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How Japan shaped Asia's future

May 25, 2005

Most investors, both globally and in the region, have more or less given up on Japan. When was the last time you heard of anyone mention Japan as an important input into their decision-making on Asia.

Everyone knows the country has the lowest RoE (return on equity) of any of the major global markets, an ineffective and stagnant corporate sector that has been trying to restructure itself for the past 15 years, and little regard for shareholder value creation.

Most people are also aware that the Japanese market has gone through a wrenching 15-year bear market, with the Nikkei dropping from nearly 40,000 (1989) to current levels of 11,000-odd.

The Japanese economy has also gone through a crushing deflationary episode with almost no economic growth over the last decade.

The demographic issues faced by this homogeneous island nation are also well flagged. Japan's National Institute of Population and Social Security Research has estimated that the country's population will shrink from 127 million in the year 2000 to 92 million by 2050, and 46 million by 2100.

Based on the same projection, the number of people aged 65 years and above will increase from 17 per cent currently to a peak of over 41 per cent by 2070.

If these demographic projections are even near the truth, then why bother figuring out this country, the bears argue, for it is bound to become irrelevant.

You may wonder, what is the connection between Asia and its financial markets, on the one hand, and Japan, on the other?

Asia is a young, dynamic, rapidly growing economic bloc with rising financial markets, the exact mirror image of a Japanese economy mired in deflation and enduring a 15-year bear phase.

Current investors in Asia may be either too young to know or old enough to have chosen to forget, but the fact is that Japan was an important factor behind the strong performance of the Asian markets in the late 80 and early 90s.

Investors have got so used to writing off Japan that one can forget how big and powerful the country remains in economic terms.

Despite 15 years of secular underperformance, Japan even today is the second largest economy in the world, accounting for 12 per cent of global nominal GDP (2003 in dollars).

The rest of Asia, in contrast, accounts even today for only 11 per cent, with China's contribution being 4 per cent. Even on the basis of the IMF's PPP (purchasing power parity) metric, Japan remains the third-largest economy in the world.

Its size and prominence would not be intuitively obvious, given the lack of attention paid to this slumbering economic giant by Asian investors, even more so when compared to the hype and hoopla surrounding China.

Investors also forget that as recently as 1990, Japan had a percentage share of global stock market capitalisation higher than that of the US.

Japan's share of world stock market capitalisation peaked at 40 per cent in 1988 (the US share was 29 per cent) before declining over the past 14 years to its current weight of approximately 10 per cent.

During its bull run of the late 1980s, Japan had an important and positive influence on the rest of Asia in many different ways.

It was held up as the premier example, from both a macro and micro perspective, of the huge growth opportunities that Asia could look forward to.

It provided a template in terms of high savings rates, work ethic, and export domination as to how the Asian miracle would spread throughout the region.

From a macro standpoint, the reference was to Japan's growth spurt from 1960 to the mid-1980s, when it had the fastest economic growth rates in the world.

From a micro point of view, the success of Japan's automobile manufacturers and consumer electronic firms in taking market shares in the western world were examples that all Asian companies could aspire to.

Japan's phenomenal success gave investors the confidence that this growth and industry leadership will spread throughout the region.

A new template for economic success was established, which investors then used to search for the next Japan. The huge financial returns captured in tracking Japanese stocks through the 80s encouraged investors to broaden out in search of new countries/companies in the region where they could duplicate these returns.

Besides providing a crucial precedent for what was economically possible, Japan also dominated the regional investment scene and for a short period even the global investment backdrop.

By the end of 1998, Japan accounted for 91 per cent of Asian market capitalisation and 40 per cent of global capitalisation, compared to 29 per cent for the US.

At that time investors in Asia looked towards Tokyo for short-term market direction not New York. Brokers would worry more about the Nikkei's trading pattern instead of fretting over the previous night's Nasdaq close as they do today.

Japan was the mother market that made the entire region relevant, worth visiting and exploring. For how could anyone ignore what was the world's largest market?

Once physically in Asia, investors' awareness and understanding of the smaller Asian markets inevitably rose as well.

By the time the Japanese bull run was in full flow in the late 1980s, it offered investors elsewhere in Asia a very profitable arbitrage.

As equity valuations in Japan expanded, the smaller markets in Asia looked increasingly cheap. By the end of 1989, MSCI Japan was trading at 46 times forward earnings, while MSCI Asia-ex Japan was on 11 times (source: CLSA).

This huge valuation differential encouraged flows into the regional Asian indices, increasing multiples across the region.

Japan, therefore, in my view, played a very important role (one not really acknowledged these days) in raising the profile of the smaller Asian markets and strengthening the emerging Asia equity story.

Indeed, as many people who were actually there will tell you, had the huge run in the Japanese equity markets not happened, the development of the broader Asian equity markets would have been much slower and subdued.

This supposition rings even more true when you consider that in the early 90s most European funds had more money in Asia than in the US markets.

An Asia that Hong Kong, Singapore, and Malaysia dominated (accounting for more than 75 per cent of the regional indices, as China/India/Korea/Taiwan were not fully open to foreigners).

It is hard to imagine these three markets gathering so much attention on their own, without the influence of Japan.

Asia also benefited economically from Japan's growth and prosperity during this period. This happened in a three-stage process:

First, growing FDI into Asia from Japanese manufacturers shifting manufacturing facilities to low-cost locations to combat a strengthening yen.

Secondly, Japanese banks significantly hiked their lending to the region as they followed their corporate clients offshore.

The Japanese banks at one point (end 1988) accounted for 44 per cent of all bank foreign claims on Asia, and 95 per cent of the increase in these claims between 1984 and 89.

Japanese banks were by far the most aggressive lenders to Asia at this point.

Finally, there was the deluge of Japanese portfolio investment in Asia, which peaked in 1993 along with the regional markets.

Japan will recover, that much is for sure; no country of its significance and intellectual capability can remain down forever.

Given the length of its bear market, most investors have forgotten how much of a tailwind a strong Japanese economy and financial market can be for the rest of Asia.

This tailwind should be even stronger today, given how much more economically aligned Japan is with Asia currently as compared to the late 1980s.

As Japan eventually recovers and comes out of its 15-year slumber, its tailwind will help Asia just when no one is expecting it to.

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Number of User Comments: 2

Sub: Recommendation on books

Well caught, Nitesh! Would you or the author know of any book that chronicles the Meiji transformation, Japan\'s subsequent rise and stagnation? A recommendation on ...

Posted by Mahesh

Sub: hope it's just a typo!

"By the end of 1998, Japan accounted for 91 per cent of Asian market capitalisation and 40 per cent of global capitalisation, compared to 29 ...

Posted by Nitesh Khandelwal


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