Sunrise or sunset?

As the Japanese government's popularity fades but the first of many planned reforms kick in, the position for Japanese equity remains as uncertain as ever. Victoria Hartley finds out how the top funds extract value from such stormy markets.

Global equity asset allocators have been gradually contracting their allocations to Japanese equity for well over a year now, keeping an underweight position on the off chance of a brighter tomorrow.

But last month increased concern over the banking sector led Barings Asset Management amongst others to halve or significantly lower or reduce to zero Japanese equity allocations for the first time.

"You have to be quite brave to keep exposure to Japan," says Brewin Dolphin's Mark Bousfield, which cut allocations to nothing last month.

On the domestic front, the negative economic news has been snowballing consistently for a prolonged period. Japanese retail sales fell 2.2 per cent in December and 2001 was a record fifth straight year of declining sales. The country has entered its third recession in a decade and the Tokyo Shoko Chukin small business survey indicated that corporate bankruptcies in 2001 stepped up to 2.1 per cent from the previous year with unemployment continuing to spiral upwards, reaching 5.6 per cent in December.

The catalyst for much of the more animated disquiet over the banking sector is that on 1 April, two major banking reforms are scheduled to take place at the same time.

The government's plans include a withdrawal of the blanket deposit insurance on all call or notice accounts, which has set the cat amongst the pigeons in a nation of savers.

The move limits insurance to Y10 million ($75,200) per depositor at each account-holding bank. Many savers are already peppering their money out to a variety of banks in Y10 million parcels or into other types of deposits which will remain insured for another year. Japanese capital flight from deposits into gold was a contributing factor which pushed the price of gold over $300 last month, from $265 to $270 per troy ounce.

The second reform will force banks to value their shrunken Japanese equity portfolios at market prices for the first time, which will outline in black and white for the first time the real fragility of the banking system.

But the government is not standing idle. The Bank of Japan is ready to pump public funds to the tune of Y10 trillion - or US$ 75,703,500 million - into the banks and is expected to increase its purchase of government bonds to Y1 trillion per month - US$ 7,570,350 million - an increase of 25 per cent, to support the government's anti-deflation package.

Avoiding a banking crisis is Prime Minister Jinichiro Koizumi's priority ahead of reflation of the economy.

But commentators seem divided over whether injections of public funding will be positive for the economy in the long run. Barings observes public funding of the banking system can only prolong the country's economic problems and further rubbish the bank's reputations in the eyes of the Japanese who hold them personally responsible for the current mess.

Others believe that signs of an upswing in the US will eventually work their magic on the Japanese export market, pulling the economy out of a recession which has already been boosted by the weakened Yen, which is currently at a three-year low.