Japan's strength is lost in translation
The country's economic fundamentals are being overlooked because of the hot new competition

Pedestrians cross a busy street in the Shibuya Ward of Tokyo on May 30, 2011. Japan has transformed its economy from a big-box producer to a central part of the global supply chain.

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  • Japan's impressive manufacturing is often overlooked because of the hot new competition @michaelauslin

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  • The Japanese economy's stagnation leaves it in the curious position of getting little respect

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  • What threatens Japan's economic health? Political inertia and misguided policies @michaelauslin

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With the euro zone now on the brink of implosion, weakness in the U.S. economy and rising concerns over China's sustainable growth, is Japan the economic tortoise to the rest of the world's hare?

Japan's economic performance has largely been written off over the past two decades. It shouldn't be—reform could build on the country's strong fundamentals.

"Japan retains the building blocks of a world-class economy." --Michael Auslin

Japan's impressive manufacturing is often overlooked because of competition. Although it is surpassed by China, Japan remains the world's second-largest steel producer, at 109 million metric tons. Japan also remains a major auto maker, with four companies among the top 10 global manufacturers, although South Korea, Germany and the U.S. have reduced Japan's old qualitative lead. The story is the same in consumer electronics, where world-class companies like Sony, Toshiba and Panasonic face competition from South Korean and Chinese businesses.

Despite a decade spent cleaning up bad banking loans, Japan has transformed its economy from a big-box producer to a central part of the global supply chain, as became evident after the March 11 earthquake and tsunami. This steady evolution has gone all but unnoticed as China has taken the lead in producing and exporting lower-end consumer goods and in assembling electronics whose parts come from Japan and the U.S.

Thanks to its macro stagnation, the Japanese economy gets little respect. But some recent data points show how the microeconomic picture in Japan may be rosier than the macro view.

Many of its companies remain not only globally economically viable but also, as recently noted in Canada's Financial Post, a decent investment. Canon, Honda and Takeda Pharmaceutical have had returns of well over 100% since the collapse of the Japanese asset bubble back in 1990.

Last week, Warren Buffett made his first visit to Japan and dropped hints that he was looking for a billion-dollar investment opportunity. Moreover, the Japan Times recently cited a New York Stock Exchange survey in which over a quarter of 371 CEOs indicated that Japan was "crucial or important for their companies' future growth."

Japan retains the building blocks of a world-class economy. While its infrastructure is aging and needs to be renewed, it has a highly skilled, literate work force and spends nearly 3.5% of its gross domestic product on research and development, far outpacing China's 1.44%. Whereas China's state-owned enterprises have been getting larger and remain coddled from market forces, Japan's companies, relative to China's, have undergone restructuring, shed workers and hustled for foreign markets.

What does threaten Japan's economic health, however, is political inertia and misguided policies. Tokyo faces a turning point in securing Japan's economic future, especially with China starting to slow down. Success or failure will ripple throughout Asia and the world.

Japanese politicians have consistently refused to tackle the country's macroeconomic problems. Looming over everything is the public debt, which hit 220% of GDP in 2010. Because more than 90% of that debt is held domestically, Japan has so far not faced the crippling choices of Greece.

But as Japanese savers begin to spend their savings, the government may have to look for buyers for that debt outside Japan. That means raising interest rates, which have been near zero for decades. The moment this occurs, the high debt burden will hit the country. The ruling Democratic Party of Japan has been unable to come up with a credible debt-reduction plan.

Japan's corporate leaders share the blame, since they still harbor resistance to liberalization. The revelation of problems at Olympus (which makes cameras and medical equipment) only underscores concerns that businesses need far more transparency and global standards of accounting.

The country is also in danger of turning more inward. The number of Japanese students studying abroad has dropped precipitously, and even major corporations remain resistant to hiring foreigners for senior management positions, citing cultural differences, as the former CEO of a major Japanese trading company told me.

All this suggests that Japan needs more structural reform, particularly in three areas: reducing regulation, opening up to foreign direct investment, and expanding free-trade networks. Prime Minister Yoshihiko Noda's recent decision to join negotiations over the free-trade Trans-Pacific Partnership is a good start, but he needs to overcome opposition in his own party to assure full participation.

Moreover, the government must embrace deficit-cutting to help stabilize public finances. It should reject the pork-barrel politics that lead to ever more numerous recipients of subsidies and preferential treatment, like farmers and the construction industry.

Without such basic steps, Japan's macroeconomic picture is unlikely to improve. Worse, no reform may drag down the economy further, ultimately affecting those jewels in the crown of Japanese manufacturing.

Michael Auslin is a resident scholar at AEI.

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