I am very glad to be here with you, and thank you very much Anthony for that introduction and for being so very kind as to invite me to come and speak to the Business Group.  I am sorry that we are a bit later than we were scheduled; that is my fault, because of the editorial schedule on the Economist for which Monday morning is particularly important.  But I am very grateful to you for being flexible.

My subject is Japan´s revival. I think, like other speakers on this subject no doubt, that there are quite simple questions that should be asked about Japan´s revival.

First of all is it genuine, ie, is Japan actually recovering?

Secondly will it last?

And third how different is the recovery this time, ie, is the nature of Japan different compared to previous recoveries and certainly compared to the bubble period, and the 1980s in particular, when Japan was last seen as a great economy.  By that question I especially have in mind the changing context within Asia for Japan and its economic recovery.

So: is Japan really recovering? I know I am not the first speaker to this group to address this and I think I won be the last because it is going to be a question that is going to continue to need to be asked in the coming months and in the next year or two. 

At the moment if one just looks at the data the answer is yes, Japan is in an economic recovery.  It has had seven successive quarters of positive growth.  The fourth quarter of 2003 showed a particularly strong growth rate, albeit revised down last week from 7% plus to 6.4% on an annual rate.  But that is still a remarkably fast rate.  And in particular although the overall figures were revised down it is still clear that capital spending in the private sector was a very strong part of that growth.  And signs in this quarter, the first quarter of 2004, are that this growth has been continuing 

Economists have a joke in Japan about the recovery.  They say the proper question to ask is not whether the recovery real but rather whether it is nominal.  Economists´ jokes are often not very funny but they enjoy them!

The point of this question is that in a country with deflation the traditional measure of growth, or rather the measure that has become traditional since the inflationary 1970s, of real, inflation-adjusted GDP growth, is less relevant because if prices are falling rather than rising then real GDP measures provide a misleading indication of the volume of output growth. It is really nominal growth that you should look at to see whether output has increased. And a significant thing in the fourth quarter of 2003 is that growth did exceed deflation on all the normal measures of deflation. And that deflation, again depending on your chosen measure, shows signs of slowing.  So the the chance now exists that actual positive nominal growth might be being achieved in Japan for the last quarter, for the current quarter, and perhaps into the future.

And so the data is clear there is a recovery on the way.  But the questions of why is it happening and will it last of course are absolutely crucial ones.  There are three big aspects of this recovery that we must pay attention to. 

The first is a very positive one. This is that to a degree at least this recovery does reflect a change in monetary policy in Japan.  Outsiders have for years been criticising the policy of the Bank of Japan as being insufficiently expansionary, and they have criticised it for allowing the financial markets to expect that monetary conditions will be tightened quite rapidly once growth becomes established. What has changed in the past year  has been that the Bank of Japan has gained a lot of credibility through its change of governors and gradual change of declared policy. There have been modest but steady increases in the additions to the money supply that they have been pushing through.  There are however still question marks about the Bank of Japan´s future policy, in particular about how quick the Bank of Japan will be to raise interest rates as they see the recovery take hold, if they see the recovery take hold.

This really means a question about the inflation tolerance of the Bank of Japan.  I think that the Bank of Japan should be highly tolerant of inflation in the current environment, in other words it really ought to make clear to the market that it will err on the side of leniency in terms of raising interest rate.  It ought to wait for a long time before it starts raising interest rates to deal with inflation.  

But I would say it is not yet clear whether the Bank of  Japan will actually take that position and I think one question hanging over the recovery going forward is whether or not the Bank under  Governor Fukui will permit inflation in the future.

The second aspect of the recovery is exports, and particularly exports to China and to a lesser degree other Asian countries.  The trade between China and Japan has been increasing at 30% plus per annum and has switched from being a deflationary effect because of price competition in recent years—and one that has engendered a certain amount of protectionist sentiment in Japan—to becoming an inflationary effect because of the great demand that China is putting on Japanese producers of all sorts of commodity related and capital products.  We had a nice little article in the Economist last week about the inflationary effect on cardboard prices in Japan and the recycling prices.  There is now a cardboard shortage in Tokyo according to our correspondent.    That is one small example of how the demand from China is turning from having been a deflationary trade towards being on balance an inflationary influence.

Demand from other Asian countries has also been strong. Together with Chinese demand the welcome outcome is that exports from Japan still continue to rise and grow rapidly, pulling along the recovery, despite the strength of the Yen against generally falling Dollar.

The third reason for the sustained recovery is corporate restructuring. This is one of the most welcome aspects that have been seen and does I think add some confidence that this time the recovery will last.  The bigger companies in Japan have been repaying their debts and have been achieving quite a substantial rise in profits with the result that last year the Standard & Poors credit rating agency upgraded more non-financial companies than it downgraded. Previously, downgrades had exceeded upgrades. The bankruptcy rate fell last year from roughly 19,000 or 20,000 a year to around 16,000 bankruptcies a year.  And the liabilities of those bankrupt companies fell by almost 15% last year. 

It is still true that smaller firms carry much of the bad debt, or at least are the borrower´s end of much of the bad debt.  And smaller firms have not restructured to the degree that big companies have.  But nevertheless there have been some positive signs there with profits of smaller firms rising at a slower rate and their debts falling.  The overall result is that the non-performing-loan totals now appear to be falling at the banks.  The question is whether they will continue to fall, but the trend has turned for the time being.

Will these positive forces last, and what will be their consequences? I think that the most important area to look at is the export side both because it sets the context for the recovery within Asia but also because it is the biggest area of risk. Exports to China have been a very, very important part of the recovery and it would be foolish to assume that exports to China are going to continue to rise at a 30% annual rate.  The Chinese economy is in a state of over investment.  Some patches of it are overheating in a classic economic sense of demand outpacing supply and producing rises in property prices.  But mostly the Chinese economy is better characterised as being an economy in which supply is outpacing demand because of over investment in car factories and steel and road building and so on and so forth.

This is likely I think to produce some sort of reaction and change.  In this morning´s papers the Chinese Premier Wen Jiabao was quoted as expressing a lot of concern about this pace of growth and over investment and wishing to find ways to rein it back by restricting bank lending and to try to cool down some of the growth that has been taking place inside.  I think that as far as the Japanese end of this is concerned it looks to me as if one shouldn´t expect a sudden drop in Chinese demand, or a sudden collapse in the Chinese economy.  But looking forward the rate of growth in exports to China is more likely to slacken than to grow and therefore the impetus given to the Japanese economy from China is likely to be less than it was before.

I´m not forecasting a collapse.  You can´t rule that out altogether but there is no obvious sign that that will happen. Rather, my point is if official efforts are made to choke off some of this lending that is fuelling some of the investment then you will start to see a slow down in the rate of growth in exports.

Meanwhile demand elsewhere from the United States and from Europe is likely to be a bit healthier but it will be moderated, at least in the United States, by of course the Yen/Dollar rate.  But the prospects are that the broad world economic recovery is likely to continue. Therefore there will continue to be some positive influence from exports  for the Japanese economy.

As far as the Bank of Japan is concerned I have already talked about that to some degree.  I think that the monetary policy does look set to stay and consistently expansionary but we can´t be sure yet about the interest rate reaction as and when they start to worry about inflation.  I would suggest though that that is the sort of problem that would be a good sign if Japan has to deal with it.  In other words it will be a sign that the recovery has been continuing for quite a period and that deflation has finally been conquered. In other words it is not a near term problem, but could be something that happens over the coming 12 or 24 months as a result of the cyclical recovery having been actually sustained rather strongly.

What are the consequences of what I have been describing  - a clear but always fragile recovery?  I think the biggest consequence is that there is a prospect that corporate and financial Japan will turn from having had a vicious circle in past decade, a vicious circle of slow growth or no growth, and an increase in bankruptcies leading to piles of non-performing loans and then trouble for the banks, to a virtuous circle. There is some prospect that as the economy rises non-performing loans drop, bank problems decline, financial reforms move from being on paper to some sort of reality, and banks begin to allocate capital on a more rational and disciplined basis.  That virtual circle could even leak into the wider policy reform process but I will show some scepticism about that in a minute.

However one should keep this in a clear perspective.  The basics in Japan are not significantly changed despite this cyclical recovery, despite the beginnings of a virtuous ircle, despite the seven successive quarters of positive growth.  There remains a surplus of savings in Japan.  There remains misallocation of capital.  There remain a substantially unreformed relationship between the state and the economy.  Many highly regulated sectors of the economy persist, and reforms to state entities have been modest at best.  Public debt remains at 160% of GDP and although higher tax receipts will result from faster growth it will only stabilise that debt, not cut it significantly. And of course Japan continues to have a rapidly rising burden of pension and health costs because of its ageing population.

So it is still going to be a hard slog, just one made a bit easier by the recovery that is taking place but not I would say transformed altogether.  Then there is the issue of whether recovery will encourage or discourage the structural reform process. As in the past, it may be that policy makers in the LDP decide they need  not  bother to take painful measures that hurt their supporters when the economy is plainly recovering itself. Alternatively, one could argue that growth will provide an opportunity to make reforms less painful and so it might encourage politicians to push them through.

In the short term it seems to be the former that is happening not the latter. There is little sign of accelerating reform. The current effort to push through the privatisation of public highway corporations and to start serious discussion of the privatisation of the postal savings system do not seem to be gaining speed or strength. At least, that is the impression I get looking at it through my telescope from London. The political situation since the election in November has not been good for the LDPor for Prime Minister Koizumi.  And I think that that is helping to slow down reform.

In the longer term though I would offer a somewhat more optimistic view which is based on the fact that the November elections produced for the first time a real opposition party.  The strong gains in the election made by the DPJ showed an unusual degree of unity given its previous high degree of disunity and the party at last clearly stood for reform, at least on paper.  That has produced a situation in Japanese politics I would suggest in which there is the possibility of substantial change. This could arise not only at the next Lower House election in several years time but more imminently, thanks to the presence of a serious opposition dedicated to some forms of reform and with a sort of possible credible long term future. That presence might offer a temptation to some of the government´s coalition partners.  In particular Komeito, and its backer Soka Gakkai might even consider switching alliances.  The DPJ will be tested in the Upper House election this summer.  And around that Upper House election and around the stability of the coalition and the maintenance in office of Prime Minister Koizumi the fortunes of the Japanese forces in Iraq will be extremely important. It is reasonable to imagine after the bombings in Madrid on Thursday that at that summer election there will be increased nervousness, even greater nervousness about possible attacks in Japan as well as in Iraq itself.  And even if that is unfounded nevertheless it could add further to the tensions within political circles about the support of the war and presence of their soldiers in Iraq.

There is therefore in my view not a slow road being followed in Tokyo towards an alternative government with the possibility of replacing the one in power.  And even if that alternation does not transpire soon the political strength of the DPJ should help to change at least some element of the LDP´s thinking about whether to resist or encourage reform.  On balance still the resistance to reform is powerful but I suspect that that isn´t going to be true on a 3 or 4 year view even if it is true on a 3 or 4 month view.   

I should return to my basic questions of whether the recovery real, will it last and is it different, how different is it and what is really different about the context for it? Well I have touched some of these points already.  It is different in that it is private-sector led at the moment, producing some signs of a virtuous circle.

Most important, though, is the fact that this recovery is taking place amid a wider debate about Japan´s role in the world and its position in Asial.

The biggest change now compared with previous recoveries and with the state of the world when the bubble burst in 1990 is that the Asian context has changed.  China´s economic growth is a very, very important aspect of the recovery and that growth is fuelling a wider growth within East Asia and South East Asia regions as well.  This has, I think, both good and bad  aspects to it.  The bad aspect is that it does, I think, add to vulnerability of Japan´s recovery.  But the good side is that I think it is altering bit by bit Japan´s relationship to China and I think it is producing a different sort of political relationship between the two countries. 

Instead of competition between Japan and China, as so often in the past, what is developing is a sort of co-operative context for those two countries.  In other words a mutual economic dependency and even a strong mutual interest in trying to prevent the dollar collapsing by both becoming big holders of US Treasury bonds.  There is also a new mutual dependency at the political level in working together on negotiations over the region´s biggest security threat, namely North Korea. All this may not produce a loving, sincere and deep friendship between Japan and China but it is a shift from a highly competitive and adversarial atmosphere between the two countries towards a more constructive mix of competition and co-operation.  It is important to build on this new relationship and my belief is that behind the diplomatic scenes and in private exchanges there are efforts underway to try and do just that.

It is important in any case for Japan of course to rebuild its own strength as an economy through the reforms that must take place in order to be able to get stronger at a time when its Chinese neighbour needs it as a parallel force for good rather than thinks of it as  competitor as it might do in a few year time.  But also because of Chinese growth this is an opportunity for Japan to repair some of the historically very bad relationships between the two countries and to seek co-operation and dialogue on the basis of that mutual dependency. 

This raises an important and intriguing possibility. That is that the huge growth in trade and investment links between the two countries, Asia´s two biggest economies, will encourage them to develop further the inter-governmental forums for dealing with economic and political issues within Asia. Thus, things could develop in a similar way to what has occurred in the European Union over the last 50 years.  Asia is a long way from developing an equivalent to the EU. But with this mutual dependency there is some possibility that Asia´s two greater powers could produce the sort of sense of mutual interest  that has pulled together France and Germany, the old enemies of Europe. This is not an imminent expectation. But, tentatively, one can say that the possibility is beginning truly to emerge.

Thank you very much for listening.