By Martin Hutchinson
I have been much more positive about the Japanese economy than most other analysts in recent months, largely because I believed that many of the problems from the Japanese recession of 1990-2003 were finally in the country's rearview mirror. In particular, I believed that the Japanese budget deficit – which, by 2003, had become quite acute – was well on the way to being solved through public spending restraint. That, in turn, would allow Japan to pay down its excessive public debt, giving its private sector room to expand.
But the surprise resignation of Japanese Prime Minister Yasuo Fukuda on Monday suggests I may have been wrong about the country's near-term prospects.
Japan Gives Investors a Bubble Bath
The Japanese stock market and real estate bubble of the 1980s is now the stuff of stock-market legend, for it sent that country into a tailspin in 1990-91, after which came more than a decade of very slow growth. There were a number of causes – one was the appalling quantity of rubbish loans that Japanese banks had put on their books during the bubble (sound familiar…. perhaps we are we seeing a reprise here in the U.S. market?), and the second was the inexorable expansion of the Japanese public sector.
Prime minister after prime minister would propose "stimulus packages" of public spending, mostly on roads and bridges in rural areas (always popular with politicians from those areas). The largest package – by Prime Minister Ryutaro Hashimoto in 1998 – was more than $400 billion, the equivalent of 10% of Japan's gross domestic product (GDP).
Apart from covering Japan's beautiful scenery with unsightly overpasses, these capital infusion packages had two very clear effects:
- They increased Japan's public spending – from 31.5% of GDP in 1991 to 38.1% of GDP in 2002.
- And they created a huge public debt problem; Japan currently has public debt of 182% of GDP, the highest ratio in the world.
These stimulus packages had one very obvious shortcoming – they didn't stimulate. And with good reason. These programs did nothing useful to revive the Japanese economy because the mostly useless public works projects they financed (in terms of GDP, these projects were more than twice as large as those of the next-most-profligate public-works spender – France) were using up all the domestic capital that should have been financing private-sector growth. In the parlance of economics, this is known as "crowding out," and can be quite damaging, as Japan's experience demonstrates.
Japan's Prime Minister Troika
Since 2003, the key figure in Japan's economic recovery is former Prime Minister Junichiro Koizumi (2001-06), who stopped building "bridges to nowhere" – prompting major protests from the Liberal Democratic Party (LDP) "old guard." That stopped the growth in debt and then gradually brought the budget deficit down. As a result, Japan's economic growth resumed in 2003.
Koizumi was succeeded briefly by Shinzo Abe, and then by Fukuda. Like Koizumi, Fukuda was a proponent of reducing public spending – he wanted to balance the Japanese budget by 2011. Indeed, Koizumi and Fukuda were actually quite close: Koizumi got his political start under the premiership of Fukuda's father (also a tight-budget man) in the 1970s. So you can see why I was so confident that Japan's public spending would be kept under control and that the Japanese economy would continue recovering.
Japan's GDP showed a surprise dip in the second quarter, shrinking by 0.6%. As a result, public clamor arose for a "stimulus package" of public spending or tax cuts. The reality, however, is that Fukuda had been having a hard time since July 2007, because the upper house of the National Diet (which has considerable power) had been controlled by the opposition Democratic Party of Japan, blocking legislation.
Fukuda's weakness was demonstrated by his Aug. 1 appointment of his political opponent, Taro Aso, as secretary general of the LDP. When Fukuda's cautious Aug. 29 stimulus package of $18 billion – which consisted mostly of loans – was decried as inadequate, he realized that the clamor for extra spending would be unstoppable, and resigned.
Fukuda will likely be succeeded by Aso, a protégé of the big-spending barons of the rural constituencies.
Déjà vu all Over Again
The bottom line is that the public sector is likely to grow again, as it did in the 1990s, producing larger Japanese budget deficits, packing on more debt and stifling private sector development. Since Japan's public debt is already so high, the chances are good that the country's debt rating of AA (Standard & Poor's) /Aa3 (Moody's Investors Service (MCO)) will be downgraded. That would increase borrowing costs for all Japanese companies and damage the economy badly.
For more than a year, I had been positive on the Japanese economy, even as the market declined. But it's finally time for a shift in outlook:
- In the near term – until the political situation can be sorted out – it's better to underweight Japan in our portfolios.
- Long-term, however, we still believe that Japan is superbly positioned to capitalize on its proximity to China; indeed, as we've noted, the two countries are quietly forming what may one day well be the most powerful trading alliance on the planet.
In the meantime, until it becomes clear that this China-Japan connection can pump up the Japanese economy, there's another Asian market – actually, one of the "Four Asian Tigers" – that's clearly worth a look as an alternative.
And that market is Korea.
Korea's Profit Promise
The Korean government recently improved with the election of president Lee Myung-bak and a pro-business party with a substantial majority. Korea's economic growth is likely to accelerate, particularly if we have seen the worst of the commodity and energy bubble, since Korea is primarily an importer of commodities and energy goods.
The Korean stock market has been beaten down this year, dropping 20%, and currently trades at only 10 times earnings. But this low valuation is undeserved, since the Korean economy is expected to grow at better than a 4% clip for both this year and next, according to the respected global-economics magazine, The Economist.
Take a look, for example, at the Korean exchange-traded index fund (ETF), the iShares MSCI South Korea Index Fund (EWY), which tracks the Morgan Stanley Capital International Korea index. The ETF currently carries a Price/Earnings (P/E) ratio of 10.3 and features a dividend yield – after expenses – of about 1.9%.
[Editor's Note: For additional insights on Korea, check out Money Morning's investment research report: Why South Korea is set to Become the Biggest Economic Story of 2008. The report is free of charge. For broader investment insights on Asia in general, check out our research report on the once-in-a-lifetime profit plays being created by China's emergence – and find out how you can get a free copy of investing guru Jim Rogers' bestseller, "A Bull in China." Money Morning recently ran a two-part story (Part I and Part II) detailing our most recent exclusive interview with the global-investing guru.]
News and Related Story Links:
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- Money Morning Economic Analysis:
The Lost Decade: How the U.S. Financial Crisis Resembles Japan's Ten Years of Misery – And How to Play it (Part I of II).
- Money Morning Economic Analysis:
The Lost Decade: How the U.S. Financial Crisis Resembles Japan's Ten Years of Misery – And How to Play it for Profit (Part II of II).
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Two Ways to Profit as China and Japan Quietly Forge the Most Powerful Trading Alliance in the World.
- Money Morning News Analysis:
Japan Plans Stimulus, but Economy Still Likely to Fall into Recession.
Japanese National Diet.
Democratic Party of Japan.
- Money Morning Foreign Market Analysis:
Six Ways to Capitalize on Korea's Growing Global Muscle.
- Money Morning (Free) Investment Research Report:
Why South Korea is set to Become the Biggest Economic Story of 2008.
Four Asian Tigers.
- Money Morning Exclusive Jim Rogers Interview From Vancouver (Part I):
Exclusive Interview: Jim Rogers Predicts Bigger Financial Shocks Loom, Fueling a Malaise That May Last for Years.
- Money Morning Exclusive Jim Rogers Interview From Vancouver (Part II):
Exclusive Interview: Jim Rogers Continues to View China as the World's Best Long-Term Profit Play.