Why Japan Is Investing Again

The most overlooked surprise of the week so far was 6.2% rise in Japanese capex planned by large companies for this fiscal year. That's the first anticipated capex rise since at least FY08, and the details get even more aggressive: large manufacturers plan to raise spending by 12.4%. Why is it happening?

It's not as if Japan's immediate cyclical or structural signals or the global environment especially inviting.

Japan's industrial sector modestly lost momentum during April and May, although the 6m momentum trendline remains positive. In May, industrial production rose 6.2% yoy, with exports up 10% yoy in yen terms and 13.8% yoy in volume terms. However, the inventory/shipment ratio jumped in April and retreated only mildly in May, leaving it still a full standard deviation above the long-term average, and capacity utilization remains about 0.2 standard deviations below the long-term average. This is not disastrous - there is no comparison with what happened in 2009 – but it is an unlikely foundation for the start of a new capital spending cycle.

The structural situation for Japanese industry is not particularly compelling either. The Ministry of Finance's quarterly survey of private sector balance sheets show not only that ROE remains at extremely low historic levels, but also that there's been only the mildest upturn in the crucial asset-turns ratio (sales/total assets). Although obviously there is some recovery from the disasters of 2Q and 3Q, for Japan's private sector as a whole, 1Q asset turns were just 1.01, which is unchanged from 1Q11.

The rest of the Dupont ratios aren't going anywhere good quickly, either:

• operating margins have recovered from the catastrophes of mid-2011, but at 3.04% for 1Q and 3.12% on a 12m basis, are still below pre-2009 levels. More, the ratio of cost-of-goods sold seems to have bottomed out in late 2010, and is modestly rising;
• financial leverage (total assets/equity) appears to have bottomed out at about 2.71x, after falling for the last 21 years. But net debt/equity has been steady at around 60% since around 2007. It seems unlikely that Japan's ROE will be rescued by higher leverage ratios any time soon.

So what is motivating Japan's sudden resurgence of investment spending? The intuitive answer is that last year Japanese industry discovered unexpected vulnerabilities, both at home (earthquake, tsunami etc) and abroad (Thai floods). The surge in capital spending is what it takes both to fix and diversify those supply-lines.

This may be part of the motivation, but if so, it has arrived at a very opportune moment. For there are two factors operating within the companies themselves, which are also mandating the rise in capital spending.

First, depreciation has accelerated sharply, rising by 6.6% in the 12m to end-March. This is the most rapid rise in depreciation since at least 2000 (where my data stops). Without a corresponding rise in capital spending, the capital stock of industrial Japan will shrink, and fast. In fact, even with capital spending rising 3.3% yoy in 1Q, those additions to capital only barely cover the depreciation write-offs. In other words, regardless of the health of the world's business cycle, if corporate Japan is going to attempt to maintain its position, it has no choice but to start investing.

At the same time, corporate Japan is awash with cash. In fact, the amount of cash on corporate Japan's balance sheet, expressed as a number of months' sales, is the highest it has been since the immediate aftermath of the bubble bursting (1991). Cash now accounts for 11% of corporate Japan's total assets – again, one of the highest proportions in Japan's post-bubble history. Japan's return on assets may be fairly paltry at around 3.4% (annualized 1Q11), but the return available on new equipment is unlikely to be worse than that on cash.  

What's more, the drag of cash on the balance sheet is going to get worse. Cashflows were up 72% yoy in 1Q and up 40% on a 12ma. In fact, corporate cashflows seem to have been in recovery since the nadir of early 2009, and that recovery does not seem to have been particularly compromised even by the disasters of 2011.

I think these twin considerations are important prompts behind Japan's reinvestment.

There is, of course, a radical alternative view, of corporate Japan's available choices. The 'hospice option' holds that the proper corporate response to an aging and shrinking population is precisely for companies to shrink their balance sheets and capital stock, whilst spinning off sufficient cash to allow for a peaceful demographic decline. By the look of things that's not where corporate Japan wants to go.