Japanese Recession Risk Leaves Goldman Wondering: William Pesek

Japanese Recession Risk Leaves Goldman Wondering: William Pesek

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By William Pesek


Aug. 24 (Bloomberg) -- Here we go again!

That's likely to be a common reaction as investment banks such as Goldman Sachs Group Inc. wonder aloud about the risk of a Japanese recession. If the world's second-biggest economy grinds to a halt, it will be no small blow to a financial system that has gotten used to flying on several engines, not just the U.S.

The good news is that the odds don't favor that happening. ``It is too early to conclude that a recession is inevitable,'' Naoki Murakami, an economist at Goldman Sachs Japan Ltd., wrote in an Aug. 22 note to clients.

Such statements aren't as reassuring as investors might hope amid so many global challenges. The meltdown in the U.S. subprime-mortgage market hasn't just sent the yen soaring, but raised big questions about the health of the U.S. economy.

Japan's recovery is solid enough to withstand swings in global markets, though a broad-based, global slowdown would imperil the outlook. The bigger question is how vulnerable Japan would be to a modest U.S. retrenchment.

To Richard Jerram, chief Japan economist at Macquarie Securities in Tokyo, the answer is: not very.

``Historically, total Japanese exports have tracked the path of total U.S. imports, with the main exception being in 1998 when the Asian crisis drove down Japanese exports,'' Jerram said. ``However, over the past 18 months the two series have diverged, showing an ability of Japanese exports to prosper even without strong demand from the U.S.''

Economic Steroids

Yet the inconvenient truth about Japan's longest recovery since World War II is that it's based on three artificial pillars: an undervalued currency, near-zero interest rates and the highest debt-to-gross-domestic-product ratio among developed nations. Japan's growth is largely based on the economic equivalent of steroids.

Getting off these stimulants is the key to Japan becoming a ``normal'' economy again. Rates certainly aren't being normalized; the Bank of Japan left its key interest rate at 0.5 percent yesterday. While Governor Toshihiko Fukui says markets should expect higher Japanese rates, traders aren't buying it.

All along, policy makers in Tokyo hoped these three financial boosters would create a self-reinforcing growth dynamic that got consumers and companies to spend, raising GDP and wages.

That's not happening as planned, which is why Goldman Sachs's report -- titled ``Is a Recession Likely?'' -- raises eyebrows. It's a reminder that for all the changes in Japan, all the growth, government changes and corporate restructuring, its revival is stuck in second gear.

Second Gear

Getting into first gear involved banks disposing of bad loans and companies reducing capacity. Things clicked into second gear in recent years as investors began rediscovering Japan, property prices stabilized and deflation pressures eased.

At many stages since 2002, Japan seemed on the verge of accelerating. Certainly, bulls will argue the economy is well into third gear, if not fourth. Their rationale is that a mature, $4.5 trillion economy growing about 2.3 percent is reason enough to cheer.

The missing ingredient, though, is also the key to getting Japan to grow faster, end its addiction to steroids and defeat deflation: consumer optimism.

Every quarter, investors get excited about the BOJ's ``Tankan'' survey of business confidence. It's often a misleading indicator because it says little about whether Japan's aggressive savers will soon consume more.

Stagnant Consumption

A more telling indication of what's to come may be found in a recent Nikkei newspaper survey. It showed that Japanese in their 20s are becoming less interested in buying cars, drinking and spending money on leisure activities and are opting to save.

Economists will be heartened to see that the average monthly disposable income rose by 4,000 yen ($35) to 64,400 yen compared with a previous survey in 2000. They will be less happy to find 36 percent of respondents saying they are allocating more of their disposable income to savings.

Such trends are unwelcome news for companies. Stagnant consumption and a shrinking population bode poorly not just for tomorrow's profits, but today's. Japan's rapidly aging population has been rattled by a recent scandal involving missing pension records. It hardly instilled confidence in the future for many households.

A major wildcard for Japan is how credit-market woes affect the U.S. economy. John Richards, head of debt markets strategy for the Asia-Pacific region at RBS Securities Japan Ltd. in Tokyo, offers the following scenario: The U.S. subprime crash and resulting global-liquidity squeeze kill Japan's export markets at the same time as an equity crash slows Chinese growth.

`R-Word'

While Richards isn't predicting that will happen -- or a recession in Japan -- ``the R word would be more likely'' to apply if global turmoil worsened.

Even so, it hardly helps that the economy isn't one of Prime Minister Shinzo Abe's priorities. As low-cost China and India rise in influence, high-cost Japan needs to work harder to maintain its standard of living. That means increasing business productivity and boosting entrepreneurship -- two issues that are barely on the government's radar.

None of this means Japan is about to slide back into stagnation. It does mean that anyone expecting Japan to grow at its true potential over the next few years will be disappointed.