The economic recovery in Japan has been going for nearly two years now, and accelerated sharply in the last quarter of 2003 when real GDP (gross domestic product) growth surged to 6.4% a year, mainly thanks to climbing exports and a pickup in investment. Its longevity already sets the current upswing apart from its predecessors.

But there are also other factors that point to Japan's expansion being more sustainable. First, it has had little to do with government spending. It is taking place in the context of tighter fiscal policies, and in particular a clampdown on public investment projects, with more impetus from the private sector.

The expansion has also broadened, so it is no longer just about exports. An upswing in the US economy and strong sales to China and the rest of Asia may have started Japan's expansion, but domestic investment and household consumption are increasingly making a positive contribution as well.

See the difference
Investment is rising because corporate restructuring is well advanced, corporate balance sheets are in better shape, and profits are improving. Of course corporate restructuring should be well advanced considering it's 15 years since the bursting of Japan's 1980s bubble, but it is better late than never, and there has been a significant decline in corporate debt.

On the household side, incomes and the labour market have improved, which has encouraged a reduction in the household savings rate. A persistent decline over the long run in Japan's household savings rate would lead to problems given the large budget deficit that has to be financed, but for now a decline in savings is very helpful. It allows personal consumption to rise ahead of personal incomes.

The third factor is all to do with the positive impact of structural changes and policy improvements. Greater pressure from the authorities, including the nationalisation of failed institutions and the injection of public funds, has forced banks to reduce their non-performing loans and raise more capital. Co-operation has also improved across the main economic policy-making institutions, and especially between the Ministry of Finance and the Bank of Japan (BOJ). It now seems less likely that Japan will repeat its recent economic policy mistakes - the lifting of consumption tax too early in the late 1990s, or the raising of interest rates in 2000, for example - which contributed to the end of previous economic upswings.

Finally, the Bank of Japan is making concerted efforts to end deflation, which, although it persists, is not the problem it once was. The most closely watched measure - core consumer prices - is now falling by only around 0.5% a year, after dropping by between 1% and 2% a year in the middle of 2003. There is even some anecdotal evidence that property prices are rising in major cities, particularly Tokyo and Osaka.

The BOJ is committed to keeping short-term interest rates at zero until core consumer prices are not only positive, but are also expected to stay positive over the long run. In effect, this means that the BOJ has already moved to something close to an inflation target and that short-term Japanese rates will likely stay at zero until well into 2005. The move out of deflation encourages consumer spending and also means lower real interest rates, which acts as another positive force for economic recovery. There were many doubts over BOJ governor Toshihiko Fukui when he took over, but he would get my vote as the world's best central banker over the last 12 months.

Still suffering
Despite all this good news, Japan still clearly has significant problems. But the problems look manageable and are being worked through. The banking sector is off the 'critical list' but is still in intensive care, and bank credit to the private sector is still falling. If the economy were to stall again for any reason, the banks would soon be back in trouble and would accentuate any downturn.

Not only that, corporate debt is still very high at around 140% of GDP, compared with US corporate debt at around 90%, which means the process of corporate and financial-sector restructuring still has some way to go. Japan's declining labour force means that further reforms to boost productivity, such as more service-sector deregulation, are essential to keep economic growth at a reasonable pace over the long run.

Finally, government finances have yet to show any significant improvement, despite the budgetary restraint of recent years. According to Fitch, a debt ratings agency, Japan's gross government debt is now equivalent to 160% of its GDP, by far the highest ratio of any OECD country.

This means that fiscal policy will need to be tightened further at some point, potentially pulling economic growth lower. Nevertheless, the risk of a fiscal crisis remains small as interest rates are likely to stay very low, whilst the still-large pool of domestic household savings should continue to provide the Japanese government, via Japanese banks, with the financing it needs.

Is it too late to invest?
For investors, there is still time to move into Japanese equities, even though the market is up a long way, some 50% higher than at its April 2003 low point. The recovery looks sustainable, corporate profits should continue to grow strongly and Japanese equity valuations remain reasonable. Price-earnings (PE) ratios always look very high compared to other major markets given the lingering impact of cross-shareholdings and a tendency to understate profits, but relative to historical levels they don't look so bad. We estimate the current market PE at 42 times earnings, compared to a 20-year historical average of 50 times.

What could go wrong? Well, the risks from investing in Japan remain significant, although they are probably lower now than at any point since the late 1980s. The main danger is that the yen might move too strongly, hitting export competitiveness and corporate profits, and forcing down local-currency equity returns. But well-advanced corporate restructuring and strong regional demand probably means that Japan can cope better now with a stronger currency.

We don't think that the yen is overvalued and suspect that its long run equilibrium level against the US dollar is around 100, not too far from where the yen was at the end of March. In addition, although the Bank of Japan appears to have eased off, it is unlikely to completely abandon currency intervention, buying dollars and selling yen. Investors should probably expect more yen strength against the US dollar over the next year, but only moderate strength, taking the yen to the 95-to-100 range.

A second risk is another external shock, or a case of history repeating itself. Japan's mid-1990s upswing was partly stalled by the Asian crisis that began in 1996, while in the late 1990s improvements were held back by the collapse of the global technology sector in March 2000. The biggest external risk to Japan at the moment is arguably China suffering a hard landing, but there is currently a lot of forward momentum in China's economy. A hard landing only looks a significant risk for 2005, not for this year.

That just leaves the possibility of political upset. Japan's prime minister, Junichiro Koizumi, is much more popular with the markets than within the ruling Liberal Democratic Party. Opposition parties made gains in 2003's general election and could make further gains in important upper-house elections set for July this year.

It's possible (although by no means a significant risk) that the ruling party might do so badly in July that Koizumi is ousted as leader and his departure would hit Japanese markets for a time. But all the most likely replacements would follow similar pro-reform policies, which are also heavily supported by the main opposition parties. And that makes any fall in Japanese equities on the back of a political upset a good long-term buying opportunity, not a reason to take flight.