It is not difficult to find reasons for being pessimistic about Japans economic future. Low growth, chronic deflation, a record fiscal deficit, a rapidly ageing population and now the near certainty of being eclipsed by China are just some of them. Yet prime minister Yukio Hatoyamas still young Democratic Party of Japan-led (DPJ) government is gambling on turning the situation around.
Since seizing power last September from the Liberal Democratic Party (LDP), which had ruled Japan for half a century, the DPJ has been putting together a strategy for changing Japans basic orientation away from the West and more towards Asia; away from exports and more towards domestic demand, and away from bureaucrat-dominated to politician-led government.
The strategy is expected to be unveiled in June when the DPJ publishes its manifesto for a critical July election, which could give the party an absolute majority in the upper and lower houses of Japans parliament and the power to enact reforms without opposition. With the LDPs power base crumbling, this seems likely despite the DPJs own problems.
One man who believes that the strategy can work is Eisuke Sakakibara, former vice finance minister for international affairs and more recently an adviser to Hatoyamas DPJ. Meanwhile, he plays down some of the problems facing Japan, such as deflation and the fiscal deficit, and argues that these are not reasons to be pessimistic about the countrys future.
Deflation has brought consumer prices in Japan down to a 17-year low, and some fear it could deter consumption and investment, resulting in a double-dip recession and
possibly a deflationary spiral. But Sakakibara argues that deflation is due to the rise of China and other emerging economies as sources of cheap goods and labour and that Japan will adjust to it.
Others, such as chief economist Richard Jerram at Macquarie Securities in Tokyo, worry that the high real interest rates implied by deflation are strangling Japan, while former Bank of Japan official Masaaki Kanno, now chief economist at JP Morgan in Tokyo, fears that low nominal rates are driving government over-borrowing, which could spur a fiscal crisis.
The government is expected to produce a plan for cutting the deficit, but Sakakibara is relaxed about it. The fact that government outstanding debt has reached 200% of GDP will not trigger a fiscal crisis, he says, as nearly 95% of the debt is held internally and Japan has household savings equal to 300% of GDP, a current account surplus and $1 trillion of foreign exchange reserves.
While markets are focused on fiscal deficit and deflation, the thrust of underlying reforms in Japan is being missed, Sakakibara says. By stepping up social benefits such as child allowances, and legislating an increase in minimum wages, the DPJ is aiming to increase domestic consumption, which will reduce Japans chronic dependence on exports. It should also help to alleviate the population decline by encouraging larger families.
A reversal of current demographic trends is critical if Japan is to avoid a future crisis. Japans population is projected to decline by 10% as early as 2030 and by 30% in 2055. There is also a low possibility that Japan will accept immigration to offset this, says Nomura Research Institute. Contracting GDP and a rising social security burden loom as a result.
Probably the most radical and most difficult of the orientation shifts planned for Japan by the Hatoyama administration is that of achieving what the prime minister terms a more equal and more arms length relationship with the US than has been the case since World War II, and at the same time a closer relationship with China and east Asia.
Controversial though this is turning out to be especially in generating friction with Washington over the relocation of US military bases in Okinawa the shift is simply bringing Japans foreign policy into line with economic reality: China became Japans biggest single trading partner in terms of imports and exports last year, displacing the US in this regard.
China has also become a major investment destination for Japanese businessmen, who see it as a key production base where Japanese technology and production know-how can be combined with Chinas huge and relatively low-cost work force, according to the Japan External Trade Organization (Jetro).
Chinas economy looks certain to overtake Japans in terms of overall size this year, assuming that China achieves its targeted 9.5% growth in real GDP while Japan will be lucky to achieve 1.52% real growth (with even that boosted by deflation, while nominal growth will be nearer 1%).
The significance of this for Japan is not so much that it will slip into third place behind the US and China although not in terms of per capita GDP where it remains well ahead of China but that it confronts the nation with deciding where its future lies: with the US or with China. Japanese businessmen are poised to favour China in their future investment plans and trading strategies, and official Japan may not be far behind.
Japans leading business lobby, Nippon Keidanren, organized the first meeting of business lobbies from across Asia, including China, in March to push for closer integration of the regions economies. For a long time, the West has led the global economy, but now the wind is blowing from the east, says Keidanren chairman Fujio Mitarai. Japan-China cooperation is being stepped up at government level too.
Japanese industry is adjusting to these changing realities. With exports of automobiles and high value-added electronic consumer goods to the US and Europe slumping in the wake of the financial crisis-cum-global recession, the need to seek comparative advantage in new areas is being realized.
Infrastructure building in emerging economies is one of these areas. Jetro has set up a special support division for Japanese firms bidding on infrastructure contracts overseas after the recent losses by Japan, bidding for nuclear power contracts in Abu Dhabi and Vietnam that went to South Korean and Russian contractors. The DPJ election manifesto will also include measures to strengthen Japans competitive position in marketing infrastructure services overseas.
Jetro is also urging corporate Japan to focus on what it calls the BOP (base of the pyramid) market in emerging economies for relatively low value-added goods, ranging from cheap computers and educational aids to medical and environmental devices. Poorer consumers of today will be the middle classes of tomorrow, Jetro argues. Corporate Japan must be prepared to lower its sights for a while to enter the new so-called volume zone of tomorrow.