An overriding objective for the Western industrial nations during the East Asian financial crisis has been to limit the contagion in the region - specifically, to keep it away from Japan. There has been a clear awareness that Japan, the world's second most productive economy, has acute problems in both its political structures and financial system, but the lingering belief has been that with patience and some careful repair work Japan could grow its way out of the crisis. Indeed, a Japanese economic recovery, after several years of low or no growth in the mid-1990s, has been seen as critical to keeping the world economy on course.

Yet the facade of calm erected around Japan has begun to crumble. The global consequences could be severe. In the first instance, the re-emergence of Japan's weaknesses is causing severe disruption on the foreign exchange markets, with the dollar shooting up against the Japanese yen. This comes at a time when the dollar is already enjoying unusual strength as a result of the 'safe haven' effect being felt due to the pending arrival of the single European currency. The countries outside the euro trading bloc are seeing unusual capital flows into their financial markets pending the final details on locked exchange rates and the shape of the European Central Bank.

The result is that at the end of a long upswing in the US economic cycle, when the dollar might normally be expected to be weakening, it is strengthening. This is likely to produce a cost problem for non-US airlines, although the impact is being softened by the oversupply of oil on world markets - despite revived attempts by Opec to restrict output.

Fresh concerns about Japan stem from three sources. The first is the vanishing prospect of an economic recovery in 1998. Last year's International Monetary Fund projections for Japan were originally for a robust recovery of 3 per cent this year. These were downgraded to 2.1 per cent in October 1997 and to 1.25 per cent at the end of last year. Now the Japanese economy seems to be in reverse, shrinking in the first quarter of 1998 as the East Asian crisis bit hard into trade.

The second factor undermining Japan's confidence has been some tough talking by one of the country's senior industrialists; Sony chairman Norio Ogha, who warned in early April that Japan was on the verge of collapse and this could spark a world recession.

Ogha's comments were unusual. Japanese businessmen are normally reluctant to criticise their government in public. Furthermore, leading central bankers and financial officials have long sought to maintain that the Asian crisis is containable. But that would only apply if the contagion has not spread to Asia's economic superpower. In effect, Ogha has punctured a conspiracy of silence.

The final factor impinging on confidence was the decision by the Moody's credit rating agency to change its outlook for Japanese debt to 'negative.' This action has the potential to raise borrowing costs for Japan, and has already led to the postponement of bond issues on the Japanese capital markets.

Of these three factors, the Moody's decision may be the most potent, not simply because of the short-term impact on corporate fund raising. It refocuses attention on what has long been Japan's Achilles heel, the weak and antiquated state of the broader financial system, from banking to capital markets.

Some effort has been made to tackle the weaknesses, which include an estimated $575 billion of risky debts in the banking system. But the progress on the government's rescue package, announced last November and passed into law in February, has been slow. The authorities are reluctant to close down the weaker institutions for fear of provoking further chaos of the kind which ensued when Yamaichi closed its doors.

Among the key reforms seen as necessary is improving the efficiency of the nation's financial system. At present companies quoted on the Tokyo Stock Exchange produce returns on equity of a pitiful 4.4 per cent, against the 20 per cent achieved by their European counterparts. As a result, London has overtaken Tokyo as the world's second most important equity market.

So where does Japan go from here? At the April Group of Seven meetings in Washington and the May heads of government summit in Birmingham, Japanese prime minister Ryutaro Hashimoto will come under increasing pressure to unveil the tax cuts being demanded by his US and other Western counterparts to stimulate and reflate the economy. Until recently Japan has been more concerned with bringing the local and public sector deficit down to 3 per cent of gross domestic product than with ensuring that the economy stays afloat.

If the renewed international focus on Japan's economy serves to speed up the necessary reforms in the financial structure, including the banking system and changing the country's fiscal approach to stimulating the domestic economy, then the present bout of lost confidence will pay off over the longer term. But no-one should underestimate the short-term impact on the world economy and currency markets. A substantial slowdown in Japan this year, together with the East Asian crisis, the arrival of European Monetary Union and the developing cyclical easings in the US and UK, will mean that 1998 will be a far tougher year for global growth than has broadly been anticipated.

These developments will also have an impact on currency markets. The yen is likely to remain weak and the dollar strong, increasing trade tensions across the Pacific if Japanese exports to the US start to take off. The current high exchange rates in the Anglo-Saxon economies can be expected to persist until the markets are convinced that Japan's sluggish system of government can force through change and that EMU has the prospect of success.

Source: Airline Business