This summer a spicy scandal is mesmerising Tokyo economists. After the government shocked the markets by announcing an annualised growth rate of 7.9 per cent in the first quarter of this year, some local journalists have accused officials of deliberately fiddling the upbeat figures.

In the event, the Bank of Japan and Ministry of Finance have vehemently denied the allegations. And most private economists suspect that seasonal adjustment problems were to blame for the apparently
freakish figure.

But, either way, what the rumours have highlighted is the sheer scale of controversy - and confusion - now afoot as economists ponder the path of the world's second-largest economy. For after five quarters of recession, the latest gross domestic product data suggests the economy could have reached a critical turning point. And many foreign investors have consequently been rushing to buy shares in recent weeks on these recovery hopes.




What remains crucially unclear is whether this recovery will prove "real" - or simply peter out later this year. As one senior bureaucrat at the finance ministry says: "We think the economy downturn is now bottoming out. What we don't know, however, is whether a recovery will be sustainable."

The judgment is particularly controversial because the economy is being buffeted by both structural and cyclical factors. On the cyclical side there is good reason to expect an upturn - not least because last year's downturn is flattering this year's figures.

After a spiral of pessimism, many companies are finally becoming more optimistic again, according to recent surveys by the Bank of Japan. Consumers, who tightened their belts aggressively last year in response to tax rises, are also beginning to raise their spending in some areas, partly due to replacement cycles. Household expenditure data in May, for example, was 1.3 per cent higher than a year before.




Although Japanese exports have been falling over the last year, there are even hopes that the upturn in Asia - and continued strong demand in the US - will provide some support. The Organisation for Economic Co-operation and Development, for example, is currently forecasting that the recovery in south-east Asia will deliver a small positive boost to growth in 1999, after acting as a severe drag last year.

Furthermore, the Japanese government is fuelling this cyclical swing with policy measures. Last autumn, for example, the government unveiled a stimulus package that was nominally worth ¥24,000bn. Although it remains unclear how much of this dizzying sum has actually been spent, government spending has surged: between the fourth quarter of 1998 and the first quarter of 1999, for example, public investment rose almost 11 per cent.

The Bank of Japan (BoJ) has also relaxed monetary policy, pushing overnight rates towards zero by flooding the markets with liquidity. Some critics claim that even more dramatic measures are still needed, given that the economy is expected to slip into deflation later this year. But the BoJ's policy does appear to have helped support both bond and equity prices in recent months, and effectively eased the financial crisis that dogged the markets last year.

These measures have left most economists predicting that growth will be flat, or even fractionally positive, during this calendar year. But the big uncertainty is what will happen when the current round of public spending runs out at the end of 1999. For the last time the economy showed any recovery, in 1996, this collapsed when the government tighten fiscal policy again. Although the government has vowed to avoid this mistake this time, with debt levels rising fast it cannot afford to keep spending indefinitely.




The fundamental problem is a structural one: namely that nine years after the collapse of the 1980s "bubble" in asset prices, Japan has still not created an economic structure that can cope with the demands of a modern, mature economy. Although the government is now - belatedly - attempting to implement the necessary structural reforms, these risk causing more economic pain before they deliver any longer-term recovery.

One of these post-bubble issues is the scale of bad assets that still dog the financial sector. Although the banks are writing off these bad loans, they remain reluctant to sell the real estate that lies behind the assets. This has left the property market illiquid - and affected by falling prices.

Another problem is the excess capacity and falling productivity levels that now dogs Japan's mighty industrial sector, which invested lavishly during the bubble years without any consideration for the cost of capital. This excess capacity now totals Y85,000bn, equivalent to the entire annual capital expenditure that the Japanese corporate sector has made in recent years, according to the Economic Planning
Agency (EPA).

Japanese companies are now attempting to tackle this problem: the EPA reports that capacity shrank 0.7 per cent last year, and the Ministry of International Trade and Industry (Miti) is trying to accelerate this process through reform measures. But this process, at best, will dampen capital expenditure - and at worst trigger bankruptcies and rising unemployment.




However, the most pernicious problem is the consumer. In the 1980s Japanese consumers assumed that rising asset prices would boost their wealth and the lifetime employment system would guard their incomes - and consequently spent freely. But the first assumption was shattered by the bubble collapse, and the second is being eroded by corporate restructuring. As a further blow, there is rising public panic about pension underfunding.

This consumer malaise cannot be resolved by simply returning to the past, since companies cannot afford to retain large, inflexible workforces. Instead, what is urgently needed is wholesale reforms to the pension system, the introduction of a social safety net system, and the type of sweeping corporate restructuring that could lead to the creation of new jobs in new industries.

Some of the brighter bureaucrats, businessmen and politicians recognise this - and are pressing for urgent reform. As Kaoru Yosano, Miti minister, says: "Before we see a real recovery we have to pass through a dark tunnel." If such reforms were implemented in tandem with loose monetary and fiscal measures, these momentous changes could be made less painful over the coming years.

But pulling off this type of juggling act will require far more policy co-ordination and courage than any Japanese government has shown in recent years. With or without any statistical scandals, in other words, it is still far too early to declare that Japan's economy is recovering in any sustainable way yet.


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