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Japan, the land of the rising sun - and, for much of the past two decades, the land of the banking crisis, the ageing workforce and the falling stock market. So, in the wake of the largest financial and economic catastrophe for generations, why should investors look east?

Undoubtedly, Japan is closely tied to the global economic cycle. Manufacturing dominates the economy, with manufacturers making up more than half of the Topix. Unsurprisingly, therefore, the sharp fall-off in global demand has had a major impact, and while Japan was a spectator in the early phases of the global banking crisis, it has since been sucked into the morass.

So what grounds are there for optimism? Well, Japan went through something very similar before – and not too long ago. The tough lessons learned during the banking crisis of the 1990s have not been forgotten. Consequently, the authorities have been able to reach for a number of ‘off-the-shelf’ solutions.

The government has announced four successive stimulus packages, focusing on tax cuts, public works, loan guarantees for small and medium-sized businesses and support for financial markets. These amount to roughly 5 per cent of GDP – more than twice the proportion spent in the US. The Bank of Japan, meanwhile, has cut interest rates effectively back to zero and taken steps to improve loan growth.

The other vital lesson Japan has learned from the 1990s is the avoidance of excessive leverage. As a result, debt is simply not a threat. Corporate balance sheets remain strong and the banking system liquid. Indeed, lending is now as strong as it has been since the early 1990s, with banks welcoming back customers they have not seen for decades. And although the housing market has stuttered ahead of the introduction of massive tax incentives, it remains solid. All of this leaves Japan in a much better position to survive the current crisis than its G7 peers.

Importantly, the inventory cycle now appears to be bottoming for many products. The sharp decline in demand was exacerbated by a dramatic drop in production aimed at reducing inventories at the end user, the sales channel and the factory.

The economist Richard Jerram has pointed out the inventory-adjustment process could lead to a record-breaking rise in industrial output between March and June as restocking gains pace. Using the automobile sector as an example, he notes that to maintain a "normal" level of inventories, production output will have to rise by 50-60 per cent from its low point in the first quarter. Indeed, underpinning Mr Jerram’s comments, car makers Toyota and Nissan have already announced their intention to increase production levels from the summer. Meanwhile, there are some particularly encouraging signs from Japan’s Asian trading partners - the Chinese purchasing managers’ index has now risen above the level associated with economic expansion.

And while the global inventory cycle is crucial for Japan, domestic demand appears to be improving, too. Swift intervention by the authorities - in the form of tax cuts, job-support measures and subsidies for buying durable goods - appears to have taken effect, and Japanese consumer confidence is recovering sharply from its nadir of late last year. Confidence also appears to be rising among small businesses - an important indicator the cycle is about to turn - while the latest Tankan survey, issued by Japan's central bank, suggests most companies will enjoy a healthy recovery in profitability, despite falling sales. Cost cutting appears to have worked.

We should also remember to distinguish corporate Japan from the Japanese economy. Many companies are global players and have the potential to be net beneficiaries of the global crisis. They have also taken falling demand seriously. These companies have strong balance sheets, and many are using their excess capital to undertake major restructuring programmes to maintain profitability while demand remains depressed. So, like the governmental response, the corporate response to the current downturn has been rapid. Given the history of change in Japan throughout the malaise of the past two decades, this is particularly encouraging. Those companies that can restructure aggressively during the current crisis should be able to emerge from it as long-term global winners.

Japan has many such companies, across a broad range of sectors. Examples include Sony and Panasonic in consumer electronics; Hitachi Chemical and Shin-Etsu in chemicals; Fujifilm and Konica Minolta in precision instruments; Toyota and Honda in automobiles; Mitsui Mining and Smelting and Sumitomo Electric Industries in non-ferrous metals; and Hitachi Metals in iron and steel. All of these should prosper in the ruthlessly Darwinian environment engendered by the current crisis.

The collapse in global demand has led to a massive cut in earnings expectations by analysts across the whole market. But the ‘street’ in Japan has a particularly marked tendency towards extremes of sentiment. Japanese analysts tend to chase their tails. Peter Eadon-Clark at Macquarie Capital Securities (Japan) thinks earnings expectations are now at reasonable levels overall and, in many cases, too pessimistic. Overly negative earnings assumptions offer great upside in stock performance – especially when combined with the positive change from restructuring. There are real opportunities for astute investors here.

Currency is another consideration. After a period of strength during the first stage of the global crisis, the yen has weakened against most major currencies this year. Because most Japanese companies are manufacturers that depend on external demand, a weaker yen is good for earnings. Most analysts’ forecasts have included average estimates of ¥85-¥90 (50p-60p) to the US dollar for the current year.

So, the current level of roughly ¥100 to the dollar should boost exporters’ earnings this fiscal year. Better still, last year’s strong yen prompted many Japanese companies to intensify their restructuring efforts to reduce their break-even ratios. This should strengthen their relative competitive positions in global markets in time for the upturn in demand. In recent years, a weaker yen has led to a recovery in the Japanese stock market. On historical comparisons, the market has still to catch up with the currency.

A key question for the direction of the Japanese stock market is the attitude of overseas investors. Increased net buying by foreign investors normally leads to a rally, while net selling pushes the market southwards. Last year, foreign net selling was worth ¥3.7trn (£24.3bn). This was the first year of net selling by overseas investors since the ¥2.4trn sell-off in 2000 after the tech bubble burst. But given that foreign investors were already significantly underweight Japan at the end of December, recent selling is likely to have pushed them to a more substantial underweight. Any continuation of the current cyclical rally should lead to increased net buying of the Japanese market by overseas investors.

Finally, Japan’s gearing into the global economic cycle means its stock market should rise when the world economy shows the first signs of recovery. The good news is that a bottoming in the OECD leading indicators may be around the corner. This has a strong correlation with earnings revisions in Japan. Because of the stock market’s exposure to manufacturing, any upturn in global demand should lead to a recovery in earnings – especially for companies that have successfully restructured.

Keith Donaldson is head of the Japan team at Martin Currie Investment Managers

Lessons learned from the 'lost' decade

- 'Off-the-shelf' solutions include tax cuts, public works, loan guarantees for small and medium-sized businesses and support for financial markets

- The Bank of Japan has cut interest rates effectively to zero and taken steps to improve loan growth

- Japan has avoided excessive leverage following the 1990s banking crisis and, consequently, bank lending is now as strong as it has been since then, with corporate balance sheets remaining strong and bank systems liquid

- Swift intervention by the authorities, in the form of tax cuts, job-support measures and subsidies for buying durable goods, has helped boost domestic demand

- As with the governmental response, the corporate response to the current downturn has been rapid, with cost-cutting measures appearing to allow profits to rise despite falling sales