Japan's recovery is fraught with danger

Manabu Hara, The Asahi Shimbun, Tokyo

The domestic economy has made remarkable gains since the beginning of this year, but there are ominous signs overseas to Japan's growing recovery, notably in China and the United States.

Now that the Upper House election is over-the main opposition Minshuto (Democratic Party of Japan) made big strides Sunday-the government of Prime Minister Junichiro Koizumi and the Bank of Japan face new economic challenges.

The election showed that the ruling Liberal Democratic Party (LDP) is not as strong in rural areas as it used to be. The countryside traditionally was a stronghold for the LDP.

Many experts say that uphill battles in those constituencies stemmed partly from Koizumi's policy of restraining spending on massive public works projects-the traditional means to pump funds into outlying areas.

Many places, especially those far away from big cities, are still in dire straits despite the overall growth of the national economy.

Speculation is rife that curbing public works expenditures in local areas, a centerpiece of Koizumi's structural reform, will be strongly challenged from within the conservative party.

Rehabilitation of provincial economies could also pose a threat to Koizumi's policy on the disposal of huge debts held by local financial institutions.

The government plans to continue tightening the screws on ailing banks next April, when it will lower the amount of depositors' money to be insured in the event a bank goes under. In doing so, the government remains determined to reorganize financial institutions. But like curbing public investment, the hard-landing policy on resolving the debt burden likely will face strong opposition from within Koizumi's party as well.

While trying to sort out these domestic problems, overseas issues likely may start to overshadow the government's macroeconomic policy.

China's strong economy, which is surging, helped lift Japan's moribund economy. Throughout the election campaign, Koizumi and his LDP claimed that economic growth was evidence that his structural reform is working.

In reality, though, the recovery is mostly due to brisk exports to China. Japan's annualized gross domestic product registered an impressive 6.1 percent in the first quarter. But how long will this blessed wind from Beijing continue to blow, especially since China's economy has been overheating and the leadership has felt compelled to curb excess investment in production?

A Chinese government official was recently quoted as saying that the economy likely will achieve its soft landing in the second quarter. If China's economy fails to cool, it could result in adverse winds for Japan's exports.

Meanwhile, the U.S. Federal Reserve recently hiked interest rates by a quarter point. It tied the hike to modest inflation that has begun to emerge. Many experts believe U.S. monetary authorities will gradually rise interest rates this year.

Higher interest rates affect Japanese bonds. The Bank of Japan would need to be able to respond in timely fashion by intervening in bond markets to restrain a rise in rates. The central bank wants to maintain its ultra-easy monetary policy until deflation is vanquished. But higher interest rates in the United States narrow the policy options, dashing arguments that the BOJ should begin considering when to part with its zero-interest policy.

To be sure, some experts say the U.S. economy has or is about to peak and its recovery pace will slow in the latter half of the year. This would negatively affect Japan's exports to the world's main economic power.

Tokyo will need to be skillful in its macroeconomic management, given these domestic and overseas factors. This is especially true in light of Koizumi's weakened leadership as a result of Sunday's election.

Failing to properly deal with changes in economic conditions means could dampen the robust recovery. Even now, some people are expressing concern that the pace of Japan's economic rehabilitation will slow next year. This means the economy needs more time to get back on the full recovery truck.

So while Koizumi brags about economic recovery, some important economic indicators suggest it is premature for him to claim the government should be credited for current conditions. For instance, the Nikkei stock index is still more than 2,000 points below what it was when Koizumi assumed office three years ago. The jobless rate is improving, but it is a bit lower than three years ago. Moreover, public debt continues to rise despite his advocacy of structural reform.

Now that the Upper House election is out of the way, political observers are wondering if Koizumi's pet project, postal service reform, will proceed as planned.

What is sure is that the government has its hands full on the economic front. In a sense, it is caught between a rock and a hard place.