Suddenly, improbably, the Japanese economy—and its stock market—are hot. Since April, the Nikkei 225 stock index has jumped more than 35%, to about 10,300, making it one of the world's best performers so far this year. Foreign investors have rushed in, becoming net buyers of Japanese stocks for 22 consecutive weeks through mid-September, pumping just under $48 billion into the market since May. "It has been such a dramatic change in investor psychology," says Masaaki Kanno, chief economist at JP Morgan in Tokyo. But considering Japan's history of false-start recoveries over the past decade, the nagging question remains: Is this rebound for real?
What has turned the industrialized world's chronic underachiever into everybody's favorite comeback story is a stream of unexpectedly sunny economic news. The most notable number: the government's recent announcement that Japan's economy grew at a sprightly annualized rate of 3.9% in the second quarter of this year. Not only was that far greater than the already healthy 2.4% annualized rate previously forecast, but it was also the fastest growth rate during that quarter for any of the world's major industrialized economies.
There are other signs that Japan's economic fog is lifting. Despite their reputation for chronic unprofitability, the country's major listed companies posted a combined total annual income in fiscal 2002 that was 20% higher than in the previous record year of 1990, according to Merrill Lynch. Meanwhile, periodic routine government updates on key indicators, such as job growth, wage growth, executive sentiment and capital investment, have all revealed significant improvements. And most recently, the International Monetary Fund has joined the party, revising its projected 2003 economic-growth rate for Japan from 0.8% to 2.0%—while downgrading the Eurozone's rate from 1.1% to 0.5%. Not too long ago, Japan was considered at risk of dragging the rest of the world into recession. Now, along with the U.S., it has become one of the industrialized world's best bets for expansion for the rest of this year, if not beyond.
All this has prompted a host of foreign and domestic observers to conclude—as many have during every uptick since the early 1990s—that Japan's decisive economic turnaround has finally begun. Merrill Lynch's chief Japan economist, Jesper Koll, has gone so far as to declare in the Daily Yomiuri newspaper that the economy has reached an "inflection point." "Make no mistake," he asserts. "Japan is back."
Politically, this wave of economic euphoria has been a huge boon to Prime Minister Junichiro Koizumi. He boasted frequently about the buoyant economy during his successful campaign to win re-election two weeks ago as president of the ruling Liberal Democratic Party (and, thus, Prime Minister). As he tells it, the healthier statistics are proof that his structural economic reforms are working. As a sign of the increasing political capital that the rebound has provided him, Koizumi quickly shuffled his Cabinet, reappointing his controversial finance czar Heizo Takenaka and replacing the ailing 81-year-old Finance Minister Masajuro Shiokawa with Sadakazu Tanigaki, a younger, more reform-minded legislator.
Even the most skeptical investors—ordinary Japanese—appear to believe the tide has turned, egged on by investment banks, such as Morgan Stanley and Goldman Sachs, that are counseling clients to continue to load up on Japanese stocks. "I doubt the index will rise to 20,000 anytime soon, but I'm hoping this positive growth will continue," says Yoko Maekawa, a 29-year-old Tokyo software engineer who is buying shares of Japanese companies. "Compared with before, I certainly feel I have better odds."
Take that spectacular 3.9% annualized second-quarter growth rate. In a pair of reports entitled The Paradox of Deflation and The Paradox of Deflation Solved, HSBC Securities senior economist Peter Morgan concludes that Japan's gross-domestic-product figures are increasingly skewed by discrepancies in how price changes for different types of goods (particularly computers and other information-technology products) are calculated, thereby creating significant distortions. "This suggests that official GDP data are substantially overstating economic growth," he writes. Morgan's own second-quarter GDP-growth estimate is just 2.1%. "Things may not have been as bad as everybody thought they were even half a year ago," Morgan tells TIME, "but they are not as good as everyone thinks, either."
Many Japan bulls declare that even if the estimates are off, at least the quality of Japan's recent growth is higher, because it stems more from domestic demand and new business investment than from the wasteful public-spending projects used in the past to prime the country's economic pumps. Even so, a larger concern remains: Japan's continuing over-reliance on the export sector, which has been propped up by the Japanese government's massive and unprecedented foreign-exchange interventions designed to keep the yen weak.
A weak yen makes Japanese products cheaper and therefore more competitive abroad. The yen's relationship to the dollar is particularly important, because the U.S. is a primary customer base for heavyweight Japanese companies, such as Sony and Toyota. Under former Finance Minister Shiokawa, the government spent in just the first 8 1/2 months of the year the unprecedented equivalent of $110 billion to buy dollars on the open market, in an attempt to keep the yen from climbing against a weakening greenback.
This intervention—which was far in excess of the government's previous record annual expenditure of the equivalent of $66.4 billion—irked the U.S. and other Western industrial countries, where domestic manufacturers claim the tactic is an unfair trade policy. At the G-7 meeting of finance ministers and central bankers in Dubai two weeks ago, representatives led by U.S. Treasury Secretary John Snow issued a statement calling for "more flexibility in exchange rates," a move widely acknowledged as a criticism of currency policies in Japan and China.
It's uncertain that Japan can continue to prop up its exporters through currency intervention. Immediately after the G-7 meeting, the yen appreciated to 111 per dollar, its strongest level in nearly three years. Since 115 yen per dollar, a much weaker level, was widely assumed to be Shiokawa's target, currency traders are now waiting for Tanigaki, the new Finance Minister, to show his hand. Although he has already said that exchange rates "should stably reflect fundamentals" and that he would "take action to make sure that happens," Tanigaki hasn't yet demonstrated how much, if at all, he will allow the yen to rise. "People are waiting to see if he tests a new level," says JP Morgan's Kanno.
Few envy the delicate task Tanigaki faces. On the one hand, he must make some attempt to soothe the concerns of other industrialized nations and to demonstrate that Japan is committed to free trade. On the other, exchange rates have a direct and measurable impact on exporters—and Japan's recovery is still fragile. Credit Suisse First Boston estimates that every 10% appreciation in the yen could cut recurring profits in the manufacturing sector by 10% and reduce annual GDP growth by nearly a third of a percentage point.
That Japan must play this currency game at all suggests that the country's economy is still in disarray and that the growth a weak-yen policy has helped to produce does not provide the foundation of a lasting revival. As economist Richard Katz writes in a recent issue of his newsletter, the Oriental Economist, "If Japan's economy were basically healthy, then most of the recent economic indicators would justifiably be taken as the classic signs of an economy in recovery." But Japan's economy is not basically healthy, he argues, at least not yet. Although there have been some gains in areas such as financial reform (for example, bad loans at the nation's large banks declined in 2002 for the first time in six years), progress in other areas of the economy has been scanty. Deflation persists, public debt still totals a daunting 140% of GDP and unemployment remains relatively high.
Indeed, despite frequent claims that structural reform is finally taking hold, Japan Inc. overall is not getting measurably more efficient. Although many companies have successfully cleared out excess debt, labor and capacity by cutting costs and streamlining operations, Katz argues that such improvements have so far been confined mainly to large companies. That's good news for lots of punters, but it is less significant for the economy as a whole. Katz notes that according to the Finance Ministry, Japan's 5,600 largest companies employ only 11% of the workforce and account for just 17% of GDP. And although large companies enjoyed a 17% jump in operating profits last year, small companies suffered a 12% drop.
Unless the laggards begin streamlining their operations as the multinationals have done—and quickly—the great Japanese rally of 2003 may well go down as yet another false start.