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ON JAPAN: Wishful Thinking--Tigers or no, the economy's not going anywhere

Author: Edward J. Lincoln, Director, Center for Japan-U.S. Business and Economic Studies, New York University
July 28, 2003
Newsweek Japan


Wow! The rally in the Tokyo Stock Market in the past two months is astonishing. As I write this, the Nikkei average hovers near 10,000, up 30 percent in just the past two months. The combination of the rally plus some positive economic data seems to be leading to considerable optimism that the worst is over. It's a good thing that I am not an investment banker whose career depends on jumping into and out of markets at the right time because the market's rise caught me completely by surprise. Nonetheless, the rally has not convinced me that this optimism is warranted.

Stock market rallies often precede clear indications of economic recovery. Investors try to get into the market before everyone else has realized that recovery is taking place. As a result of that competition to be first, eager investors drive up stock prices before GDP data or unemployment data reflect real improvement. That has been happening in the United States in the past several months, where investors are betting that real recovery will be occurring by the second half of this year. In the United States, analysts can make the case that the recovery that many had expected last year will finally occur soon— the uncertainty of the war in Iraq is over, excess capacity in the manufacturing sector is diminishing, and the combination of low interest rates and fiscal deficits will stimulate demand. The evidence of an economic upturn in Japan is much milder, and yet the stock market rise is even stronger than in the United States.

Sure, some data appear more positive. Machinery orders are up and the tankan is less negative than previously. But even these bits of evidence are weak. Machinery orders usually gyrate widely, rising strongly when firms gear up for a new round of plant and equipment investment. By that standard, the recently announced six percent increase is small. Meanwhile, the tankan remains negative, even though it is less negative than before. And I shuddered when I heard that the price of Hanshin Department Store stock was rising sharply because the Hanshin Tigers are winning. Even if Hanshin Department Stores benefits from fans buying Tigers paraphernalia, it is doubtful this effect will be big enough to have much impact on overall sales, and certainly not an impact that will last beyond the end of the baseball season.

Frankly, when I look at the data, I see other items that are not encouraging. The unemployment rate has stabilized, but employment continues to fall. Deflation has diminished a bit, but there is really no sign that it is coming to an end. Economic analysts are revising their forecasts upward for the current year, but only by a small amount. Even with the end of the war in Iraq and the waning of SARS, expectations seem to be for growth of one percent or less. Given the slack in the economy, a real recovery ought to involve a period of strong growth on the order of three or four percent for a year or two.

The stock market rally itself will do little to help the economy. To be sure, banks may be relieved that their stock portfolios are performing better, but those gains are largely offset by the drop in bond prices (higher interest rates mean lower bond prices). More importantly, the overall rise in the stock market does not alter some important fundamentals, especially deflation and the enormous buildup of non-performing loans. These are the areas where I would want to see real change before becoming optimistic about the economy.

True, the Resona Bank bailout was a step in the right direction. But I am not yet convinced as to how thorough the cleanup will be, and even less convinced that the Resona deal is the start of a sustained policy of fixing the banking system. The recent decision of the Financial Services Agency to proceed to allow banks considerable flexibility in counting deferred-tax assets in their capital-base calculations, after a strict limit was used to bring Resona Bank under government control, is a case in point.

Surely many Japanese are as aware of these factors in the economy as I am, which makes the stock market rally puzzling. Part of the answer seems to be that the rally has been driven largely by foreign investors (mostly American). Even though investment bank analysts have been very cautious about the economy, foreign fund managers and individual investors have not been. The rest of the answer appears to come from Japanese who are so tired of the problems of the past decade that they are willing to grasp at even unrelated bits of upbeat news, like the Hanshin Tigers, to produce a sense of optimism about the economy and stock market. I wish the Tigers well, but I do not share the view that real economic recovery is on the way yet.

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