RISING AGAIN

Haruhiko Okamoto is visibly enjoying his visit to the Tokyo Stock Exchange. Beaming, he lifts his 7-year-old daughter Yuriko off the ground. The little girl, clad in a blue and white school uniform, swings a hammer against an old steel bell--and rings in the first day of trading in the shares of her father's company. "I think I'm a lucky man," says Okamoto, declaring that his flourishing Create Restaurants chain has chosen just the right moment to go public. "After the long stagnation, I think we are seeing a different psychology from the consumers. They're feeling liberated."

And how. On the day Okamoto's company had its initial public offering, Sept. 28, the benchmark Nikkei index finished at its highest level in four years. Investors have been flocking to Japanese stocks in the wake of Prime Minister Junichiro Koizumi's resounding electoral victory on Sept. 11, when his Liberal Democratic Party won an overwhelming mandate from voters responding to Koizumi's strong pro-reform message. But while the election victory gave a psychological boost to the market, Japan's economy has been showing signs of vitality for months now. After years of restructuring, Japan's corporate sector is healthy again, and profits are surging. Retail sales and employment are at their highest levels since 1997. Recently released data on real-estate sales show a noticeable uptick in Tokyo land prices for the first time in 15 years--fueling hopes of an end to deflation, the bane of Japan's economy ever since the asset-price bubble burst at the start of the 1990s.

Even bullish analysts were caught off guard by the government's Sept. 12 announcement that GDP had grown in the second quarter at an annual rate of 3.3 percent. All of which explains why, according to recent business- and consumer-confidence surveys, the Japanese are finally feeling good about their economy again. "Ten years have gone by, and every year you've taken a few steps," says Jesper Koll, chief economist at Merrill Lynch in Tokyo. "Then, four or five years later, you find you've run a marathon. And you don't feel tired, but refreshed."

Time for a hype alert? After all, Japan's long slump has been punctuated by periodic signs of recovery, invariably followed by disillusioning decline. But the experts insist that this revival is different. "Unlike the head-fake recoveries of the 1990s, this one is driven by domestic demand instead of public spending or public works," says Kathy Matsui, chief economist at Goldman Sachs in Tokyo. "So it's likely to be more self-sustaining, less dependent on government or the external environment."

That would be a huge change. Japan's economy has been powered by exports since the end of World War II. And for the last several years, Japan has greatly benefited from the rise of China and a surge of machinery and information-technology exports to that country. But amid worries that U.S. and Chinese demand might start to ebb, the Japanese consumer seems ready to pick up the slack. Recent data show that citizens are spending robustly as their incomes grow, albeit modestly. According to Macquarie Securities economist Richard Jerram, wages in the 12 months ending in July rose 1.3 percent, after falling for most of the last seven years. And meanwhile, companies are plowing profits back into their operations at home, giving even more of a boost to demand. "Japan is no longer joined at the hip with the world economy," says Matsui. "We've almost decoupled--because there's a domestic story now."

The government has played a role in this recovery, too--by resisting its tendency to meddle in the economy. The brief growth spurts in the 1990s were usually the result of bureaucratic pump-priming, typically involving lavish spending on public-works boondoggles that, if anything, only exacerbated the country's long-term public-debt crisis. Under Koizumi, government spending on high-profile development projects has dried up. Instead, Tokyo has focused on encouraging foreign investment. According to Japan's External Trade Organization, foreign direct investment doubled between March 2004 and March 2005.

Even more important, say economists, has been the Koizumi administration's aggressive push to clear up the huge burden of nonperforming loans clogging the financial system after the spending orgies of the '90s. Before the workout, notes Macquarie economist Jerram, the distressed banks had to prop up weak borrowers because they didn't have enough capital to write down bad loans--and couldn't lend to strong companies for the same reason. "Now, when the situation is normalizing," he says, "the inefficient companies shrink, the efficient ones expand and productivity goes up. And that has a ripple effect throughout the economy." Bank-lending figures recently rose for the first time since the Bank of Japan started tracking the data seven years ago.

Still, the private sector has done most of the heavy lifting. Not only have Japanese firms cleaned up their balance sheets, they've altered their fundamental business model. Japanese managers have unwound cross-shareholdings--the linchpin of the incestuous keiretsu system--and are now focusing on shareholder value. What's more, "the corporate sector has paid off $2 trillion worth of interest-bearing liabilities over the past 10 years," says Koll. "The ratio of private debt to GDP is the lowest in a generation--last seen in 1970." Companies have shed many of the noncore assets acquired during the bubble years. They've outsourced less-skilled work to low-wage countries (40 percent of Japan's productive capacity is now located abroad, compared with 10 percent a decade ago). The old lifetime-employment system has been replaced by that painful staple of U.S.-style capitalism: layoffs.

The cost cutting is finally bearing fruit for ordinary Japanese, too, not just shareholders. Employment figures show that companies have started hiring young, full-time workers--after years when low-benefit, low-wage part-timers seemed to have established a permanent presence in the Japanese workplace. Needless to say, the new jobs are cropping up mainly in companies that have undergone such radical restructuring that they can afford to hire again--or in new companies that have sprung up as the result of the corporate transformation. It's a moment that reminds many economists of the great industrial reorganization that took place in the United States under the Reagan administration, when deregulation triggered a shake-up of complacent industries.

Those changes ushered in a surge of U.S. growth and productivity--and now Japan, say some optimists, is poised to repeat the experience. The big industrial conglomerates of the past, the zaibatsu, have broken down under the pressures of international competition. And as the dinosaurs have downsized, those laid off have migrated to the rapidly expanding Japanese service sector or headed out to found their own businesses. Robert Alan Feldman of Morgan Stanley cites recent studies saying that some sectors--ranging from IT to real estate--are suffering from labor shortages. "There's an increasing mismatch in the labor market," says Feldman, "between areas where high skill sets are in demand and areas where people don't have enough skills to move between sectors." More change is on the way. Says Tokyo executive Shinjiro Yamada: "It's like the U.S. in the 1980s, when the dream of working for the big companies disappeared."

He should know. Once a junior engineer at Mitsui, part of a now moribund trading and shipping conglomerate, Yamada left in 1990 and, with a colleague, founded a company called INCS Inc. It designs and produces state-of-the-art prototypes for customers ranging from Toyota to Nokia--just the sort of lean, high-value-added specialty that increasingly characterizes Japan's new industrial landscape. As INCS CEO Yamada sees it, the key moment in Japan's economic revival came in the summer of 2002, when flagship corporations (Fujitsu, Toshiba and Hitachi) broke a longstanding taboo by announcing huge staff cuts--and nobody protested. "The people of Japan agreed that companies could cut employees. They were willing to accept it because they understood how bad the economy was." Ironically, despite his firm belief in downsizing, Yamada is spending most of his time these days hunting for new employees. Right now his company (2004 sales: 10.1 billion yen) employs 320 people--but he's just hired 80 more to cope with rising demand for his services. He proudly notes that half of his revenues now come from the firm's consulting business--a striking departure from the once monomaniacal Japanese focus on making things.

That's still a Japanese specialty, of course. And, in fact, Japanese manufacturers are heartened by signs that some production capacity is returning to the homeland. Lately, some firms have actually been "insourcing"--relocating selected production units back to Japan. Among the reasons: China's slowly but surely rising wages, unpredictable infrastructure and lax attitude to the protection of intellectual-property rights. The last issue matters a lot when you're spending big amounts on research and development--as Japanese corporations continue to do. Last year Canon opened a new digital-camera factory in the home islands. The higher labor costs didn't prevent the consumer-product giant from posting record profits of $5.2 billion in 2004.

Plenty of potential problems could derail the comeback train. Though the country has substantially reduced its reliance on oil since the 1970s energy crisis, high crude prices are a drag on growth. And no one disputes that vast areas of efficiency remain to be unlocked from many businesses. Says Yamada: "Restructuring must continue for the next 10 years." Other challenges--such as the graying of Japanese society--could also tamp down growth unless the government and populace can agree on a looser immigration policy. For the moment, though, the Japanese aren't in the mood to brood. They're enjoying economic sunshine again, and who can blame them? It's been a long wait.

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