The outlook for investors in Japan

20th July 2010

If at first you don't succeed, read the instructions, dummy, and try again.

Well, that's what we'd have said to Japan's new Prime Minister, Naoto Kan, right up until July's Upper House elections, which wiped out his Democratic Party's effective majority – and, with it, many of his ideas for reforming a national economy that's never fully managed to pull itself out of the mire that it got into after its property market collapsed back in 1989.

No Kan do

Yes, that's 21 years that Japan has been waiting for Mr Kan's patent economic medicine, and now it looks as though he'll have to go away and think again about the recipe.

It's a particularly cruel turn of events, considering that he only took office a few weeks ago, after his disastrous predecessor Yukio Hatoyama had also fallen on his ceremonial sword – having committed just about every blunder in the book during a premiership of just eight months.

From bowing to the Americans over the Okinawa air base to dragging his own feet over economic reform, Hatoyama had got it all wrong.

And then, when Hatoyama's aides had finally got their fingers sticky in a corruption scandal, Kan's big chance had finally come.

And now it's probably gone again…..

Twenty years of blunders

Okay, that's rather a lot of information to take in at one go.

The main background fact that you need to know is that, incredibly, it's still only ten months since Mr Hatoyama's Social Democrats were swept to power in a landslide electoral victory that had washed away six almost unbroken decades of Liberal Democrat rule.

The old LDP politicians, who had successfully managed the economic miracle of the sixties and seventies before totally hashing up the eighties, nineties and noughties, had made themselves infamous for factional infighting, back-room fixing, criminal association and corruption – and, then, when the economy failed to respond in the nineties, by opening up the bond-printing presses and trying to sustain the entire country on credit.

For twenty years, Japan had staved off the unemployment figures by launching vast public construction schemes – bridges, airports, car parks, ski slopes, you name it – without any obvious concern for the fact that they were eventually going to have to pay for it all.

By the time that the doomed Mr Hatoyama gave the Finance Minister's job to Mr Kan, last autumn, his inherited burden of government debt was already 200% of GDP, and rising.

Kan did his best to mitigate the disaster, firstly by ordering a slowdown in new government job-creation projects, and secondly by recommending that his boss should desist from extending the fiscal stimulus programme started by his predecessors for a second year.

The tax breaks and other incentives designed to boost Japanese consumer demand were duly wound up when the last financial year ended in April 2010.

After that, it should have been getting easier. Well, in theory anyway.

Japan's economy grew by 5% year-on-year in May, and even the surliest of forecasters were predicting 3.1% growth for the year as a whole. They still are.

Industrial production rose by an amazing 26% in April, with most of the growth happening in export markets like China. And even retail sales were up by between 4% and 5% during the spring, which didn't sound so bad at all.

The snag was that the early-year figures were being distorted out of shape by a vast consumer boom caused by householders who were desperately buying up big-ticket durables before a planned 2% rise in sales taxes.

It was a one-off illusion, and it was never going to be repeatable.

Certainly, other kinds of consumer sales are still on the floor. Inflation is running at minus 1%, which is always a bad thing because it means that consumers are likely to postpone their purchases while they wait for things to get cheaper.

Unemployment ticked up to 5.2% in May. Banks are trying to lend money, at the government's urging, but business simply isn't taking up the loan offers.

Overall bank lending to Japanese businesses was by down by 2% in the year to May, the worst decline since 2005.

No change now, then

Does that sound like a vibrant economy to you? No, we thought not. Which is why the public was never going to take kindly to Mr Kan's next move now that he'd become Prime Minister.

The new man had publicly declared in June that he was "considering" a doubling of consumption taxes, probably from 5% to 10%.

Except that, as the 11 July elections approached, he'd suddenly changed his mind and said it wouldn't happen for several more years.

Meanwhile, he said, his government would carry on borrowing as before. (The best current guess is that taxes cover only half of the total budget requirement – the rest is always borrowed.)

Rather predictably, Mr Kan fouled it up in every direction.

By abandoning his tough stance before the voters, he just managed to make himself look weak and indecisive.

Businesses hated his retraction on the debt issue, because it left them with no immediate prospect of any lasting improvement in the economy.

And the LDP – those shifty, stodgy, faction-ridden villains of popular political culture – laughed all the way to the ballot box as they trounced the new man.

So here we are in July, with a Premier who still holds power in the Lower House of Parliament, but who might struggle to get anything ambitious past the Upper House.

He's alienated the voters and alienated the business leaders too. Not bad going for the Democrats' second attempt at firm leadership in the space of ten months.

Nice try, but no cigar

But the most ironic thing is that Mr Kan's plans wouldn't have made more than a scratch on the deficit even if they'd been implemented in their entirety.

I mean, think about it. Raising consumption taxes by 5% might bring in the equivalent of 2% of GDP every year.

It'll hurt consumers (surely a bad idea?), but it won't even begin to address a national debt that's already 200% of GDP and costing 4% of GDP every year just to service.

To make that kind of a dent, Tokyo needs either to raise corporate and personal taxes by an unthinkable 15%, or come up with the biggest damn economic expansion plan in the history of the post-war world.

Sad to say, there is no sign whatsoever that Mr Kan is acknowledging the size of this challenge, or making any credible plans to meet it.

Or that the voters will forgive him if he does.

There are no credible leads to a more prosperous future in the outcome of this election.

The outlook for investors

As Nathan Gibbs,  manager of the Schroders Japan Equities fund says, the outlook is mixed for investors in the region.

"For the region's equity market, there are likely to be both positive and negative ramifications

"A rise in consumption tax now seems much less likely in the near term. Th
is was one of the key themes associated with Prime Minister Kan going into the election, and the defeat

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