OBSERVER - POLICY: The biggest risk in Japan is the policy vacuum. Japanese policy-makers have been complacent in the face of a seriously illeconomy

The Japanese economy is in bad shape. It has been for some time now and, according to the Bank of Japan, that's not going to change soon. This year the economy will decline by more than 1 per cent and the Bank of Japan sees more or less the same outcome for the following year.

The depth of the problem becomes more apparent when we look at what's going on within the economy. Retail sales are down nearly 5 per cent in the past 12 months and manufacturing has imploded, with industrial production suffering a 12 per cent decline over the year. The unemployment rate is at a record (by Japanese standards) 5.6 per cent.

These are significant figures by any measure but perhaps the clearest picture of how deeply ingrained the problems in Japan are is the fact that retail prices have been declining for more than two years. Inflation in Japan this year is minus 1.5 per cent.

Deflation like this is a problem for an economy. It means that even very low interest rates are higher in real terms for consumers and they are in no hurry to make purchases as they expect prices to decline further.

The health of the economy is mirrored in the performance of the Japanese stock market. The Tokyo index is down more than 30 per cent from its high of the past 12 months. Japanese equities are more than 65 per cent lower than they were in December 1989.

Does this matter for Irish investors? In one sense not as much as it did. In the late 1980s, many Irish pension funds had up to 15 per cent of their international stock market exposure in Japan. Today the corresponding figure is just under 5 per cent.

However, Japan has, in the past, shown itself to have a disproportionate effect on fund values - when it moves, it moves big. It is also, as the world's second-biggest economy, pivotal as regards the future direction and health of the global economy.

As dire as the economy appears in Japan, it is possible to see a situation where it could muddle through.

The benefits of a global pick-up will filter through to the flagship exporting sector in Japan. We have seen some slightly better figures on the production side recently but it is still too soon to regard this as a bottoming.

Equally, we would draw little positive news from the yen's depreciation. A weaker yen has much less effect on the Japanese economy than it might have done 10 years ago. Japan's industry has "hollowed out" significantly, relocating many operations overseas to overcome a previously strong yen in the late 1980s.

The biggest risk in Japan is the policy vacuum. Unlike the concerted and dynamic efforts we have seen in the US, Japanese policy-makers have been complacent in the face of a seriously ill economy. Last year the new Prime Minister Koizumi appeared to offer the hope of serious reform. To date we have seen little.

Much was expected of the new government package but it was very disappointing. There was little detail of the much-needed capital injection into the country's banks. All we got were some measures to address short-selling in the market and an attempt to shift blame on to the Bank of Japan.

In the past, Japan's policy-makers have shown themselves to be capable of addressing a crisis but less sure-footed when it comes to the next steps required to move the economy forward. There is a reluctance to take tough action when it is required.

This was very visible in the recent case of Daiei, a large supermarket chain in Japan that was bankrupt but bailed out by the banks (with the support of the government), who swapped their debt for equity.

No tough action was taken to address the problems. The supermarket was allowed to retain core assets such as its baseball team and its stadium, rather than surrender them to pay off creditors.

The risk is that this approach could become the norm for banks in dealing with the huge bad debt problem that exists in Japan.

The banks remain the key area that the government needs to address. It is hard to see this not requiring firm action and the current idea of the Resolution and Collection Corporation (which is the Japanese equivalent of the Resolution Trust Corporation, which dealt with the S&L crisis in the US in the early 1990s) is too vague, under-resourced and powerless to deal with it effectively.

For the investor this means the market, based on book values, is as cheap as it's been for more than 25 years. But it is hard to see any pick-up in profits until 2003. Its low valuation offers some comfort that any downside may be limited, but there has been a feeling for a while that Japan, as an investment case, comes with a risk-label attached.

The case for the market firmly rests with policy-makers taking effective action. History doesn't inspire confidence. Good policy-makers always seem to be a few steps ahead of the curve; in Japan they still seem to be trying to find it.

Eugene Kiernan is head of asset allocation in Irish Life Investment Managers