The Japanese economic recovery continues to defy expectations. With gross domestic product, exports, corporate profits and private spending all increasing, it currently looks unstoppable
Spring 2006 has seen an interesting phenomenon - economists upgrading their growth forecasts for Japanese gross domestic product (GDP) this year to levels that are well above those in Europe and fast approaching the US.
The reason for this is simple. There are clear signs of the Japanese economy moving in the right direction. For a start, the country's most recent GDP data shows robust annualised growth of 5.4% and detailed analysis reveals that half of the economic growth during the final quarter of 2005 was attributable to domestic demand.
This is just the latest evidence of the economy's strength in the current cycle. Earlier this year, export growth accelerated on the back of increased demand from the EU and North America. In addition, there was a sharp rebound in demand from China following its New Year.
Reliable data for domestic economic fundamentals remain hard to find but more accurate lead indicators continue to paint a rosy outlook. The correlation between private spending and corporate profit growth remains valid, and with corporate profits and cashflow still on an upward trend, capital expenditure should continue to grow.
Although it is the headline capital expenditure numbers grabbing the attention, the underlying trends are also worth noting. There is a move towards repatriation of capital expenditure, particularly in the electrical industry, with companies like Sharp, Canon and MEI all announcing innovative plans.
Rather than investing in low-tech plants in China or Asia, they are expanding their investment in hi-tech facilities alongside their existing factories in Japan in order to come up with vertically integrated systems.
MEI, for example, now has the ability to carry out the complete manufacturing process - from components to the end product - to produce plasma screen televisions in one plant. There are two reasons for this reallocation of capital to the domestic economy.
Firstly, as products become more complex, more value is contained in the components. A vertically-integrated set-up allows these parts to be produced in-house, therefore reducing risks and maximising profits. Secondly, labour cost as a proportion of total production cost is falling and this removes the biggest traditional reason for offshore production bases in Asia.
While manufacturers are cranking up spending, there is also more evidence of the service sector relaxing the purse strings. This is most apparent in the financial sector where a combination of restored balance sheet health and sector deregulation are giving Japan's financial companies the confidence to invest.
The mega-banks have finally rid themselves of the huge burden of non-performing loans that date back to the post-1998/99 bubble, and are now beginning to repay the public bail-out funds they received. Once this process is completed, the next step will be to build up their retail banking franchises and their investment banking capabilities.
The initial phase in this process will focus on retail banking, as banks increase their ATM networks, begin to open new branches, and invest heavily in IT systems that are necessary to build up fee income. This is assuming greater importance given recent changes in the behaviour of individual investors. Traditionally they have accumulated savings in bank or post office deposit accounts yielding next to nothing.
No lack of interest
Although interest rates are set to rise modestly over the next few years, there will be a noticeable gap for some time between dividend yields and the returns from bank accounts in favour of the former. Evidence suggests investors are seeking to take advantage of this by re-allocating proportionally more of their incomes and cash savings into investment vehicles. Japanese households have a total of Y1,400 trillion (£6.8 trillion) of financial assets. Only around 10% of this is in equity-related products, some 5% of which is in mutual funds or investment trusts, compared with a figure of 40% for similar US households.
Company cashflow is supporting business investment, which also suggests a healthier outlook for private consumption. Employment numbers have been drifting higher and we are now seeing almost daily announcements of graduate hiring. Car manufacturer Honda, for example, will take on more graduates than they have done for 10 years, while Mizuho Financial Group and Sumitomo Mitsui Financial Group will recruit record levels of graduates in spring 2007 once they have repaid the public funds they borrowed several years ago. As the economic environment improves gradually, more companies are complaining of a lack of suitable personnel.
This tightening of the labour market is positive for wage growth, although over the medium term it will lead to growing pressure on costs. Major automobile companies have been meeting union requests for salary hikes and we expect this to broaden out into other sectors. Growth in bonuses, still a large part of total remuneration for Japanese workers, remains high.
Strength in the housing market is also starting to build. Rising employment and an improving income picture should fuel a recovery in housing where, with residential land prices in urban areas rising after 15 years of decline, the Bank of Japan likely to raise interest rates within the foreseeable future, and the prospect of a consumption tax hike in 2007 or 2008, there could well be a rush towards house purchases in the next 18 months.
Rising land prices, allied to negative real interest rates, are leading to a sharp increase in real estate investment. The latest official land prices showed a sharp acceleration in the pace of land price appreciation in Japan's major cities. However, these official land prices significantly lag the real transaction price level in the market, and there are anecdotes of transactions taking place at multiples of the official land price. The presence of Japanese Real Estate Investment Trusts and other private funds specialising in real estate investment is also helping to push market prices higher.
The majority of business investment is still funded from cash balances. This is perhaps understandable when it has taken companies 15 years of balance sheet restructuring to reach a position where they are confident enough to start to raise leverage. From a company's perspective this is a rational decision with interest rates still at ultra low levels. However, some firms with stronger balance sheets, which could fund their spending in a much more cost effective manner by raising debt, given the current interest rate environment are choosing alternative, more expensive options such as secondary equity offerings.
An additional source of stock coming onto the market is the unwinding of cross-holdings in the private sector. When the market was at its trough point, the government stepped in and bought cross-holdings from financial institutions such as Long Term Credit Bank and Nippon Credit Bank. These stocks are now held by independent bodies such as the Bank Shareholding Purchasing Committee (BSPC). It is understood to be getting ready to sell stock back into the market, or ideally selling it straight back to cash rich companies.
Bank of japan takes care
The Japanese economic recovery looks set to continue. As with other post-bubble recoveries, the external demand boost from global economic growth is very welcome, but this time around the domestic economy looks more capable of standing on its own two feet. Meanwhile, the structural impediments to a normalisation of the Japanese economy have all but disappeared. With a cyclical recovery underway, rising asset prices and a supportive policy mix, the positive surprises from the Japanese economy may not be over quite yet.
Adding to the positive tone is the determination of the Bank of Japan to avoid a repeat of the errors that thrust the economy into recession in 2000 after interest rates were raised too quickly.
The most recent evidence of this measured approach by the bank came in March with the announcement of a widely anticipated alteration to monetary policy. Since 2001, the bank has manipulated the levels of liquidity in the economy by regularly injecting cash into the banking system. This quantitative easing is now being halted.
The Japanese stock market has also risen around 40% in the past year. Nevertheless, from a cyclical viewpoint the economy should continue to expand. Global growth remains steady and there is clear evidence to support the view that the domestic economic recovery is sustainable. The biggest risks to this scenario remain a global economic slowdown, a rocketing oil price, or a policy error by the Bank of Japan.
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