Optimism in Japan gives way to fears of a market collapse

Is Japan about to sink into a fresh deflationary spiral, with catastrophic consequences for the world economy? Barton Biggs, Morgan Stanley's legendary stock market guru, is advising clients not to wait any longer for that elusive recovery in the Tokyo market and cut their losses. Richard Lloyd Parry assesses Japan's growing economic ills and finds that remedies are in short supply.

To casual foreign observers, the popular notion that Japan is on the verge of a recession has often seemed a laughable one. For all the genuine gloom here, and for all the big changes that are taking place within the Japanese economy, Tokyo still looks, smells and feels like one of the richest and most confident cities in the world.

All over the capital, buildings are torn down and thrown up again in an endless orgy of construction; in the streets immaculate teenagers still clutch pounds 500 handbags. At 3.5 per cent, unemployment is still the lowest in the industrialised world, and growth last year was the highest since 1991.

Since the bursting of the bubble economy in the early 1990s, Japan's re-entry into the real world has brought relative hardship - but to any European who lived through the economic slumps of the 1970s and 1980s, the self-pity which has enveloped Japan for the last two years has looked very like the sulk of a spoiled brat which had its own way for too long.

Even if the pace does not satisfy everyone, the government of Ryutaro Hashimoto has at least begun the job of reforming Japan's financial institutions and exposing them to much-needed competition. The country's banks have gone a long way to writing off the bad debts left over from the collapse of the bubble.

Last spring, the government's cleverest economist, Eisuke Sakakibara, put it into words when he spoke of the country's "irrational negative exuberance", and for a brief few weeks, Japan began cautiously to chirp up a little. Half a year later, that delicate dew of incipient confidence has evaporated completely, in the heat of a stiflingly dramatic summer.

Brave optimism has given way to almost unanimous pessimism in Tokyo: the question is no longer when the long-awaited recovery will get under way, but whether the stock market can pull itself out of a downward spiral which could have grave consequences far beyond Japan. After years of waiting for a rebound in the Tokyo stock market, many foreign investors are giving up on the country and ordering big reductions in their exposure.

The crisis has been precipitated by the wave of currency devaluations which swept through South-east Asia this summer, beginning in Thailand and spreading quickly to the Philippines, Malaysia, Indonesia and now South Korea.

The currency drama is taking its toll on Japan in two ways. For a start, there is renewed pressure on Japanese banks, whose Asian creditors suddenly find the cost of their yen-denominated loans soaring. And secondly, the country's exports are suddenly extremely expensive in countries where spending, both corporate and consumer, is being cut back anyway.

Some 46 per cent of Japan's exports go to Asia, and two-thirds of these are demand-sensitive goods. As their currencies have plummeted in value, Asians have less money to spend all round, and less inclination than ever to spend it on imported goods. South Korea, for instance, accounts for 7.1 per cent of Japan's exports: for every 1 per cent decline in Korean GDP, the amount of Japanese goods the county imports drops by more than 3 per cent.

According to Jesper Koll, chief economist of JP Morgan Securities in Tokyo, the decline is Asian growth will cut Japan's exports by 7 per cent in the coming year. Reduced exports will lead to reduced production, lower corporate earnings and then to reduced wages, overtime and finally reduced employment levels.

And if the fortunes of Japan's exporters are uniquely tied up with Asia, so are those of its banks. In Thailand, for instance, American banks have lent $5bn (pounds 3bn) to creditors whose repayments are suddenly 40 per cent more expensive than they were six months ago. For Japanese banks, however, the equivalent figure is $37bn.

The continuing wobbliness of the Japanese banking system, despite genuine efforts to write off and clear up the remaining bad loans of the bubble period, was emphasised last week with persistent but unconfirmed rumours that a major regional player, the Bank of Yokohama, was planning to sell its stocks in order to balance its books. Speculation - denied by the bank - drove the Nikkei share average down by more than 4 per cent.

Further concern about Japan's banks was expressed yesterday by IBCA, the international rating agency which said it was reviewing its ratings of Japanese banks downwards. IBCA warned: "The persistent failure of the Japanese economy to recover from its long period of stagnation is burdening banks with continuing asset quality problems, while the weakness of the stock market threatens them with large valuation losses on their excessively large holdings of Japanese equities."

The general sense of nervousness in the Tokyo Stock Exchange is compounded by anticipation of Japan's so-called Big Bang - the planned deregulation of the financial markets. The buffeting to which this will expose many firms is encouraging them to liquidate their assets to provide a safety net against imminent foreign competition.

The consequences of all this change are uncertain. In theory, deregulation, reform and the bracing winds of competition will in the long run whip Japan's companies and its economy back into shape. But the medium term is bleak. At best, the country faces a prolongation of the economic sluggishness which has already made it so miserable. At worst, a panic sell-off of stocks by Japanese companies could cause stock market collapses world- wide.

Modern Japanese are not used to biting the bullet and slogans like pain before gain are politically risky. The problem for Mr Hashimoto is that he cannot even release cash by cutting interest rates - because interest rates are virtually at zero anyway. In his last package, unveiled last month, the centrepiece was a feeble proposal to have more public holidays on Mondays, in order to encourage Japanese to spend more during their long weekends.

The most alarming thing about the present malaise is the almost complete lack of available remedies.