With a change of government, after 50 years under the LDP, Michael Wilson assesses the outlook for Japan.

It’s fair to say that nobody was very surprised when Yukio Hatoyama, the leader of the opposition Democratic Party of Japan, swept to power during the national parliamentary elections at the end of August. Or that 50 years of almost unbroken rule by the ruling Liberal Democrats had finally come to a dramatic end.

For months, the opinion polls had been flagging up all-time lows for the outgoing prime minister, Taro Aso, who had been in office for less than a year. And nobody would have denied that the mood on the high street was little short of catastrophic.

Unemployment was getting steadily worse, consumer spending had stalled and there seemed no hope at all.
Even so, the sheer size of August’s electoral landslide seemed a bit harsh on Mr Aso, whose conservative political style had helped him to avoid at least some of the policy mistakes that other world leaders had been making during a year of global economic crisis. His latest stimulus package had done quite a lot to help Japanese businesses get back on their feet, and his foreign policy management had been reasonably adept. But the unavoidable truth was that, after half a century of LDP rule, the voting public were simply hungry for new ideas. It was time to give somebody else a chance.

Sitting tight
Unfortunately, a month after Mr Hatoyama’s victory we were still waiting for him to say anything much about what he intends to do. The new premier says he wants to modernise the economy, cut Japan’s hefty government spending bill and pursue an active foreign policy. Just like his LDP predecessors, in fact. And Japanese business opinion is openly sceptical about his chances of turning the country around. The Keidanren, the country’s biggest employers’ federation, was always a solid LDP supporter, and it says it’s not impressed with the new premier yet.

That’s a pity, because some of the indicators are looking quite good. The latest figures show that the economy grew by 3.7 per cent in the second quarter of 2009 – largely because of Mr Aso’s temporary stimulus package, says the Keidanren. For the year as a whole, the sceptics are still expecting a 6 per cent decline in the national economy, because they say the export situation has been so dire in recent months. But the stock market has been bouncing quite nicely, with a 50 per cent rise since its March low that has taken the Nikkei 225 index all the way to 10,500 in mid-September. You won’t find many developed world markets that have made that sort of growth in the past six months. But can the optimism last?

A downward spiral
Optimism, say the sceptics. What optimism? Let’s remember that 30 months ago the Nikkei was at 18,000. And that its all-time high of nearly 40,000 in December 1989 was almost four times what it is today. Yes, Japan’s stock market investors have lost three-quarters of their savings in two decades. Property prices are barely half what they were in the 1980s, and anyone who was relying on his house to pay for his retirement is now looking at a miserable old age. Meanwhile, high unemployment is making consumers reluctant to spend. Consumer prices actually fell by 1.8 per cent in the year to June – a sure sign that everyone is feeling the pinch.

Things aren’t much better on the international front. Japan’s exporters have been suffering hideously from the strong yen and the weakening dollar. Japan’s foreign sales in July were 36.5 per cent down on the levels of mid-2008, which suggests that the optimists’ hopes of a quick recovery are probably a bit premature. Sales to the US fell by 39.5 per cent year-on-year, and Japan’s exports to China were down by 26.5 per cent, with a big drop in steel sales. But the worst news came from Europe, where the EU’s purchases of Japanese goods were down by a massive 45.8 per cent.

Indeed, the only real consolation was that Japan’s imports were also down by 40.8 per cent, mainly because of lower fuel prices (which have since gone up again). And besides, a steep fall in imports doesn’t look so much like an improvement – more like a sign that Japan’s industries are scaling down their operations for the medium term. Overall, Japan’s trade surplus for the year to June was just US$9 billion – barely half of what it had achieved in a single month during early 2006.

Time for change
But Mr Hatoyama’s biggest challenge, as he himself acknowledges, is to bring about a fundamental change in the structure of Japan’s economy. The prosperity of the post-war period was based on a manufacturing economy that turned out cars, computers, audio systems and motorcycles for affluent export markets. But these days Japan’s role has been largely grabbed by cut-price manufacturing centres in other parts of Asia.

Of course, many of these operations are still being run by the usual Japanese brand leaders, who are simply setting up offshore subsidiaries. But the difference is that they’re now creating foreign manufacturing jobs instead of Japanese ones. And it’s also the Japanese jobs that get the axe whenever the pressure is on. When Toyota needed to reduce its global car production levels last year, it opted to chop its domestic output by a third but to keep its other production centres running almost at full throttle. No wonder people are depressed.

So now it’s all down to whether Mr Hatoyama can rejuvenate the service sector to take manufacturing’s place in the economy. And that’s a problem. Japan’s service industries have never been exactly famous for their vitality or their inventiveness – a legacy, some say, of the old Japanese school system that discouraged individuality and independent thought in favour of teamwork and conformity. So, although Japan’s banks and insurance companies are among the worlds largest, they’re hardly powerhouses of whizz-bang innovation.

In some ways, of course, that’s a good thing. The past 12 months have taught us that whizz-bang banking is a dangerous thing –  and, sure enough, Japan’s ultra-conservative banks have mostly escaped the global upheaval that have scarred Europe and America’s financial institutions. But Japan’s banks are still stuck with vast burdens of outstanding loans to struggling businesses, which wouldn’t be so bad if they didn’t also own huge blocks of shares in those same businesses. They have a lot to lose if things don’t work out well.

Can Mr Hatoyama pull it off? If not, it certainly won’t be for want of trying. But his party has no experience of ever being in power, and the business community is not helping him much. For an investor, the best hope is that the rising tide of world stock markets will lift a market that’s been scarily volatile in recent years – but which is still quite undervalued, historically, by its own standards. Here’s hoping.