MW-61 -- Euro Rethink Will Help Japan

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 61
Tuesday, January 27, 2004

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++ Viewpoint: Euro Rethink Will Help Japan

The Bottom Line:

o As Money Watch pointed out last week, the euro's appreciation
and US dollar's depreciation have finally reached the pain
threshold for European monetary authorities and individual
countries like France and Germany. Verbal intervention has
already begun and could be followed by European Central Bank
rate cuts. It is ironic that 26 trillion yen of intervention
by the Bank of Japan was largely ineffective in turning the
yen's appreciation against the dollar, while mere verbal
intervention by euro monetary authorities has caused a bounce
in the dollar, at least against the euro. This is because
recent investor surveys reflect a growing view that the euro
was becoming overvalued against the dollar.

o Meanwhile, the yen has been depreciating against the euro,
helping to offset the pain of a weak dollar for Japanese
exporters. In addition, accounting scandals in two of Europe's
largest firms (Parmalat and Adecco) threaten to become
Europe's Enron, hurting bullish sentiment on European
equities. This could incrementally help Japan draw more
foreign investment flows, as global investors already believe
that Japan is still a late-coming market. This is especially
true if it takes some of the short-term pressure off the
yen-dollar rate.

o Recent economic indicators (METI's all-industry index -- a
supply-side measure of economic growth) showed unexpected
weakness for November, the latest month released. However, the
Japanese stock market already discounted this as it was
confirming downside resistance last November-December and has
since gained another 1,000 points in terms of the Nikkei 225.
Thus the weakness indicated in the November economic numbers
last year is expected to pass. In addition, the fact that
Japanese basic material producers are now able to raise
product prices for practically the first time in the Heisei
Malaise is one of the clearest signs yet of abating deflation
in Japan.

o While strategic and cross-holding financial institutions and
corporations continue to be net sellers, domestic
institutional investors are becoming increasingly bullish on
Japanese equities. By December of last year, the average
equity allocation for domestic institutions had recovered to
43.4% from a low of 39.6% hit in May at the height of
bearishness about Japan's stock market as well as its economy.
These allocations look to be headed for prior highs of 52%
unless Japan's economy seriously stalls in the second half of
2004 -- a scenario that Money Watch does not foresee.

o By sector, while the very good quarterly numbers and the rally
in US as well as global IT stocks has pulled up Japan's IT
sector with it, Japan's telecommunications sector has so far
not responded to rallies in US and global telecom stocks.
Japan's telecom sector has massively under-performed the Topix
since the peak of the prior IT mini-bubble in Japan in 2000
and so far has shown little signs of life. But NTT now
compares very well to the other largest global blue-chip firms
in terms of market capitalization to cash flow and is now more
attractively priced than SBC Communications, Verizon
Communications, Bell South and IBM in the US, as well as
Toyota and Nissan in Japan, and Nokia in Finland.

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++ Viewpoint: Euro Rethink Will Help Japan

As Money Watch pointed out last week, the dollar was looking very
oversold versus the euro and apparently had reached the pain threshold
for Europe. US$1.30 per euro appeared to be a trigger level at which
European monetary authorities began "verbal" intervention.

Last week, the euro had its biggest drop against the dollar in a long
time after Reuters reported that the European Central Bank (ECB) may
lower its benchmark interest rate in response to the euro's
"too-strong" rally. The ECB has so far kept its bench market interest
rate at 2%, twice the level of the US Federal Reserve's target rate.
ECB President Jean-Claude Trichet said last week that he was concerned
with the "brutal moves" in the exchange rate. Comments by a Bundesbank
board member, Hans-Helmut Kotz, added more verbal intervention. "The
ECB is paying great attention to the volatility of exchange-rate
developments," he said. Peter Bofinger, who will join a panel of
economic advisers to German Chancellor Gerhard Schroeder in March,
indicated that the Bundesbank may start buying dollars to stem the
euro's gains if it rallies beyond $1.30. But what seemed to affect the
currency markets the most late last week was a Reuters report that
euro zone ministers attending a G-7 meeting next month will argue that
further strength in the euro might warrant an interest rate cut by the

Investor concern heretofore had been that continued US dollar weakness
would encourage international investors to shun US bonds and stocks,
negatively affecting not only the US stock rally, but US market rates
and the Treasury market as well. Yet when the dollar actually
rebounded last week, the reaction was the opposite. The dollar's
rebound sparked concern among traders that Asian central banks could
cut back on their purchases of dollars and US treasuries, implying
that upward pressure on the yen and the Asian currencies must continue
for the US to keep drawing massive amounts of Asian and Japanese
central bank money into Treasuries to keep US bond yields under
control. The US Treasury compounded this by indicating it might start
issuing 20-year TIPS (inflation-indexed bonds), which sparked concern
that the US government might reintroduce the 30-year bond.

Efforts to get the euro's appreciation under control is not the only
issue facing European equities. The scandal involving Italy's Parmalat
has been dubbed "Europe's Enron." Parmalat was declared bankrupt after
a 4-billion-euro hole was found in the balance sheet in what appears
to be massive fraud. The investigation in Italy continues to widen.
The chairman of the firm's Cayman Islands subsidiary at the heart of
Parmalat bankruptcy, Grant Thornton, has resigned, while Italian
authorities have jailed the firm's financial officers, and Italian
politicians are calling for the reform of Italy's financial regulatory
system. At the same time, the world's biggest labor hire firm, Adecco,
has admitted to "material weakness in controls" at its North American
business and accounting irregularities elsewhere. Their auditors,
Ernst and Young, are refusing to comment. EU internal market
commissioner Frits Bolkestein called for the member states to quickly
implement new accounting rules. These issues will have an effect on
investor confidence, particularly among overseas investors. Because
Japan was already considered a late-coming market, these new
developments work to further increase its relative attractiveness to
overseas investors.

Unexpected Easing: What is the BOJ Trying to Say?
The US dollar fell to a one-week low of 105.94 yen on Thursday, just
short of a three-year low of 105.70, but the dollar avoided slipping
to new lows on Friday on wariness over renewed intervention by the
Bank of Japan (BOJ). The Japanese government's stance is clear: It is
ready to do whatever is necessary to keep the yen from appreciating
beyond 100 to the dollar, with the current defense line being 105. At
the behest of the Finance Ministry, it intervened massively in 2003,
buying over 20 trillion yen worth of dollars; so far in January, it
has bought another 6 trillion yen or so.

Last week, the BOJ surprised the financial markets with further
quantitative easing, raising its target for the balance of current
accounts deposited at the bank to 30-35 trillion yen from 27-32
trillion yen. The bank also eased its criteria for purchasing
asset-backed securities. Why does the BOJ see the necessity to ease
now amid market speculation of an eventual return to "normal" monetary
policy. For one, the move is apparently aimed at reinforcing and
further improving the prospect for recovery, which in the bank's eyes
remains modest due to persistent structural problems.

The central bank also apparently wants to further cushion the
deflationary impact of the yen's continued climb against the dollar.
The proactive move is also intended as a policy message to demonstrate
to its G-7 critics the BOJ's resolve to fight deflation. The BOJ
continues to be criticized by Glenn Hubbard of the US Council of
Economic Advisors and others overseas for not cooperating enough in
easing monetary policy and fighting deflation. Critics claim that
Japan should try to weaken the yen with an easier monetary policy, not
intervention. The timing of the BOJ's recent move appears aimed at
showing its overseas critics that its actions are part of coordinated
Japanese government and central bank countermeasures. Given the
massive level of intervention in the currency markets, the BOJ is
faced with mopping up the excess funds.

Finally, there is the issue of decelerating money supply growth. M2+CD
money supply growth in 2003 was the lowest in 10 years, while growth
in the balance of cash and demand deposits supplied to financial
institutions (the monetary base) dropped under 20% year-on-year growth
rates last November. Because of a classic liquidity trap, high
monetary-base growth is not being converted into money-supply growth,
while growth in the monetary base itself is decelerating.

However, this is not an immediate threat to Japan's economic growth
because the supply of domestic credit is actually accelerating from
negative year-on-year growth rates between April 2002 to March 2003 to
3.1% year-on-year growth rates as of November 2003. Moreover,
corporate balance sheets continue to improve with higher stock prices
and ongoing restructuring. Additionally, despite the continued upward
pressure on the yen, the decline in domestic prices is abating because
of an improving supply-demand gap. Indeed, the slowing of deflation is
occurring faster than the pace outlined in the BOJ's own "Outlook
Report" at the end of December 2003.

November's Weaker Economic Activity Just a Temporary Glitch
Economists remain sanguine about the tone of Japan's economy, even
though business activity slowed in November for the first time in four
months, as several sectors pulled back from previous sharp gains, and
unseasonably warm weather took a toll on retail sales. The Ministry of
Economy, Trade and Industry's all-industry index -- a supply-side
measure of economic growth -- fell 1.3% from a month earlier, while
its service-sector-focused tertiary index slumped 2.3%. Many sectors
suffered mild backsliding after strong gains in previous months. The
biggest decline came in the communications sector, where activity
cooled 8.5%. But that followed a 25.9% surge in October.

Financial-sector activity fell 3.9%, the first decline since Japanese
share prices began to rebound from 20-year lows hit in April.
Unseasonably warm weather was also partly to blame for November's weak
data, as sales of winter clothing, heaters and other cold-weather gear
were weak. Overall retail activity fell 3.1% from October. It wasn't
the first time the weather affected economic activity in 2003.
Clothing stores stuck with stocks of winter clothing on their shelves
in November were also dogged a few months earlier by an unusually wet,
cool summer.

But basic material producers and shippers are finding that they are
able to raise prices for the first time in a long time. Because of
expectations for strong growth in world trade in 2004, the CRB futures
index hit a 19-year, seven-month high. Steel scrap prices in Japan, a
raw material for finished steel, are on the rise, reflecting higher
prices and strong demand in Asia. Tokyo Steel has raised shipment
prices by 10% in 2004. Shipping rates for steel-product exports to
Asia are also on the rise. Cargo rates for hot-rolled steel have risen
steadily since last July. International spot prices for coal used in
electricity consumption are also rising, reflecting strong demand from
China, and spot prices are at 10-year highs. Japan imports essentially
all of the 160 million tons of coal it consumes per year. In addition,
Japan's major petrochemical-product producers are moving to raise
prices by 10-15% on strong Asian demand and full operations at
downsized domestic factories.

These price hikes are not only driven by overseas prices and Asian
demand, but recovering domestic demand as well. Japan's crude steel
production in 2003 was the highest in 13 years. Domestic shipments of
paper and paperboard increased for the first time in three years,
thanks to growing demand for digital consumer electronics, as these
new products required new catalogs, instruction manuals and shipping

In addition, Japan's stock market has already made note of the
November economic weakness, as reflected in the brief retrenchment in
the Nikkei index, which dipped back below the psychologically
important 10,000 mark during that month. All-industry activity
remains comfortably above the level of the July-September quarter and
is believed to be on course for a strong quarterly rise in the
October-December period. Thus, in terms of three-month moving
averages, both indexes continue to trend upward, and the apparent
assumption being discounted in the stock market is that the tertiary
index and the all-industry index could continue trending upward
through 2004. Consequently, the Nikkei index has taken note of the
temporary weakness and moved onward to 11,036 at the end of last week.

Despite continued net selling by strategic and cross-holders of
Japanese stock, exposure among domestic asset managers (at least among
the 22 firms surveyed by Nikkei) is increasing, partly because of the
market gains and partly because of the increase in allocations to
equities. By December of last year, the average equity allocation had
recovered to 43.4% from a low of 39.6% hit in May at the height of
bearishness about Japan's stock market and economy. Unless clear
evidence that Japan's economic recovery is stalling emerges, we expect
the preference for domestic equities in asset allocations to continue
rising to the 52% level seen in March of 2001.

Telecoms Are the Obvious Late-Comers
The best performing Topix sectors from September of last year have
essentially all been basic industries such as shipping, nonferrous
metals, glass/ceramics, oil/coal, pulp/paper and iron/steel. In terms
of total market cap, these industries have a share of just over 5% of
Topix, compared to over 15% for electronic equipment and over 10% for
telecom services.

Foreign investors, who have been and continue to be the main driving
force of net purchases in the market, have tended to be underweight
these sectors, implying that as a whole they have under-performed the
Topix. On the other hand, the real-estate sector is a good example of
the increasing preference for late-coming sectors from the third
quarter of last year. With all of the basic-industry sectors already
having had a good run, Japan's high-tech sectors are looking
increasingly as late-comers, both among their domestic sector peers
and versus their overseas peers.

The S&P Japan 500 index consists of subsectors that are more
comparable with the global benchmark indexes. Over the past month, the
basic materials group (including steel, chemicals, rubber, pulp &
paper, cement and textiles) has been consolidating, while the
information technology and energy index (including oil, natural gas
and mining) have been supporting the index. In other words, when the
lower quality stocks are excluded, the Japanese IT sector's relative
performance looks much better, supported by: a) some very good
quarterly earnings reports and a 5.7% rally in the US S&P 500 IT
sector, a 6.5% rally in the S&P Global 1200 IT sector and expectations
of similar earnings surprises in the Japanese tech sector with strong
demand related to a digital consumer electronics boom.

Conversely, Japan's telecommunications-services sector is looking
increasingly like a late-comer, having waffled so far in 2004, while
the US telecommunications services sector of the S&P 500 is up 6.0%
with a similar gain seen in the Global 1200 telecommunications
services sector.

One major reason the telecom sector in Japan has been dull is NTT
Docomo (9437). The company under-performed the market benchmarks in
2003 as it recorded its first operating profit decline for the interim
to September 2003. The company simply is not gaining enough new mobile
subscribers to pay for the cost of maintaining existing subscribers.
Moreover, it was surpassed by KDDI in terms of annual net new
subscribers last year. Other issues negatively affecting investor
sentiment is the government's plan to sell off another big chunk of
NTT this year and the introduction of a liquidity-adjusted Topix,
which could eventually become the new benchmark for Japanese
institutions and especially public pension funds. Both NTT, NTT Docomo
and Vodafone would see their weightings fall noticeably in liquidity-
weighted portfolios designed to track the Topix 1000. But the sector
has massively under-performed Topix and its global peers since the IT
blow-off in 2000.

NTT: One of the Best-Valued Majors in the World
When the world's largest companies are compared in terms of market
capitalization to cash flow, NTT shows up as one of the most
reasonably valued of the global majors. According to a compilation by
Nikkei Business, Tokyo Electric Power Co. (9501) and NTT (9432) rank
among the top global firms in terms of the size of their cash flow to
market capitalization -- ahead of SBC Communications, Verizon
Communications, Bell South, IBM, Microsoft and Intel in the US, Nokia
of Finland, and Toyota and Nissan in Japan.

-- Darrel Whitten

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Written by Darrel Whitten

Edited by J@pan Inc staff (


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