Could Japan Shrug Off the Dollar's Dive?

The yen's surge hurts export-driven growth. But trade with China, slashed commodity costs, and resurgent consumer spending may ease Japan's pain

An assembly-line worker at Nissan Motor Co.�s facility in Zama City, Japan. Koji Watanabe/Getty Images

by Ian Rowley

With the yen at a 12-year high against the dollar, and the U.S., a vital export market, in a subprime-fueled funk, Japan's economic growth is looking distinctly wobbly. But could the world's second-biggest economy be more resilient than many pundits and investors believe?

The question is not as far-fetched as it might seem, according to some analysts. For instance, Lehman Brothers' (LEH) equity strategists Ian Scott and Paul Danis cautiously draw some positives out of Japan's current challenges that could bode well for its equity markets. "In no sense can we describe the economic outlook [in Japan] as 'good' but, with expectations already low, and the speed with which sentiment regarding the U.S. economy has deteriorated in recent weeks, we think a better relative performance is justifiable," they wrote on Mar. 18 in a note to clients.

For sure, there are plenty of reasons to be gloomy about Japan's prospects and undoubtedly the rapidly rising yen is the major worry. Trading at 99 yen to the dollar, the Japanese currency has strengthened by over 20% against the greenback since June and is at its strongest since 1995. Before the Federal Reserve once again slashed interest rates on Mar. 18, the dollar briefly fell below 96 yen. Political squabbling in Tokyo has also led to paralysis at the Bank of Japan at a time of global financial instability (BusinessWeek, 3/18/08).

Exports Still Drive Japan's Growth

The strong yen is tough on Japan's automakers and other exporters that rely on U.S. for a large chunk of earnings. Nomura Securities projects that if the yen falls to 95 yen to the dollar, pretax profit will rise just 1.4% at Japan's 347 leading nonfinancial companies in the financial that begins next month. A Japanese government survey in January showed that 106 yen to the dollar was the average rate at which 356 exporters said they could run a profit. At Toyota (TM), which is on track to post record earnings, every one yen appreciation against the dollar shaves $350 million off its operating earnings. (For the current quarter, Toyota's projections assume an average yen-dollar rate of 105.)

Even more worrying is that Japan's economy, enjoying its longest run of unbroken growth since World War II, relies on exports for the lion's share of its growth. In the past two decades there have been just two years when the Japanese consumer has driven economic growth, notes Jesper Koll, president and chief executive officer of Tantallon Research Japan. "They were the peak years of the bubble economy. Since then we've had an export-driven economy plus public works," he says.

The stock market is certainly due for a bounce. This year the benchmark Nikkei 225 index has shed over 20%, compared with a 9.7% fall on the Dow Jones industrial average, despite Japan's conservative banks (BusinessWeek, 2/21/08) having largely avoided the kind of problems enveloping Wall Street.

Consumer Spending Is Finally on the Rise

Improving macroeconomic data could help. Lehman's Scott and Danis note that sentiment among small and midsize Japanese businesses has recovered after falling sharply in 2007, machinery orders increased 4% in January and bank lending, after sliding last year, is also rising.

Just as importantly, consumer spending is climbing. Despite weak sentiment (BusinessWeek, 3/7/08), consumer spending actually increased 3.6% in January—its fastest rate since May, 2004. While that pace will surely slow, Lehman projects gross domestic product growth of 1.6% this year. That's hardly stellar, but better than the 1% it projects for the U.S.