A Very Comfortable Recession

Japan seems to be stuck in a never-ending recession. Turn on CNN or read a major newspaper, and a pessimistic picture is usually presented. There are innumerable things wrong with Japan, and there is little concrete action being taken. At least, that is the picture we were familiar with before recently spending two weeks in Japan. While there, we saw that there are indeed serious problems. But we also realized that the purely negative picture painted in the media is somewhat simplistic. After searching a bit, we saw that things are changing in Japan, and that there is reason for optimism. Here, we will discuss a few of the bigger issues Japan seems to have, and some of the hidden changes we see taking place.

Starting a quick tour of what does not work in Japan, the banks are central to the problem because they must first be fixed if one is to use them as a tool to fix the rest of the economy. The issue is that most banks are in bad shape, and many are viewed as not even being solvent. From our research, this assessment seems accurate.

The government is doing things to correct this problem. First, by creating the new Financial Supervisory Agency (FSA), Japan has introduced a more hard-line watchdog to the industry. The FSA has acted quickly, closing two of the more blatant living-dead banks. The FSA has also conducted in-depth audits into the loan books of the banks, and in so doing has given complacent bankers a crash course in the concept of credit quality. This is new, in that as little as a year ago, no one thought banks would actually be shut down — expecting instead forced mergers or bailouts for the worse-off banks. Now, the rules have changed in that banks are on notice that they actually risk being shut down, and that it is no idle threat.

With every stick usually comes a carrot, and for the Japanese banks, this is being presented in the Government’s recent raise in yields. Higher yields create a bigger spread, which creates bigger profits on lending for the banks. One estimate is that with a bigger spread, Japanese banks could earn their way out of the current problem in as little as two years. Finally, to make sure the message is clear, the FSA is readily offering very low cost capital to the banks that cooperate, and capital somewhat later and at a higher cost to those that do not. The message is new, and clear: clean up your books, take our money, and start lending again — else, the longer you wait, the more expensive the money will get, and if we do not like what we see, we might even shut you down. For an industry used to no bankruptcies, this is really a novel approach.

Impotent Stimulus Plans?

The various stimulus plans come next, where a new one seems to be announced every other month. The government’s practice of including in the value of the plan previously announced measures makes it very difficult to determine how much of a plan is really new, and therefore likely to affect the economy. With near-bankrupt local governments slated to contribute half the funds, it is not clear if these will ever materialize. Finally, with a multitude of existing under-utilized white elephants (empty public buildings, under-utilized bridges and tunnels) the fruit of prior such plans, one wonders what would be the point of further such projects.

Regardless of how the money is spent, what tends to get lost in the translation is how huge the most recent versions of these plans are. At some point, they are bound to have a positive effect on the economy. And these plans are not onerous to the government. The amount of funds may be large, but the cost of funds is very low. Most funds are raised via the sale of Japan Government Bonds (JGBs), at very low interest rates, to the Post Office savings and retirement accounts — which with about 1/3 of total household savings provides a seemingly endless source of funds. The message we hear from this situation is that Japan remains a wealthy nation with the means to restart its own economy.

The 1997 rise in the consumption tax (VAT), from 3% to 5%, is one measure attributed with knocking the wind out of Japan’s budding recovery at that time. Since then, this tax has not been reduced — much to the consternation of outside observers, and to the annoyance of domestic consumers. But when weighed against other changes in the tax system, there is a logic. One not so obvious cut being pushed through is the slow process of reforming company law so that corporate groups can have true accounts pooling, and to thereby use acquired tax loss carry-forwards. This would give incitement to increased M&A, but in the short term, would result in decreased corporate tax receipts. In this light, the government’s decision to maintain the higher VAT, also at least in the short term, seems reasonable in order to balance the budget. This policy might be working, as one of our contacts at an investment bank in Tokyo reports a large upswing in small and medium-sized M&A deals and even a few management buyouts — but as these are not the kind of deals that make front-page news, observers abroad cannot easily pick up this sort of change.

The monetary side is more complex. On the surface, there seems to be an argument for Japan to deflate its currency in order to stimulate foreign demand for Japanese goods. But this argument does not take into account the fact that Japan is basically a trading nation. For everything it sells, it buys some components or raw materials elsewhere. A deflated currency would therefore reduce Japan’s ability to buy from its neighbors, which at this point in the greater Asian crisis, would not do anyone — Asia, the Americas or Europe — any good. So on this count, we feel quite comfortable with a stable yen, while awaiting a boost in demand from some other quarter — such as a recovery in commodities funding an increased demand for Asian goods.

Traditionally in Japan, companies did not lay off employees, and failed companies got merged into healthy companies so as to protect employees and to present a facade of tranquility. In some ways, this makes sense. One manager we met explained that by not engaging in layoffs, now that times were tougher, he could ask his employees to do nearly anything. But, he continued, the moment he fired anybody, he would completely lose that ability.

Not everyone is still so sure of this arrangement. One mid-level manager we met with related the story of his opposite number at a struggling competitor, recently fired along with others characterized as ‘non-essential personnel.’ We got the feeling our host was very aware of his new-found mortality. Another sign of change is at the national airline, ANA, where employees have organized the first employee’s union in Japan. These are employees who are worried and acting to protect themselves.

From the point of view of Japanese companies, the need to change is also apparent. After adding between 1988 and 1992 the approximate productive capacity of France, over-capacity is rampant. And household reluctance to spend does not help this picture. Industry is addressing the problem via participation in the various government spending voucher programs. More desperate companies are also attempting pay-in-kind programs. For example, at this past holiday season Mitsubishi paid a portion of its annual employee bonus in purchase coupons for its own equipment.

It is the future that the Japanese are still worried about. In many ways, we found Japan reminiscent of a Fifties version of America, with the Japanese \"salaryman\" the equivalent of the American \"company man\" of that epoch. In the US, that social contract faded with the decrease in employer/ee loyalty, the rise in temporary employment, and the increased mobility of the workforce. We feel that Japan is on the first important steps of this journey.

Lastly, consider the people of Japan. We are constantly reminded of their discontent via signs such as chronic low voter turnout, and the aforementioned housewife spending strike. But during our visit and in talks with friends, we were reminded that things really are not yet that bad. Mainly, people still have jobs. Also, since most people live at home until they get married, this creates a lot of disposable income. The result is that people still have a lot of luxuries. On a train ride outside of Tokyo, we saw a large number of golf driving ranges, and one of the new enclosed artificial ski hills (friends assure us it is always busy). Nearly everyone we saw had a cellphone, and stores were selling an endless selection. The electronics stores were also doing a brisk business in all the latest gadgets, from the new Sega Dreamcast video games, to the personal headset viewing goggles, to Sony’s newest videocameras and slim-line portable computers. With few exceptions, nearly every restaurant we went to was crowded.

From our visit, we observed firsthand that things in Japan are not really as gloomy as read in the daily papers. Though bad news makes the press, it seems that small pieces of good news, or small advances in the right direction, do not attract the same interest. We saw that Japan is taking these first steps. The FSA is dealing with the banks in very clear action and language. The government is launching huge stimulus plans that will have a positive impact on the economy. Tax and monetary policy are being clarified, and in these areas it must be remembered that the choice of no change in policy is, in and of itself, a clear choice of policy. The employer/ee relationship is being redefined, much like the demise in the US of the \"company man\" after the 1950’s. Finally, while the populace is not happy, it cannot really be said to be unhappy either. For Japan, this results in a relatively comfortable status quo, against which real change is taking place in the background. Unseen for now by those who prefer to focus on Japan’s more visible difficulties, these seeds of change represent opportunity for those who do take notice.

January 1999
^© Tocqueville Asset Management L.P.