Welcome Back, Optimists

The case for Japan’s turnaround in 2013

By Jesper Koll

Acouple of years ago I started quibbling in public speeches that I’ve got one of the hardest jobs in the world: I am one of the last Japan optimists. And in my world – the world of economics, finance & policy making – being a Japan optimist almost feels like being someone who tries to convince people that Elvis Presley is still alive.

Surely, the King is long dead. However, Japan’s economy  is very much alive, and if anything, my optimism about Japan’s prospects and investment opportunities has grown in recent months.

Let me make one thing clear at the outset: my Japan optimism is not based on potentially positive changes in domestic politics or policy making. Yes, politics can help, and yes, I’m sure my job would get easier if the government returned to be stable, consistent, and focused on governing rather than politicking.

Hope for better politics springs eternal, but let’s stay focused on what really matters. In the end, wealth creation and sustainable growth can only be generated by private companies, entrepreneurs and risk takers. This is the root cause of my optimism: I have great confidence that Japan’s private sector dynamics are at a fundamental inflection point.

Specifically, I am watching the following private sector trends. All of them started in 2012. You may agree or disagree with my thesis, but these are the empirical data points we all need to watch carefully in the coming six-to-twelve months to verify – or falsify – the case for Japan optimism.

 

Money and credit cycles are taking a positive turn

Japanese bank credit and loan growth started to turn positive in early 2012. Growth has been slowly rising at around one percent, but this is real growth and marks an important turning point after almost 20 years of net credit contraction. Clear speak: Japan’s credit crunch and deleveraging cycle is over and a new re-levering cycle could be starting. When the money and credit economy turn up, real economic growth is poised to follow.

Analysis of this upturn leaves room for caution. About one-third of the increase in credit demand traced back to the rebound in demand triggered by the March 11 triple disaster. Also, about 15 percent comes from the ‘special loans’ that the government guaranteed to tide over cash-strapped utilities companies. So about half of the upturn in the money economy can be directly traced to post-March 11 factors. These will now begin to fade – and the other half must get stronger. I expect more acceleration in the recent increase in private sector credit demand.

This spike in demand is largely attributable to three factors: a rise in mortgage loan demand as a younger generation of Japanese buys homes and mansions, a jump in consumer credit demand due to a rise in demand for durable goods, corporate investment spending as companies restructure and upgrade their capital stock, and Japanese banks venturing outside of Japan to lend in overseas markets.

In my view, these private credit demand drivers are more important than much of the media debate about the Bank of Japan. Yes, the central bank may be buying more government bonds to help liquefy the economy and postpone fiscal austerity. But to get bullish on Japan, we need to see growing demand for credit and loans from private households and companies. I’m upbeat about the start of a positive cycle, but will watch the money supply data like a hawk in the coming six to twelve months.

 

The real estate market is bouncing back

From what I can see, Japan’s real estate investment cycle is beginning to take a turn for the better. Last year brought positive news on rising housing starts, tightening demand and supply conditions in the condominium market, as well as an increase in real estate transactions. In 2013, we will likely see follow-through.

First, we should get evidence that commercial rents will go up. At least one major real estate company has indicated that rents in downtown Marunouchi will rise from April 2013. As I suspect, others will follow. The up-cycle in rents is bound to be a key indicator to global and local investors that real change for the better is underway. Second, we should see evidence of land prices rising. To be sure, this will likely happen only in prime and central locations in Tokyo and perhaps a few other major cities. But this is where new up-cycles always start.

A key point: Japanese banks are willing and capable of providing mortgage credit. At the same time, a new generation of “echo-boomers” – the children of the boomers – is beginning to see accelerating growth in their income. That’s my thesis at least. The bank credit and residential property markets are the points of reference to prove or disprove it.

 

Corporate activism and investment for growth

In 2012 there was a surge in corporate metabolism, with global and domestic M&A activity reaching historic highs. For large companies, most of this activity was “outward-bound” (i.e. increasing the global footprint by buying overseas companies or building new factories, distribution hubs, retail malls or R&D centers). For small- and medium- sized companies, domestic M&A became a big theme, with aging owner-founder presidents actually coming off the fence to merge with and acquire competitors, or become integrated with them.

Importantly, the surge in corporate metabolism was broad-based, across multiple industries, from food and beverages, steel and car parts to retail, telecommunications and financials. While cases-by-case analysis is important, the aggregate results of these forward-looking investments should start to materialize from 2013.

How? While 2012 brought the inevitable costs of acquisition, consolidation and restructuring, 2013 should bring concrete signs of a structural rise in corporate profitability and investor returns as positive synergy delivers growth in productivity and higher margins. And yes, by the end of 2013 or early 2014, we should even begin seeing a return of price power among newly consolidated industries.

 

The great stabilizer

So there you have it – a clear-cut case for being bullish on Japan, based on a private sector-led upturn, raising land and asset prices, and a proactive growth strategy for the corporate sector. In clear speak, the “animal spirits” are returning to Japan and risk takers stand to be rewarded more than their safety-seeking, cash-hoarding counterparts. The government could clearly play an important role in accelerating these private sector trends. But what’s officialdom to do?

In my opinion, the biggest wish is political stability and consistent policy. Over the past decade, the constant merry-go-round of Prime Ministers, cabinet ministers and political parties has greatly undermined Japan’s fundamental strength. How can you expect private entrepreneurs to invest in a country that constantly flip-flops on essential policy matters related to tax policy, labor law, healthcare, pensions and social security. Remember that just two years ago corporations were promised tax cuts, while in fact taxes have gone up.

Japan’s national economic policy has been consistently marked by vacillations and u-turns. If we had a stable government, led by a Prime Minister who actually stays in the job for two or three years, consumer and corporate confidence to invest in the domestic economy is poised for growth.

The good news is that the risk is low that Japan’s government would increase public sector spending or raise public sector interference in the economy. Why? Because of the fiscal deficit. With a debt-to-GDP ratio above 200 percent and tax revenue of less than half of total public spending, one thing is certain. No matter who rules Japan, the government’s focus will inevitably shift to more efficientless expensive public spending.

While the debate rages on about monetary and fiscal policy, the real trick will be creating a consistent policy setting that offers new growth opportunities for the private sector by speeding up privatization and deregulation. There are a plethora of high-growth opportunities. All we need are simpler rules and deregulation to empower private risk takers, creating profit and jobs.

Since the private sector has reached a fundamental turning point, now I simply wish the government would step up to the plate and create consistent policy. Japan’s private sector deserves it. Ah, hope springs eternal.