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The Japanese Economy in 1998: A review of events and challenges for the future- Recovering from the aftereffects of the bubble's collapse -

Chapter 1: The Economy in 1998

Chapter 2: Reviewing the post-bubble decade

December 1998

Research Bureau, Economic Planning Agency

Chapter 1 Part 1: Negative growth for four consecutive quarters

1. Economy

Demand slumped dramatically as Japan's economy contracted for the four quarters from October-December 1997 through July-September 1998, widening the GDP gap.

2. Household

a) Employment picture remains grim

As the recession lingered, joblessness soared to unprecedented levels. This was due mainly to weak demand prompting a decline in the hiring ability of small and medium sized companies, which had until recently buttressed job growth. The recession has had a similar effect on wages, with a particularly severe reduction in employee bonuses in small businesses.

b) Weak consumption

During the Oct-Dec 1997 period, both propensity to consume and real income suffered a fall, with the former subsequently showing a continued decline. This indicates that weak consumption was brought on principally by dampened consumer sentiments. Consumer confidence received a further blow when a string of large financial institutions faltered, raising the prospect of further corporate restructuring and fanning qualms about long-term employment and wage outlook. Further, it is believed that as public debate on the consequences of the continued fiscal deficit deepens, household fears are mounting over such prospects as pension payments in an increasingly aging society.

c) Housing investment dips further

Housing construction, which has been languishing since 1997, further lost ground and fell to exceedingly low levels during the April-June 1998 period. The minimum level for growth of housing stock had traditionally been at least the rate of growth in the number of households. But the most recent trend is for housing growth to undershoot household growth.

Individuals' housing purchasing power has been boosted by tax breaks and other policy measures but demand remains weak because of the murky outlook for the economy and individuals' income. Other reasons include waning incentives to hold assets in the form of real estate as hopes for land price appreciation fade.

Figure 1-1-2 Changes In GDP gap

GDP gap, which had been narrowing until the Jan-March 1997 period, began to widen again. The expansion was especially conspicuous during the third quarter as negative growth continued. As a consequence, the gap had grown to roughly 3-4% of GDP by the April-June period.

(Note)
  1. 1. Line a takes into account resiauals when estiwatry average GDP. In line B, the residenth are smoothed out by HP filter.
  2. 2. Please refer to annotation (1-1-1) for the estimation methods used.

Figure 1-1-12 Cycles of housing stock and house construction

In examining the cycles of growth of house construction and growth of housing stock, it is evident that recent data deviates from the normal cyclical movement, with growth in the number of houses clearly exceeded by growth in the number of households.

3.Corporations and Finance

a) Capital investment decreases regardless of type and size of business

Capital investment has contracted dramatically, especially among small and medium-sized companies. This is believed to be the result of the credit crunch triggered by failures of large financial institutions, which have weighed more heavily on small and medium-sized firms. An additional misfortune has been the low level of demand that has hurt company profits. Capital investment is decreasing across all industry sectors and business sizes.

Capital coefficient, which is figured by dividing capital stock by real GDP, is however growing ahead of its traditional growth trend, raising fears of massive stock adjustment.

b) Credit risk rises

It appears that the decline in sales and profit and increased number of corporate failures are causing institutional lenders to take an even more cautious attitude to lending. The deteriorating balance sheet at corporations since the burst of the bubble economy is serving to spur this trend.

c) Lingering concerns over the financial system

In a new corporate finance trend, as lending by private banks decreases, loans by public lenders and direct financing methods such as commercial papers and bonds are gaining favor. Under these conditions, corporations are taking precautions against liquidity risks and increasing liquidity on hand.

4. Fiscal conditions, international economy, and prices

a) Effects of economic stimulus are beginning to be felt

Public works had been on the ebb on an annual basis, but the effects of the April 1998 ”Comprehensive Economic Package” have begun to be felt as the government implements projects ahead of schedule and as public works assigned under the first 1998 supplementary budget begin to get underway.

b) Foreign exchange movements affect balance of payments

The Russian crisis and other events caused wild swings in foreign exchange rates in October 1998, and international movements of capital drew much attention. Based on a simulation using customs balance data, a 10% rise in the yen in 1998 would result in a balance of payments deficit of about 800 billion yen. This would have the effect of pushing down real GDP by about 0.3% over the next year.

c) Demand affects consumer prices

Consumer prices have held steady as a basic trend but have sagged below year-earlier levels. It is believed that demand as a whole has weakened, widening the gap between supply and demand. This, in turn, has applied downward pressure on consumer prices.

Figure 1-1-16 Relationship between profit margins and capital investment growth rate during phases of economic downturn ( manufacturing industry )

A comparison of recent and past downturns in capital investment shows that the pace of the current downturn exceeds the decline in profit margins (ordinary profit as a percentage of net sales). Banks' tough attitude towards lending had an additional negative impact.

Figure 1-1-17 Capital Co-efficient

Even as capital investment falls, capital coefficient, calculated by dividing capital stock by real GDP, is rising beyond traditional growth levels. If GDP grew at a rate of about 2% this would not have been so conspicuous, but in the current recession, demand has decreased faster and more drastically than in any previous phase of economic downturn

Figure 1-1-20 Capital adequacy ratio on a market-to-market basis

A calculation of real capital adequacy ratio based on a balance sheet with stocks and real estate re-valued on a current market price basis shows that capital adequacy is on a downhill slope especially in non-manufacturing companies. This is because assets have been eroded as land prices continue to slide, while firms have also been slow to reduce debt.

Chapter 1 Part 2 The impact of the unstable Asian economy on the Japanese economy

The Asian currency and financial crisis had repercussions in Russia, Latin America and other emerging markets, and those impacts are now reaching Japan via Western economies and the international movement of capital. At the same time, the more direct effects continue to be felt: falling Japanese exports to Asia, the declining profitability of Japanese companies' Asian operations, and the increase in non-performing loans made to Asian nations. Diminishing growth prospects for the Asian economy are a further negative influence on the corporate mindset.

The Asian economy remains in the doldrums, but possible signs of a recovery are revealing themselves especially in export industries. Japan's imports from Asia had been declining due to the weak Japanese economy and the fact that Asia's price competitiveness did not rise as much as expected; new signs show that this downward trend may have been arrested.

Japanese companies in Asia are also showing signs of recovery, especially food processing, electric machinery enterprises and other export businesses that procure raw materials locally. Also, while Japan's direct investment in Asia has fallen dramatically, the region is still regarded as a promising location for long-term investment. However, cash-flow at many Japanese companies in Asia is deteriorating as Japanese banks trim their assets in Asia and turbulence in local financial systems continues.

The amount of non-performing loans in East Asia is massive, exceeding 36.9% of GDP in Thailand, for example. Loans extended by Japanese banks are owed mostly by local Japanese operations and local blue chip firms, and the ”non-performing rate” is deemed relatively low. Japanese banks are coping by trying to reclaim loans and setting up additional reserves. It is hoped that an export-led economic recovery in Asia and at the same time Japan's economic recovery will usher in a healthy upward business cycle.

Figure 1-2-6 Business sentiment of Japanese corporations in Thailand

In Japanese companies in Thailand, especially those engaged in export, business sentiment has been improving since the beginning of 1998. Compared to the non-manufacturing sector which depends on local sales, manufacturing firms, which are export-oriented, have demonstrated a relatively faster pace of recovery. Within manufacturing, export-oriented electric machinery and electronics manufacturing exhibits better business sentiment than the more locally-driven transportation equipment manufacturers. Business sentiment for electric machinery and electronics manufacturers has been improving since reaching its lowest level during the latter half of 1997.

Figure 1-2-8 The credit crunch and its impact

Japanese banks are pulling their funds out of Asian countries, especially from Thailand, Indonesia and other ASEAN countries that were the biggest casualties of the currency and financial crisis. This is due not only to the continuing turmoil in the Asian economy but also to the need to improve their balance sheet and profitability. Coupled with the turbulence in the local financial system, about a third of the Japanese companies are facing funding problems as they fall victim to the credit crunch. About a third of those companies are reorganizing their business plans and a seventh are feeling the effects at their home office in Japan.

Chapter 1 Part 3 The risk of a ”deflationary spiral” and fiscal and monetary policies

Fears have recently been raised about the prospect of a deflationary spiral. For the purpose of this discussion, ”deflationary spiral” here is defined as the simultaneous progression of price depreciation and economic contraction, each having an effect of worsening the other.

Sluggish demand alone does account for the decline in domestic wholesale price, but supply-and-demand factors (the GDP gap) shows that this sluggishness is a major factor contributing to the drop in prices. On the other hand, price themselves are not directly causing the economic contraction.

In this sense, what is happening now does not fit the aforementioned description of a ”deflationary spiral.” However, it is possible that decline in asset prices and contraction of total demand are progressing simultaneously, and if ”prices” is extended to include ”asset prices,” then the argument could be made that a ”deflationary spiral” is taking place.

Figure 1-3-1 Nominal GDP growth rates

( compared with previous quarter, seasonally adjusted )

In the April-June and July-September of 1998, real GDP, GDP deflator, and nominal GDP all recorded a decline compared with the previous quarter.

Figure 1-3-4 Factor analyses of ratio of ordinary profit to net sales

( compared with previous quarter )

When the ratio of ordinary profit to net sales is subjected to factor analysis, it becomes clear that the quantitative decline in sales is the largest factor pushing down the profit margin. In this case, factors used in the analysis include terms of trade (shifts based on changes in terms of trade, which is the ratio between output price and input price), sales price factor (changes reflecting increase or decrease of fixed costs per unit) and the quantitative factor (changes based on increase or decrease of sales or input quantity).

In Table 1-3-5 Verification of the ”Induced inflation policy” using a VAR model

the following points are verified as a way to examine the effectiveness of the ”so-called çš„nduced inflation policy”.

  1. If monetary expoutin is executed, will it affect the expected inflation rate?
  2. If the expected inflation rate is chenged, will the real interest rate be affected as well?

    (Is it possible that nominal interest would change as much as expected inflation rate and that the real interest rate would remain constant?)

  3. Would changes in the real interest rate affect plant and equipment Investment?
  4. Would quantitative deregulation affect asset prices?

The findings show that changes in high-powered money do affect asset prices; since falls in asset prices inhibit consumption, housing investment and capital investment, the end of falling prices or the upturn in prices could support the economy. On the other hand, no clear conclusions could be drawn on the issue of whether quantitative deregulation would affect the expected price inflation rate. It is further argued that when studying the ”Induced inflation policy”, the cost of controlling inflation and the impact on the household should be factored in as well.

  1. Effect on plant and equipment investment
  2. Effect on asset prices

Chapter 1 Part 4 Weak consumption leads the economic slowdown

Weak consumption ushered in the current recession. In 1997, the rise in consumption tax resulted in a larger-than-expected dip in spending. A slight recovery was observed later but consumer's confidence deteriorated after autumn that year, checking the progress of the recovery.

Behind the wild swing in consumption is the growing weight of consumption within the economy, especially optional spending. The growing percentage of spending on durable goods, and the increased circulation of durable goods stock are also spurring this trend.

Amid changing consumption patterns, policies aimed at altering consumer's confidence are needed, as consumption is becoming more vulnerable to consumer's confidence and deteriorating consumer's confidence remains a huge influence on the current consumption slump.

In order to effect a favorable change in consumer's confidence, it is imperative to remove consumer qualms about future outlook rather than simply attempting to lift the economy through measures to generate demand. Specifically, this means:

  1. Stabilizing and strengthening the financial system by settling bad loans.
  2. Carrying out further structural reforms including deregulation to generate new employment.
  3. Implementing structural reforms in nursing care and pensions and removing potential worries for the increasingly aging society.

Figure 1-4-2 Contribution of capital investment to economic recession

( as percentage of GDP )

(1)When the current recession set in, consumption and housing investment, which are both household demands, deteriorated ahead of other factors. After the beginning of 1988, in the midst of the credit crunch, the economy further languished with the slump in capital investment leading the way.

This time

Figure 1-4-6 Breakdown of increases in optional expenditure

As the economy matures and income rises, optional spending is occupying a more significant part of total consumption. Durable goods and optional services (eating at restaurants, going to movies & concerts, etc) are not necessities, and the money for them is therefore savable. Consumers can freely determine the timing of their spending, so this type of spending is vulnerable to consumer's confidence. Expansion of optional spending is eroding the floor to the spending slump.

Figure 1-4-7 Consumption becomes more volatile

Along with the increase in optional spending, the same goods and services that were once necessities are taking on optional characteristics. For example, clothes are semi-durable goods but as fashion and functionality become integral features of them, they are becoming increasingly optional.

Note:

Standard deviation for each term compared with the previous term

Chapter 2 Part 1 The impact of the collapse of the bubble economy on the substantive economy

The collapse of the bubble economy brought down the value of stocks and real properties between 1990 and 1996, a capital loss amounting to about 840 trillion yen, or 170% of GDP in 1996, was suffered by corporations and households. This fall in asset value curbed consumption through reverse wealth effects. It also compromised corporations' fund raising capability and, along with the credit crunch, put a crimp in capital investment. Domestic demand shrank, bringing on a further fall in asset prices and creating a vicious circle of asset decline and economic slowdown.

The reverse wealth effect pushed consumption down by an annual average of 0.8% between 1991 and 1993. Such effects were however small from1993 through 1996.

As for impact on housing investment, the depreciation of financial assets curbs housing investment due to the reverse wealth effect, but the depreciation of real estate assets is perceived as a fall in construction costs and spurs investment. While housing investment dropped about 20% in 1991, thereafter the change of asset prices actually spurred housing investment.

As for effects on capital investment, asset depreciation drives down companies' fund raising ability by bringing down the value of their collateral, lowers ability to take on risk, and restrains capital investment by reducing cash flow as debt servicing and writing off bad debts take their toll on the companies. These factors had the effect of pushing down capital investment by at least around 5% on average each year from 1991 through 1997.

All told, the decline in asset prices had the effect of pushing down growth by about 2% on average each year between 1991 and 1993. More recently, the direct effects of asset depreciation are becoming limited as the credit crunch has played a bigger role in slowing growth.

Figure 2-1-2 Wealth effect and reverse wealth effect on consumption

Between financial assets and land assets, the more liquid financial assets have a larger negative assets effect on consumption. Compared to other general goods, durables, which tend to have a luxury element, are more subject to price variations and thus more vulnerable to reverse wealth effects. In general, price rises and falls are thought to have the symmetric effects on consumption.

consumption expenditure on durable goods

Figure 2-1-6 Deterioration of corporate balance sheet and capital investment

Capital investment is always accompanied by risk, but when asset prices depreciate and lower the value of company assets, it lowers the ability of the company to take on risk. When the capital adequacy ratio is used as an explanatory variable that accounts for companies' risk-taking capability, one finds in a capital investment function that regardless of industry and company size, a falling capital adequacy ratio curbs capital investment. Especially in non-manufacturing industries, the 1998 fall in capital adequacy ratio has served as a restraining factor on capital investment. A fall in asset price appears to have a larger impact on investment than does a rise.

Non-manufacturing

Chapter 2 Part 2 Bad loans at financial institutions and their impact on the economy

During the 1980s, as large companies increasingly ”weaned themselves away” from banks, the banks increased their lending to small and medium-sized companies. A shortage of accumulated financial information about these smaller firms forced banks to use of real estate as collateral for the loans. This gave rise to the lopsided emphasis by banks on real estate collateral when making lending decisions.

After the collapse of the bubble economy, banks became saddled with a large amount of non-performing loans, the recovery of which became protracted for the following reasons.

  1. Hopes lingered that land and stock prices would recover at some point, since the long-term growth of asset prices had until then been a solid, long-term trend.
  2. The banks' ”don't break ranks” mentality (where the players follow each others' move and do not take a fresh initiative).
  3. Lack of information disclosure.

The banks' lending attitude remains extremely severe from the borrowers' perspective. Behind this rigid attitude is the banks' weakening capital base brought on by writing off bad loans, a condition that makes it difficult for them to lend actively. It is expected that the credit crunch will relax as public funds are injected into banks to boost equity under the Early strengthening of financial fuactions law hat passed the Diet in October.

On the other hand, bank lending as a percentage of GDP, the condition of the corporate balance sheet, and the banks' equity and profits as a ratio of total assets, point to the possibility that lending by banks in Japan is excessive. Japanese banks are likely to place greater emphasis on soundness and profitability over the mid to long term and re-evaluate asset size and their loan portfolio, and these considerations may serve as a factor holding back lending growth.

Banks' changing attitude to lending has affected capital investment of small and medium sized companies as they lack alternative fund raising means, a condition that has contributed to the capital investment slump since the latter half of last year.

Figure 2-2-9 Market assessment of Japan's financial system

The ”Japan premium” has expanded since the end of last year. Similar experiences were reported in 1995 and these reflect the harsh verdict on Japan's financial system by overseas markets. Meanwhile, for a gauge of how domestic market participants see the system, a large gap between the highest and the lowest call rates was observed for the first time last year. The lack of a sense of crisis regarding the financial system may be another factor that has delayed settlement of the problems.

Figure 2-2-7 Changes in ratio of total balance of bank lending to GDP

The total balance of loans grew as a percentage of GDP during the bubble economy but has not fallen in any noticeable way.

Figure 2-2-15 Capital investment and the credit crunch

Banks' severe lending attitude has had a debilitating effect on small and medium-sized firms' capital investment. According to factor analysis, it is found that the changing lending attitude by banks has been pushing down the growth of small and medium-sized companies capital investment since the latter half of last year.

Factor analysis for capital investment by small and medium-sized companies (all industries)

Chapter 2 Part 3 Why is capital efficiency falling?

Return on assets (ROA) has been declining in recent years. One can only surmise that capital efficiency is deteriorating. The following possible causes have been identified:

1. Japan's industries made belated efforts at growing out of the mass-production oriented industrial structure; 2. Only a low return on investment was yielded during the better economic times; 3. The operating ratio for capital is faltering with the weak demand; 4. Savings continue to exceed spending in Japan, pushing down real interest rates and reducing the number of opportunities to make high return on investment.

As for the first two factors, ROA had begun to slip during the bubble period, especially in non-manufacturing industries. It is believed that a large percentage of investments yielded low returns. After the bubble burst, productivity gains slowed considerably. Inefficient investment not only drove down profitability but compromised capital adequacy and generated other negative burdens.

The third factor was conspicuous in the manufacturing industry. As demand fell under facility stock adjustments, the capital distribution rate slipped while wages failed to decline, and the capital coefficient grew beyond the traditional growth level. Concerning the fourth factor, real interest rates in Japan and the United States have in general showed similar movements, but Japan's real interest rates have been lower than equivalent rates in the United States, except for the bubble economy period when the upward pressure on asset prices was high. Most recently, the gap has grown to about 2%. This indicates that the ”high level of investment is induced by the high level of savings.”

Figure 2-3-8 Changes in capital distribution rate

Real growth rates in manufacturing wages overshot productivity gains from 1992 to 1994, and as a result, the capital distribution rate for the manufacturing industry fell dramatically. This impact accounts for most of the drop in the capital distribution rate after 1992, and for the 2% decline in ROA.

Notes

  1. Graph data taken from EPA's System of National Accounts
  2. Capital distribution rate = 1- employee income / (gross domestic product - indirect tax - income of individually-owned enterprise)
  3. As for individually-owned enterprises' income, it is assumed that the ratio between income per business owner and income per employee is the same for different industries and is distributed proportionally to each industry.
  4. ---- shows hypothetical data had the real rate of wage increase for the manufacturing industry been the same as the productivity growth rate between 1992 and 1994.

Figure 2-3-9 Total productivity growth in all industries, manufacturing industry and nonmanufacturing industry

Growth of the total factor productivity (TFP) has slowed especially for the non-manufacturing sector. Over the 10-year period since the bubble period, the rate has declined about 1.3%. ROE for the non-manufacturing sector fell about 3% recently. TFP accounts for 1.6% of the decline.

Figure 2-3-12 Real long term interest rate

Real interest rates in Japan and the United States have shown similar movements, and over the mid to long term, the rate gaps are expected to level out.

But, except for the bubble period when hopes for higher prices lifted asset values, Japan's interest rates have been lower than in the US. The lingering low rates appear to support the high level of capital investment.

Conclusion

The three rings of recession

The fall in demand gives rise to a fall in production, which in turn depresses income. This causes a further fall in demand. This vicious cycle is common in most recessions, but the current recession in Japan is beset with two additional dilemmas.

One is a vicious cycle in the financial system. Financial institutions' shortage of capital has led them to reduce their assets and lending. As a result, demand, including capital investment, has become depressed, aggravating the recession. And through further declines in land value and stock prices, non-performing loans have piled up, debilitating the strength of financial institutions, thus creating a shortage in equity and a vicious cycle therein.

Second is a vicious cycle with regard to household finances. A massive fall in demand not only cuts current production and income, but also presents the danger of increasing unemployment. A string of financial institution collapses also did damage to confidence in long-term employment and wages. The lack of institutional readiness (laws and measures) for the aging of society has further driven down consumption, especially non-obligatory spending.

Consistent low growth since the bubble's collapse

With the exception of FY 1995 and 1996, real GDP growth in the post-bubble period has consistently posted zero or less. The economy was on a path to recovery in 1995 and 1996 as deregulation spawned the growth of the mobile telecommunications industry and caused spillover effects. A economic stimulus package was implemented and demand rolled in ahead of the consumption tax hike. However, the rebound lacked teeth as the country was still suffering from the aftereffects of the bubble's collapse. So, when the positive factors vanished, smoldering issues such as insolvency and the credit squeeze resurfaced, bringing home the fact that the scars from the bubble's collapse would continue to hold back the economy. Another reason for the slow growth in the 90's was the country's late efforts to grow out of the industrial structure designed to mass-produce standardized products. Potential growth rates disappeared, compromising the mid to long term growth potential and served to sink stock and land prices.

Delays in settling bad loans and resulting harm

The effects of the collapse of the bubble economy far exceeded initial forecasts. Behind this were the following circumstances that protracted the settlement of non-performing loans.

  1. Optimism lingered that a subsequent surge in asset prices would naturally work out the problems as land and stock prices had historically risen over the long term. This was not simply an incorrect forecast but was a consequence of conception on the part of the government and the private sector that ”what could happen will not happen.” Japan had never had to settle such a large amount of non-performing loans, and lacked an institutional framework for such a monstrous bad loan problems in a smooth fashion.
  2. A ”follow-the-pack,” decision-making style.
  3. Regulations on information disclosure and the accounting discipline were such that they allowed companies to shun facing imminent realities.

Delays in the settlement of bad loans brought on a host of serious consequences. Firstly, banks suffered huge losses, stiffening their lending stance, which in turn doomed the entire economy. Secondly, collateralized properties stayed idle for an extended period of time. Thirdly, the failure to decide how burden would be shared stagnated the economy for an extended period of time. Fourthly, banks and companies that have been suffering from the bubble's collapse were unable to direct their resources in attractive business. Instead, they focused on patching up past failures, depressing morale and weakening human resources. Efforts to break with the traditional ways were thus slow.

Since the collapse of the bubble economy wiped out a considerable portion of national wealth, an early settlement of the non-performing loans would have inflicted a sizable blow to the Japanese economy anyway. However, consequences of the procrastination described above could have been averted. ”The failure to recognize the failures invited further failures”------ this is a good description of what happened in both the public and private sectors.

Non-performing loans create the kind of wound that does not heal naturally. Without assessing its full impact on the economy, the government resorted to the conventional prescription for recession and drew up demand simulation programs to lift the economy. The effects were thus limited, while the fiscal deficit grew, working to dampen consumer spending. These were consequences of tackling problems in the myopic way of putting off mid to long term issues. Meanwhile, the full impact that land price depreciation could inflict on the finances of small and medium-sized enterprises was not felt until recently. In the transition of the Big Bang, the possibility of early corrective measures causing banks to trim lending, the chances of market speculation leading to bank failures, and the need for a sufficient system of direct financing, were not adequately foreseen. The short-term implications of the mid- to long-term issues were not sufficiently examined.

Impact of the bubble's collapse on demand

The downward movement in asset prices had the effect of pushing down annual GDP (total of consumption, housing investments, and investments in plants and equipment) by about 2.0% on average between 1991 and 1993. Since then, the direct effects on GDP have softened, and between 1994 and 1996, the ”downward effect” settled at around 0.8%.

The decline in asset prices weighed heavily on growth immediately after the bubble's burst, but such effects are dwindling recently. Today, economic stagnation appears to have its roots more in the aforementioned failure to settle the problems earlier.

Declining capital efficiency and investment ratio

Capital efficiency is low in Japan compared with foreign countries. Four possible causes have been identified. Firstly, Japan was late in outgrowing the kind of industrial structure that was suited for mass-producing standardized industrial products. The suppliers are not ready to provide for a consumer-oriented society built around diverse values. Secondly, investments were made in low return businesses during the bubble period. Back then, the views were strong that land and share prices would continue to rise steadily. Corporations, large ones in particular, resorted to equity financing which was presumably cheap, and this easy financing lowered the capital operating ratio. Fourthly, the country saves far in excess of spending. If the international flow of capital were perfect, return on capital would even out eventually. Such convergence of investment return is to some extent observed but in a country where saving is excessive, the massive amount of available funds likely result in money flowing into thin margin investments (a high level of investment generated by a high level of savings). Foreign exchange risk and country risk are additional factors debarring smooth cross-border capital movements.

Investment rate in Japan

Compared with foreign countries, the investment rate in Japan is high even when the level of capital accumulation and economic growth rates are incorporated, but not all investment is propelled by the high savings factor. Given that Japan's industrial structure is capital-intensive due in part to the high ratio of manufacturing industries, Japan could simultaneously achieve somewhat higher private capital investment as a percentage of GDP and about the same level of return on capital as overseas countries, even if the country's growth rates were equal to those in leading Western countries.

Savings and investment

What do the above-mentioned observations imply for future capital returns and the investment rate? Firstly, considering that growth will for the time being be lower than that in leading Western countries, the level of investment rate justified from the level of return on capital will not be much higher than the Western countries', even when Japan's industrial structure and degeneration of some of the existing stock are factored in. Meanwhile, the savings rate in Japan remain much higher than that in overseas countries and the question remains as to how this gap between investment and savings could be adjusted amid hope for economic recovery.

If the flow of capital becomes more global and the chances for recurrence of the bubble economy become small, one possibility would be that Japan's savings would move abroad on a massive scale in search of better investment opportunities. Under this scenario, however, Japan's current account balance would balloon. The process of return on capital evening out internationally is a process of reallocating worldwide resources more efficiently, but doubt remains as to whether international public opinion would be amenable to this scenario.

It would be necessary to make adjustments both from the investment side and the savings side. As for investment, along with the increased spending on public works included in the Economic Emergency Measures, further deregulation must be sought in such a way that there is an increase in the return on private investments. Productivity in the non-manufacturing sectors in Japan is lower than its Western counterparts, and there is room to raise capital efficiency using deregulation, technological innovation and concentrated efforts at altering the traditional industrial structure that was best suited for mass-producing goods. It has been reported that the outlook for demand is higher in areas where deregulation was well promoted.

Meanwhile, it is expected that the household savings rate will decline. However, consumption should not go to areas where resources might be wasted or the environment polluted. Instead, a diverse range of products and services that could stir individual consumption must be presented. Policies helping non-manufacturers make this structural transition would be needed. This includes spurring entrepreneurial opportunities. And, given that qualms arising from the aging of society and unemployment are discouraging consumption, structural reforms aimed at improving nursing care and the pension system, and increase employment are imperative.

Aiming for ”non-bubble” growth

In a challenge it has not faced in decades, Japan is now battling 3 historically significant ”challenges of the 1990s.” Through these challenges, it is working its way toward revival. The first challenge is regarding the aftereffects of the bubble's collapse. On top of the dramatic fall in asset prices, which is a natural consequence of an economic collapse, costs associated with procrastinating the clean-up process have weighed heavily on the economy. However, an institutional framework (laws, regulations, and organizations) to tackle the lingering problems was established and ready for use in 1998.

The second challenge concerns departure from the mass-production oriented industrial structure. If neither ”catch-up” style growth nor bubble-oriented economic growth is a possibility, then Japan must find a new way of engineering growth. It must grow by taking on risks and making use of diverse talents and creativity. The economic structure must be changed to accommodate new demands. In financial circles, large corporations had traditionally managed their finance largely by following each other's moves with steadily growing hidden reserves as a comfortable cushion, while small and medium sized corporations relied on indirect financing using real estate as collateral. As hidden reserves run short and the strength of real estate as collateral evaporates, traditional financing methods will no longer be reliable. This gives rise to the need to attract ”risk” funds, which draw on the future flow of earnings, and to entrepreneurially explore business opportunities.

It is important that not only the funding system, but also the workers, the labor market, management and the government all respond to the changes. The Industrial Revitalization Plan and the Leading 21st Century Project, which are part of the Economic Emergency Measures, support such efforts.

The third challenge is the institutional preparation for the aging of society. Aging is an inevitable trend in Japan. An improved system for senior employment, pensions, nursing care, and taxation must be developed to remove the concerns currently hanging over households.

The Japanese economy is trapped in a number of cyclical dilemmas and is unable to get itself back onto a self-sustaining growth track. It is also faced with a short-term agenda while facing increasing pressure to immediately deal with mid- to long-term issues. This, however, does not necessarily spell ruin. The Japanese manufacturing industry has superior product development capability that allowed them to overcome the oil shocks and the yen crisis, and Japan's people possess a great deal of creative potential. Within what little time remains of this century, if these issues are effectively tackled in parallel with the Economic Emergency Measures supporting demand, the Japanese economy will have a solid foundation upon which it can start anew in the 21st century, free from the shackles of past failures.

(Please refer to the ECONOMIC OUTLOOK AND BASIC POLICY STANCE ON ECONOMIC MANAGEMENT FOR FY 1999 on the government's picture of the economy for fiscal year 1999.)

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