Japan desperately needs an avatar. Like paraplegic war veteran Jake Sully in James Cameron’s 3D science-fiction movie extravaganza ‘Avatar’, Japan’s sclerotic economy could use a new, sinewy body to climb out of the deep hole it fell into two decades ago. Both Sully and the Japanese economy have one thing in common: they’re both paralysed. How they deal with that debilitating condition, however, is what sets them apart. While the spunky Sully retains a try-anything attitude, Japan’s policy makers seem to have given up a long time ago.

On December 29, 1989, Japan’s Nikkei index, the most widely watched stock market index, topped 38,916, at the peak of a roaring asset bubble (primarily in stocks and real estate) that engendered rumours that the Imperial Palace grounds in Tokyo were worth more than all the real estate available in California.

After the bubble burst, economic growth seemed to have frozen in time. All through the 1990s, the Asian nation, once hailed as an economic miracle because of its impressive growth and productivity since World War II, reported output expansion at a mere 1.5 per cent every year. The global economic boom of 2002-07 pulled up growth to a better level, but the financial crisis once again plunged the exports-driven Asian nation into its worst recession since the 1950s (it climbed out of it last June, but only just).

If only Japan, like Sully, could resort to a powerful avatar like the ten-foot Na’vis (a race of humanoids) in Cameron’s movie, it could have been a nimble yet formidable economic creature, capable of taking down threats such as deflation and low growth with decisive blows. Certainly, Japanese policy makers could learn a thing or two from Sully. If only.

A third lost decade?

As it stands today, the nation that introduced the world to popular cultural icons such as Godzilla, Pokemon, Game Boy, walking-talking robots and Anime and Manga comics, looks set to enter a third decade of economic slump. Sure, it crawled out of the global recession in the September-ending quarter last year, but it hardly cut a heroic figure. Growth for the three months was revised down to an annualised 1.3 per cent from an earlier 4.8 per cent by the government recently. The revision came amid fears that growth will again contract by the second half of the next financial year, prompting the government of Yukio Hatoyama, the prime minister, to announce a new 7,200 billion yen ($80 billion) fiscal stimulus package last month. Meanwhile, deflation, that old enemy, threatens to pillage the economy again.

Don’t expect a miracle in 2010. The Nikkei is currently trading at around 10,850 – 70 per cent off its 20-year peak, although it did claw back 50 per cent or so after it fell to a 26-year low in March last year. The expectation is that the benchmark will seesaw in the 8,000-12,000 range; apparently, this will not be a record-breaking year for stocks, although it may positively surprise investors, according to some experts.

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Anaemic pace

GDP has stagnated below 2% since 1991

Source: Bloomberg

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Engines of growth

Exports and investment are the drivers

Source: Cabinet Office via Ecowin (Provided by Smithers & Co)

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But for the most part, stocks are taking their cue from the long-stagnant economy: even as it enters a new decade, Japan is dogged by the problems of the earlier two -- low domestic demand, deflation, excessive corporate investment and high public debt. The big change is in the government -- the opposition Democratic Party of Japan (DPJ) finally won power last September, breaking the stranglehold of the Liberal Democratic Party, which had ruled since World War II. They have promised to usher in a new era of reforms by making the economy more domestic-consumption oriented and less dependent on public works – a feature that dominated fiscal spending all through the 1990s – and exports. Japan is the world’s fourth-largest exporter, behind China, Germany and the United States.

As part of that agenda, the government last month announced an ambitious growth plan, setting an economic growth target of more than 2 per cent for the coming decade. In a boost to employment, the plan aims to create 1.4 million jobs in the environment industry, 2.8 million positions in healthcare and 560,000 jobs in tourism by 2020. Trade within Asia will also be expanded.

Nice, but rather unrealistic, retort economists. Japan has never averaged 2 per cent GDP growth since the 1980s, and with no sure remedy to fix its current ailments, experts wonder if that kind of growth is really sustainable. Besides, ambitious growth programmes require lots of money, and where will the government find this? Gross government debt is already forecast to swell to 862 trillion yen ($9.5 trillion), or close to 200 per cent of GDP, by March 2010 -- the highest for any developed nation. Apart from the intensive network of roads and rail networks criss-crossing the country, high public debt is the most visible inheritance of previous government attempts to resuscitate the economy over the past decades, now dubbed the “lost decades”. Between 1991 and 2008, Japan spent more than $6 trillion on construction-related spending, mostly through deficit financing (issuing government bonds).

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Overseas allure

Exports have buoyed Japan’s growth in recent decades

Source: Bloomberg

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A yen for exports

A falling yen is expected to boost exports and carry trade

Source: Bloomberg

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But there was no high-octane jolt to growth. This year, in a post-war first, while new bond issuances will be around 53,000 billion yen ($538 billion), the administration’s tax take will only be about 37,000 billion yen ($407 billion). Even as Japan figures out how to escape the maze of low growth, arch-rival China looks set to snatch its crown as the world’s second-largest economy later this year.

Pump up demand

So is the Japan, portrayed in Michael Crichton’s 1992 best-selling novel “Rising Sun” as the next big threat to US economic dominance, in danger of being relegated to a has-been?

For sure, Japan has some deep-rooted structural problems. “What the current recession vividly demonstrates is that Japan’s overwhelming macroeconomic problem is the combination of lack of aggregate demand and its unbalanced structure,” writes Hugh Patrick, director of the Centre on Japanese Economy and Business (CJEB) at Columbia Business School in the US, in a recent paper. “There was great reliance on growth of exports and domestic business investment. Related to this, mild but persistent deflation is a significant concern.”

Yes, deflation has been the big killer of consumer demand in Japan. After the 1989 bubble burst, prices started to fall, which caused profits of companies to plummet, forcing them to cut back on wages and jobs. That, in turn, led to lower consumption. It was a vicious circle that got entrenched through the stop-go nature of fiscal and monetary policies through the 1990s. “Fiscal policy in the 1990s was not a failure,” writes Patrick. “It was a success when it was allowed to work. Its inadequacies existed because the fiscal stimulus was too little, too late, too ad hoc and too uncertain. When successful, it was prematurely terminated in 1997.”

The government has promised to make the economy more consumption oriented and less dependent on public works and exports

Ditto for monetary policy. Rates were slashed only in the mid-1990s after an extended period of policy dithering. There were other mistakes: It took a decade to force banks to write down their bad loans, even as they continued to squander credit to ‘zombie’ companies, because if those companies went down, the banks would go down too. Corporate Japan, meanwhile, was struggling with falling demand. “From the early 1990s to 2003, Japan was struggling with balance sheet adjustments,” says Seiji Shiraishi, chief economist for Japan at HSBC Securities in Tokyo. “Companies were repaying their debts, rather than borrowing money from banks. This indicates negative demand for borrowing, and monetary policy does not work when nobody wants to borrow money.” Bank lending has contracted at a monthly average of 1.2 per cent since 1991, although it has improved somewhat in recent years.

Poor economic performance across two decades has kept a lid on jobs and wages. In November 2009, the average monthly income per household (two persons or more) stood at 428,219 yen ($4,715), down 2.5 per cent in nominal terms and down 0.3 per cent in real terms from a year ago, according to Japan’s Statistics Bureau. The average consumption expenditure was 303,564 yen ($3,342), down 2.1 per cent in nominal terms, but up 0.1 per cent in real terms in the same period. Meanwhile, the cost of energy and unfinished goods for Japanese companies fell by 3 per cent in December, the 12th straight decline. “Household income depends on employment and wage payments, and both are determined by demand for labour, which is dependent on GDP growth,” points out Patrick. ‘For consumption to rise significantly, wages have to increase significantly.” That’s unlikely to happen with Japan’s unemployment rate at around 5 per cent.

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Monetary momentum

Interest rates were lowered to just 1 per cent in 1995

Source: Bloomberg

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Credit in a corner

Bank lending has picked up a little in recent years

Source: Bloomberg

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Because consumers were refusing to take the lead, companies – and the government – had to look elsewhere for growth. Since the 1990s, whatever growth Japan has shown has come from exports and government sector (spending). Much of the industrial investment that occurred has also been directed towards boosting exports. In fact, companies went overboard on that front. “Years of over-investment have left Japan with much unutilised plant capacity and a depressed return on capital,” points out Andrew Smithers, founder of Smithers and Co, an economics and investment research firm in the UK. “Excessive investment has been a feature of both domestic and export-oriented companies.”

That over-investment is also inhibiting companies from hiring more people. They tend to make-do with non-regular workers, the kind they can pay less and fire easily and make little or no pension provisions. Non-regular workers accounted for a third of the Japanese work force by 2009, up from about 20 per cent in 1990. Finding full-time jobs has become a big challenge for Japan’s young people. “Japan is not short of labour,” writes CJEB’s Patrick. “For almost two decades, labour has been in surplus because Japan has been unable to achieve sustained, full employment growth.”

Older, not always better

Making things worse is Japan’s demographics. The country’s population is shrinking at the fastest rate in human history; by 2025, Japan will claim the largest share of population aged 65 and above (29 per cent) to the total population among developed nations, up from 17 per cent in 2000. Pensioners are not consumers who splurge, and those who can (15-65 years old or so) don’t have the incomes to support it. No wonder then that consumption accounts for just 55-57 per cent of GDP – the lowest for any developed nation.

“Years of over-investment have left Japan with much unutilised plant capacity and a depressed return on capital”Andrew Smithers, Smithers and Co

Now add to this mix a plunging savings rate. Yes, the country that once boasted one of the highest savings rates among industrial nations in the 1960s and 1970s today has a savings rate of 3-4 per cent. Many economists believe that it won’t be long before the rate sinks to zero.

In a 2007 paper titled “A survey of household savings behaviour in Japan”, Charles Yuji Horioka of Osaka University argues that contrary to popular belief, culture does not predispose the Japanese to be great savers. He says the high rate of savings seen during 1950s-1980s can be attributed to a combination of institutional and economic factors such as the low level of household wealth, unavailability of consumer credit, the young age of the population, the pay structure (more bonuses in the past), tax breaks for savings and low pension benefits. The grip of most of these factors has weakened, Horioka’s paper says. Yet, even as the savings rate has declined, Japan remains a very wealthy society, with households owning more than 1,400 trillion yen ($15 trillion) in financial assets.

Japan’s savings have played different roles through the decades. From spurring economic growth and social infrastructure in the country in the 1950s-1970s, it has also been lent overseas to savings-starved nations such as the US. In fact, it is the second-largest buyer of US debt, behind China, with some $750 billion in treasury holdings. Yet, experts believe, that pretty soon Japan may itself need to borrow from foreigners.

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Mood swing

Foreign investors are trickling back into Japanese equities

Source: Bloomberg

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New-found confidence

The Nikkei is expected to trend higher in 2010

Source: Bloomberg

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And this is where it gets tricky. With such swollen debt levels, what if foreigners become jittery about holding Japanese bonds? For now, that is not the main worry. “The risks of the high gross debt to GDP ratio are exaggerated and overly feared; they are not catastrophic,” writes CJEB’s Patrick. “Almost all the debt is owned domestically; foreign holdings are too small to create exchange rate or balance of payment difficulties.” As far as the constant drumbeat of warnings about high fiscal deficits goes, he says it shows how most people are failing to understand the high cost of inadequate aggregate demand. Indeed, because there is no imminent balance of payments crisis (Japan is still a current account surplus nation) and the low interest rate environment, the yield on ten-year bonds still remains a modest 1.3-1.5 per cent.

Try something new

Slackening demand was Japan’s problem in the 1990s; in 2010, it’s the same story. Hatoyama’s administration has pledged to create 100,000 jobs by March and preserve existing jobs by providing subsidies to employers to keep workers on payrolls. In another bid to boost consumption, the government also plans to funnel 312,000 yen as an annual cash allowance to families with children.

But until the death spiral of deflation is broken decisively and more jobs are created, consumption is unlikely to pick up significantly or sustainably, say experts. In Cameron’s Avatar, protagonist Sully in his genetically engineered avatar form, decides to do something audacious in a bid to regain the lost trust of the Na’vi clan – he attempts to ride a ferocious flying dragon (Taruk), a feat achieved only by an extremely select few. In the face of extraordinary danger (the Na’vis are threatened with extinction), he decides extraordinary measures are warranted.

Even as the savings rate has declined, Japan remains a wealthy society, with households owning more than $15 trillion in assets

If Japan wants to avoid a third lost decade, it will need that kind of spunk in policy-making to spur demand. A big, sustained fiscal stimulus push to up domestic consumption and a loose monetary policy is the prescription some experts like Smithers advocate. More importantly, the government needs to keep at it until it sees visible results and not backdown from these measures over pressure from fiscal deficit hawks. Growth, not a balanced budget, is the key priority at the moment, they say. Still, it will be tough to dislodge the conservative thinking of the new goverment, which also seems inclined to worry about excessive deficit spending. Prime Minister Yukio Hatoyama’s government’s $78 billion fiscal stimulus package is equivalent to about 1.5 per cent of GDP. Much more will be needed to give a real push to the slumbering economy.

While its current mainstay, exports, could recover along with the current global economic recovery, many experts believe that Japan’s edge in the business is blunting as other countries, like China, build up their own skills in the former’s competitive areas such as manufacturing and automobiles. Meanwhile, nothing seems to be moving on the domestic demand front. Japanese machinery orders – a gauge of overall industrial demand – in November crumbled to a 23-year low, highlighting the continuing lack of domestic demand.

No doubt, Japan is in a proper fix at the moment. What can it do? “Japan is rather uncertain about its role on the world economic stage at the moment,” says Marc Chandler, global currency strategist at Brown Brothers Harriman (BBH), a US partnership bank. Today, China is viewed as Asia’s leading engine of growth, with Japan having relinquished that role a long time ago. China is now Japan’s biggest trading partner, with the US in second place. The performance of these economies is crucial to Japan’s export success.

Meanwhile, its other big growth driver, business investment, has been sliding since the 1990s, but that’s not such a bad thing. Experts say a mature economy with a declining population requires investment levels no higher than 10-11 per cent of GDP. Japanese investment is currently equivalent to 13 per cent of GDP. “Falling investment reduces demand, but helps profit by cutting depreciation,” adds Smithers. He says that depreciation accounts for two-thirds of pre-depreciation profits in Japan, compared with less than half in the US, and falls in depreciation thus have a much stronger impact on Japanese profits. That should improve their return on equity, a gauge of how effectively shareholder money is being used to generate profit, something companies have not bothered about much in the past.

Deflation will keep interest rates low and should lead the yen to regain its preferred status in the carry trade business in 2010

Also playing a role here will be the yen’s value against other currencies. The Japanese currency rallied to a 14-year high in November last year, fuelling speculation that the central bank could intervene in the currency markets to rein in the appreciation. Many experts believe we may have seen the last of the yen’s gains and it might slide back to 95-100 against the dollar. Lending support to that view is the recent spike in US bond yields. Ten-year bond yields jumped to 3.9 per cent from 3.2 per cent over the past month on rising expectations of an interest rate hike, as the US economy shows signs of recovering faster than Europe or Japan. Inflation expectations also seem to be building up. Even a 25-50 basis point rise in rates will make interest rates markedly different between Japan and the US, and should increase the value of the American currency versus the Japanese yen. Currently, overnight US rates are in the 0-0.25 per cent band, while the Japanese overnight rate stands at 0.1 per cent. “I think the yen will weaken as other countries raise interest rates,” says BBH’s Chandler. “The longer the yen remains strong, the more harm is being inflicted on the economy. The yen’s strength aggravates deflation and has undermined the competitiveness of the economy.”

Of course, a weaker yen may also allow the currency to reclaim the throne as the world’s carry trade currency, a title it held for seven years until mid-2008, after which the dollar took over. A carry trade involves investors borrowing a low-yielding currency to invest in high-yielding assets. In 2008, as the global credit crisis exploded, the yen rose sharply as equity investments made using the yen were frantically unwound. That pushed the Japanese currency to levels not seen since 1995, hitting the export-oriented economy badly. Now, a jump in interest rates (or bond yields) will increase the cost of carry trade using the dollar. Funding the carry trade with the greenback lost money in December for the first time since February, as the US currency gained 4.8 per cent against the euro. In contrast, with deflation stalking Japan again, monetary policy is expected to stay hyper-loose for the foreseeable future. Stable and low interest rates should see the yen regain its preferred status in the carry trade business in 2010.

Better times for stocks

Certainly a stronger yen is not justified by the economy, which is expected to expand by 1.2-1.3 per cent in 2010 by most economists. Yet, surprisingly, an increasing number of international stock strategists are reasonably positive on Japanese stocks in 2010. “We think it will be a year in which the performance of Japanese equities relative to global equities will bottom out,” says a Nomura Securities report released in December. “In terms of investment strategy, we continue to focus on measures to mitigate global warming, a field that we expect the new government to continue to support and demand from emerging economies such as China, which we expect to see continuing to invest heavily in infrastructure and to see strong consumer demand. But we would also like to emphasise cyclical themes such as a reassessment of Japanese competitiveness, as the yen peaks and Japan emerges from the worst of deflation.” The brokerage also says that “expectations for Fed funds rates to be raised sooner than previously anticipated could weigh on global equities, but it would be favourable for the performance of Japanese equities relative to global equities.” Other brokerages such as Macquarie and Mitsubishi UFJ seem to be betting on technology and export-oriented companies making a comeback, the former because of the continuing needs of Japanese banks to up their productivity, and the latter because of a possible weaker yen and a revival in global trade. Indeed, Japan still has some of the world’s most well-recognised companies in electronics and autos – Sony Corporation, Panasonic, Bridgestone, Toyota, Honda, etc. Bets are especially strong in companies that Macquarie dubs “global survivors” – a group of companies with production and distribution facilities already established in emerging markets.

After years of benign neglect, there are increasing expectations that investors will return to Japanese stock markets. Foreign investors deserted Japanese equities from mid-2007, over worries about the spill-over impact of the US subprime crisis on Japanese banks. Even as the banks proved to be relatively immune to the crisis, investors started to fret over how a highly export-dependent Japan would cope with a slowing US economy. Since mid-2007, more than $121 billion left Japanese stocks until the global rally that started in March 2009. Now there seems to be a reversal in fortune. Investors have poured in $9 billion since the start of this year. Japan has always been a part of the global investment strategy of investors. “Japanese stocks have been important because the market is a large part of any global benchmark and has the potential to outperform or underperform significantly due to local factors, often related to policy,” says Richard Jerram, chief Japan equity strategist, Macquarie Securities. So far, successive governments have just muddled through Japan’s economic problems with old-style measures which, frequently, were withdrawn prematurely. “If there is an overarching lesson from Japan’s lost decade, it is that half measures don’t pay,” a recent editorial in the International Herald Tribune noted. Yes, a shock-and-awe policy is way overdue.

To sum up, as Asia recovers from the global crisis, Japan is in no position to lend a helping hand to the region’s growth; China holds the steering wheel here. However, Japanese stocks may experience a renewed period of mild confidence, given the fledgling recovery in exports. But overall confidence in the economy remains low with investors waiting to see signs of self-sustaining growth.

Will 2010 usher in that kind of growth? Seems unlikely. Unless Japan learns to ride the Taruk, another listless year beckons.