It was a tiny increase, from zero to just 0.25%, but when the Bank of Japan raised interest rates this summer for the first time in six years, the little bump heralded the end of 15 years of a deflationary spiral and painful economic restructuring that has forever altered the Japanese way of life. Japan seems to be back on track economically, but Wharton faculty and analysts warn that the country may still hit some potholes down the road.

Chief among them are security concerns, particularly with Japan’s troublesome neighbor, North Korea, which has recently conducted nuclear tests. Japan is also increasingly vulnerable to slowdowns in the economies of its major trading partners, the United States and China. And Japan may have trouble sustaining growth if domestic income and consumer spending do not pick up. “There has been an economic revival underway, but I think a lot of things are happening in Japan and in the world that could become problematic,” says Wharton finance professor Franklin Allen.

For now, the country is experiencing GDP growth of 2.5%, and the Bank of Japan’s most recent quarterly tankan report indicates that business confidence has reached a two-year high.

In October, the Bank of Japan (BOJ) kept interest rates unchanged as it released its semi-annual report on inflation, economic growth and monetary policy. The nation’s core consumer price index rose 0.3% in August after rising 0.2% in July. Unemployment rose slightly to 4.2% in September. “I think the expectation for continued hikes this year is becoming a less likely scenario, though not impossible,” says Wharton finance professor Ayako Yasuda. “While business spending has increased, household spending increase is not as robust, so the BOJ is emphasizing a slow expansion.”

According to Allen, the economic uptick comes after an extraordinary 15-year stretch of contraction and ultra-low interest rates. “It’s been an unusual period to have zero interest rates for so long in a country,” he says, noting that some analysts argue that Bank of Japan officials should have raised rates earlier. “I think they were grappling with very difficult problems in deciding exactly how to proceed. Given that we hadn’t seen those conditions for so long — if at all — it’s not surprising it took a while to come up with policies. Nor was it surprising that Japan was cautious aboutdoing the unorthodox things Western economists suggested.”

John Percival, Wharton adjunct finance professor, says the period of zero interest rates helped the Japanese government manage an outsized deficit that had built up during attempts to kick-start the economy. In the end, government-sponsored infrastructure projects failed to stimulate growth and mostly benefited large construction firms. “There is some question about how long you can, and should, maintain zero interest rates. People need returns. Retired people depend on returns. Now there’s pressure to raise interest rates, but the government is in a horrible dilemma. If it raises rates, the huge deficit will come home to roost.”

The Bank of Japan and the government of former Prime Minister Junichiro Koizumi appear to have managed a successful transition to more realistic interest rates based on supply and demand, Percival adds. “I think they did a remarkable job of managing the process, which could have turned into a disaster.”

Akinari Horii, an executive director of the Bank of Japan, points out that it took nearly a decade to reform many parts of the economy following the spectacular collapse of Japan’s asset bubble in the early 1990s. “At the same time, global competition became much fiercer because of the entry of China and India into the world economy. Japanese corporations had to restructure and reorganize their business model.”

Only in the past year or two has there been enough momentum to generate growth, he notes. Fundamental improvements set the stage for this summer’s interest rate increase, signaling the end of deflation and economic contraction. “Japanese prices are expected to move up gradually, not dramatically,” so that the economy grows at a healthy rate “and there is a smaller and smaller probability of deflation coming back to Japan.”

Long-term rates at other institutions have also remained low, at less than 2%, following the Bank of Japan’s lead, Horii adds. “The future course of monetary policy in Japan is cautious. The risk of inflation is nowhere in the offing and the Bank of Japan can operate monetary policy very cautiously. There is no intention to raise interest rates steeply; the market understands this correctly. I think the financial markets and the capital markets understand BOJ monetary policy so well that [when rates increased] there was no hiccup in the bond market in Japan or even in the equity market.”

Abe’s Agenda

Former Prime Minister Koizumi, who left office in September, is credited with forging much of the deep and politically difficult reform, such as the restructuring of Japan’s postal savings system. His successor, Shinzo Abe, is generally expected to continue in Koizumi’s path.

Abe is a scion of a political family and the grandson of a conservative former prime minister, but is relatively inexperienced, according to Yasuda. “So far, he has done well by quickly arranging summit meetings with the leaders of China and South Korea, just in time for the North Korea crisis. It is expected that he will push for mended relations with these Asian neighbors in order to strengthen economic ties and make it easier for Japanese companies to build a presence in China and the rest of Asia.”

Abe has also taken steps to improve relations with China that were strained by Koizumi’s insistence on visiting a Japanese shrine memorializing convicted Japanese war criminals. The shrine is viewed by China and South Korea as a monument to Japan’s militaristic past. A longtime defender of visits to the Yasukuni Shrine, Abe has shifted gears since taking office. He now says he will neither confirm nor deny whether he has prayed at the shrine, but he allows aides to inform the media that he has visited the site.

“Abe seems interested in being a bit more accommodating,” says Yasuda. “But again, it’s too early to say how much of a material economic impact his diplomacy could have on the state of the economy. After all, most of the growth in GDP depends on domestic demand, not exports. And domestically, his economic vision is not that clear.”

Japan can never be expected to embrace a free-market economy to the same extent as the United States or many other developed nations, adds Percival. “There is now a Japanese version of free markets that is a little more free market and a little less the traditional Japanese way of looking at things. Some of that was forced by the restructuring and some of that, Japanese companies and regulators did kicking and screaming. But it will never be a true free-market economy the way the United States is. That’s their choice, and it’s probably the right choice for Japan because the culture is different.”

Despite optimism about Japan’s recovery, economists have some concerns about its sustainability. In a recent report, Morgan Stanley chief economist Stephen Roach writes that the mood in Tokyo is more sober than six months ago, and domestic consumption and income growth are a major worry. Roach cites data showing private consumption is up just 1.6% since the first quarter of 2002, well below overall GDP growth of 2.3%. Meanwhile, consumer confidence slipped for a second quarter in a row in September.

Roach also points out that sluggish real wages in Japan remain a drag on purchasing power. Compensation per employee rose 1% in 2005, but is up just 0.5% this year. Meanwhile, the long-awaited halt in deflation is generating mild price increases.

Intertwined with China

According to Roach, Japan faces the same problem as many other industrialized nations where globalization is driving down wages and stalling growth. “In my view, this is an unmistakable manifestation of one of the great paradoxes of globalization — a powerful global labor arbitrage that continues to put unrelenting pressure on the labor-income generating capacity of high-wage industrial economies,” Roach writes. “Until, or unless, the industrial economies figure out how to convert productivity improvements into enhanced labor income-generating capacity, their private consumption dynamic should remain under pressure. That may be an uphill battle.”

Weakness in domestic spending makes the Japanese economy dependent on capital expenditures and foreign demand, which could also become a problem. According to Morgan Stanley, China and the U.S. account for 37% of Japan’s export market. China’s share is growing, to 14.1% this year from 6.3% in 2000, while the U.S. share has dropped from 29.7% in 2000 to 22.5%.

Horii suggests that the Japanese economy is growing at a rate that will be difficult to maintain. Heavy state involvement in China’s economy also makes it difficult to forecast how and when that economy could downshift. “If Chinese growth slows, it will have an immediate impact on Japan,” he says.

Tensions with North Korea could also have an impact on the Japanese recovery, says Yasuda, adding that Japan’s economic sanctions against North Korea are not a problem because trade is so minimal anyway. “But North Korea is not an isolated event. The general fear about instability in the Middle East — where some may try to buy nuclear technology from North Korea — could result in a hike in oil prices again, which could then dampen spending and end the already lukewarm boom that the economy is in. Overall, there is increased uncertainty about the future.”

Horii predicts that 2008 will be an important political year in many countries — which could have an effect on Japan. Russia, Taiwan, South Korea and China — in addition to the U.S. — will elect new leaders that year. China will also be focused on the Beijing Olympics. Horii points to growing protectionist sentiment in the U.S. and also to elections in France and The Netherlands that rejected the European Union Constitution. These developments indicate that voters are increasingly uncomfortable with market-oriented policies toward globalization, known generally as “the Washington consensus.”

Even in Japan, says Horii, sentiment is growing that the Washington consensus followed by the Koizumi administration in the last five years has resulted in some inequalities in income. While Horii doesn’t agree with that view, he suggests that by 2008, “a backlash on globalization is possible.”

Market Disruptions

In the financial world, a rise in Japanese interest rates could have implications at home and abroad, according to Jennifer Amyx, a political science professor at the University of Pennsylvania and a member of The Graduate Group in International Studies at Wharton’s Lauder Institute. In Japan, financial institutions are developing new approaches to attract savers. “A lot of individuals are now seeking investment vehicles with yield rather than being resigned to zero interest rates,” she notes. “Financial institutions are scrambling to attract those customers.”

Globally, the rise in Japanese interest rates will likely send the government debt market higher for the first time in a decade, adds Amyx, who published a book in 2004 titled, Japan’s Financial Crisis: Institutional Rigidity and Reluctant Change. Meanwhile, foreigners who converted assets to yen — in order to take advantage of low Japanese interest rates to invest elsewhere through this so-called yen carry trade — may be squeezed as Japanese rates rise. “As the Bank of Japan raises rates and more investors start to buy into Japan’s revival, the yen will appreciate. That dampens the carry trade which could lead to some disruption in markets,” she explains. “What makes the phenomenon worrisome is that nobody knows how big the yen carry trade is.”

Amyx does not think rates will rise rapidly, but adds “even a small change will have an effect on those kinds of flows.” For example, investors who used yen-denominated loans to buy secure U.S. treasuries might choose to dump those holdings. Wharton’s Allen agrees that the end of cheap Japanese loans could have a major impact on global finance. “That drying up of liquidity may change how the market works. It will be uncharted territory, not just for Japan, but for global capital markets as well.”

In any event, Japan is once again viewed as a major player in the global financial structure. “Everybody has focused so much on China and India that they really haven’t been looking at Japan,” says Percival. “Japan is always going to be there. It’s a big, strong economy with a lot of good companies and some that are not so good. There needs to be more of a focus on Japan.”