The Daily Interview: Is Japan Headed For a Recession?

Matthews Japan Fund's Mark Headley analyzes the prospects for a turnaround following Monday's weak GDP report.
By Diane Hess ,

A weaker-than-expected GDP report from Japan yesterday has investors worried about the second largest economy in the world once again.

The Japanese economy contracted by 0.2% in the first quarter, signaling that the country could be in danger of falling into a recession, its second in two years and its fourth in the past decade.


Mark Headley
Portfolio Manager,
Matthews Japan Fund

Recent Daily Interviews

Bank One Investment Management's
Tim Drake

U.S. Chamber of Commerce's
Martin Regalia

Gerard Klauer Mattison's
David Bailey

CIBC
World Markets'
John Corcoran

Commonfund's
Michael Strauss

Author
Benjamin Mark Cole

We talked to

Mark Headley

, portfolio manager of the

(MJFOX) - Get Report

Matthews Japan fund and president of

Matthews International

, a fund company that specializes in Asia, to help us figure out the significance of the latest GDP numbers for the future of Japan's economy.

With a new prime minister,

Junichiro Koizumi

, elected in April, Japan has a new lease on life. Koizumi, a rock n' roll fan, is trying to represent a new generation in Japan and is doing it, so far, with broad support. His task, says Headley, is to use his popularity to crush the factional politics of the ruling party, the

Liberal Democratic Party

, and restructure Japan's economy.

Over the past decade, U.S. investors haven't been wildly enthusiastic about Japan. To wit: the Matthews funds have $300 million under management in its Asia funds, but only $10 million in its Japan fund. In a

Daily Interview back in March, Headley recommended that investors stay away from Japan. Whereas the Matthews China fund is up 50% year to date with $30 million under management, the Japan fund is flat for the year.

TSC: What does Monday's GDP result mean?

Headley:

The report means that Japan is probably slipping into a recession. But the real issue is what it means for government policy, what it means for the leadership

the

Liberal Democratic Party

in general, and for

Prime Minister Koizumi

, in particular. Koizumi is running very high in popular support. Will that be maintained in the face of continued economic weakness?

It doesn't matter much if the economy is growing 0.2% or shrinking 0.2%. Japan needs to figure out the best proposal to address the situation. The $64,000 question: Can Japan be successful in bringing about painful restructuring in the middle of an economic slowdown? Or, does it try to get economic growth back on track before it makes bank write-offs?

To be perfectly honest, there are pros and cons to both solutions. On the one hand, Japan needs to convince people it is determined to restructure. If the world believes the country is restructuring, the exact time and pace of it is less important. People need to get the sense that the LDP is not just mouthing, that they aren't going to find a way out of it because they are beholden to the interests that need to be restructured.

TSC: What kind of urgency does an impending recession give Japan?

Headley:

Recession puts pressure on people to actually do something. There has been a sense that, somehow, economic growth will come back. But no, the country is really going to have to push through a number of painful changes. It's going to have to see a lot more bankruptcies. And while there is a limit to how many bankruptcies an economy can take, as long as they have government support, within a grander scheme of taking the economy to sustainable growth, foreign investors will stand up and cheer.

I would like to see pressure on the government and political parties. The opposition,

the Democratic Party of Japan

is using this opportunity to put forward a comprehensive list of changes. I think Koizumi is adopting a pretty significant number of them. The question is, can they actually be implemented in the LDP framework? Either, the LDP starts to get the country back on track, or Koizumi's star is going to fall. At that point, it may well be the end of the LDP.

TSC: What has he done to address weakness in the economy?

Headley:

Japan hasn't put out a hard and fast proposal for how it is going to stimulate the domestic economy and resolve the bad debt. Obviously, the bridge-to-nowhere policy of the last 10 years doesn't work. I think Koizumi has rightly moved to end subsidies to the construction industry, which were having no productive benefit.

He has brought a certain sense of urgency. He has said we need to bite the bullet; we are going to suffer some pain over the next twelve months. What needs to happen next is for the

Bank of Japan

to print money. The money growth in Japan is totally anemic. They are still in a deflationary trap and they've got to flood the economy with liquidity. We do it here and the dollar doesn't crash.

We watched deflation kill the bottom line of so many Chinese companies. And the government took a number of dramatic steps in terms of spending. They added 50% to the salaries of all public officials, for one thing. Now, the rate of growth in China is slowing, but the domestic economy is booming. That's what Asian companies need to strive for in a period of slow global economic growth.

TSC: Where does Japan stand now in its restructuring?

Headley:

We haven't really seen the details of Koizumi's policy. But he has put a focus on the economy, which everyone appreciates. He's saying we must deal with the bad-debt problem. The banks are burdened and if the banking system is dysfunctional, it's a blockage to the entire economy. Japan needs to fix the banks and stop relying on poorly spent public funds and find other ways to stimulate growth.

Underneath it all, the restructuring of Japan on a micro-basis is going forward. But it's happening very slowly. And companies are doing it against enormous social resistance. To fire people in Japan is still a traumatic thing. The labor force, in general, is inflexible. What that means is Japanese companies are moving their operations to China, or to the U.S.

TSC: How has consumer spending held up?

Headley:

It's down and has been trending down for the last six months. Wages aren't growing and job losses are creeping up. To a certain extent, these are all signs of restructuring at the micro-level. Japanese are undoubtedly overpaid relative to Chinese employees. Why anyone is making things in Japan, as opposed to China, is beyond my comprehension. Yet, there are still significant domestic industries making things that could be made at a fraction of the cost in China.

A lot of industries in Japan are non-competitive globally. It's the same thing we went through in the U.S. Japan did it to us in the '60s. Korea and Taiwan did in the '70s and '80s. Japan is facing the exact same pressures, and they simply have to let the economy adjust. They need to deregulate and allow entrepreneurs to develop new businesses. There is enormous resistance to that. It is harder for wealthy nations, than it is for poorer ones, to change. They simply don't have the gun to their head.

TSC: How much is the U.S. exposed to Japan's woes?

Headley:

Japanese consumers have not been consuming for a decade. Despite a brief burst in '99, the economy has been in pretty grim shape for most of the last decade. U.S. imports to Japan are not a huge factor. And there is a growing

willingness to give the U.S. opportunities there. There isn't anything particularly ominous going on in Japan. What we're seeing is that the U.S., Germany and Japan are all slowing down at the same time. That's ominous.

TSC: What is the impact of a weakening yen?

Headley:

Should the yen weaken, that would be bad for the U.S. It's gone from 107 to 122 in the last five or six months. That's hard on U.S. companies. While

Toyota

may build most of its cars here, there are still a lot manufactured in Japan and shipped around the world. If the yen weakens significantly, it hurts the

Motorolas

, it upsets the

IBMs

, and it makes life more difficult for

Intel

. It also makes it tougher for Taiwan, Korea and Singapore.

TSC: What's your strategy now for investing in Japan?

Headley:

We tend to own what we own in all our Asian portfolios, financial, consumer retail, and technology stocks. We have roughly 25% of our money in each one of those sectors and 10% of it in pharmaceuticals as a fairly defensive play.

I believe the brokerages have been restructuring in Japan, and they will be the prime beneficiaries of any recovery in the Japanese economy. So, that's a fairly aggressive position. We're saying, "Hey, it's impossible to say when, but we do believe sooner or later that Japan is going to come out of this." There is a bull market out there. Owning these brokerages gives us exposure to the financial system without all the bad debt.

There are a lot of innovative companies delivering products to Japanese people, whether Chinese-made goods or auctioning systems. Consumer retailers are doing a good job of gaining market share in a pretty stagnant market. Finally, Japan has some of the best technology companies in the world. Of all the New Economy spin, what we believe in is entertainment.

Nintendo

and

Sony

are core gold through thick and thin.

Technology in Japan is, ultimately, alive and well. They are restructuring; there is a lot of IT work to be done to catch up with the rest of the world. Companies will benefit from that. I don't own

NTT DoCoMo

, because I can't justify the price. But I own

NTT

, because it's a way to get exposure to DoCoMo, which is doing some very exciting things.

TSC: Are you making any changes in your approach, based on the new numbers?

Headley:

I think these economic numbers are already reflected in the market to a large degree. There hasn't been a lot of optimism in the Japanese market. It

the

Nikkei

hit a 16-year low in March. Yes, we've bounced off of that. But I think these numbers are simply a confirmation of what most investors already knew.

There is no quick fix for Koizumi. But if he is the right guy, sentiment will gradually improve. The story in Japan is about restructuring and it's about micro -- company by company -- change. Koizumi is going to make mistakes and he's not going to be perfect. But I love it when he stands up there and says, we have to tighten our belts and the next 12 months are going to be tough. That's not a popular message for a politician to deliver. But he's got the guts to deliver it. And the Japanese are giving him real credit for it, which is a big change for the country.

Loading ...