Nikkei hits its highest since twin towers attack - but is Japan's revival for real?

The IMF has described Japan's recovery as 'sustainable', though others disagree

Japan's normally reserved financial services minister Heizo Takenaka has a spring in his step these days. Plucked from academia to apply his reformist zeal to rusting old Japan Inc., Mr Takenaka can finally point to a series of rising economic dials after enduring withering criticism that his brand of tough medicine was making things worse.

Japan's normally reserved financial services minister Heizo Takenaka has a spring in his step these days. Plucked from academia to apply his reformist zeal to rusting old Japan Inc., Mr Takenaka can finally point to a series of rising economic dials after enduring withering criticism that his brand of tough medicine was making things worse.

The economy expanded 2.7 per cent last year, and at an annualised 7 per cent in October-December, its sharpest growth in 13 and a half years. Capital spending by manufacturers leapt 15 per cent in the same quarter from a year earlier, evidence of rising business confidence. And yesterday, the key Nikkei index closed above the 12,000 mark for the first time in 32 months, climbing more than 40 per cent since April 2003.

The economic revival was given the seal of approval recently by Horst Koehler, the managing director of the International Monetary Fund, who pronounced the recovery "sustainable" on a trip to Tokyo and praised Mr Takenaka personally for his efforts to clear Japan's mountain of bad bank loans.

After three false starts in the 14 years since the collapse of the bubble economy, you can almost feel the country collectively holding its breath as it waits to see if this time will be any different. But unfortunately the message from most economic analysts here in Tokyo is decidedly mixed.

On the optimistic end of the scale is Waichi Sekiguchi, a senior business analyst at the Nikkei newspaper. "I think Japan is on course for a slow, gradual recovery," he says. "The last time we were here, in 1997, the recovery was killed off by a new consumption tax, but we're in a healthier position now."

While he acknowledges that the current Japanese recovery is somewhat dependent on China, he is confident the Chinese government will keep its foot on the accelerator in the lead-up to 2008. However, the pessimists have lined up to pour cold water on these predictions. A typical view comes from the economist Noriko Hama in a recent Japan Times op-ed piece: "The ongoing recovery is nothing more than an extremely fragile, precarious and narrowly based pick-up in activity for large businesses that is more or less dependent on exports and the digital household equipment boom."

Most commentators at least recognise that Mr Takenaka's tough love has forced the big banks to prune the worst of their bad lending, and they accept that unlike the past two revivals, the latest upturn is not almost completely sustained by massive government spending.

Given the mind-boggling size of Japan's public debt, estimated to reach ¥720 trillion by the end of March 2005 (or 140 per cent of the nation's total economic output), the cabinet of Prime Minister Junichiro Koizumi has little option but to slash public works spending, which fell 12.3 per cent in the last quarter of 2003. Even this is not enough to guarantee a key Koizumi pledge to cap annual bond sales at ¥30 trillion; more than ¥36 trillion worth of new bonds are up for sale this year.

But government help comes in all shapes and sizes, and the sheer extent of Tokyo's intervention in the currency markets has raised eyebrows everywhere. Japan's currency reserves last month grew $35.61bn for the sixth consecutive month of increase, and the country now sits on a record $776.86bn, easily the largest reserve in the world and enough to earn a rare rebuke this month from the US Federal Reserve Board chairman Alan Greenspan. Recent reports indicate the intervention has ended, and not before time said Bloomberg economist William Pesek Jnr. in a commentary this week: "Now is as good a time as any to step back from the most aggressive effort to steer the currency markets in modern history."

The controversy over the dollar-buying spree may be new but the strategy is certainly not. Tokyo's aim is to shore up exports - particularly by large manufacturers - to the US and China (which accounted for about 80 per cent of this export growth last year, according to Merrill Lynch), by preventing the yen from rising against the dollar. It is an approach that is certainly boosting some of Japan's economic targets, says Kiichi Murashima, the director of economic and market analysis at Nikko Salomon Smith Barney in Tokyo: "We're basically seeing an export-led recovery based on manufacturing, and this has sent up corporate spending, especially in the manufacturing sector. There is no doubt about this recovery, but there is a lot of doubt about how widely this has spread among the rest of the economy. My view is that the recovery is still limited and that its spillover to the household sector is frustratingly slow."

One person who believes in the Japanese economy is Guy Hands, the UK financier who arranged $20bn of takeovers as the head of Nomura Holdings Inc.'s principal finance group. He suggests that Japan offers the best return for private equity investors this year as funding costs decline, adding: "Financing here is cheap and is getting more available."

But the pessimists say that while the government carefully tends to its large showcase exporters, Japan's much larger army of small manufacturers is being neglected, thanks to the breakdown of what Mr Hama calls the "trickle-down relationship" between parent and subcontractor, one of the key factors behind Japan's post-war miracle. Instead of turning to their traditional subcontractors, Toyota, Hitachi and the rest of the giants are increasingly looking for bargains overseas, meaning disaster for thousands of smaller firms and the millions of people who depend on them.

It is hardly surprising then that most of the optimistic notes about the economy are being sounded by corporate heavyweights such as the NEC chairman Hajime Sasaki, who believes that the economy has "finally turned the corner." The latest Tankan business sentiment survey, however, finds midsize corporate Japan, particularly non-manufacturers, as pessimistic as ever. The widening gap between successful and less successful firms in each industrial sector is one of the distinct features of the current recovery, according to Akira Kojima, the managing editor of Japan's business daily, the Nihon Keizai Shimbun.

Moreover, the billions thrown at the currency markets have not stopped the yen from appreciating to its highest level in four years, making Japanese exports more expensive, imports cheaper and stoking deflation, which is now in its fifth year. "The government's whole economic strategy depends heavily on this very narrow approach, which now seems to be losing steam," one analyst said.

Most commentators say Japan will struggle to achieve long-term economic recovery until it manages to coax consumers to open their wallets. While there has been a recent rise in sales of household digital products, deflation is still eating away at prices and assets, most consumers are taking home smaller pay packets, and there is more hardship to come, says Nikko Salomon, Smith Barney's Mr Murashima: "Tax on social security and pensions will be hiked this year and tax burdens on pensioners will be raised next year. The public pension premium will be raised every year for the next 40 years. These hikes will suppress spending. And nobody knows what else is coming from the government."

There are other ominous signs. Despite the market-pleasing mantra of reform that wafts from the cabinet office of Prime Minister Koizumi, some experts doubt whether Japan Inc. has really changed its ways. Japan specialist Ron Dore, a senior research fellow at the London School of Economics, recently said he believes many of the changes that have taken place are cosmetic. "There has been a distinct falling off in the reforming zeal since the American model was tarnished by the collapse of the Nasdaq stock market and the Enron scandal."

After more than a decade of slump, thousands of bankruptcies and millions of blighted lives, everyone is willing Japan on, and there is room for some optimism. "As long as global expansion recovery continues Japan will ride the wave, and we're certainly bullish about the US and China until next year," Mr Murashima says. But with a recovery so confined to one fairly narrow sector, few are willing to bet on how long it will stretch. Everyone is basking in the sunshine from the latest economic upturn, but the message from many commentators is, keep your umbrella near by.