Is The Worst Over?

By Barbara Rudolph

THE SIGNS ARE TENTATIVE; THE EVIdence is sometimes shaky. But finally a consensus is building that the ailing economies of Europe and Japan may be limping, slowly and painfully, toward recovery after years of recession. The balloon of prosperity is not fully off the ground, but hopes are lifting.

That is good news for the entire world. Even with the U.S. well into its recovery, the slump in Japan and Europe has dragged down the global economy, hurting demand for raw materials and other export goods from developing countries. But last month the Organization for Economic Cooperation and Development (O.E.C.D.) reported that it was revising upward its 1994 growth estimates for Germany, the powerhouse of the European economic engine, from 0.8% annually to 1.8%. The organization now predicts the Japanese economy will expand 0.8% in 1994 -- last year it grew 0.1% -- and the European Union 1.9%, vs. a drop of 0.3% in 1993. In a welcome note of optimism, last week the ever cautious Bundesbank declared that the "recessionary tendencies in the West German economy appear to have been overcome."

Most of the recovery will be led largely by corporations, not consumers. Throughout the E.U. and Japan, voters still have only shaky confidence in their economies, which typically means their checkbooks will stay closed. But thanks to a surprising boost of exports in Europe and successful cost cutting in Japan, many companies expect an improvement in corporate profits by the end of the year. This should eventually spark further growth. "Things began to turn toward the end of the year, and the signs have multiplied since then. This is a recovery that is gathering pace and is still being underestimated," says Ian Harwood, director of global strategy for the S.G. Warburg investment house in London. "It won't be derailed."

Maybe not, but cracks in the foundations of these economies could yet cause shudders in the nascent recovery. In Japan deflation continues to haunt the economy as banks struggle to cope with swollen portfolios of bad debts. Many Japanese firms still suffer as well from excess capacity and bloated payrolls. In Europe high interest rates, fueled by the bond market's fear of an outbreak of inflation, could still put the brakes on the recovery.

Even in the best of circumstances, the lift-off will not be pretty. Growth will stutter more than roar. And unemployment rates, which will reach an estimated 11.7% this year in the E.U. and 2.8% in Japan, will decline only after the economic recovery has been better established. Herewith, tidings from the various fronts:

JAPAN

"I feel things are beginning to move. I have a gut instinct about it," says Shizue Tanaka, whose family runs Tanakatei, an upscale restaurant in Tokyo's posh Akasaka area. Tanaka's sentiments are now shared by most influential businessmen: a quarterly survey by the Bank of Japan, which tracks the mood in boardrooms, recently reported the first upturn in business optimism in five years. "The possibility is strong that the economy has moved one step toward recovery," says Bank of Japan governor Yasushi Mieno. "But we must carefully watch the sustainability and tempo of the upturn."

Other hopeful signs include a surge in new housing construction. April housing starts were up 11.6% over last year's level. Consumer electronics companies and car manufacturers are also expected to ring up especially happy results. Example: thanks to unexpectedly strong orders for its four-wheel- drive RAV4 recreational vehicle -- about 17,000 a month, vs. an anticipated 2,000 -- Toyota's profits should increase for the first time in four years.

Even with corporate revenues climbing, however, economists expect no immediate pickup in Japan's capital spending, which accounts for a third of the economy and which has been declining steadily for the past three years. Most firms have more than enough factory capacity to keep up with demand, and when they do expand, many are looking overseas to cheaper labor markets in the rest of Asia. Capital spending, says Yoshio Terasawa, director of the government's Economic Planning Agency, is "the key point. Should there be any signs that equipment investment started increasing, then I really think the economy would catch up."

The bad news for workers is that at the same time, further job cuts seem inevitable, since most companies have more employees on their payroll than they are likely to need. The unemployment rate, now 2.8%, could double in four to five years, forecasts Johsen Takahashi, an economist at Mitsubishi Research Institute. Moreover, Kyodo News Service recently conducted a survey of 100 major firms listed on the Tokyo Stock Exchange, which revealed that half the companies plan to cut their work forces this year.

Japan's financial institutions are another obstacle to faster growth. Last month the country's 11 major commercial banks reported a fifth year of declining profits; overall, the banking system may face about $130 billion in bad debt. The decline in property values has prevented banks from collecting on the collateral -- most often real estate -- that stands behind the piles of bad loans. The Tokyo government continues to claim the worst of the financial bloodletting is over, but independent analysts dismiss that as wishful thinking. "No one knows the true magnitude of the banking problem," says Shinji Okabe, assistant vice president of Moody's Japan K.K., "because the system of disclosure is so bad. Even bank managers don't know how bad their own portfolios are."

Still, the pervasive pessimism of Japan about its economy has eased. "We now have a brake on the fear that the economy will get worse," says Richard Koo, a senior economist at Nomura Research Institute. That in itself is no ; small change.

EUROPE

"The E.U. economies are walking, but they're not running," says J. Paul Horne, an economist for the Smith Barney Shearson investment firm in Paris. Indeed, Britain has been in a recovery for the past 18 months, and its gross domestic product is expected to grow 2.7% this year. The 11 other E.U. economies, however, are only beginning to perk up. After a disastrous 15% plunge last year, European auto sales should increase 3% this year, adding $5 billion to manufacturers' revenues. Most airlines report steady gains in the sensitive indicator of intra-European traffic, up more than 9% this year, though all major airlines are expected to lose money once again in 1994, the fifth straight year of red ink. Nowhere is the trend more critical than in Germany, which has long dominated the European economy both in weakness and in health. For the previous 24 months that influence has been negative. Then earlier this month Bonn reported that the West German economy, after its worst recession in 40 years, expanded at a 2.1% annual rate for the opening quarter of 1994, as compared with the same period last year. This was the first such gain since 1992. The government also forecast a 1.8% increase in Germany's G.D.P. for this year, to be followed by a 2.5% gain in 1995. "The recession is behind us," asserts Gert Becker, chairman of the German Association of Chemical Firms.

Becker's view may be optimistic, but German exports are once again climbing, pushing the expansion ahead: exports last month were up 13% over May 1993. The increase was particularly surprising in light of Germany's relatively strong currency and high labor costs. The most impressive performers include chemicals and communications equipment manufacturers, with the most important destinations being Britain and the U.S. After a serious bout of corporate restructuring and streamlining, German goods are now more competitive on world markets.

Consumer spending had little to do with the uptick. Pocketbooks are opening once again in France: consumer spending on manufactured goods is up 0.7% for the first quarter, compared with the same period last year. But in Germany and most of the rest of the E.U., wallets have stayed shut. Bonn recently gave citizens additional reasons to remain tightfisted by raising gas and social security taxes. Some analysts predict a 3% decline in consumer purchasing power this year.

Will the recovery be weighed down by rising interest rates? Business / executives, bureaucrats and factory workers share that concern. Last week the Bundesbank said it would make no further rate cuts "for some time," but that announcement exacerbated worries that inflation might be poised for a comeback. European bond-market investors have already bid up long-term interest rates appreciably. Ten-year French bonds now yield 7.6%, more than 5.6% in mid-January, and German bonds yield 7.1%, up from 1.6% in April. Many economists nonetheless argue that the Bundesbank is overstating matters and that prices are well under control. The E.U. expects the average inflation rate among members to fall from 3.3% this year to 2.9% in 1995, with the O.E.C.D. forecasting a modest annual German inflation rate of less than 2%. With Continental interest rates still stubbornly high -- one-year bonds yield 5.8% in France and 5.08% in Germany -- many economists contend rates must drop further if the general sense of prosperity is to deepen.

Despite the obvious fragility of the optimism, no one should discount the most heartening sign of all -- the fact that the mood of businessmen and investors is shifting, however delicately. The most unfathomable aspect of any upturn involves psychology: the more reasons people find to be hopeful about the economy, the more likely they are to act upon them. Economic indicators will flutter back and forth, but for the first time in years, the signs and statistics are drawing a sizable contingent of optimists.

CHART: NOT AVAILABLE

CREDIT: [TMFONT 1 d #666666 d {Source: OECD}]TIME Chart by Joe Lertola

CAPTION: GETTING OFF THE GROUND

With reporting by Jay Branegan/Brussels, Edward W. Desmond and Satsuki Oba/Tokyo and Bruce van Voorst/Bonn