might change in the near future."

Some 80% of household deposits are held by people aged 50 and above, who favour government-backed post office savings products, according to a recent Nikkei survey. This means that ¥231tr is deposited with the Post Office.

"However," says Yoshio Maruyama, senior managing director of investment banking and fixed income at Daiwa Securities SMBC, "these deposits and others held with banks and insurance and pension companies are in turn invested by these institutions in Japanese capital markets, in one form or other, whether it be the money market, equities, or the JGB market."

Maruyama also notes that the government is considering privatising the post office. "If it proceeds and if even a proportion of these funds flows into the capital markets, that will represent a huge increase in direct individual investment.

"This is because the post office's special status as a provider of government guaranteed saving products is a key factor in the slow development of Japanese financial and capital markets."

What money the Japanese retail investor has directly in securities is largely in fixed income. A small percentage of this has been going into overseas currencies, a diversification strategy that has paid off handsomely.

"The typical retail investor is not the salaried worker, but is over 60 with substantial savings and time on their hands to study opportunities," explains Nobuyuki Iwamoto, general manager of the international finance department at Daiwa Securities SMBC in Tokyo. "They only diversify a small, albeit growing percentage of their wealth to overseas assets, or to foreign currencies. They are generally very smart operators, often thinking and acting like an institutional investor.

"They have done particularly well in recent years buying the euro, or other currencies such as the Australian dollar, both of which have rallied strongly at the same time as yields have fallen and therefore bond prices have surged."

Japanese retail investors are largely credit risk averse when it comes to foreign assets. Nowhere is this clearer than in the rise of the Uridashi market at the expense of the Samurai market, for which retail interest has been patchy at best. The top tier of triple-A global credits dominates the Uridashi market.

"The retail market is being offered a greater diversity of fixed income product and showing itself much more interested in spreading its assets among different currencies," says Vince Purton, managing director debt origination at Daiwa Securities SMBC Europe.

Currency but not credit risk
Stefano Ghersi, managing director and head of debt capital markets at Nomura in London, believes that Japan is likely to greatly outperform the euro zone in the next three to five years, as there is a slow realisation that the fundamentals in Europe resemble those of Japan in the early 1990s.

Given this view on the relative economic strength of Europe in the foreseeable future, it might seem strange that Nomura is encouraging more Japanese investor diversification to the euro. "Currencies and economies do not tend to correlate neatly," Ghersi says, "and the flows into the euro have been driving the currency to some extent contrary to the economic indicators. That is not new, as we have seen the yen outperform in recent years against a background that has been far from encouraging."

Given this viewpoint, Nomura has set about adapting its fixed income business. "We have reshaped our platform here and the profitability has grown dramatically," explains Ghersi. "We recognised, for example, that the time is right for Japanese investors, both retail and institutional, to have more multi-currency exposure. We have therefore been pushing a massive diversification away from purely yen assets."

A brighter future?
To many, even the most erudite of its citizens, Japan is an enigma, a seeming mass of contradictions. On a summer Sunday afternoon in Tokyo, the streets are full and the economy appears extremely robust. But Japan watchers note that the faces of the same people when they are at work the next day paint a different picture. In their offices, they are worried about their jobs and are concerned about the stagnation of their earnings.

If the 1980s was the decade of the rising sun in Japan and the 1990s was the lost decade, many wonder how the first decade of the 21st century will be remembered. Will it be the same sorry story, or has Japan turned the page? Most still fear the former but there now seems more optimism that a more promising chapter might soon unfold.

14 Nov 2003