Is Japan poised for an economic revival?

This question is being asked amid newfound optimism by foreign investors in Japan’s stock market. It has been the one of top-performing markets globally this year, with the Nikkei 225 index rising by 23 percent to a 33-year high. The catalysts are mainly value related: Japan’s stock market is now considerably cheaper than the U.S. market after it lagged considerably for three decades. Also, the 20 percent depreciation of the Japanese yen against the U.S. dollar during 2021-2022 improved the international competitiveness of Japanese businesses. 

There is also an important geopolitical consideration at play: Namely, Japan is now being viewed as an alternative investment outlet to China, as multinational companies diversify their supply chains in the wake of the COVID-19 pandemic and heightened tensions between the U.S. and China. For example, seven of the world’s largest semiconductor makers have made plans to increase manufacturing and deepen tech partnerships in Japan according to the Financial Times. 

Still, most economists are skeptical that the Japanese government can revive the country’s dynamism in the 1970s and 1980s when it rivaled the U.S. economy. Japan’s economy has languished since the bursting of the stock market and real estate bubble in the early 1990s, and it has struggled with deflation for the past three decades. In the meantime, the economy’s potential real GDP growth has slowed to 1 percent per annum as the labor force has shrunk over time.

Against this backdrop, Prime Minister Fumio Kishida launched his “new capitalism” initiative one year ago with the goal of boosting economic growth and lessening income inequality. The essence of the concept is to produce a “virtuous cycle of growth and distribution” in which faster economic growth supports social goals through higher wages and household tax deductions.  

When the idea was floated in early 2022, it was greeted with skepticism by many observers. One critique was that the attempt to enforce Japan’s equal pay for equal work laws by offering public sector workers a one-time raise and pressuring private companies to do the same was not new. It had been tried by former Prime Minister Shinzo Abe to little avail. Furthermore, the Kishida administration is resisting dealing with Japan’s chronic labor shortage by allowing more foreign workers into the country.   

A more basic criticism by The Economist is that the rhetoric of the new capitalism represents a misdiagnosis of Japan’s economic ills: “It has barely budged since the 1990s. Growing inequality is less of a problem than a lack of dynamism.” 

In response to these and other criticisms, Kishida offered more specifics about his economic action plan in a recent speech. He stated that his economic strategy will focus on investment in human resources, science and technology, innovation and startups. Among other initiatives, the government is targeting spending on green and digital transformations to serve as catalysts for private-sector investment. 

So, what are the main obstacles Japan faces in achieving economic success? 

Economist Robert Feldman of Morgan Stanley offers his take in a report titled, “Japan’s New Grand Strategy.” He sees Japan’s economic strategy as emerging but also believes that achieving its aspirations will require enhanced capabilities in four key areas: a faster rate of technology adoption, the need for enhanced labor market mobility that will require retraining and reallocating the labor force, better corporate and national governance to improve economic efficiency, and the need for fiscal rebalancing to reduce costs in traditional areas and via pension reform with the goal of stabilizing Japan’s debt/GDP ratio. 

While it is too early to assess progress in these areas, Morgan Stanley’s economists are optimistic about the country’s economic prospects because the threat of deflation has lessened. In a recent report, they observe there has been a momentous shift in Japan’s growth of nominal GDP. They are forecasting that Japan’s nominal growth trend will shift up above 2 percent over the medium term after temporarily surging to nearly 5 percent this year due to higher inflation. They see benefits from higher nominal growth in terms of increased wages for workers and higher tax revenues for the government. In their view, these developments would help to sustain further increases in Japan’s stock market. 

My own take is that international investors need to take a closer look at corporate governance in Japan. Hiromi Yamaji, the new head of the Japan Exchange Group, has stated that companies should implement Japan’s Corporate Governance Code by looking more carefully at their price-to-book ratios, capital costs and share price, while also engaging in a “constructive dialogue” with shareholders. Accordingly, some investors are hopeful that stricter enforcement of governance standards will be positive for shareholders.

Yet, the Financial Times observes that Kishida’s own philosophy of corporate governance is less shareholder friendly. Whereas Prime Minister Abe began his term by promising more shareholder-friendly governance, the word “reform” is virtually absent from Kishida’s vocabulary. Moreover, there is still strong opposition among Japanese companies to laying off workers when profits plummet. In this respect, Japan’s “new capitalism” still seems a far cry from its U.S. counterpart.

Nicholas Sargen, Ph.D., is an economic consultant for Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books including Global Shocks: An Investment Guide for Turbulent Markets.