The New and Improved Japan Inc.

Posted July 15, 2008

In the summer of 2008, the global economy faces unprecedented challenges. Torn between the threat of asset deflation in America and rampant commodit-price inflation in emerging markets, something will have to give. A global slowdown seems inevitable. For forward looking investors, the really interesting question is now which country and which market is likely to emerge as the winner once the downturn dust settles. In my view, Japan is poised to be next star performer. Yes, that’s right, watch out for Japan to emerge as a great winner once the next global up-cycle starts.

Why? Four reasons: two microeconomic and company specific, and two macroeconomic. Since all economies are essentially the parts of the individual players, let’s start with the micro.

One word—hypercompetitiveness. During what seemed like a "lost decade," corporate Japan was building the right foundation for a strong future. First of all, corporate Japan has invested very aggressively in research and development. Despite banks being bankrupt and politics being terrible, R&D spending was ramped-up aggressively since the mid-1990s, rising from barely 2% of GDP to almost 3.5%. This investment in the future is now paying off. Whether in cars, electronics or even fashion, Japan’s innovation power spans almost the entire spectrum of consumer and capital goods.

T-shirts that feed you vitamins? Hybrid cars? The new global standard for next generation DVDs? Robots that can weld with one-micron of precision when the competition can not even manage 10 micron? Best quality steel that no global carmaker can do without? Yes, that’s right, all made in Japan, or rather, only made in Japan. The relentless focus on R&D during the lost decade is now paying off and puts Japan back at the cutting edge of global competitive power.

But innovation is only one part of a business, cost control is the other. And here Japan Inc. has also taken huge strides. Supply-chain management has improved dramatically, sales and administrative costs have been cut and domestic factory automation has gone into overdrive. The bottom line speaks for itself—productivity has been surging at rates of more than 3% for the past 12 months, a stunning performance against a backdrop of global slowdown. Corporate profit margins have surged to new historic highs. If you exclude currency effects—dollar depreciation hurts profits as exports earn fewer yen—Japan is poised for a fifth consecutive year of double-digit profit growth.

Make no mistake, the combination of relentless investment in R&D plus unprecedented cost cuts and operational rationalization have turned Japan Inc. into a competitive powerhouse that is posed to take global market share from the U.S., European and Asian competitors in the current global downturn, while at the same time delivering better returns and profits. And of course, once the global economy starts to pick up, the upside gearing of Japan Inc. will turbo-charge profits.

OK, so corporate Japan has restructured and invested for the future. What about Japan’s economy? Here, the scope for positive surprises is also better than commonly assumed. Two reasons—one structural and one cyclical. The structural one is inflation. Yes, for Japan inflation is actually very good news. This is because, until last year, Japan had been stuck in over a decade of deflationary rot. During a decade of deflation, consumers and corporations were stuck in a perverse cycle. It was actually rational to hoard money, to keep cash because as prices fell you could count on the purchasing power of your cash to constantly increase.

The result is an unprecedented mountain of “futon money.” Indeed, more than 1.5-times Japan GDP is stashed away in household savings. Mr. and Mrs. Watanabe have been hoarding cash as it was the right thing to do. Deflation breeds deflationary expectations which breed further deflation. Such was the vicious cycle of Japan’s long domestic recession.

Now that prices have begun to rise, this vicious cycle will turn to a virtuous one. Money will come out of the futon because Mr. and Mrs. Watanabe know that the purchasing power of their hoarded cash is starting to decline. The velocity of money is poised to rise for the first time in almost two decades, which should ensure a structural pick-up in domestic demand growth in Japan.

Put another way, Japan’s cash hording amassed during the lost decade now puts Japan in a great position to enjoy a structural upturn in growth. Japan is poised to be the one country where cost-push inflation actually triggers demand-pull inflation.

The cyclical reason is also straightforward. Last year, Japan’s private sector was hit with a triple tightening of policy. Fiscal policy, credit policy and regulatory policy were all tightened together, choking off consumer demand as well as forcing a sharp rise in bankruptcies amongst small- and medium-sized companies. Consumer confidence started to slide and the household savings rate surged to more than 16% from barely 12% of incomes .

All this because of policy tightening under Prime Minister Shinzo Abe. The good news: that explains last year’s domestic recession. Mr. Abe got ousted after loosing last year’s election and his successor, Yasuo Fukuda, has been a welcome pragmatist.

This year, Japan gets no new taxes, the credit crunch is largely passed and, with a little luck, business will not be stifled by new rules and regulations like last year’s Draconian construction code change and pension debacle (the government admitted to having lost records for about 60 million pensioners, i.e., about half of Japan’s 128 million people). All said, last year the cycle was choked-off by policy tightening, but this year, policy is not tightened, so a headwind is turning into a modest positive.

Yes, Japan has been a huge underperformer over the past decade. However, past performance is no guarantee for future performance. While China and India and the other BRIC economies have been grabbing headlines with high growth rates and population dynamics, Japan has been written off as stuck in graceful decline at best, demographic death-spiral at worst. Beneath the headlines, however, corporate Japan has restructured and innovated and invested in the future.

On top of this, the turn from deflation to inflation puts Japan in a better-than-ever position to emerge as the great positive surprise during the current global downturn. In other words, Japan is poised to win big.

Mr. Jesper Koll is the president of TRJ KK, a Tokyo-based investment-research firm.