The New York Times July 19, 1998

Leader Exits, but It May be too Soon to Invest in Japan

by Joseph Kahn

The day after Japanese Prime Minister Ryutaro Hashimoto resigned, adding politics to the left of Japan’s financial and economic woes, one of the country’s leading financial newspapers topped its front page with this headline: “The Time Has Come to Buy Japan!”

The newspaper, Nikkan Toshi Shimbun, put that optimistic spin Tuesday on what has been an almost unrelenting barrage of negative news about Japan, the world’s second-largest economy. At last, the paper and others are saying, Japanese voters have demanded more decisive leadership that will dare to cut taxes, clean up the banks and stimulate an economy that has fallen into it’s deepest slump since World War II.

The hope is that change at the top will enliven Japan’s stock market, which has failed to sustain a rally since the country’s sky-high stock prices collapsed nine years ago. The Nikkei index of 225 stocks rose sharply last week, partly on expectations that any new Prime Minister would have to respond to calls to tackle the country’s most pressing problems.

Still, many economists, fund managers and stock pickers speak with one voice when it comes to investing in Japan. In a word, they say, don’t. At least not now.

“Why people would be even remotely in this environment is beyond me,” says Martin Armstrong, an economist at Princeton Economics International, an advisory firm in Princeton, NJ, that specializes in global economics issues.

“Long-term, I am very optimistic that Japan will come back and be the real power-house of Asia. But until things get worse, politicians there are not really going to budge” on fundamental reform, Mr. Armstrong said.

Like a tire riddled with holes, Japan’s economy defies every attempt to pump it up. Government stimulus packages, political and corporate changes and bank-over-haul plans have all fallen short. The stock market does not stay inflated for long, either. Five times in as many years the Nikkei has staged mini-rallies, cresting around 20,000, only to slump back toward its lows of just above 14,000. It closed on Friday at 16,570.78.

Whether the latest setback at the polls for the dominant Liberal Democratic Party represents a turning point is an open question. But many analysts doubt that a new Prime Minister—the front-runner is Keizo Obuchi, the Foreign Minister, a conservative with backing from powerful elders—will take office with an agenda to shake things up.

“I do not see anything in the vote that makes real change more likely,” says David Malpass, chief international strategist for Bear, Stearns in New York. “My reading of the voters is that they want less conflict and lower taxes. But this is not the start of fundamental reform.”

In fact, the cautionary factors that any stock investor would need to consider before betting on a Japanese recovery are so numerous that they overwhelm potential gains, analysts say. Following are just a few:

THE YEN: In the early 1990’s, the yen worked in favor of foreign investment in Japanese stocks. It consistently rose in value against the dollar and produced solid dollar-based portfolio returns even when. stock prices meandered. Now, the reverse is true: the yen has sunk from a high of 80 to the dollar four years ago to about 140 to the dollar now, with no signs of strengthening.

Some analysts are so bearish on the yen that they regard any Japanese stock as highly risky. Mr. Armstrong of Princeton Economics, for example, says the yen could tumble as low as 278 to the dollar by 2002, a decline so sharp it would destroy any dollar gains from even a roaring stock market rally. Many other economists see more modest declines in the yen, at least in the short term, but few expect a climb.

BANK TROUBLES: Bad loans threaten to overwhelm the Japanese banking system. Official estimates put unrecoverable bank debt at $500 billion; unofficial estimates range up to $1.2 trillion. In either case, the crisis has weighed much heavier on the Japanese economy than any banking crisis has in the United States since the Great Depression, and the Government has so far made only initial progress in solving it.

Elizabeth J. Allan, an Asian equities fund manager for Scudder Kemper Investments, said she saw few signs that the election heralded a faster approach to financial changes. Before Mr. Hashimoto’s resignation, the G9vernment laid out a plan for new “bridge banks” to help speed the closure of troubled banks. And Mr. Hashimoto has pushed a “big bang” approach to changing financial markets. But the election did not turn on such issues, Ms. Allan said.

“There may be a disconnect in what U.S. people are seeing and what they in Japan are thinking,” she said.

Though it is still early, she said, “my impression is that tackling the financial system is not on the agenda,” even under a new Government.

TAX ISSUES: Some analysts see changes in the Japanese tax system as the key to turning around the economy. Taxes were an issue in the recent elections—but only in terms of reducing the tax burden on consumers, not in overhauling the tax code.

Mr. Malpass of Bear, Stearns argues that Japan needs to start anew, scrapping the high tax on real estate capital gains, lowering the value-added tax and making loan-loss provisions tax deductible to speed changes in banking. “It is still very unclear how or whether these kinds of things will be carried out,” Mr. Malpass said.

THE ECONOMY: Japan has slipped into a recession and shows few signs of turning around quickly. Salomon Smith Barney projects that the economy will contract by 0.8 percent this year and then grow hardly at all in 1999.

The Japanese Government has promoted its latest stimulus package, which would include 3.6 trillion yen for construction projects, in theory creating ripple effects that would benefit the economy widely. But Salomon says the stimulus would merely reverse a contractional fiscal policy and do little to offset a sharp decline in private business investment.

For investors determined to place a bet on a Japanese turnaround despite these many cautions, stock pickers tend to favor only the largest and most international Japanese companies, especially those that have already adopted Western management methods.

Among the perennial favorites of mutual fund managers are Sony and Canon, both consumer electronics makers with a bias toward overseas sales and a proven track record in navigating Japan’s stormy market. Mr. Armstrong also likes a few less well-known Japanese companies that he says have become true multinationals, including Alpine Electronics, a car radio maker, and Amada, a machine tool manufacturer.

Ms. Allan of Scudder has two long-term holdings in her closed-end Scudder New Asia fund, both of which are leading consumer products companies with extended foreign operations: Uni-Charm, a manufacturer of sanitary napkins, and Nintendo, the game maker.

“We are looking for companies that will prosper whatever the outcome is domestically, and that means the most international ones,” she said.