Talkin' Tankan--Japan's year-end surprises.

THE HEAVYWEIGHTS OF CORPORATE Japan ended 2003 with a forecast-busting vote of confidence in current business conditions.

In the Bank of Japan's quarterly Tankan survey, a majority of the country's manufacturing titans declared their most positive view of the business environment since 1997, giving the market a glimmer of hope that the likes of Toyota, Matsushita and Hitachi may finally be hardening their defenses against a persistently strong yen.

Leading the optimists were the electrical equipment makers, who definitively shed the worries they had earlier last year. Boosted particularly by strong domestic and Asian demand, they have been thriving on a ravenous consumer appetite for the so-called "holy trinity" of home equipment: the flat-panel television, DVD player and digital camera. The non-ferrous metal sector, which provides materials used in electronics, was also buoyant in its opinion of the market, and automakers' optimism made a dramatic jump.

The large manufacturers, whose views are seen as the most critical commentary on the Japanese economy, pushed their part of the Tankan's critical Diffusion Index (DI) to a reading of +11--its highest level in six and a half years and the second straight quarter of improvement.

The result, which is calculated by subtracting the percentage of companies with a negative outlook from the percentage of positives, contrasts strikingly with the misery back in March of last year, when Tokyo stocks plunged to a 20-year low.

The December 2003 survey showed positive results for only the second time since December 2000.

Analysts, including Mamoru Yamazaki of Barclays Capital, point out the significant change in dollar/yen exchange rate assumptions made by large manufacturers--a yen strengthening to 111.40 and higher for the second half from the previous level of 117.53. "Since the yen is currently stronger than even this revised rate, its direction should exert some negative impact on profits going forward," Yamazaki tells us. "Still, the DI improved sharply and sales forecasts were revised upwards for the sector in the second half, indicating the Japanese economy has strengthened its resistance to yen appreciation."

The market had been expecting a moderate improvement, with an average forecast of just +6 on the large manufacturers' business condition diffusion index.

The results appeared to take the 1,365 major companies that answered the survey by surprise as well--their consensus prediction back in September was for a DI reading of +3.

Although the Tankan is a reliably explosive market mover, the surprise leap to +11 did not produce the sort of rally that many expected.

Accompanying the major companies' cheerfulness on the current conditions was a note of caution on the short-term outlook--they believe that the sentiment index will be at +8 in the imminent March 2004 Tankan.

Medium and small manufacturers also became more positive, mainly because they expect to reap the rewards of expanding spending plans by the big players. But outside that sector, the improvement was less striking and in the case of large non-manufacturers did not propel the reading into net positive territory. Across the board, the widening gap between manufacturers and non-manufacturers provides skeptics of the apparent recovery with evidence Japan is too depedent on exports.

Construction is feeling the effects of a sharp drop in public works projects, and the telecom companies, already savaged by fierce competition, are expecting many months of price war still to come.

YEN MENDING

The survey provoked the Japanese government into one of its biggest bouts of market intervention ever.

Although the Bank of Japan and Finance Ministry keep very quiet about their levels of intervention in the dollar/yen rate, traders believe the government lavished more than $17 billion during year-end trading in a giant effort to stop the yen from climbing against the dollar.

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The move added to what was already a year of record intervention. By the end of November, the Bank of Japan had sold [yen]17.8 trillion in its attempt to stem the yen's rise. Reports from Finance Ministry sources suggest that the government may seek to raise the amount it can use in intervention efforts to [yen]20 trillion per year from fiscal 2004.

The dollar continued falling steadily against most major currencies, but the fall gives the greatest headache to Japanese companies who are now relying on their exports to fuel the nascent recovery.

--The Editors

THE WORD ON THE STREET FROM THE HEART OF TOKYO