Many worry that Japan's current upswing will turn out no different to Japan’s last two expansions, but we think that Japan’s current upswing is different from the last two and will resume soon.

Firstly, government policies have improved. The Bank of Japan has kept monetary conditions very loose to defeat deflation through its quantitative easing policy and aggressive intervention to stop the yen appreciating too far.

Secondly, financial system reform has surprised on the upside. NPL figures are now regarded as realistic and have been falling since 2002. In major banks at least, NPLs are on track to meet the government’s target that, by March this year, they will have halved from their peak at 9% of all loans in 2001.

Finally, corporate restructuring has led to a large reduction in leverage, excess capacity and excess labour. The move offshore of much of Japan’s mass production manufacturing capacity has helped.

External Risks
In Japan’s case the biggest threat is an external shock. The main concern is that the yen will be forced too strong by U.S. dollar weakness. But the yen still looks relatively cheap on an inflation-adjusted trade-weighted basis, and much cheaper than the euro
(see chart).

Another external risk is a hard landing in the U.S. and China. Even if it were to happen, we suspect the impact on Japan would not be disastrous.

Japanese foreign investment into China's coastal regions should limit the damage from a China hard-landing. Much of what Japan ships to China is re-exported elsewhere, and so isn’t especially vulnerable to weaker Chinese domestic growth.

Domestic Worries
The biggest domestic threat is that consumers pull back their spending. The savings rate, for several reasons, should stay low rather than climb sharply any time soon.

Firstly, the ageing of Japan’s population will keep savings low. As the elderly retire, they tend to spend more. Workers entering the peak savings age ranges won’t be enough of an offset. Although wage growth is still weak, the employment market has improved enough to lift wages in 2005 and to keep consumers spending.

Another domestic worry is that paying down debt will stay the dominant business theme, pulling back investment again and GDP as well. But pent-up demand and the need to stay competitive should mean that business investment grows faster than GDP.

Meanwhile, the economic pick-up we expect should bring higher inflation and higher BOJ rates. But the BOJ will be aware that the cost of tightening too soon and forcing the economy back into even worse deflation would be greater than the cost of overshooting on a desired inflation rate.

Overweight Japan Stocks
For the investor, we think now is a good time to overweight Japanese equities. Our models suggest typical Asian-based investors should hold around 11% of their portfolios in Japanese stocks, up on our benchmark allocation of 8%.

We expect the yen to strengthen against both the U.S. dollar and the Singapore dollar. Our forecast is for the yen to rise to 95 per USD by the end of 2005. Against the Sing dollar, the yen should rise to around 59.