GMO

White Paper
April 2011

After Tohoku: Do Investors Face Another Lost

Decade from Japan?
Edward Chancellor

T he phrase “lost decade” used to refer to the debt-ridden, stagflating basket cases of Latin America of the 1980s.
In those days, Japan was the up-and-coming nation. This was the era when the Sony Walkman was invented,
Japan’s car industry crushed Detroit, Tokyo property values and the Nikkei soared to the moon, and the mighty yen
swept through the world’s financial markets as the Japanese accumulated a pile of trophy assets from Van Gogh’s
Sunflowers to New York’s Rockefeller Center. From the mid-1990s onwards, the “lost decade” epithet came to be
applied to Japan as its economy sagged under the collapsing stock and property markets and the country’s once
mighty banks were crippled by huge losses on their loan portfolios.
The next decade wasn’t much kinder to Japan. The Walkman was trashed for the iPod, Korean consumer electronics
companies supplanted the Japanese, Tokyo land prices continued to fall, and the Nikkei slunk back to its level of the
early 1980s. What remained of Tokyo’s reputation for sound economic management was shredded by another decade
of weak growth, continuing deflation, and surging public debt. As Japan’s population started to shrink, the country
looked increasingly staid compared to South Korea, a former colony, and to the overwhelmingly more populous
China. While China emerged as the world’s workshop and second largest economy, Japan’s share of global trade fell
by one third.
Things have continued to get worse. Although Japan hadn’t enjoyed a credit boom for many years, it ended up suffering
more than any other major economy during the Global Financial Crisis. After September 2008, exports, investment,
and discretionary spending all collapsed. In the 12 months to March 31, 2009, Japan’s economy contracted by 10%
and the consumer price index fell by 2.5%. The Japanese referred to this trauma as the Lehman shokku. The recovery
of Japan’s stock market has also been relatively tepid. While the S&P 500 doubled between early March 2009 and the
end of last February, the sickly Nikkei rose by just 50%. Then on March 11, a great earthquake struck Japan, followed
by a devastating tsunami with an untold number of casualties, and soon after by a nuclear emergency, which continues
at the time of writing.
The purpose of this essay is to address certain common perceptions, or rather misperceptions, about Japan that
prevailed before the latest crisis. In particular, I wish to examine the dreaded Ds which have afflicted Japan in recent
years: demographics, deficits, deflation and (corporate) decline – to which must now be added (natural) disaster. Do
investors in Japanese stocks face yet another lost decade?

Disastrous Demographics
Little more than 20 years ago, American pundits competed furiously to talk up Japan’s economic prowess and laud her
prospects.1 Up until the recent catastrophe, however, Japan has been neglected, overshadowed by the rise of China.
Much popular commentary in recent years reveals a morbid fascination with the nation’s decline, in particular with
1  See,
for instance, Harvard Professor Ezra Vogel’s Japan as Number 1 (1979), Clyde Prestowitz’s Trading Places – How We Are Giving Our Future to Japan
and How to Reclaim It (1993), and Michael Crichtons’s Rising Sun (1992).
Japan’s demographic plight. The working age population started to decline in 1995, and the total population began
shrinking a decade later. Foreign journalists nowadays are apt to visit depopulating parts of the country to describe
empty towns with dilapidated buildings. An issue of The Economist last November warned that Japan was entering
a “demographic vortex” that would lead to lower living standards, investment, and reduced risk-taking. A shrinking
economy would reduce the tax base, making it difficult to finance the burgeoning public debt. Equity investors were
in for a rough time.

Exhibit 1
A Demographic Headwind: Japan’s Dependency Ratio Soars

60%
Percentage of Working-age Population
Nonworking-age Population as

55%

50%

45%

40%
1980 1985 1990 1995 2000 2005 2010

Source: OECD, Statistics Bureau of the MIC, Bureau of the Census

This grim story conjures up visions of Japan as another Easter Island. It should be taken with a pinch of salt. In a
1937 lecture, J.M. Keynes told a British audience that although economists were not much good at forecasting, “we
know much more securely than we know almost any other social or economic factor relating to the future that, in
place of the steady or indeed steeply rising level of population which we have experienced in recent years, we shall
be faced with a stationary or declining level.”2 Keynes was wrong. At the time of his speech, the British population
was about 48 million. Since that date, it has continued to grow more or less continuously to the current level of 62
million. Economists, it turns out, can’t even predict the population.
There have been numerous false population scares in history.3 As Alexander Kinmont of Morgan Stanley points out,
we cannot forecast the birth rate, especially when births are running below the replacement rate. Some demographers
suggest economic circumstances can temporarily influence the fertility rate. The US fertility rate, for instance, fell
during the economic downturns of the 1930s and 1970s, but subsequently recovered. Given that Japan’s birth rate
may already have bottomed, demographic forecasts out to 2050 are probably too pessimistic.

2  “Some Economic Consequences of a Declining Population,” Delivered before the Eugenics Society on February 16, 1937.
3 Alexander Kinmont, “The Irrelevance of Demographics,” March 2, 2010. France suffered a population scare in the 1920s, when it was predicted that the

population would fall by 30% over the next half century. As it turned out, by 1980 the number of French actually increased by around one third. Kinmont
points out that the Japanese fertility rate appears to have already bottomed out.

GMO 2 After Tohoku – April 2011

Besides, long-term demographic forecasts aren’t particularly relevant for equity investors. It’s true that changes in
the population have a sizable impact on GDP growth. But stock market returns are not positively correlated with
economic growth.4 Returns from equities are a function of valuation and future returns on capital – a subject to which
I will return later – rather than changes in GDP. Nor is there a positive correlation between population growth and
stock market returns.5 In short, investors should not get too hung up on inherently unreliable long-term demographic
projections for Japan.
Over the medium term, economic growth depends on changes in productivity and employment rather than movements
in the total population. Most commentators would agree that Japan has plenty of room for improvement on both
of these fronts. Labor is used less efficiently in Japan than in other advanced economies. The quality of service is
remarkably high, but foreign visitors are invariably struck by how many surplus people are employed attending car
parks, minding elevators, directing traffic, waiting in hotels and restaurants, serving in electronics stores, and so forth.
Productivity per hour worked in Japan is a third lower than American levels.6
Furthermore, there’s huge slack in Japan’s labor market. The employment rate for female graduates is 10 percentage
points lower than in the US, owing largely to the fact that Japanese mothers tend not to return to the workforce after
giving birth.7 Goldman Sachs estimates that if female employment rose to male levels, the workforce would increase
by more than eight million, providing a sizable boost to potential economic output.8 Women are not the only persons
under-employed in Japan; in 2010, only 58% of university graduates found jobs.9 There are also millions of under-
utilized temporary workers.10 If there really were a labor shortage in Japan, then incomes would be rising. That has
not been the case. Given the immense slack in the labor market and the great potential for productivity improvements,
there’s no reason Japan’s economy cannot grow at a healthy clip for years to come.

Dangerous Deficits
When it comes to scaremongering about Japan, demographics often take second place to the parlous state of the
nation’s public finances.11 On the face of it, the numbers are pretty horrific.
Japan has been running fiscal deficits every year since the bubble burst in 1990. During this period, the economy has
not grown in nominal terms. As a result, the ratio of public debt to GDP has continually risen and last year reached
227% of GDP, a level far above that which roasted Europe’s unfortunate PIIGS. This debt is more than seven times
larger than the government’s revenues. By contrast, Russia defaulted in 1998 when its debts were only five times
venue. Much of Japan’s debt is also short-term. Even before the earthquake struck, the IMF estimated that Tokyo
needed to find buyers for its bonds equivalent to an estimated 58% of 2011 GDP (see Exhibit 2).
Japan’s fiscal irresponsibility has been facilitated by very low long-term rates. In 2010, the cost of funding the public
debt was actually lower than a decade earlier. But what would happen if rates were to increase? Masaaki Kanno,
JP Morgan’s chief economist in Tokyo, calculates that if interest rates rose by 2 percentage points within a decade,
interest charges on the public debt would consume the entire government revenues.12
4  For instance, see Jay Ritter, “Economic Growth and Equity Returns,” Pacific-Basin Finance Journal, 12 (2004).
5  Between July 2000 and July 2009, for instance, the US population increased by nearly 9%, while the S&P 500 fell by 37%.
6  Andrew Garthwaite, Credit Suisse, February 14, 2011.
7  Kathy Matsui, Womenomics 3.0: The Time is Now, October 1, 2010.
8  Ibid.
9  Pasona Group Inc., January 13, 2011.
10 A note from colleague Toby Rodes: “There are presently 3 million Japanese people out of work and looking for a job, or roughly a 4.6% unemployment rate,

which would be considered the frictional rate of unemployment in the developed world. Taking a closer look at the composition of employment, however,
paints a darker picture. According to the Japan Institute for Labor, from 2003 to 2007 almost 2 million jobs were shifted from ‘regular’ to a ‘seasonal’ status
– call it shift work. On top of that, roughly 14 million people in the labor force are ‘part-time workers’ with roughly a third, call it 4 million, forced into this
employment because they cannot find a position as a ‘regular employee.’ In round numbers, the Japanese labor force has almost another 10% that is grossly
underemployed on top of the 4.6% presently unemployed.”
11 I have to confess to have contributed on this score, see my “Japan’s Sovereign Debt Crisis Looms,” Financial Times, November 1, 2009.
12 Masaaki Kanno, “Time to Enjoy a Cyclical Upturn in 2011,” J.P. Morgan Securities Japan, February 2011. Kanno argues that JGBs are in a classic bubble,

fed by loose monetary policy (low rates), over-confidence (due to strong past investment returns from this asset-class), and extreme mispricing (current
yields provide no compensation for risk).

GMO 3 After Tohoku – April 2011

Exhibit 2
Rollover Risk: Forecast 2011 JGB Sales Equivalent to 58% of GDP

60

Budget Deficit
Government Debt Issuance as % of GDP

50 Maturing Debt

40

30

20

10

0
GBR IRL ESP PRT ITA GRC USA JPN

Source: IMF

To date, Tokyo has had no problems selling bonds. But that’s partly because some of the largest buyers of Japanese
government bonds (JGBs) have been related to the government, including the Postbank, the Bank of Japan, and the
public pension system. For various reasons, these quasi-public entities are losing their appetite for bonds.13 Japan’s
commercial banks have also bought mountains of JGBs. But bank deposits are not growing and if Japanese households
or businesses ever decide to borrow again, the banks will have correspondingly less to lend to the government.
The household savings rate has declined as Japan’s population has aged. By the middle of this decade, it is set to
turn negative. At that point, Japan may need foreign support to finance its deficits. Foreigners will likely demand
higher rates, which will put government finances under even greater strain. A debt spiral threatens. Already Tokyo
is reported to be preparing for “X-Day” – Japan’s financial Armageddon.14 This sovereign credit narrative ends in a
terrible dénouement, with the country facing the prospect of a Weimar-style hyperinflation. As with the population
story, however, Japan’s sovereign debt woes have been somewhat exaggerated.
Japan’s fiscal situation has little in common with Europe’s PIIGS. For a start, sovereign defaults tend to afflict
countries that depend on foreign capital. This was the case for Greece and other countries in the European periphery.
Japan, on the other hand, remains the world’s largest international creditor and the overwhelming bulk of its public
debt (roughly 94%) is domestically held. It is very rare for democratic countries to default on debt held by their own
nationals. Sovereign defaults may also be prompted by economic contraction in countries that are locked into an
uncompetitive exchange rate. But unlike the PIIGS, Japan has its own currency, controls the central bank, and can
devalue if necessary. Japan also runs a large current account surplus, whereas the PIIGS sport deficits. Banking crises

13 The Postbank is in the process of privatization and is looking to diversify its near 100% exposure to JGBs. The Bank of Japan has already breached its
internal rule to restrict its maximum JGB holdings to the number of bank notes in issuance. Meanwhile, the public pensions are net sellers of bonds as the
population ages. For more, see various notes from Independent Strategy, e.g., “Oh So Long Ago” (June 11, 2009), “JGBs: Financing the Deficits” (January
21, 2010), and “Who’s Buying JGBs?” (August 3, 2010).
14 See J. Kyle Bass, “The Cognitive Dissonance of it All,” Hayman Capital Management, February 14, 2011.

GMO 4 After Tohoku – April 2011

can induce sovereign debt crises, as Ireland and Iceland have recently shown. But after huge write-offs during the past
two decades, Japan’s leading banks have robust balance sheets.
The focus on the downward trend in household savings is highly misleading. Unlike Greece and, for that matter, both
the US and UK, Japan’s gross savings rate (at 23% of GDP) remains high. In fact, Japan’s fiscal deficit is the result
of too much saving. Since the bubble burst in 1990, Japanese companies have been paying down their debts and
raising cash. The financial surplus of the private sector has produced a shortfall in aggregate demand, which has been
plugged by government deficits.15 Once corporate deleveraging ends and the Japanese start spending more and saving
less, then (everything else being equal) the government deficit should automatically contract.16

Exhibit 3
Private Thrift, Public Profligacy: Japan's Fiscal Deficits Matched By Private Surpluses
20%

15%
Private Nonfinancial
10%

5%
% GDP

0%

Government
-5%

-10%

-15%
1980 1985 1990 1995 2000 2005 2010

Source: Bank of Japan and Cabinet Office

There are other reasons to be relatively sanguine about Japan’s sovereign credit. The headline debt figure at more than
twice GDP overstates the problem. This number includes debt held by various government entities and sterilization
bonds, but excludes the government’s large foreign exchange reserves. A more appropriate figure is the net debt,
which stands at 114% of GDP (see Exhibit 4). By this yardstick, the debt is only four times tax revenues.
One should also take into account the fact that government revenues are currently depressed (see Exhibit 5). After
two decades of deflation, the tax take is lower today than in 1990. Corporation tax receipts are around half their 1990
level. Economists often refer to the “inflation tax,” which occurs when the effective tax rate increases with inflation.
Japan’s public finances have suffered from the opposite effect – a “deflation tax rebate.” The Japanese are not heavily

15 For more on this see Richard Koo, The Holy Grail of Macro-Economics: Lessons from Japan’s Great Recession, Wiley, 2009. As Koo writes in a recent note
(“No End in Sight for Japanese Crisis,” Nomura Securities, March 29, 2011), “When the private sector begins saving more in spite of zero interest rates, GDP
will shrink in a deflationary spiral unless the government borrows and spends the resulting surplus in private savings.”
16 According to Deutsche Bank economist Mikihiro Matsuoka (“Restoration Demand and Japan Crash Thesis” Revisited,” March 25, 2011), the “financial

surplus/deficit in the private non-financial sector and the general government sector are almost perfect mirror images of each other. It is not just that private
sector saving has induced government deficits. As the public debt increases, increases in the fiscal deficit appear to be matched by greater public sector sav-
ings. This looks like an example of ‘Ricardian equivalence.’”

GMO 5 After Tohoku – April 2011

Exhibit 4
Look Below the Headline: Japan’s Net Debt Is Only Half the Gross Figure
250%

200%
Japan Public Debt to GDP %

Gross Debt

150%

100%

Net Debt
50%

0%
1980 1985 1990 1995 2000 2005 2010

Source: IMF WEO

Exhibit 5
The Deflation Tax Rebate: Tokyo’s Revenues at 1986 levels!
120
Japanese Government General Account

100

Expenditures
Finances in Yen Trillion

80

60

Revenues
40

20

0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Source: Ministry of Finance

GMO 6 After Tohoku – April 2011

taxed by modern standards. Government revenues are approximately 30% of GDP, compared to an average of around
40% in Western Europe. Consumption tax in Japan is much lower than in the West.17 The greatest beneficiaries of the
deflation rebate have been the elderly who, directly or indirectly, own most of the government debt but aren’t paying
their share of the fiscal burden.18
Nor is it true that Japan’s public finances must necessarily collapse if interest rates were to rise. This would only be
the case if rates rose while tax revenues remain unchanged. In fact, Japan’s tax revenues have shown themselves to
be sensitive to changes in nominal GDP. If rates rise because deflation has ended and economic growth is picking up,
then revenues may well rise faster than any increase in debt service. Under these circumstances, the government’s
ratio of debt to GDP would rise initially but start falling after a few years. Interest payments on the outstanding debt
would never become unmanageable.

Debilitating Deflation
In order to escape its debt trap, Japan needs a return to nominal GDP growth and for real interest rates to remain at or
below the rate of economic growth. In order to achieve these conditions, Japan needs to dispel deflation. The trouble
is that Japan has been mired in deflation for a seeming eternity. Since 1990, US prices (as measured by the GDP
deflator) have climbed by 58%, whereas the Japanese price level has fallen by 10%. There is a popular perception
that Japan will never escape this curse – a view that was reinforced by the Lehman shokku. Nevertheless, there is a
reasonable expectation that Japan’s deflation fog will lift in the coming years.
The initial impetus for deflation was the collapse of the bubble economy in 1990. After the bubble burst, land values
fell by nearly 90% and the Nikkei shed two-thirds of its value. Some Y15,000 trillion of wealth was destroyed,
according to Richard Koo of Nomura, who observed that Japan was suffering from a “balance-sheet recession.”
Companies have spent two decades paying down their debts.19 Today, the deleveraging of corporate Japan is largely
complete. Private sector debt relative to GDP is around half the level of the US. Japanese corporations are less
levered than their foreign counterparts and sit on piles of cash (see Exhibit 6).20
Deflationary episodes tend to involve a relative adjustment of prices. This has already happened in Japan. Since the
turn of the century, Japan’s domestic prices have fallen by a third relative to the US, according to Morgan Stanley.21
Japan used to be an extremely expensive place to live. Today, a cup of coffee in Tokyo costs about the same as a latte
in London or New York. External deflationary forces have also abated. Since 1990, the cost of Japanese imports has
fallen. But the downward trend for import prices is over. Today, Japan is exposed to soaring energy costs and rising
Chinese export prices.
A best-selling book ascribes deflation to the decline in domestic demand caused by Japan’s shrinking population.22
(This view is summed up by a comment from a large Japanese retailer who told us that “In Japan, a shopper dies every
day.”) The failure of Japanese businesses to adapt to the slowdown in the country’s growth rate has exacerbated this
problem. The amount of floor space devoted to retailing, for instance, has increased since 1990 despite sales trending
downwards (see Exhibit 7). Japan’s large output gap may shrink as companies increase foreign investment at the
expense of domestic capital expenditure (see below). Furthermore, the disruptions caused by the Tohoku Earthquake
constitute a “supply shock” to Japan’s economy, which further reduces deflationary pressures.

17 In 2006, Japan’s consumption tax receipts as percentage of GDP were 2.6% of GDP, compared with VAT revenues of 7.2% of GDP in France and 9.1% of
GDP in Sweden.
18 In Japan, people over the age of 65 own more than 80% of financial assets. This cohort of the population is a net recipient of government transfers. Because

Japan owes its national debt to itself, one way to reduce the debt mountain would be to raise taxes on these aging retirees. Japan’s top rate of inheritance tax
is high, but revenues as a share of GDP at 0.3% (in 2005) are no higher than in the US. One reason the elderly pay so little tax is because they are over-rep-
resented in the Japanese Diet. This March, the Supreme Court ordered a redrawing of electoral boundaries. This reform, if enacted, may tilt political power
away from.
19 Private sector credit in Japan fell from nearly 200% of GDP in 1990 to around 140% of GDP by 2008.
20 Japanese companies (ex-financials) have reduced their debt to equity ratio from 2.5x in the early 1990s to around 1.6x today. By comparison, companies in

the EAFE ex-Japan are levered about 1.75x. Japanese companies have cash equivalent to 23% of shareholders’ equity (versus 13% for EAFE ex-Japan)
21 March 17, 2011
22 Kousuke Motani, Defure No Shotai (The Truth Behind Deflation).

GMO 7 After Tohoku – April 2011

Exhibit 6
Great Corporate Deleveraging: Japan Inc Now Less Indebted than the Rest of EAFE

400%

350%
Corporate Debt to Equity Ratio

300%
Japan
250%
(ex-Financials)

200%

150% EAFE ex-Japan

100%

50%

0%
1982 1986 1990 1994 1998 2002 2006 2010
Source: GMO

Exhibit 7
Old (Retail) Habits Die Hard: Retail Floor Space Has Continued to Rise Despite Falling Sales

200

180
1988 Values Rebased to 100

Sales Floor Space

160

140

120
Retail Sales
100

80

60
1988 1991 1994 1997 2000 2003 2006 2009
Source: Seven & I Holdings

GMO 8 After Tohoku – April 2011

There is one source of deflation that appears more robust than ever; namely, the entrenched deflationary expectations of
the Japanese people. For nearly two decades, Japan has been the poster child for Keynes’s “liquidity trap.” Deflation
expectations today are the converse of the inflationary mindset of the 1970s – they are self-fulfilling. Although banks
are awash with cash, there has been little demand for credit. Incomes haven’t been growing and people expect prices
to continue falling. The longer consumers defer gratification of their wants, the weaker the economy has become, and
the more reason they have had to postpone purchases.
The Bank of Japan’s role in this long-running deflation saga should not be overlooked. After all, the central bank kept
monetary policy deliberately tight in the early 1990s in order to clamp down on real estate speculation. The central
bank didn’t attempt quantitative easing until long after deflation had become entrenched. This monetary experiment,
which ran for five years from March 2001, merely flooded the banking system with excess reserves.23 Since the
Global Financial Crisis, the Bank of Japan’s monetary response has been conservative by comparison with the Federal
Reserve and the Bank of England. Consequently, Japan has experienced strong currency appreciation and higher real
interest rates than either the US or UK.
In the near term, the Tohoku Earthquake may increase risk aversion and lead to restrained consumption. Nevertheless,
it has forced the monetary authorities to loosen policy. Soon after the disaster struck, the Bank of Japan provided
emergency funds to the credit system, increasing the monetary base by around 5% of GDP. This rate of increase is
more rapid than any move by the Bank of Japan since it embarked on quantitative easing in 2001. Relative to GDP,
it is also greater than Bernanke’s second round of quantitative easing. The central bank has also doubled its planned
asset purchase program from Y5 trillion to Y10 trillion. Furthermore, the G7 countries intervened in the foreign
exchange markets to prevent a rapid appreciation of the yen, an outcome which might have had severe deflationary
consequences.
It is too early to say whether the response to the tragic events of March constitutes a decisive change in monetary
policy. This will depend on the extent to which the Bank of Japan finances the cost of reconstruction by printing
money; how quickly the central bank soaks up the emergency funds it has issued; and whether households and
businesses become more risk-averse as a result of the catastrophe. For the moment, at least, monetary policy has
become looser.

The Decline of Japan Inc.

Economists generally agree that deflation is bad for profits. In particular, it is difficult to cut wages when prices
are falling. Returns on equity are derived from leverage, asset turnover, and profit margins. Deflation in Japan
is responsible in part for the country’s low returns on equity.24 Over the last two decades, Japanese companies
have deleveraged and hoarded cash. Asset turnover has also declined. Profit margins are very low by international
comparison – but then, margins always were wafer-thin, even in Japan’s glory days.
Japan’s corporate management, once the envy of the world, is to blame for poor profitability. Companies have
continued investing to maintain market share, even though their domestic market is shrinking. One aspect of Japan’s
exceptionalism lies in the embarrassing number of companies serving its shrinking domestic market: there are eight
car manufacturers (for a market of 5 million cars a year), 11 fridge makers, and a multitude of manufacturers of flat
screen TVs, cell phone handsets, washing machines, and photocopiers.
Too often in the past Japanese companies have issued new stock, diluting existing shareholders, only to earn dismal
returns with the capital. Since 1990, Japan’s return on sales has averaged 2.3%, compared with an average of 6.2%
for the rest of EAFE (see Exhibit 8). The best excuse for this dismal performance is that Japan’s corporate tradition
of a life-time employment hampered companies’ ability to cut costs when growth slowed. But Japanese management,
in general, has also shown scant regard for the principles of shareholder value, to the despair of foreign investors.

23 Japan’s first round of quantitative easing involved loans from the Bank of Japan to the banks. This failed to spur credit growth.
24 Alexander Kinmont, “Darkest Before Dawn,” Morgan Stanley, April 21, 2009.

GMO 9 After Tohoku – April 2011

Exhibit 8
Underachieving by a Large Margin: Japan’s Profit Margins Lag the World

12%

10%

8%
Return On Sales

EAFE ex-Japan
6%

4%

Japan
2%

0%
1979 1985 1991 1997 2003 2009
Source: GMO

There are signs, tentative signs admittedly, that things are changing for the better. Japanese companies may be losing
their penchant for over-investment. Total corporate investment has been declining in recent years, which will lead to
lower future rates of depreciation. Andrew Smithers reckons this development will boost Japanese profit margins by
one percentage point.25
Japanese companies have been losing ground to Asian competitors. The ascent of an increasingly assertive China has
created a sense of urgency. It is now generally recognized that Japan’s domestic market offers little hope for future
growth. Many Japanese companies are stepping up investment in Asia. About one-fifth of Japanese manufacturing
now takes place abroad.26 As companies produce more offshore, they are better able to cope with the strong yen.
Before the earthquake struck, profit margins had already returned to their pre-Lehman levels.
The severity of the economic contraction in Japan has acted as a catalyst for change. Several bellwether Japanese
corporations were stricken by the Lehman shokku. At the low point, Hitachi’s share price had returned to its 1970s
levels and the company had a negative enterprise value (i.e., the market capitalization of the parent company was
worth less than the value of its stakes in listed subsidiaries). Hitachi has responded by exiting the flat panel TV
business, selling its hard drive operations, delisting several subsidiaries, paying down debt, and adopting a divisional
cash flow return on investment target.
When colleague Toby Rodes and I visited Japan in February, most of the companies we met with claimed that the
events of September 2008 had changed their behavior, or rather speeded up the rate of change: Retailer Daiei had
closed 17 unprofitable stores; convenience store operator Seven & I Holdings reduced the number of outlets; Seiko
Epson was exiting its LCD panel business; and Toshiba had adopted a target 10% return on investment. During our

25 Andrew Smithers, “Japan: The Dramatic Jump in Profits Should Be Sustained,” Smithers & Co, March 25, 2010.
26 Masaaki Kanno, ibid.

GMO 10 After Tohoku – April 2011

visit, Nippon Steel announced its merger with Sumitomo Metal Industries. The combined entity is set to control
some 40% of the domestic steel market. In the past, the Japan Fair Trade Commission wouldn’t have condoned such
an overweening market share. The merger may be a sign that Tokyo’s bureaucrats are prepared to accept the much-
needed rationalization of domestic industries.
Japanese companies have a reputation for promising, and subsequently failing, to deliver. The country’s network of
“stable shareholdings” has protected underperformers. But even here, change is afoot. As banks, corporations, and
insurance companies have sold down their stakes, cross-holdings have fallen to below 50% of outstanding shares.
This process has further to go. The introduction of new accounting standards will make ownership stakes in other
companies less attractive.27

Exhibit 9
The Unwinding of Japan’s Cross-Holdings: Will Japan Inc Now Pay More Attention to Shareholders?
35

Corporations
30
Ownership by Type of Investor

25

20

15

10
Banks
5
Foreigners

0
1986 1991 1996 2001 2006 2011

Source: Tokyo Stock Exchange

Corporate governance reforms are pushing in the same direction. Companies must now report and explain their
largest cross-holdings. They must also reveal the result of proxy votes and provide details of compensation for top
earners. Because foreigners own around a quarter of Japanese shares, it’s conceivable that a genuine market for
corporate control may one day emerge in Japan.

After the Earthquake: The Case for Japanese Equities

The Tohoku Earthquake triggered a sharp decline in the Nikkei. While this event had a huge cost in human lives,
history suggests that its impact on Japan’s economic output won’t be permanent. Equity markets have recovered
in the past from far greater natural disasters. The great bull market of the 1920s, for example, was preceded by the
devastating Spanish flu pandemic, which killed between 50 and 100 million people. The Tohoku Earthquake will
reduce 2011 GDP growth and many companies will suffer a hit to their earnings. But Japan’s longer-term economic

27 Theintroduction of international accounting standards to Japan (between 2012 and 2014) will lead to changes in the market value of a company’s cross-
holdings appearing in the profit and loss accounts, thereby adding volatility to earnings.

GMO 11 After Tohoku – April 2011

growth prospects and stock market returns remain unchanged. The market’s initial 19% decline in the aftermath of
the disaster was overdone and half of those losses were soon recovered.
What does the future hold? By the end of March, the Nikkei was trading at levels first reached in the early 1980s.
Long gone are the days when Japanese stocks sold for 70 times earnings or more. Today, the market’s earnings
multiple is roughly in line with the rest of the world. Some will suggest that a lower multiple is justified, owing to
the poor earnings growth of Japanese companies. In fact, since 2000 Japanese corporate distributions (dividends
and buybacks) measured in US dollars have actually grown faster than the rest of EAFE (see Exhibit 11).28 In other
words, all of Japan’s relative underperformance within the EAFE index has come from declining valuations.

Exhibit 10
Finally at Parity: Japan’s Valuation Premium Has Disappeared
60

50
Japan
Price to Normalized Earnings

40

30

20

EAFE ex-Japan
10

0
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Source: GMO

Using the price-earnings ratio to compare Japan with other markets does it no favors. Japanese companies have
much larger cash holdings, equivalent to 30% of their market capitalization. Their free cash flow yield (see Exhibit
12) in March rose to a record 10% (admittedly at a time when investment was depressed). On an enterprise value
to operating cash flow basis (EBITDA), Japan trades at a large discount to the rest of the world. By late March, the
Japanese stocks were also selling at a 10% discount to their book value (and a 21% discount to EAFE).
Investors in Japan have lost money for more than two decades. But it’s often overlooked that the main cause of these
miserable returns has been the long decline in Japanese equity valuations from their absurdly inflated levels of the
early 1990s. For the first time in the careers of many investors, the Japanese stock market is now no longer expensive.
Yet instead of looking on the bright side, investors appear transfixed by Japan’s poor demographics, fiscal deficits,
continuing deflation, and low returns on equity.
We have argued that Japan’s economy is capable of growing again despite the population decline and that demographics
are not strictly relevant to equity investors. Japan’s vast public debts merit serious consideration. However, unlike

28 Since 2000, Japan’s earnings per share measured in US dollars have also grown faster than S&P 500 earnings.

GMO 12 After Tohoku – April 2011

Exhibit 11
Surprising News: Japanese Corporate Distributions Have Been Rising Faster than the Rest of EAFE
3.5

3.0
Total Distributions to Shareholders –
Dividends + Buybacks in US Dollars

Japan
2.5

2.0

1.5 EAFE ex-Japan

1.0

0.5

0.0
2000 2002 2004 2006 2008 2010

Source: GMO

Exhibit 12
Corporate Cash Cows: Falling Capital Investment Has Produced Huge Free Cash Flow

12%

10%

8%
Japanese Non-Financials
Free Cash Flow Yield

6%

4%
Average = 2.7%
2%

0%

-2%
1994 1996 1998 2000 2002 2004 2006 2008 2010

Source: Datastream

GMO 13 After Tohoku – April 2011

Europe’s PIIGs, its fiscal problems are not intractable. We have also argued that market expectations for continuing
deflation in Japan are too gloomy and that the economy, fiscal deficit, and corporate profitability should all benefit
from the end of deflation. The low returns on equity of Japanese companies are bothersome but, with stocks trading
at below book, they are priced into the market and there’s plenty of room for management to improve returns.
In the aftermath of the March decline, our valuation model forecast an annual real return for Japanese equities of
nearly 5% over the next seven years. Japan appears as relatively attractive compared to the US, which has expected
returns of less than 1% a year. Our forecast assumes only a small improvement in Japan’s return on sales. If corporate
Japan Inc raises profit margins to international levels, then stocks will do considerably better than we currently
project.29 In short, our modest Japan forecast has plenty of potential upside.

Time for a Change

In the 1980s, “Japan is different” was a proud boast. The last two decades have shown Japanese differences in a less
flattering light. But some of its achievements have been glossed over. Japan still compares favorably to the US on
many measures: its energy efficiency is far greater; the population enjoys greater longevity while spending far less on
healthcare; income inequality is much less pronounced; since 2000, Japanese GDP per capita has even outpaced the
US. Japan’s car industry still leads the world and, as recent events have shown, Japanese components manufacturers
continue to occupy many vital niches in the global supply chain.
Nevertheless, Japan has been slow to adapt to changing realities; whether to the collapse of the bubble economy,
the decline in its population, or the rise of its Asian neighbors. Far from conforming to Schumpeterian notions
of economic development, Japan has followed its own unique path of “creative self-destruction.” If the country
continues on its recent path, the doomsters’ dire predictions will eventually come to pass. Tokyo needs to get its fiscal
house in order. The country needs to improve its trend growth rate. Deflation must be dispelled. Japanese companies
must generate better returns.
These are not impossible demands. The fiscal situation can be rectified. Taxes can be raised on consumption and on
the elderly. Tax revenues will rise once deflation ends and the economy starts growing again. With sufficient political
pressure, the Bank of Japan might be persuaded to achieve its inflation target. This should bring down real interest
rates. If properly incentivized, corporate managers might find the will to raise profit margins. They might even find
a way to consolidate the over-supplied domestic market. Numerous supply-side reforms could improve productivity.
The workforce might be expanded with greater female participation, or foreign immigration (heaven forbid!).
There’s little doubt that Japan’s economy is capable of growing again and that returns on investment are capable of
improving. All that’s needed is the will. As a nation, Japan has often moved at a painfully slow pace. But few peoples
have demonstrated such a capacity for rapid change once they have decided upon it. The Japanese modernized at a
blinding pace after the Meiji Restoration of 1866. The same spirit was on display during the reconstruction miracle
after the Second World War. It had become fashionable to decry the unadventurous younger generation as stay-at-
home “herbivores.” Yet the world’s admiration for the Japanese people has been rekindled by their stoic response to
the most recent national catastrophe. If this spirit and sense of unity were directed toward Japan’s economic revival,
a third lost decade would surely be averted.

29 For instance, our forecast would climb to double digits if Japan’s return on sales were to reach the EAFE average.

Mr. Chancellor is a member of GMO’s asset allocation team and focuses on capital market research. He has worked as a financial commentator and consultant
and has written for the Wall Street Journal, New York Times, Financial Times, and Institutional Investor, among others. He is the recipient of the 2007 George
Polk Award for financial journalism. Mr. Chancellor is the author of several books including Crunch Time for Credit (2005) and Devil Take the Hindmost: A
History of Financial Speculation (1999), a New York Times Notable Book of the Year.
The views expressed herein are those of Edward Chancellor as of April 8, 2011 and are subject to change at any time based on market and other conditions.
This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are
for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
Copyright © 2011 by GMO LLC. All rights reserved.

GMO 14 After Tohoku – April 2011