Economic Outlook: Where is Japan Heading?

February, 2008 AWF event with guest speaker Robert Feldman, Director of Japan Economic Research, Morgan Stanley Japan Securities Co., Ltd.

Robert began by talking about demographics and, in particular, the labour participation rate. As a response to many commentators and economists who claim that Japan’s labour shortage will be met by the increasing number of women participating in the Japanese labour force, Robert clearly illustrated why this is just not so.

While it’s true that female participation has been rising over the past 15 years, the fundamental fact that cannot be overlooked is this: aging (which pushes people into lower participation rate categories as they age) is outpacing the rise in participation (in given age categories). As a result, overall, actual female participation in the labour market has dropped (-1.5% since 1990). The drop in male participation is even bigger (-4.06% in the same period), which underscored Robert’s point that “Gender is not the issue: participation rates must be raised by extending the length of everyone’s working career.”

If the solution to a shortage of labour is not really female participation, this leads to the question of productivity. Essentially, as the population declines and the number of eligible workers drops due to aging, productivity becomes an issue: output per worker will have to increase in order to soften the effects of the decline in participation. How can productivity be raised? The obvious answer is “more machines, or technology (i.e., raise the capital to labour ratio)”. Increasing the quality of capital stock will make labour more productive (Robert cited the example of his Blackberry and how it has enabled him to work on-the-go in places he would not have been able to work just a few years ago). To put it simply, if GDP must rise while labour input falls, then capital stock must rise or technology must (or some combination of the two). Technological advancements will absorb some of the need for increased capital stock, but much will have to come from increased use of machinery and software.

The other element of this equation is for businesses themselves to increase productivity through corporate restructuring. While this is already happening in Japan, there “is still a lot of work to be done”. Robert returned to this theme a little further on in his talk.

An overview of the labour market was then given: wages are not rising and the productivity curve has shifted. The simple fact is that wages are not rising in Japan. Robert cited the example of the cost of a chocolate bar at the convenience store: volume (or actual weight of the product) has dropped but the retail price is the same (i.e., you are paying the same price for less volume) and this in turn affects the individual’s ability to buy things, which then holds labour (wages) down.

The productivity issue is basically determined by the interaction of wage, age, and productivity. “The archetype is for a worker to enter at a low wage and the wage rises over time; productivity starts low, increases over time but then drops as the ability to learn drops.” However, there has been a notable shift in the productivity-age curve in recent years as older workers cannot keep up with changes in technology. Added to this, wages will not be growing as baby boomers retire over the next few years. According to Robert, this is “good news for corporates because there will be no pressure to increase wages, but bad news for consumption.”

The talk then shifted to corporate restructuring: “raising ROE is the next challenge”, said Robert. He continued to explain that “around 2005, margins passed the peak of the previous bubble, but turnover fell with deflation and leverage is at historical lows”. In addition, margins are not high when compared to international levels.

Touching briefly upon the market for M&A, Robert also went over the question of what efficiency actually is: “corporates focus on operating margin, while investors focus on ROA”. He said it’s important to look at the two together if you really want to understand whether or not a company is a good candidate for a merger. As an example, he talked about the General Contractors segment of industry and cited the 2.4% average operating margin as evidence that, indeed, “there is still a lot of room for shake up”.

Just what will bring about this shake up led us into the final segment of the talk: the current political landscape in Japan. Starting with the statement “I’m pretty depressed”, Robert talked about the fact that there “is a lot of value out there, but what is going to trigger people to be active or actually shake things up.” He basically maintains that something BIG needs to happen. How big? “We need something big and it has to be on the front page of The New York Times, and it has to be in politics.” He went on to say that the two-party system is not right for Japan because it doesn’t accurately represent the actual situation: the LDP is completely divided over policy and the same is true for the DPJ. As for the next election, he had this to say: “the LDP cannot survive a defeat and the DPJ cannot survive a victory”. According to Robert, the latter is true because the DPJ will then be forced to make decisions that will inevitably make some of their supporters unhappy. He predicts a major reorganization of the parties, but claims that “there won’t be a party remaining that is big enough to obtain a majority”.

As a result, he foresees three possible outcomes:

1. Reform victory
• this will be “Koizumi on steroids”
• Koike, Maehara, Asao, and T. Kono are all strong candidates and serious politicians, but “Koike is looking very good and, therefore, the next Prime Minister could be a woman”.
2. Grand coalition
• essentially what we have now (“which is not working”).
3. Reactionary coalition (this “makes his Japanese clients groan”.)
• old LDP and old Socialists get together (Murayama/Hashimoto, the socialist/LDP coalition in 1994, a good example of this)
• the “Old Guard” will align themselves

Regardless of what election outcome is predicted, one crucial fact dominates: there must be party realignment in order for Japan to have an effective government. If realignment does not occur, the government will remain divided and policy will remain in gridlock.

At the end of the talk, Robert fielded questions from several audience members. The questions covered the following areas:

• The current mapping or configuration of the political parties
The questioner stated that, at present, there was more “squashing towards the middle and more of an overlap between the LDP and the DPJ.” Robert, however, maintained that the voting populace is more radical than Diet members and that the parties are still bound to their traditional supporters and still factionalized.

• Immigration – what kind of impact will it have on labour participation?
Robert answered that citizens are “way ahead of the bureaucrats” on the issue of immigration. However, the fact is that “the pace of immigration is not fast enough to ease demographic pressures.” As for some types of immigrants (for example, in the medical and agricultural sectors), there will have to be some type of big crisis to spur the government into action. At present, 10% of land is lying fallow in Japan because regulations on agricultural land sale are too strict.In addition, despite shortages in the nursing industry, the nursing union does not support importing foreign nurses. Robert maintains that as baby boomers start retiring en masse in the next four years, there will be some type of hospital care crisis and this is the only thing that will bring about real change. He then referred to the CRIC cycle (Crisis, Response, Improvement, and Complacency). As with politics, a big crisis will need to occur if the doors are really to be opened to immigrants.

• Asia/Pacific Market – what kind of influence does he see from other countries (such as India, China, and Vietnam)?
Robert answered that there is external pressure and that “Japan is losing, especially in financial market competitiveness”. He also talked about fear (the Japanese fear that “China is buying all the oil”) and the old-fashioned approach that many Japanese politicians cannot seem to get out of: they tend to look at the world as a triangle of balance between the US, Europe, and Japan, and they make policy decisions based on this very old model of looking at the world. It’s simply a byproduct of their upbringing: their world views were shaped post-WWII, and they cannot really see that the global balance has shifted dramatically.

• Valuation of Japan and the change-averse nature of the Japanese
Robert agreed with the questioner that equity valuation was low. He tied this in to the political situation by citing 37% under-representation of urban districts in the Upper House (because the seat allocation in no way reflects the population distribution – Tokyo an nine other urban prefectures are under-represented). This then brought us back to the CRIC cycle and the question: how far does the market have to go down before the Diet takes things seriously? The answer, unfortunately, was not promising.

The AWF board would like to express their thanks to Robert Feldman for a very informative and interesting presentation and discussion. An excellent start to our 2008 presentation series.

 

Summary prepared by L. MacKinnon (based on notes taken during the talk)