Beware Japan's phantom recovery

COULD JAPAN be the great buy of 1999? While all eyes have been on Wall Street's run, Tokyo's Nikkei has emerged from the shadows to become the best-performing major market in the world this year.

Not bad for a country still wallowing in the depths of its worst postwar recession. The rush of money into Tokyo is drowning out the warnings of the pessimists, but they may yet have the final word.

Encouraged by some promising signs of an imminent recovery, foreign investors have been on a near-panic buying spree this month, spending a record 777bn yen (pounds 4bn) in the second week of March alone.

"The market went up 700 points in one day, and you had a lot of foreigners suddenly thinking that something had changed and they bought. They didn't have time to think what to buy, they just bought," said Garry Evans, strategist at HSBC Securities in Tokyo.

The Nikkei is ahead a sharp 12 per cent on the year. In comparison Wall Street, for all the talk about the 10,000 barrier, has risen by only 5 per cent and the FTSE has inched up a sluggish 3 per cent.

But then Tokyo's market often rallies at this time of year and Japan's central bank has helped, pushing down short-term interest rates and driving investors from the bond market to stocks.

Optimists have taken their cue from a string of indicators that show the slowdown is stopping. "All the signs have been flashing," said the bullish Richard Jerram, chief economist at ING Barings in Tokyo.

Industrial production and household spending are no longer falling, business confidence appears to be reviving and bankruptcies are on the decline.

"Being aggressively underweight on Japan looks like too big a risk too take," Mr Jerram said. "The overall situation has gone from a pretty nasty recession to stability. It is quite feasible you could get a positive cycle developing."

It's almost enough to make you believe Tokyo's elderly finance minister, Kiichi Miyazawa, who earlier this month said: "The tide is turning." Astonishingly he predicts a recovery as early as May, although few others would go quite that far.

But the appealing pick-up in these indicators is mainly thanks to 40,000bn yen (pounds 210bn) in government public works spending last year. When the effect of this dries up, the indicators will quickly lose their shine and the pressure will again mount on Tokyo for yet another stimulus package. This high-spending policy has held back a recovery in private demand this decade and served only to balloon Japan's deficit.

Perhaps investors are right to be excited about the feeling that corporate Japan has finally decided it must drastically restructure, even if that means cutting staff despite the entrenched job-for-life culture.

The electronics giant Sony, in particular, has shaken the market. Here was a healthy blue-chip, which had just reported strong third-quarter earnings, announcing that it would cut 10 per cent of its staff, close plants and reorganise its business.

If a totem such as Sony can do it, surely the hundreds of troubled companies across Japan could follow suit. "Sony has had the biggest psychological impact. Here was a company that didn't desperately need to restructure. In the past companies only restructured because they were making big losses," said Mr Evans of HSBC.

Sony's president, Nobuyuki Idei, realised that the future for the company lay not with the televisions and videos that have brought it this far, but with the Internet and related businesses. He even admitted to concerns about overcapacity in the firm's electronics plants.

The market has defied conventional wisdom by assuming that some companies can still offer good returns to shareholders despite the economic wasteland that lies around them. It believes others will follow Sony's lead. "The expectation is that somehow corporate assets are going to be delinked from the economy. Will the momentum continue? Probably," Mr Evans said.

Yet Sony has never been a conventional Japanese company, and a good slice of its profits come from abroad. There are all too few signs that the other major blue chips that make up Japan Inc are likely to be as ruthless in their restructuring.

Even at Sony the job cuts will come through natural attrition - by not hiring new employees and not replacing retired staff. But at least Sony is cutting plants and looking in new directions.

Take NEC, a leading but loss-making electronics manufacturer. Its restructuring involves a similar 10 per cent staff cut, but other key proposals are based on little more than temporarily reducing capital spending, management expenses and executive pay.

"This wouldn't be called restructuring in the West," said Hiroshi Kuribayashi, head of Japan research at Barclays Capital in Tokyo.

Instead the firm should be leading the way with actual redundancies and rewriting the book on management techniques to promote staff by merit, not by age, he said. Restructuring in Japan has to come, but it will be years, not months, before shareholders see a genuine return on their investments.

Then there are the banks. Banking stocks have been the real winners in the Nikkei's surge because Tokyo is finally doing something to tackle the bad loan problem that has plagued the country since the speculative bubble burst early this decade.

Later this month the government will inject more than 7,400bn yen (pounds 38bn) into 15 of the largest institutions to help them write off bad loans.

Shares in the market leader, Tokyo-Mitsubishi Bank, are up by 42 per cent on the year, and stock in Dai-Ichi Kangyo Bank has jumped 37 per cent.

But Japanese banks have a mountain of bad loans; not just those left over from their reckless lending in the 1980s, but also others that are souring now in the current recession.

Even Hakuo Yanagisawa, the minister in charge of fixing the banking crisis, is in sombre mood. He has already nationalised two banks and forced others to merge with rivals.

"I am not in a position to celebrate what is happening now. We have just started," he said last week. It will be years before the banks recover.

The chance of a dramatic turnaround in Japan's fortunes in the coming months is slim, and there is a chance that the economy could sink yet further. With the Nikkei strong for the moment, policymakers are in danger of taking their eye off the drive for recovery.

"A lot of problems are solved by the market going up and the sense of crisis becomes much, much weaker," said Brian Rose, senior economist at Warburg Dillon Read.

The Nikkei rally has already proven its fragility, with the index losing 6 per cent in just two days of profit taking last week. Japan may be an attractive buy now, but that is unlikely to last.