Will the circle be broken?

19 March 2001 00:00  [Source: ACN]

The recent barrage of poor economic indicators has raised even greater doubts as to whether Japan will be able to emerge from its decade-long crisis. Against this gloomy background, John Richardson examines the efforts being made by the Japanese government and the country's petrochemical industry to escape the vicious deflationary circle which is driving down demand and driving up unemployment

There are plenty of reasons to be pessimistic about the prospects for the Japanese petrochemical industry for the remainder of this calendar year and for the next financial year.

Almost every day, more disturbing economic news emerges from Japan.

For instance, as ACN went to press, one research house predicted that real gross domestic product (GDP) growth would be only 1.2% for the calendar year 2001 against its earlier forecast of 2.2%.

The same research house, SG Securities Tokyo, forecasts that Japan's corporate recurring profits will grow by 5-10% in the financial year ending 31 March 2002 against its expectation of a 15-20% increase for 2000-01. The 15-20% would itself be well down on the 29% recorded for 1998-99.

SG Securities adds that capital expenditure will in the calendar year 2001 fall to a growth of 3% against 4% last year. In December, the Industrial Bank of Japan warned that capital expenditure would slip if semiconductor demand remained sluggish. It has remained sluggish.

The other bad news includes deflation which still persists despite frequent and huge government economic stimulus packages. The attitude of consumers in Japan is: Why buy now when the goods you purchase could be cheaper next month?

And why buy at all when your job is in danger? Corporate restructuring, essential for sustained recovery but ironically seemingly driving the sustained recovery further and further away, was the major reason why the jobless rate in January reached a record high of 3.9%.

Deflation, understandably, resulted in lower overall industrial output in January. Output fell by 3.9% compared with December.

The Nikkei 225 Index fell to its lowest level in 16 years on 13 March - 11 819.70.

And as this feature went to press, the yen was at Yen120:US$1 against Yen102:US$1, its level in December last year. This is dangerously close to being weaker than the level below which the advantage to petrochemical producers of greater export competitiveness through a weaker currency is more than offset by the increased cost of imported feedstock. The Japan Petrochemical Industry Association (JPCA) places the optimum range of the yen for the petrochemical industry at Yen110-120:US$1.

The yen certainly was not helped by Finance Minister Kiichi Miyazawa's comments on 8 March that the government's finances were 'quite near to collapse'.

His remark was official confirmation of what economists have feared for a long time.

Since the early 1990s, governments have spent Yen120 000bn (US$1005bn) on economic stimulus packages. Critics of Japan's economic system argue that the packages sought to avoid the need to end practices such as state-directed bank lending to favoured companies and industries.

But the packages have not worked. The petrochemical industry and other industries have been facing stagnant demand for more than a decade.

And now with the Nikkei at historic lows and the yen in danger of going into freefall, the government has little room to throw more money at the economy.

Public debt is estimated to be currently at 100% of Japan's GDP. By the end of the financial year 2001-02, economists forecast that public debt will rise to 120% of GDP. Japan's GDP for 1999-2000 was Yen500 000bn.

It has been estimated that unless Japan drastically reduces its public debt, it will be unable to care for its rapidly ageing population.

Therefore, Japan seems to have little room to provide even more public money to at the very least halt the slide in the Nikkei if not reverse its decline and/or clean up some of the bad debts of the banks. Non-performing loans in Japan total an estimated Yen32 000bn.

It was therefore not surprising that when the government on 9 March announced a rescue package including tax concessions for individual stock market investors, an intense debate followed as to whether Japan can afford the proposed measures.

The trouble is that if the government does nothing or doesn't do enough, it risks recession.

Banks measure their capital adequacy partly by the value of their shareholdings.

In September 2000, the capital adequacy ratios of the banks were 11-12%.,The Nikkei has since fallen by 20%, driving the ratios down by 0.4-0.8%.

If the Nikkei was to keep on sliding to the point where ratios were below 10%, credit would be even harder to come by in Japan for medium and small-sized businesses. Ten per cent is the minimum capital adequacy ratio set by the Bank of International Settlements. Therefore, if Japanese lenders fall below this level, they will find it much harder to source the money they need for loans from the inter-bank market.

For the petrochemical companies and the trading majors, this is not directly a big deal. They have secure lines of credit with banks within their keiretsu and can raise money through equity and bond markets, although given the state of the Nikkei, these are currently not options.

But indirectly obviously, more bankruptcies of medium-sized and small businesses would drive down petrochemical demand.

However, on the plus side, there are Japan's enormous private savings, which Shuji Shirota of SG Securities Tokyo estimates are 11-12% of GDP. Even if half the savings were injected into the economy, then growth would be sufficient to bring down public debt to a much safer percentage of GDP.

And Japan might then be in a virtuous circle of rising prices and therefore rising demand as consumers buy now to avoid the risk of goods becoming more expensive.

But exactly how to get Japan's savers spending again remains the big issue.

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Confidence in Prime Minister Yoshiro Mori's government in addition to fears over unemployment is given as a reason for the persistent deflation. His personal approval rating is at an all-time record low for any Japanese prime minister.

Last week, Mori was teetering on the brink of resignation.

If he does go, the worry is that there is no politician in Japan with both the political clout and the reformist zeal who could replace Mori. Therefore, economists predict that Japan's next prime minister, whoever he is, will not carry out much-needed reforms such as breaking the links between the government, the banks and the favoured companies and industries.

Against this background, it is hard to see how petrochemical producers can instigate domestic price rises necessary to recover the ground they lost last year as a result of the surge in naphtha prices.

In October 2000, producers achieved very limited success in efforts to raise the prices of polymers and of intermediates such as styrene and purified terephthalic acid.

One PP major says: 'We did not manage to raise prices at all last year.'

He added of the polymer producers, only those of PE film managed to increase prices in 2000. But they only forced through increases of Yen2-3/kg, a long way short of the Yen10/kg which analysts say was their original target.

Last year's price rise attempts were motivated by naphtha prices that in H1 2000-01 were close to Yen21 000/kilolitre against the Yen19 000/kilolitre that the producers had estimated for the purpose of their financial forecasts.

In the second half of the current financial year, naphtha prices have been within the range forecasted by producers. This has been of little comfort given that in Q4 2000, prices soared to Yen25 000/kilolitre.

The irony for one PE major is that although it is benefiting from what has since been a fall in the feedstock's prices, the declines are along with the ailing economy making it difficult for it to persuade customers to accept increases during current negotiations.

What also impacted last year's talks and is affecting current negotiations is the ongoing investigation by the Fair Trade Commission (FTC) into allegations of price fixing by PP producers (ACN 26 Feb, p4).

For the PE producers who also make PP, the FTC probe is colouring PE discussions, even though PE pricing strategies are not under investigation.

Included in the present talks are efforts to persuade more customers to switch from settling prices by negotiation only to accepting naphtha-based formulas.

Mitsui Chemicals says that 30% of its PE customers have agreed to accepting prices calculated on naphtha-based formulas. The company adds that its forecasted stronger financial performance in the financial year ending 31 March 2002 is partly based on it being able to persuade more customers to switch to the formulas (ACN 12 Mar, p6).

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'No chance in the current climate. And anyway, why on earth should any customer ever exchange the fundamentals of supply and demand for any formula based on its suppliers' raw material costs?' says Nicholas Smith, Tokyo-based chemicals analyst with ABN Amro.

'You could again have the situation, such as last year, where naphtha rises to historic highs while deflation of end-product prices continues.'

The PP major adds that only for automotive end-users are domestic prices linked with naphtha.

He points to how important it is for Japanese petrochemical producers to persuade more customers to switch to formulas when he says: 'It is only in the automotive sector that PP price rises are possible.'

In acrylic fibre, the domestic market is actually shrinking. One Japanese acrylic fibre player says its sales were once split equally between the local and export markets but that now 60% of its product is shipped overseas.

'The reason for the fall in domestic consumption is the Japanese economy,' says a source at the producer.

'Japanese consumers are concentrating on saving rather than spending money because they are worried about the future.'

He adds that the acrylic fibre sector is seeing increasing imports of finished goods, another factor behind the decline in local acrylic fibre consumption.

'We have been trying to increase acrylic fibre prices but it is not easy. There was no price hike last year,' he says.

Adding to the Japanese petrochemical industry's woes are weakening export margins and sales volumes resulting from new petrochemical capacities in Saudi Arabia and Taiwan and declining economic growth across Asia. Asia's GDP expansion is slipping largely because of the US slowdown which could become a recession - another factor behind Japan's domestic economic decline.

In January this year, for instance, the 800 000 tonne/year Petrokemya III cracker came onstream. ExxonMobil's 800 000 tonne/year cracker in Singapore and its downstream plants began a sequential startup this month (ACN 5 Mar, p36), particularly bad news for Sumitomo Chemical. Sumitomo with its 50% share in Petrochemical Corp of Singapore, has often cited its strong overseas earnings as a reason why it is relatively immune from problems in Japan.

Because of this worsening export environment, the weakening of the yen has not delivered the benefits to producers that might otherwise have been the case.

'Asian prices are lower than we expected. Therefore, the weak yen is not giving us either the selling price advantage or the increase in volumes that we expected,' the PP producer adds.

However, a reason for slight optimism is that at least in the case of import competition, Japanese producers will be better off as a result of the decline in the yen.

In 2000, the industry faced tough competition from countries within the Preferential Import Scheme. These developing economies, such as Thailand and Malaysia, currently enjoy zero import duties.

Particularly hard hit by import competition had been sales by Japanese PP pro-ducers for low-end injection moulding applications.

In addition to a weaker yen, the PP major expects that the Japanese industry will further benefit through the levying from 1 April of 1-2% import duties on product from countries within the scheme.

And there are other grounds for guarded optimism.

At least for one commodity chemical - caustic soda - traders believe producers will achieve a price hike of Yen5-7/kg.

The traders' confidence that the hike will be accepted is based on the tightness in markets in Japan. Asahi Glass reduced its operating rate to 80% from end-2000. Weak PVC markets have impacted chlorine demand.

Also, global caustic soda demand is tight and domestic demand has been rising steadily if not spectacularly despite Japan's long economic decline, by 2-3%/year.

There are other causes for hope for petrochemical producers.

The JPCA insists that although this calendar year is likely to be worse than 2000 for producers, petrochemical demand will either only decline very marginally this year or could continue to grow, depending on the product. And the JPCA adds that a weaker 2001 would be partially compensated for by what was a pretty good 2000.

For instance, it says that in 2000, PP production rose by 1%, ldPE by 2% and PS by 1% to 2.6m tonne, 1.88m tonne and 1.134m tonne respectively over the 1999 figures.

The PP major adds that domestic PP demand grew by 2-3% in 2000, mainly as a result of growth in the automobile and household products injection moulding sectors. He predicts that this year, growth in these sectors will be maintained.

But still, much of the recovery was bunched in the first half of the last calendar year and was largely driven by stronger exports.

In H2 2000, exports slowed. As a result, Japan's ethylene production slipped by about 1% over 1999 to 7.69m tonne. This year, the JPCA is forecasting a 1% decline in C2 production over that for 2000.

An indication of Japan's overall industrial decline in H2 2000 is that SG Securities says corporate recurring profits surged by 40.2% in April to June last year. And yet, as already mentioned, its full-year estimate is for growth of only 15-20%.

However, the economists and financial analysts who spoke to ACN agree that while Japan's economy will slip this year, there is little danger of it falling into recession.

Shirota of SG Securities says inventory levels across all industries are at historic lows. Better inventory management means there is little danger of producers offloading goods at drastically reduced prices into an already deflationary economy, a sure trigger for a recession.

Yet another 'but' is that the economists and financial analysts' confidence that there will not be a recession in Japan is based on the belief that there will not be a recession in the US. It at present does look as if slowing growth in the States in H1 2001will be partly compensated for by a stronger second half. However, who really knows?

To be positive again, though, one financial analyst points out that the decline in the Nikkei to a 16-year low is partly the result of 'the seasonal factor'.

He says that every year, speculators try to drive the Nikkei down by spreading doom and gloom ahead of the release of corporate results and government statistics for the full financial year.

The speculators then buy into the market in the hope that after 31 March the dark picture they have painted is not borne out by the figures.

And if the petrochemical producers are correct, their financial performances for the financial years ending 31 March 2001 and 2002 will actually improve despite the weakening domestic economy and export environment.

Take Mitsui as an example.

Again, as already mentioned, Mitsui is basing its prediction of a better performance partly on the belief that it can persuade more of its PE customers to switch to naphtha-based formulas.

The company argues that despite Japan's economic slowdown, complex and lengthy negotiations with customers are likely to reach successful conclusions in 2001-02.

However, it is also basing its 2001-02 forecast on Mitsui Phenol, its new subsidiary, bringing onstream its 200 000 tonne/year plant in Singapore in August.

In a few years time, phenol will be in short supply. But in 2000, it is estimated that Asian demand will total 1.5m tonne against capacity of 1.9m tonne.

But still, it might be argued that Mitsui would not be promising what it cannot deliver for fear of the effect on investor confidence.

The company insists its forecast for operating profit of Yen62-63bn and net profit of Yen18bn for 2001-02 from a turnover of Yen1020bn is prudent. For the financial year 2000-01, Mitsui expects to return an operating profit of Yen55bn and a net profit of Yen17bn from a turnover of Yen950bn.

What about in the longer term then, beyond 2001-02? What are the prospects for Japanese petrochemical players?

Whatever your view, they should at least be lauded for trying to break out of the vicious circle of stagnant domestic demand and commodity product lines that these days are incurring deeper and longer pricing and margin troughs. Shouldn't they?

The cynics suggest that some of the companies have announced their intention to increase production of or diversify into higher value-added products without having any clear strategy as to how this will be achieved.

'It is very easy to talk about higher value added production and such talk can be good for your share price, but it is much harder to make a success of it,' says a senior executive with one Japanese petrochemical major.

But then again, companies such as Sumitomo have already made a success of adding greater value. The company is predicting a 74% surge in 2000-01 consolidated net profit, largely because of improvements in its agrochemicals and pharmaceuticals sectors (ACN 26 Feb, p7).

Also, the company adds that its acceleration of expenditure in R&D is set to reap the dividends of strong new proprietory technologies. For example, it claims possession of commercial caprolactam and propylene oxide technologies which do not produce any co-products or by-products.

In Asahi Kasei Corp's case, it changed its name from Asahi Chemical Industry in January as part of its efforts to prove that it has changed its philosophy.

Big is no longer necessarily beautiful for Asahi. Instead, the company will only increase capacities in any product where it feels confident of achieving global competitiveness (ACN 15 Jan, p26).

Asahi Kasei and several other industry players profess their intention to add to existing or diversify into electronics chemicals production.

In the longer term, it seems inevitable that demand for electronics chemicals will grow enormously.

At present, the electronics industry is in a down cycle because of the US slowdown and the fact that many computer purchases which were delayed by the Asian economic crisis were made in 1999-2000. Many consumers will not replace their personal computers for another 12-18 months, say electronics analysts.

However, in the long term, demand prospects appear fantastic. You only have to look at China where Internet use is doubling every year from a very small base to realise the potential.

But there are doubts as to whether electronics chemicals will add that much value to Japanese petrochemical companies.

A consultancy estimates that in 2000, the average net profit margin of electronics chemicals producers was 2% against 27% for the semiconductor manufacturers.

If substantially more electronics chemicals capacity is added, it could be that what appears to be already a buyers market becomes even more of a buyers market.

And as for pharmaceuticals, it can take US$500m to bring a drug to market.

It can also take years to obtain final approval for a new drug.

For established pharmaceuticals players, this is not as big an issue - they have existing portfolios from which they earn high margins to cover the R&D costs.

But for the new entrants, they will have to wait until their first few drugs are approved before seeing any return on their investments.

Also, there is the risk that final approval could be turned down, as is the case with the LG Chemical's antibiotic, Factive.

Once approval is granted, the key to high returns is having the marketing network and production capacity of a big enough scale to reap major rewards.

Analysts say new entrants may not have the scale needed to produce really strong returns.

What will also shape the industry's long-term prospects are the numerous single-product mergers and the proposed tie-up between Mitsui and Sumitomo.

It seems certain that there will be more single-product alliances. Japan Polychem, Sun Allomer and Chisso Petrochemical are, for instance, in negotiation for a PP tie-up (ACN 22/29 Jan, p5). Connected to these talks is the proposed PE merger between Japan Polychem and Japan Polyolefins.

The industry has travelled a huge distance through the single-product alliances that have already taken place. Some non-worldscale capacities have been scrapped, raw material purchasing strength has increased and employment levels have been reduced as a result of the tie-ups.

And even where operations have not been merged, capacity has been taken out. For instance, Showa Denko scrapped its 231 000 tonne/year Oita cracker in August 2000 and Mitsubishi Chemical permanently shut its 276 000 tonne/year Yokkaichi cracker in January last year.

But the feeling is that much more rationalisation needs to take place. Overcapacity still dogs many sectors of the industry.

And as for the planned megamerger, the jury is still very much out as to whether it will deliver major benefits.

Commentators believe that the merger of Mitsui and Sumitomo's polyolefins operations, which is due to be completed this October, will deliver obvious synergies. However, they add that the synergies from the merger of the rest of their businesses is not as obvious.

But to return to the positive, last but far from least are the tax changes which will provide a major boost to Japan's petrochemical industry both in the short and long term.

Registration tax is to be lowered from 1 April this year for companies formed as a result of restructuring.

And land assets from that date onwards which are sold as part of restructuring will be valued at their original registered value rather than their current market values.

Most crucially, from April 2002 consolidated tax will be introduced which makes sense of establishing holding companies.

All these measures should make it a lot easier for the Japanese industry to further restructure.

But still, the short-term gloom over the Japanese economy and the country's petrochemical industry was impossible to avoid as this feature went to press.

The hope is that all the barrage of bad economic news will not in the long term undermine all the refocussing and restructuring efforts and that the efforts in themselves prove to be correct.





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