ANDREAS SEIBERT/LOOKAT FOR TIME

SHAKY SHOPPERS: A new downturn could quash fragile consumer confidence in Japan

The Recovery Won't Last
	Koizumi has left Japan's fundamental economic problems to fester
	By Richard Katz

Posted Monday, July 5, 2004; 20:00 HKT
When Junichiro Koizumi campaigned for the Prime Ministership of Japan back in 2001, his mantra was "No recovery without reform." Three years later, the majority of observers say Japan is, after more than a decade of economic stagnation, finally recovering. That suggests three possibilities: 1) Koizumi was wrong; 2) there has already been enough reform; or 3) the recovery is not quite what it's cracked up to be.

The correct answer is 3. Yes, there has been lots of reform on Koizumi's watch, but not the critical mass necessary to spark a fundamental economic turnaround. With Japan's working-age population shrinking, higher economic growth requires a productivity revolution born of structural reform. So far, however, Japan has seen no productivity revolution. Instead, a surge of demand—driven by booming exports and domestic business investment—has led to a temporary burst of growth. That can happen in any economy operating 5% below full capacity, as Japan's was in 2001. The same thing occurred during the country's previous two cyclical recoveries, when increased government spending, tax cuts and exports provided the fuel for rallies that proved to be short-lived. Until Japan raises its long-term sustainable growth rate—commonly estimated at only 1.5% a year—recoveries like the one the country is currently experiencing will be fleeting. Indeed, the Organization for Economic Cooperation and Development predicts that growth will retreat to a dismal 0.9% from 2006-09.

That's not to say Koizumi has accomplished nothing. His biggest achievement has been to reduce the danger that Japan will be revisited by the big financial storms that buffeted it from early 1997 through early 2002. That period was marked by a series of major corporate bankruptcies, a mounting banking crisis and two serious recessions, with GDP growing at a negligible 0.3% annual rate. Under pressure from Heizo Takenaka, Koizumi's Financial Services Minister, Japan's big banks have significantly reduced their dangerously large backlogs of nonperforming loans. And companies have reduced their debts.

But financial stabilization alone will simply return Japan to something like its postbubble state in 1991-96, when growth was not horrible but merely lackluster: 1.7% a year. That's not so low as to threaten systemic crisis, but neither is it vibrant enough to deal with a declining work force, growing numbers of retirees and a mountain of government debt. Yes, Japan has brought down dud loans at the big banks, but these are only a symptom of a more pernicious ailment: inefficient, uncompetitive businesses that borrow money but can't pay it back. Many of Japan's 5,000 largest companies have become serious about improving their performance, simultaneously reducing their debt and increasing the operating profits needed to pay interest. But these big companies employ only 10% of the work force and produce less than 20% of GDP. By contrast, profit/debt ratios at more numerous small and medium-size firms remain as bad as they were during the previous two cyclical upturns. What keeps so many of these borderline companies from defaulting in greater numbers are interest rates bordering on the charitable. On nearly 10% of loans, banks charge less than 0.5%—hardly enough to pay the clerks who manage the paperwork. About one out of five loans carry interest rates of less than 1.5%. As interest rates rise, thousands of small and medium-size businesses may again find themselves unable to meet their payments.

Future growth prospects would be less anemic if companies were becoming more efficient. But by a common measure of efficiency—the return that companies make on their assets—Japanese firms have made little progress. Return-on-asset ratios at large companies are improving, although the average is still 40% below the level of 1975-90. At smaller companies, ratios remain below even the dismal average of the 1990s.

The key to greater efficiency? More competition. Japan needs to break down all of the informal anticompetitive practices that plague so much of the domestic economy, as well as the regulations that sometimes protect these practices. Unfortunately, some key indicators of competitive pressures are moving in the wrong direction. Business start-ups and closings are both down. In a majority of industries, the market share of the top three firms has increased, partly due to the merger and acquisition activity that some mistakenly hail as reform.

Except in rhetoric, improving efficiency by enhancing competition has not been a priority of Koizumi. His priorities have been cutting the public-works budget and reducing banks' bad loans. Unquestionably, those are laudable achievements, but they are only the first steps toward a genuine turnaround.

Richard Katz is the editor of The Oriental Economist Report and the author of Japanese Phoenix: The Long Road to Economic Revival

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