From Stagnation to Innovation: Japan's Economic Resurgence

Japan’s Recent Outperformance

The Japanese equities market has been one of the world’s best-performing asset classes in the last three years, outperforming even the United States. However, for Japan watchers, the million-dollar question is whether this stock market rebound is real or another false start, as observed in the past three decades. Over the past 35 years, Japan has had countless prime ministers and central bankers, each with a unique spin to revive the post-bubble economy. Some initiatives have inspired an initial jump in corporate investment and household consumption, leading to temporary stock market rallies. However, each rally has proven short-lived. Japan has been a laboratory for failed fiscal and monetary policy experimentation. Has it finally found the recipe for sustained success?

We are now more than two years into Prime Minister Fumio Kishida’s administration, and the new Bank of Japan governor, Kazuo Ueda, is still early in his honeymoon period. Do we have enough information to say that this recovery is for real?

In part one of this three-part series on Japan, I will examine this crucial question. In this article, I focus on the reasons behind Japan’s own great recession and explore the thesis that this recovery is different.

The Fall of Japan Inc., Circa 1990

To argue that Japan is finally turning a corner, we must first understand how the mighty Japan Inc. of the 1990s came crashing down. It is even more critical to understand Japan’s struggle to get back on its feet in the subsequent decades.

Most Gen Xers will remember growing up in the era of Japan Inc., where magazine covers alternated between 1) love and admiration for Japan’s better approach to “everything” from education to management to work culture, and 2) fearmongering urging the United States to deter this former aggressor to protect American economic turf against a Japanese capitalist invasion.

The spectacular economic growth from the prior two decades also created the largest real estate bubble the world had ever seen. At the peak of the craziness, the land of the Imperial Palace grounds was worth more than the entire state of California, which, at the time, would have ranked as the world’s 7th largest economy by itself! The irrational euphoria was not lost on the Bank of Japan (BOJ)—households and corporations alike heavily speculated in real estate and the stock market. This wasn’t just Mrs. Watanabe, the housewife, gambling in the market for entertainment. It was also Mr. Watanabe, the chairman of the board, leveraging the company balance sheet aggressively to acquire prime real estate.

With the yen doubling in value against the dollar, Japan was on top of the world. This was the Japanese equivalent of America’s roaring ‘20s. However, the irrational prices resulting from the asset bubble and currency bubble were untenable and soon became self-defeating. Yields and valuation multiples could only make sense based on the assumption of greater fools rushing into this Ponzi scheme. In late 1989, the BOJ began tightening to combat wanton credit expansion and reckless leveraged investing, marking the beginning of the end. And the unraveling, like it often does, came fast and furious. Real estate came crashing down in the early 1990s by 25%, triggering a systemic banking crisis. Simultaneously, the stock market tanked 35%.

Real estate crisis is not uncommon, US recovered well, why couldn’t Japan?

Having studied the US Great Depression caused by the excesses of the roaring ‘20s, the Japanese government decisively stepped in and stepped up. Interest rates were aggressively lowered, and “standard accounting principles and risk management” were suspended to avoid domino-effect bankruptcies. The Japanese actually invented QE (quantitative easing) and TARP (Troubled Asset Relief Program) before the United States made them popular during the 2007 GFC (Global Financial Crisis). However, neither the Japanese economy, nor its housing market or stock market, saw any recovery despite the aggressive government intervention. For the next five years, asset prices continued to decline. By the late 1990s, real estate had lost 70% of its value, and the stock market dropped by 65% in value from the peak. However, the sharp decline was perhaps less problematic than the lack of recovery over the next 30 years.

A great many theories have been offered on how the Japanese real estate bubble led to the subsequent lost 30 years. However, globally real estate bubbles develop and burst regularly. The GFC of 2007 was a mirror image of the Japan real estate collapse—irresponsible leverage applied to rampant real estate speculation leading to a crisis that nearly wiped out the banking sector.

After spending two years in “government ICU,” the US economy recovered into healthy sustained growth, getting the same aggressive injection of QE as the post-crisis Japanese economy. So, why didn’t Japan recover?

Below, I highlight three critical headwinds, among many in the next section. Importantly, these headwinds have now receded and are even reversing, becoming tailwinds that I believe give Japan a solid path back to growth.

1. Rate cut toward zero actually hurt Japanese consumers

One of the foundational laws of economics is that people do not consume or invest when they experience a substantial decline in income and wealth. However, culturally, how people experience wealth and income are vastly different!

When the United States dropped interest rates to 25 bps after the GFC, households experienced a meaningful increase to disposable income. Their payments for credit card debt, car loans, and (refinanced) mortgages all declined meaningfully. Their ability to borrow and spend also increased. This is the definition of a positive income effect.

For the Japanese, however, when interest rates were reduced to 25 bps, their income from bank savings fell precipitously. Whereas a million dollars at 5% generated $50,000 in income, it now generated only $2,500; Japanese household disposable income dropped by 95%. In response, the Japanese dramatically cut down on consumption as interest rates declined. Paradoxically, Japan would thrive more with the prevailing US inflation and interest rates, which Americans experience as punishing and contractionary. Whereas a “QE”-type zero-interest rate regime creates little credit or consumption expansion but actually contracts the economy in Japan—contradicting every economic theory from the ivory towers of the West.

2. Tokyo meddling created an economy filled with zombie corporations which never invest to grow

In my opinon, the biggest contributing factor to the divergence in recovery between Japan and the United States lies in the difference in the philosophy of government intervention. Both governments acted decisively to avoid a systemic banking crisis that would destroy the economy. However, the US government quickly ceded control to the free market. Yes, as the US government bailed out financial institutions, people were not wrong to label it a transfer from the taxpayers to the too-big-to-fail institutions, offering corporations cheap capital and credit guarantees. The bailout was, in part, to prevent the entire financial system from failing. But it was more than that. There was a deep belief that competition among healthy financial institutions would be critical for directing long-term growth capital to the right entrepreneurs and businesses. This bet paid off, as these financial institutions recovered and played a critical role in financing explosive US growth in the 15 years hence.

In Japan, however, the government fell in love with intervening and significantly supplemented its weakened free market with central planning. The “Tokyo meddling” ultimately prevented proper recovery. After the bailout, the Japanese government gradually took control of major financial institutions until they de facto became state-owned enterprises. In Japan, financial institutions were often at the heart of giant conglomerates (keiretsu), suppling capital to group companies as a “friendly” financier. As these financial institutions became zombies—neither able to die nor actually live truly autonomously and free from meddling—the affiliated group companies they financed also became zombies. The enormous debt overhang and the skeptical and disapproving government bureaucrats lurking in the shadows of boardrooms became a proverbial wet blanket on every risk-taking initiative. The steady refrain was not to take risks because the firm could ill-afford mistakes. Debt capital with a tight leash does not encourage long-term growth investments.

All the cheap capital from QE made little difference in driving growth in Japan. The issue was not a lack of cheap capital, but a lack of incentive: there was little upside sharing for success but career-ending punishment for failure. The extremely risk-averse management deployed low-cost capital toward safe but low ROE short-term projects. These projects would never make business sense if interest rates weren’t artificially constrained to zero. Again, contrary to standard (ivory tower) economic theory, the subsidized low cost of capital didn’t translate into more investment for growth. Instead, it simply became fuel for a variety of unproductive yen carry trades—investment schemes that arbitraged the interest rate subsidy without actually investing to grow the economy.

Zombie firms, protected and favored by the government and sustained by cheap credit and government policy arbitrages, crowd out younger firms that are investing, innovating, and competing to win. Alas, they cannot truly scale to win because a protected monopolist isn’t allowed to die.

3. Domestic wage surge + 100% yen appreciation => Japan was uncompetitive as an exporter

Domestic wages rose meaningfully during the bubble. Combined with the 100% appreciation in the yen, Japan achieved a developed world income level, reaching $42,000 in per capita income. Simultaneously, Japan became too expensive and uncompetitive as an exporter. The migration of manufacturing away from Japan to Taiwan, Korea, and ultimately China created additional headwind to Japan’s economic recovery.

This time is (finally) different!

After three decades and 17 prime ministers administering failed attempts to revive the Japanese economy, Japan finally seems to have stumbled onto a path forward. The stock market has finally recovered to its pre-crisis level 35 years ago. However, how do we know the stock market rally isn’t yet another head fake?

Beginning of the end to micro-management, intervention, and protectionism

The visible hand of Tokyo didn’t just intervene; it was fond of micromanaging. The Japanese government rightly recognized that Japanese firms made poor use of capital, with returns on capital among the poorest in the world. Firms often allocated cheap capital to non-productive uses as indicated by the low ROE. Many Japanese firms have a P/B ratio below 1, suggesting that their “growth investments” couldn’t even outperform their low cost of capital. However, the government’s micromanagement, such as demanding board and executive diversity, has had no effect. Much political waxing on how the Japanese must overcome the fear of failure to take more risk made headlines, but little else. When the inefficient government sector tries to teach corporate sector how to be efficient and innovative, one should not have high expectations.

Recently, Tokyo seems to have finally taken Management 101: To get results, demand “what,” not “how.” Instead of telling firms how to invest more productively, Tokyo is now simply demanding that firms achieve higher ROE and P/B or face punishment, specifically, delisting.

Japanese firms respond well to sticks! Since then, ROE and P/B have indeed risen! This is likely to further encourage Tokyo to stop the meddling and the protectionist policy. Some zombie firms will revive themselves, but more importantly, many will finally perish through free market competition, allowing innovative, risk-taking entrepreneurs to win and reshape the corporate landscape from a wasteland of the undead.

Covid has been a cure to bad Japanese management and work culture

Where Japan was once admired for its management and work culture, the zombification of its corporate sector has completely reversed the narrative. Until recently, Japan has become known for its bureaucratic management, absence of meritocracy and performance measurement, and a largely checked-out workforce. Work hours are still unpleasantly long, as long hours were the KPI itself, but inefficiency was the actual hallmark.

Covid surprisingly changed that! Suddenly management had to figure out how to manage and measure productivity and performance when staff didn’t show up to the office. Management was no longer monitoring hours sitting at a desk. This shock to the system also brought about research into managing the remote workforce and ultimately brought a shift toward more modern management—with an emphasis on clear goals and measurement.

Additionally, Covid forced Japanese firms to heavily invest in digital transformation to improve collaboration and knowledge-sharing among remote employees and management. Prior to this recent IT spend, Japan had fallen to 78th globally in terms of digital capability. The poor productivity was a symptom of inadequate technology spend. The lack of investment in IT to improve business productivity was a symptom of management’s lack of incentive to care about efficiency—until Covid regulations forced firms to invest.

The Covid-induced digital and management transformation brought strong dividends. Data suggests that the new remote work and hybrid culture have also increased female participation in the workforce, which has contributed to greater overall productivity.

Balance sheet repaired and disposable income jumped

After nearly 35 years, Japanese households have saved enough to repair their household balance sheets. With onerous mortgages paid off and a modest recovery in home prices, Japanese households have finally “recapitalized” and begun to spend more and save less.

The greater ability and willingness to spend has contributed to a 3.2% inflation rate for 2023 and 2.5% for 2022 after 30 years of consumer price deflation. This makes it possible for interest rates to gradually return to normal instead of remaining artificially negative at 0.1%, which essentially robs savers of their purchasing power. I believe the return to positive income from savings will additionally add to disposable income over time.

Cheap yen (cheap “export” labor)

The cheap yen policy, practiced by the BOJ since 2022, has also been a major reversal in the BOJ’s stance on currency. By depreciating the yen by 30%, Japan now has lower labor costs in key export industries than Taiwan and Korea, making Japan a competitive exporter once again.

In fact, after 30 years of wage deflation and with a sharp 30% additional discount to international firms, I would argue Japanese exports are one of the best bargains available to global buyers. Before domestic consumption growth can further drive Japanese economic growth, export growth must be the engine that could. And all evidence suggests that it will.

New tailwinds: Friendshoring

The US friendshoring of manufacturing will be a tremendous tailwind for Japan. Japan is arguably one of the friendliest shores for the United States in the Pacific Theater. Combined with low labor prices and low asset prices, Japan is attracting record direct foreign investment, especially from China. Today, Japan is one of the preferred destinations for Chinese factory relocation.

Anecdotally, real estate agents, M&A investment bankers, and M&A lawyers in Japan are doing record business servicing foreign direct investors, primarily from China.

Today, China’s exports top $3.4T, while Japan’s exports hover around $750B. If just 5% of China’s exports were to be replaced by Japan, this would represent a jump of $170B, or a 22% increase for Japan’s export sector.

The Final Analysis

The tailwinds for Japan are multiple and strong, resulting in visible green shoots of recovery, from the end of deflation, a robust equity bull market, to record export growth. Most importantly, there has been a wage increase of 5.24% after 30 years of wage deflation. Japanese firms are clearly experiencing and projecting business growth and margin expansion due to greater export competitiveness. The sustained strength in the recovery has also encouraged the government to ease off its otherwise constant meddling, pivots, and unproductive protectionist policies. The real-life Japanese version of the “Walking Dead,” where zombie companies with zombie employees walked the corporate landscape for 30 years, might just be coming to an end.

Disclosures

This article contains opinions subject to change without prior notice. This is not a recommendation to purchase or sell any securities discussed herein. This article was written by Jason Hsu, a portfolio manager at Rayliant Global Advisors, as an opinion piece and the opinions herein are those of Jason and not Rayliant Global Advisors.