Prognosis Japan: Morgan Stanley Japan’s Chief Economist Assesses the State of Japan’s Economic Health

September 28, 2007

SPEAKER
Robert Feldman, Head of Japan Economic Research, Morgan Stanley Japan Securities Co., Ltd.

PRESIDER
Margaret Moore, Senior Analyst & Portfolio Manager, DuPont Capital Management

Distinguished economist Robert Feldman of Morgan Stanley Japan spoke about the economic and policy outlook in Japan today.

"We've had a lot of political upheaval," Mr. Feldman said. "I do want to note that there is some, call it latent optimism, out there, that if Japan can somehow get things right again, get back on the reform track, then there's a lot of really neat stuff that can happen."

"I agree with that," he said. "But at the moment, my sense is that there is still a bit of naïveté about how long that's going to take and how rough the process is going to be."

To illustrate, Mr. Feldman noted that at the Harvard Law School/International House conference he attended earlier in September, the audience, 50 Japanese and 50 Americans, were asked their opinion about the future of reform, and specifically, whether it would slow down, stop or reverse. "And those are the choices, right?" he said wryly; maintaining or accelerating the pace of reform is not in the picture.

"My guess, correct me if I'm wrong on this, but the total mix, Japanese and Americans put together, about 60 percent said slow, about 39 percent said stop, and 1 percent said reverse. Guess who the 1 percent was?"

"Now what I claim is that there's already evidence that we're in fact moving backwards on the reform agenda," Mr. Feldman continued. Under Prime Minister Fukuda, top party positions and cabinet appointments have gone to members of the old-guard LDP, and a number of policy positions have a retro feel.

Thus, reform of the old age medical insurance system is being postponed. "Prior to Prime Minister Koizumi, people over 70 paid zero premium and zero co-payment when they went to the doctor. So you can imagine what doctors' waiting rooms looked like. Now, under Koizumi that was raised to 10 percent, and legislated to rise to 20 percent. Mr. Fukuda has decided to put that on hold, and it's going to cost about a billion dollars," to be paid for by floating bonds rather than cutting the budget somewhere else.

Similarly, Mr. Feldman said, "from 2001 it was adopted in cabinet policy and stuck to, through thick and thin, the succeeding six years, that Japan would take its primary balance on the fiscal accounts from a deficit of approximately 6 percent of GDP up to zero. And the reason to target zero is they thought that would be enough to stabilize the ratio of debt to GDP. Turns out it's not really, but good enough. Good first step. They're almost there. Another percent or two and they'll be there." Now, however, the Komeito party, LDP's coalition partner, "is suggesting that they postpone that target--a clear step backward."

Likewise with the issue of earmarking gasoline taxes for road construction, Mr. Feldman indicated. "It was Koizumi's policy, it was also Abe's policy, to take those road tax revenues and transfer them into general revenue, so that they could be used everywhere. Of course the road lobby doesn't like this very much," and when "Prime Minister Abe brought it up and said we want to do this, he had a firestorm of opposition. They stuck to it. Now he's gone. And just the other day, Prime Minister Fukuda has said that they should be very cautious about changing the earmarking of road taxes into general revenue. Cautious is a code word for 'we won't do it.'"

"Not all the news is bad, and in fact I think the economy itself is in reasonably good shape," Mr. Feldman continued.

"We have an inventory cycle which is much, much more stable than it used to be," and this is not something that'll be disrupted by the backsliding on reform, he said.

Due to improvements in IT and more flexible labor markets and capital markets, "production control is much easier"--"you send an e-mail to Sri Lanka, you get your production adjustment." Meanwhile, the cost of adjusting inventories has actually gone up, because product cycles are so short. In consequence, "inventories are essentially controlling themselves; management can use more time to manage the business and less time to worry about inventories. This should improve the latent growth rate or the potential growth rate of the economy."

Moreover, he said, "It's not necessary to adjust interest rates nearly as aggressively as it was necessary in the past. After all, one role of monetary policy was to control the inventory cycle, by raising and lowering interest rates to prevent inventories from getting out of hand. If inventories are controlling themselves, it's not as necessary any more."

"That said," Mr. Feldman declared, "where is the growth going to come from?" As the Japanese population declines, "the working population will fall even more, so that means every remaining worker will have to work smarter, or better, or with more capital, in order to maintain living standards. We need more investment, in R&D, in capital itself, a lot more M&A." And here, political events are going to hurt. "It's not so much political uncertainty, because I don't think there's that much uncertainty. We're going in the wrong direction. It's not uncertain--it's happening. And as that happens, I think it's harder and harder and harder for businesses to say oh, I see a new business opportunity out there, I'm going to go do something about it. So from that point of view, I think these political events have probably made the economy a bit weaker because of the impact on cap ex."

Another negative is wages, and here, Mr. Feldman said he expects "four or five more years of very subdued wage growth" until the youngest baby boomers, the 1952 cohort, finish "falling off the cliff of the seniority wage profile," which peaks at age 55 and by age 60 cuts wages by 25 percent. This "will be very good for corporate earnings, because the middle line, the wage component, will be under downward pressure from this. But we will not see a vibrant consumer, because the income growth just won't be there."

Young people won't take up the slack, he added, due to an influx of young Chinese workers and young women into the workforce, putting downward pressure on wages. Moreover, "as the young people see the country sort of going in a non-reformist direction, they are not likely to be encouraged about their long-term prospects," and this too is a negative for consumption.

On corporate governance, Mr. Feldman said, "I'm not quite as negative about what's happening as the press would have us believe. But I do think there is a problem in that the incentives for corporate managers to do the things that are necessary to raise return on equity are not quite as strong as they appeared to be a year ago."

Profit margins are much better, and turnover, the ratio of assets to total sales, has stabilized, he said. Corporate balance sheets are "much, much more solid," with the debt-to-equity ratio down to about 1.6 to 1 from its dangerous heights of 7 to 1 in the mid-1970s. "But the question is, are there incentives in place to encourage managers to work more aggressively, to raise ROE in any of those components?"

Mr. Feldman sees a huge potential "for reorganization within industries, for the stronger firms and the weaker firms to combine their good forces, release resources that can then be used elsewhere, either in that industry or in other industries where Japan needs those resources because of the drop of labor force," he said. Holding back these changes, however, is a notably confused policy scene.

"If you look at the LDP, what you see is that it's neither liberal nor democratic nor a party. The economic policy is all over the map. You have some very market-oriented people; you have some very socialist-oriented people, all in the same party. Look at the Democratic Party in Japan--it's even worse. At least in the LDP they have more or less an internationalist approach to foreign policy--more or less. In the Democratic Party, they're left to right on economic policy; they're left to right on foreign policy as well."

"We have a two-party system, there are two big tents, and you don't know who to vote for. There's no branding between the parties. So this has to change, in order to have some kind of resolution of where the country's really going to go."

The probable resolution will be the formation of a new party that unites the "Koizumi children" in the LDP with the internationalist wing of the DPJ, Mr. Feldman said. "These two groups, the two orphan groups, basically agree on economic policy and foreign policy--hey, so why not get together and do something. This I think is quite likely. Timing, very uncertain, but I think it's quite likely to happen."

"There are three potential outcomes" to this scenario, he said. One, the new party "is very popular, basically takes control of the agenda; that would get us back on track to where I think the population wishes to go--be very positive for financial markets." Two, the LDP and the DPJ "get together in one big grand coalition, go into a bunch of back rooms, decide everything, pass the laws and then go to the people"--bad for policy and not an outcome that the Japanese people will accept, in his view. And three, "the rump of the LDP and the rump of the DPJ get together, they paper over their differences on foreign policy, and they decide to go back to a large-government, more socialist-type policy outcome"--which "is a clear possibility, and it's obvious to me that that would be negative for financial markets."

"So as we sit here today," Mr. Feldman concluded, "what we see is a Japanese economy that has still tremendous potential, despite all the problems with aging, there is huge, huge potential there, a lot of very smart people, a lot of companies that want to do the right thing."

"But we are sort of overwhelmed by this difficulty in the political situation, to translate what the people want and what the best interest of the country longer term is into some kind of policy result."

"And so I think the next six months, maybe 12, maybe 18 months, will be a process of discovering how to break this political and policy impasse and then get back on the road to a more sustainable Japan."

***

To what extent do Japanese political leaders counsel with academics in developing economic policies?

"I would say that there was a huge step forward in the late 1990s" with the creation of the Council on Economic and Fiscal Policy, two of whose four private-sector members come from academia, Mr. Feldman replied.

The CEFP had a big impact during the Koizumi years, though less so under Mr. Abe, when "basically it turned into more of a debating society rather than a tool," he added.

"But at least we've got the channel for doing this. I mean, it's hard for me to imagine that the Council of Economic Advisers in the U.S. has nearly the amount of impact on policy that the CEFP can have in Japan."

What is the role of philanthropy in the financing of universities in Japan, and is there a political commitment to higher education as the foundation for economic growth?

"In my mind the key issue there is the role of the Ministry of Education in dominating the entire system," Mr. Feldman replied. "As long as you have to go to a bureaucrat to get a yes or a no on anything, it's going to be very, very slow. So my proposal is that we simply abolish the Ministry of Education. I've said this in a number of places, they all hate me for it, but that's OK."

"Obviously there are things that the Ministry of Education does have to do, so we do need national standards, et cetera et cetera. But I think a devolution of educational policy to the prefectures or more likely to regions is probably a better idea, so we can get a little competition."

"At the moment the big idea is to privatize Tokyo University and all the other national universities," and "when that happens, a huge amount of entrepreneurial spirit will be unleashed."

On the philanthropy side, things are improving, with Toyota giving $10 million to the faculty of economics at Tokyo University and an anonymous alumnus contributing $120 million to Nanzan University in Nagoya.

As China increasingly becomes an exporter of inflation these days, with presumably an effect on corporate margins, what is your perspective on some of the global pressures on Japan's economy?

"I think there's still a huge, huge untapped resource of labor in China," and therefore the inflationary impact will come not through wages in China but through commodity prices, and also through food prices, Mr. Feldman answered.

"There is not a lot more arable land left in the world, and if anything, pollution is reducing the amount of land available. So we need a lot of research in better yields in order to keep food prices under control."

"This will also have, I think, immense implications for the way the Japanese agricultural industry is organized."

Is the public actually pushing for reform and the politicians are slow to jump on board, or do we need someone charismatic like Koizumi to get the public to desire reform?

Mr. Feldman replied, "I think we definitely need some vision, but I think the issue of consensus turns out to be a little bit more complex than one would think."

"As far as I can tell, the population is more or less in three equal parts," one-third internationalist and market-oriented, like Koizumi, one-third internationalist and pro-big-government, like the old LDP, and one-third isolationist and pro-big-government, like the old socialists; but the parties as currently organized don't reflect this reality.

Total labor cost for government workers "is about ¥10 million per head. If you do the same calculation for the auto industry in Japan, you get ¥6.5 million per head. So the population sort of knows this in some sense. They may not know the exact numbers, but they know something is wrong. And they know that this system exists because of the political structure being the way it is. And I think that what's going on here is that the population is using the Democratic Party as a hammer to beat the LDP at the moment."

Will investors, whether portfolio investors or activist investors or direct investors, be more reluctant to invest in Japan because of these political developments, or will they simply look at the trend in corporate profits and keep shoveling in the money? And does the government care?

"Everybody says that they don't look at politics, but in fact they do, and when somebody says that to me, I say OK, if Koizumi hadn't been there, what would have been different? Uh oh. Yeah, OK, I guess it does matter."

"So yes, people do look at this. They may not look at it today, tomorrow on a specific company, but they do look at it as far as I can tell, and correct me if I'm wrong on this, in terms of where the country is going."

"The question on whether the government cares--that, I think, comes down to how much it impacts asset prices. If the foreigners go away, and Japan continues to underperform, stock prices keep going down, that gets attention."

"One of the reasons, for example, that Prime Minister Miyazawa finally, finally, finally came out with an economic package in August of 1992 was that the stock market had fallen from 39,000 to 14,000, and he finally got the message."

"Now I hope things don't get that bad this time. But it's a matter really of some kind of crisis occurring that even the politicians, focused on their insider concerns, will have to notice. And that's why I'm a little scared about where markets may go over the next few months."

--Katherine Hyde