JAPAN: Back From the Dead?
Big companies are raking in profits. But fiscal woes could still derail the economy.

(FORTUNE Magazine) – ARNOLD SCHWARZENEGGER may have given up on competitive bodybuilding, but on a four-day trade mission to Tokyo earlier this month, the California governor displayed impressive marketing muscle. He led an Iron Chef cook-off at a lavish reception for Japanese dignitaries and journalists to showcase California-grown fruits, vegetables, and wines. He joshed with Prime Minister Junichiro Koizumi and noshed with the chief executives from Sony and Toyota. And at a party at the residence of U.S. Ambassador Howard Baker, Schwarzenegger--"Shuwa-chan," as he's called by Japanese fans--posed for photographs with Japan's rich and famous. The sales blitz culminated in a rally in posh Roppongi Hills, complete with a Terminator-esque stunt double who roared onstage astride a Harley. "Come to Kah-lee-foh-nia!" Schwarzenegger entreated the throng of Japanese admirers. "You will love it so much, I know yooool be baaaahk!"

And as the chorus of "Hotel California" swelled from the sound system and Schwarzenegger hurled BUY CALIFORNIA T-shirts into the squealing Japanese crowd, it was almost possible to imagine that Japan really was back--back to a time when Schwarzenegger's square-jawed visage dominated movie marquees everywhere, when the unstoppable cyborg he portrayed was everyone's favorite metaphor for the Japanese economy, and when governors from nearly every U.S. state made regular pilgrimages across the Pacific to stump for Japanese trade.

Would it were so. On Nov. 12, within hours of Shuwa-chan's meeting with Koizumi, statisticians from the Prime Minister's office announced that between July and September, Japan's economy expanded at a paltry annualized rate of 0.3%--far weaker than expected and a sharp decline from the first two quarters, in which the economy grew at annual rates of 6.3% and 1.1%, respectively. The punk third quarter dismayed overseas investors, many of whom six months ago rejoiced in the prospect of a Japanese renaissance. Some now fret that far from being back, the world's second-largest economy is in the throes of another false recovery--its fourth in just five years--and remains the girlie-man of the industrial world.

"Japan will be lucky to see 1%" growth in 2005, predicts Goldman Sachs economist Kenneth Courtis, and may even contract, "depending on how much of a slowdown we get in the U.S." Alexander Kinmont, a strategist at Nikko Citigroup in Tokyo, complains that Japan's chronic overreliance on exports has left it at the mercy of developments in other markets such as the U.S. and, increasingly, China. "The Japanese economy," he says, "is a giant jellyfish, washed in the wake of the global economy."

Same old Japan, right? Wrong: The lackluster outlook for Japan's macro-economy obscures remarkable changes at the micro level. Over the past several years, while the rest of the world has been oohing and aahing about growth in China, corporate Japan has quietly set about fixing many of the structural problems long decried by Western critics. Big companies have reduced debt, severed ties with shaky business partners, shifted factories to China, and shed millions of surplus workers--and emerged more profitable than ever. Many if not most of the basic stereotypes about Japan Inc. no longer apply.

Consider: For the second year in a row, profits of Japanese companies listed on the first section of the Tokyo Stock Exchange are hitting all-time highs. Canon, with sales of $32 billion, projects 2004 profits of $3.2 billion--about what Hewlett-Packard earned in the past 12 months on sales of $79 billion. Toyota's profits last year exceeded those of General Motors, Ford, and DaimlerChrysler combined. Japanese balance sheets look better too, with corporate debt falling to 85% of GDP, down from 125% in 1996.

Japan's firms have whipped themselves into shape by rethinking fundamental components of their traditional business model. Lifetime employment, for example, is becoming a relic. While avoiding outright layoffs, Japanese firms have pushed older workers into retirement and taken on fewer new recruits, swapping full-time staff for temps and part-timers. Merrill Lynch economist Jesper Koll estimates that part-time, seasonal, and contract workers now account for more than 40% of the Japanese labor force, up from just 15% in the late 1980s. More than half of Japanese workers under 35 have never had a full-time job. Japan's workforce, Koll argues, is less expensive and more flexible than its counterparts in Europe. "Germany," Koll says, "can only dream of attempting what Japan has already achieved."

The cross-shareholding system, another pillar of Japan's postwar financial system, is also buckling as big firms sell each other's shares to pay down debt. By some estimates, cross-holdings now account for only 20% of outstanding shares on the Tokyo Stock Exchange's first section, down from more than 50% in the early 1990s. Many of those shares have been purchased by foreign investors, who now own substantial stakes in firms like Sony, Canon, Honda, and Shiseido--obliging Japanese executives to pay more attention than ever to demands for greater transparency, better corporate governance, and fatter profits.

Even Japan's moribund banking sector is coming to life. Under orders from Koizumi's economic policy czar, Heizo Takenaka, the Financial Services Agency has held banks to stricter standards in accounting for unprofitable loans. After years of foot-dragging and denial, banks have slashed bad loans to $242 billion, from $400 billion two years ago, according to the FSA. The major bank groups--Mizuho, Mitsubishi Tokyo, and Sumitomo Mitsui--are six months ahead of a government timetable for reducing bad loans to less than 5% of total lending. Notably, banks are finally cutting off "zombie" borrowers--firms kept on financial life support despite losing money year after year. On Oct. 15, one of Japan's most notorious zombies, retailing giant Daiei, was finally unplugged, as CEO Kunio Takagi surrendered management control to a government turnaround agency in exchange for financial support. In Japan's go-go years Daiei borrowed millions to buy restaurants, hotels, shopping malls, and a professional baseball team. After Japan's stock and property bust, there was little hope of repaying that debt without drastic restructuring. But for years Daiei resisted change, confident that it owed so much that creditors wouldn't dare let it fail.

The firms jockeying for the remains of the Daiei empire reflect another important facet of the new Japan: It's more open to outsiders. Daiei's retail assets may end up in the hands of Wal-Mart, which has already gained a foothold in the Japanese market by acquiring a 38% stake in Seiyu, another troubled retail chain. Outside investment funds such as Ripplewood Holdings, Cerberus, Lone Star, and GE Capital have secured majority stakes in a host of Japanese companies in recent years, as have multinationals like Renault, Ford, and Goldman Sachs.

As profits improve and debt woes fade, Japan's blue-chip firms are thinking big--about new products, more factories, and M&A targets. In recent years Japanese manufacturers relied on a rear-guard investment strategy, shifting production to China to reap savings from low-cost labor. These days, though, many are expanding at home, focusing on facilities to make advanced products with cutting-edge technologies they're reluctant to transfer to China. In Oita prefecture on the southern island of Kyushu, Canon, Toshiba, and Daihatsu Motor have each announced plans to build large plants this year. To the north, in Hokkaido, Seiko Epson is putting up a $315 million facility to make flat-panel TVs. Japan's Finance Ministry says spending on plant and equipment in Japan jumped 10% in the first half of 2004.

With all these changes, why hasn't Japan come roaring back? In part, the problem is cyclical. "Japan grew so fast last year that a slowdown this year was inevitable," says Morgan Stanley economist Robert Feldman. Turbulence in the global economy--high oil prices, the weak dollar, slower growth in China, and an uncertain outlook for the U.S.--hasn't helped. Those problems loom particularly large for Japan because its economy remains heavily dependent on exports.

Indeed, some pessimists blame companies for shoring up profits at the expense of workers and decry a "wageless recovery" in which spending power has faltered, even though the jobless rate has fallen to 4.6% from last year's peak of 5.5%. Those concerns are overdone. Government survey data show consumer confidence is at its highest level since 1991. Goldman economist Tetsufumi Yamakawa, who forecasts Japanese GDP growth of 2% through 2006, predicts a solid pickup in household spending early next year. "The feeling is that the worst is over," he says. "There's a lot of pent-up demand out there and a huge pool of accumulated savings."

One thing that could dampen sentiment is a tax hike. Koizumi has vowed he won't raise the national consumption tax, which now stands at 5%. But in a Nov. 21 television appearance, Takenaka suggested that the government wants to rescind $25 billion in tax breaks enacted in 1999. Those measures were designed to counter a 1997 consumption tax hike that sent the economy into its worst slump of the postwar era. Merrill's Koll warns that revoking the 1999 breaks could knock Japan back into recession "in one fell swoop."

Eventually, though, most observers believe that Japan will have to raise taxes to rein in the runaway national debt. Although Koizumi promised to cut government spending, under his watch Japan's debt has risen from 130% of GDP to 150% (vs. 36% in the U.S.). Defusing the debt bomb poses a major challenge, especially in light of Japan's declining birth rates and shrinking population--structural problems about which business and government leaders have done little more than wring their hands. Policymakers reject even the most anodyne proposals to take in more immigrant labor. Instead, Koizumi has been focusing on privatizing the postal system--a worthy effort, no doubt, but one unlikely to yield tangible benefits for the larger economy for years to come.

For all its failings, Japan has made a comeback. The current recovery may lack the blockbuster drama of the late 1980s, but unlike that expansion, this one seems sustainable. With a steady growth rate of 2%, Japan will remain a potentially lucrative market that foreign multinationals--and U.S. governors--neglect at their peril. Ask Californians, who do more than $1 billion in trade with Japan and have seen Japanese tourist visits plunge to 600,000 last year from 1.2 million in 2000. Schwarzenegger, who's also hoping to persuade Toyota to build a Prius plant in the state, faults his predecessor, Gray Davis, for closing California's trade and investment office in Tokyo. Shuwa-chan wants it reopened and knows just where to find the cash: rich Japanese companies, of course. He's offering to do television commercials for them on his next visit. "It's quick money," he boasted. "You work for a day, and you have a trade office open and enough money for several years." Depend on it: He'll be back.