Japan must end silence on structural problems to escape stagnation, economist says

Excessive levels of inefficient corporate domestic investment and debt may force Tokyo to explain why its current account surplus has to keep growing

by Takashi Kitazume

Japan’s economy is trapped in a vicious circle caused by excessive corporate domestic investment and debt that leaves exports as its only option for avoiding another, more serious, recession, a British economist told a recent seminar in Tokyo.

“Corporate investment in Japan is excessive, and this is a serious problem because it produces very low returns on capital and makes the corporate sector extremely vulnerable to any downturn in the economy,” Andrew Smithers, chairman of Smithers & Co., told the Jan. 31 seminar at Keidanren Kaikan.

“Corporate debts are still excessive, interest rates cannot therefore be raised easily without posing a considerable threat to the economy,” he said.

Without interest rate increases, consumer incomes will remain weak, and with household savings on the decline, “it is very difficult to see how consumption can come to the rescue of the economy,” Smithers told the audience.

Smithers, who has watched the Japanese economy for decades, was speaking on the theme — “Has Japan’s Sad Experience Taught Her Nothing?” — during an event organized by the Keizai Koho Center.

Smithers noted that a major factor behind Japan’s disappointing economic performance since the burst of its asset-inflated bubble in the early 1990s was “an unwillingness to discuss some of the major problems” and focus on peripheral issues.

The same thing appears to be happening because the latest data show that Japan’s economy is “stagnating,” he said. And the official story remains the same.

“Rather than discuss what has happened and why these continuing problems seem to recur, there is I think still a tendency to insist that a recovery is just around the corner.”

The two key structural problems of the Japanese economy — excessive domestic corporate investment and heavy debt — are either hardly discussed or played down, he observed.

Smithers cited data showing that Japan invests over 15 percent of its gross domestic product in corporate plant and equipment, whereas the United States invests a just a bit over 10 percent.

With demographic forecasts pointing to Japan’s population falling nearly 1 percent annually over the next decade and the American population rising by nearly 1 percent, “It is unlikely that Japan will grow more than half as fast as the United States” — assuming no large gap in labor productivity exists between the two countries, he said.

Assuming that profit margins in Japan will be relatively stable — as is the case in most mature economies — then profitability will depend on the efficiency of capital, he said.

“We can be reasonably sure that . . . it takes about 2.8 times more capital in Japan than it does in the U.S. to achieve one unit of output growth,” given the pattern of estimated demographic changes and corporate investment, he said.

“That leaves us with one of three possibilities. Either Japan has a labor productivity miracle . . . or we will see a major fall of investment, or we will continue to have extremely poor profitability,” Smithers told the audience.

One major reason behind the widespread belief that Japanese corporate profitability has improved is the government’s “zero-interest-rate” policy, which keeps interest costs very low, he pointed out.

Smithers also challenged the claim that Japanese companies no longer have high leverage, noting that the most favorable data show the gross debt of Japanese private nonfinancial companies is still equivalent to about 160 of the nation’s GDP.

“Although Japanese nonfinancial corporations’ balance sheets have improved in recent years, they are still very weak — both on average and even more importantly, in aggregate.

“What the data shows is that there is a two-tier structure to Japan’s corporations . . There are many more companies in Japan that are cash-rich than there are in America, but there’s also much more companies that are still very heavily in debt,” he said.

This situation is troublesome “because it prohibits a normal operation of monetary policy,” he warned.

“If inflation did start to pick up . . . there’s a major risk that the economy would fall back into precipitate recession at the first sign of rising interest rates,” Smithers said. “This is because companies’ profits would be very much damaged in nominal terms by the combination of high leverage and rising interest rates.”

But without a rise in interest rates, he noted, household spending power will remain weak.

“In fiscal 2002, Japanese household disposable income was only about 59 percent of GDP — well below the level of 70 to 72 percent in other G-5 countries,” Smithers said.

“But of course if interest rates do rise while the investment level is so high, the threat to corporations would be very strong.”

Given such a dilemma, Smithers warned that the next recession here is “going to be a rather severe one . . . In the event that net exports were to cease to expand, it is probable that investment would start to fall off within a few months, and there would be little help from consumption to offset that.”

The government’s options are limited, because there isn’t any more room to cut interest rates, and tax cuts are unlikely due to the massive budget deficits, he said. And intervention in the foreign exchange market to push down the yen would pose international problems.

Ultimately, Smithers noted that domestic investment needs to fall and that corporate debt would have to drop relative to GDP. This, he said, would require at least moderate inflation.

In order to prevent this fall in investment from having a recessionary impact and to find alternative sources of demand to support the economy, Smithers said Japan will need to increase net exports, which is the same thing as increasing foreign investment.

“Once it is recognized that Japan has excessive investment, it would be recognized that Japan’s current account surplus needs to grow,” Smithers said. This is a conclusion that would be extremely unpopular and require efforts by Japanese leaders to obtain international understanding.