Annual Report on Japan' s

Economy and Public Finance

2000-2001

- No Gains Without Reforms -

December 2001

Cabinet Office

Government of Japan


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Chapter 1

   Preconditions to Strong Recovery of the Economy

Section 1 From Short Recovery to Another Recession

   The Japanese economy had been in a slow recovery phase since April 1999, when the economy was in a cyclical trough(1). However, the economy has turned downward since the beginning of 2001. In the January-March quarter of 2001 (the seventh quarter after the cyclical trough), indicators of the corporate sector, such as exports, business investment, and industrial production, deteriorated (Figure 1-1-1). Exactly when the economy entered a phase of recession will be determined by statistical methods later. But judging from various indicators, the economy is highly likely to have entered a recession phase sometime between the second half of 2000 and the beginning of 2001. In short, the economic recovery did not even last two years, most likely the shortest phase of economic recovery in post-war Japan(2).
   The economic growth rate during the phase of economic expansion remained low at 1.4% in FY 1999 and 1.0% in FY 2000, revealing that the latest recovery was not only short but also weak.
   As was described above, the latest economic recovery was fragile, with its recovery speed being moderate and lacking in sustainability. The following three reasons can be cited for that.
(a) The engines for economic recovery (exports and business investment) were weak and it was driven by foreign demand and was too much dependent on IT-related demand.
(b) Consumption remained sluggish even after the economy picked up.
(c) Non-performing loans and excessive debts were a burden on the Japanese economy.

1 Reasons for Weak Economic Recovery

 Fragility of driving forces for economic recovery
   In the latest phase of economic expansion, exports and business investment worked as the engine for the recovery, while domestic consumption remained sluggish. Especially, an increase in exports played a major role in leading the economy to recovery. Exports to Asia increased rapidly in and after 1999. This was largely due to an increase in production of IT-related goods in East Asian countries and regions in response to a rise in IT-related demand in the United States and other countries, which in turn increased Japan' s exports of IT-related goods, such as semiconductors and other electronic devices, to Asia. However, Japan' s exports to Asia decreased, as the U.S. economy slowed down rapidly in the middle of 2000 and dampened global demand for IT-related goods.
   An increase in exports directly increased manufacturing output, leading to an increase in business investment. The increase in business investment was another factor that led economic recovery. However, the increase in business investment was supported only by limited industry sectors, such as the electric machinery industry that was buoyed by a brisk IT-related demand. Meanwhile, non-manufacturers' business investment showed no noticeable improvement and turned downward on the whole in 2001.
   Since the latest economic recovery was driven by foreign demand and IT-related demand as was described above, the economy on the whole was heavily dependent on the movement of global IT demand. Therefore, in the phase of economic slowdown, declines in production and investment in the IT-related sectors contributed greatly to the deterioration of the economy. (Figure 1-1-2 above)
 Prolonged sluggish consumption
   One of the reasons for slow growth of GDP and its weak potential for recovery was stagnant consumption. Consumption has increased little since the last cyclical trough (April 1999) and remains weak even compared with past phases of recession.
   Behind this lie the facts that (a) slow growth of income has been continuing and (b) households' concerns about the future have been constraining consumption.
 Prolonged problems of non-performing loans and excessive debts
   The lingering problems of non-performing loans and overhand debts are one of the important factors that have been hampering the revitalization of the Japanese economy. Specifically, the existence of the problem of non-performing loans is putting downward pressures on the economic growth of Japan by the mechanism of (a) a decline in banks' financial intermediary function caused by eroded profitability, (b) stagnation of resources in corporations and industries with low productivity, (c) cautiousness of corporations and consumers caused by a decline in confidence in the financial system, and (d) decrease in business investment by corporations saddled with excessive debts. The problem of non-performing loans will be analyzed in detail in Chapter 2.
   In the following, the Report clarifies the factors that made the latest economic recovery weak by scrutinizing (a) the background of the business investment movement that turned to peter out in a short period of time and (b) the consumption movement that remained sluggish even during a phase of economic recovery and the employment trend behind the movement. The analysis will reveal that a decline in corporate and consumer confidence and the fact that both corporations and consumers are unable to brighten their future prospects are behind the weak recovery of the Japanese economy.
   With the outlook for the U.S. economy becoming unclear due to the influence of the series of terrorist attacks in the United States in September 2001, business investment and domestic consumption hold the key to determine the future course of the Japanese economy. Therefore, it can be said that the analysis here has important bearings on forecasting the outlook for the Japanese economy in 2002.


2 Recovery of Business Investment was Weak

(1) Investment increased in manufacturing industries but was sluggish in non-manufacturing industries
   There were different movements between manufacturing industries and non-manufacturing industries in the latest recovery phase of business investment.
   Business investment, which increased mainly in manufacturing industries led by electric machinery and other IT-related industries, hit a peak in early 2001 and then turned downward. This was due to the fact that business investment by manufacturing industries that had led the increase began to decrease, in addition to weak business investment by non-manufacturing industries. We will confirm this point with statistical figures.
   Private sector investment (real) posted year on year decreases in 1998 and 1999 on a National Account basis but turned upward in 2000, posting a 4.5% rise over the previous year, on the strength of a sharp increase in corporate profits. However, it turned downward again in 2001, posting a 0.9% quarter to quarter fall in the January-March quarter of 2001 and a 2.8% fall in the April-June quarter.
   The latest recovery of business investment was mainly led by manufacturing industries and investment by non-manufacturing industries turned downward before showing any noticeable recovery. We will take a look at the difference in investment trend between manufacturing and non-manufacturing industries from the Ministry of Finance' s Financial Statements Statistics of Corporations by Industry, Quarterly. Investment by manufacturing industries increased steadily led by the electric machinery makers against the background of strong demand for IT-related goods, posting a year on year gain of 15.0% in FY 2000. In the January-March quarter of 2001, investment by manufacturing industries reached where it was at the end of 1997. Moreover, in view of the steady increase in sales volume of leasing, some of the business investment by manufacturing industries is believed to have been replaced by lease. Therefore, the actual investment by manufacturing industries may have posted a much larger increase. However, investment by manufacturing industries turned downward in the April-June quarter (Figure 1-1-3). Meanwhile, investment by non-manufacturing industries posted marginal increases in FY 1999 and FY 2000. In the April-June quarter of 2001, it stood at slightly above the previous bottom recorded in the second half of 1998.
(2) The manufacturing industries' business investment that was the engine for economic recovery was weak
   Business investment by manufacturing industries during the latest recovery phase was increasing steadily through the mechanism of "increase in production => increase in corporate profits => increase in business investment." However, it shifted to a phase of "decrease in production => decrease in corporate profits => decrease in business investment" in the second half of 2000, as industrial production decreased following a decrease in exports and then as corporate profits began to decrease.
   The following can be cited as reasons why the above mechanism that increased business investment by manufacturing industries collapsed in a short period of time.
(a) Since the production increase was biased towards IT-related goods, production decreased sharply when global demand for IT weakened due to the slowdown of the U.S. economy and this, in turn, decreased corporate profits. Almost at the same time, business investment also decreased(3).
(b) Although corporate profits increased thanks to efforts to cut back on personnel expenses and business investment increased along with it, corporate profits began to decrease, especially among small and medium-sized enterprises, as they were no longer able to further slash personnel expenses and this, in turn, decreased business investment.
(c) Although corporations have gotten out of a phase of capital stock adjustment, the depressed level of their expected growth rate (further economic growth rate forecast by corporations) is likely hastening the time to enter a new phase of capital stock adjustment. A phase of capital stock adjustment means the process through which corporations curb new business investment in order to adjust excessive capital equipment.
   In the following, the characteristics of increases in production and corporate profits of manufacturing industries will be examined and their factors will be analyzed in detail.
 Production increase driven by foreign demand and IT
   Industrial production continued to increase for six consecutive quarters starting in the July-September quarter of 1999 and it hit an all-time high level for a single month in August 2000. Such production increase was prerequisite to a steady increase in business investment by manufacturing industries. However, since the production increase was driven by increases in exports on the strength of the robust performance of the U.S. economy and in production of IT-related goods, it was not expansive in terms of the type of industry and production items as compared with past recovery phases. In other words, the economic recovery that started in the spring of 1999 was a recovery dependent on foreign demand and an uncertain recovery greatly susceptible to IT-demand trends (Figure 1-1-2 below)(4).
   Therefore, industrial production decreased rapidly at an unprecedented speed in and after the end of 2000, when global demand for IT weakened in response to the slowdown of the U.S. economy. Industrial production slackened to a 0.6% increase in the October-December quarter of 2000 and then fell sharply the following two quarters, posting a 3.7% decrease in the January-March quarters of 2001 and a 4.1% decrease in the April-June quarter. In August 2001, it posted an 11.7% decrease from a peak (August 2000). This translates into the largest one-year decline since the second oil crisis. The contribution of the decline in production of IT-related goods was also big in the phase of production decline. Of the industrial production decline from the October-December quarter of 2000 to August 2001, about 60% (56.0% to be exact) was accounted for by the decline in the production of IT-related goods.
 Corporate profits of manufacturing industries that increased thanks to restructuring efforts
   An increase in industrial production increased manufacturing industries' sales and this, in turn, increased their corporate profits. According to the Ministry of Finance' s Financial Statements Statistics of Corporations by Industry, Quarterly, ordinary profits of manufacturing industries increased sharply for seven consecutive quarters from the July-September quarter of 1999 to the January-March quarter of 2001 (year-on-year increases of 18.0%~64.6%). The sharp increase in corporate profits was a factor behind an increase in business investment.(5) In the April-June quarter of 2001, however, corporate profits of manufacturing industries turned downward (a year-on-year decrease of 21.2%).
   A factor analysis of increases or decreases of corporate profits by scale of enterprise shows that a sharp increase in sales boosted corporate profits of large manufacturers that began slashing personnel expenses from an early stage. (Figure 1-1-4 (1)) However, decreases in sales (sales factor) reduced profits in the April-June quarter of 2001, as demand weakened and production decreased.
   Meanwhile, small and medium-sized manufacturers, for whom the sales factor worked rather as a downward pressure on profits in and after the April-June quarter of 2000, maintained an increase in profits by slashing personnel expenses (Figure 1-1-4 (2)). However, for small and medium-sized enterprises, whose number of employees and per-capita wages are smaller than those of big enterprises, it is difficult to keep posting profit increases by restructuring efforts alone, as their flexibility to cut back on personnel expenses is limited. For this reason, cutbacks on personnel expenses (personnel expense factor) became powerless to boost profits in the April-June quarter of 2001 and corporate profits declined, also affected by a decline in sales.
 Stock adjustment and a decline in corporations' expected growth rate
   Figure 1-1-5 is a circulation diagram of capital stock that shows the movement of the flow and stock of capital to illustrate the stock adjustment of business investment by manufacturing industries. As was described earlier, stock adjustment of business investment means the process through which corporations curb new business investment in order to adjust excessive capital equipment. (See Column 1-1 "Mechanism by Which Stock Adjustment Curbs Business Investment" )
   The process of stock adjustment that began in late 1991 lasted until 1994 and it kept business investment at a low level during that period. Although business investment entered a phase of expansion in 1995, it entered a phase of stock adjustment again in the second half of 1998, resulting in a decrease in business investment. In the previous stock circulation (1991~1994), stock adjustment ended when the year-on-year growth rate of capital stock fell to around 2.5%. Therefore, it was expected that the latest stock adjustment process would end in around the April-June quarter of 1999, when the year-on-year growth rate of the latest stock circulation that began in the second half of 1998 fell below 2.5%. However, the adjustment process continued to last nearly one more year. This can be attributed to the fact that the perception of excess capital stock was not dispelled easily as the economic growth rate anticipated by corporations (anticipated growth rate) kept declining. In other words, it can be said that the decline in corporations' anticipated growth rate prolonged the decrease in business investment.
   In the second half of the 1990s, a stock adjustment process tended to begin again in a short period after the previous adjustment process ended and business investment began to increase. This can also be explained by the decline in corporations' expected growth rate.
   This point can be illustrated by a chart that puts growth rate of business investment on the vertical axis and "business investment / capital stock" ratio on the horizontal axis. The curves in the chart show a sharp leftward shift in the first half of the 1970s and in the second half of the 1990s (Figure 1-1-5, lower figure). In a hypothetical situation where growth of capital coefficient (capital stock K divided by income Y) and the disposal rate of capital stock are constant, dots placed at a certain expected growth rate form hyperbolas. (In other words, dots in the same hyperbolic curve mean the same expected growth rate.) The more a hyperbolic curve is placed in the left side, the more it corresponds to lower expected growth rate. Therefore, the leftward shift of the above curve suggests that corporations' expected growth is declining. The chart shows that corporations' expected growth rate has remained at a low level of around zero percent since the second half of the 1990s. If the expected growth rate rises, business investment will continue to increase for some time, as corporations increase capital stock actively to the level corresponding to the growth rate. However, under the present situation where no increase in expected growth rate is expected, even if business investment increases after getting out of a stock adjustment phase, it will enter an adjustment phase again in a short period of time, as the business investment soon reaches a capital stock level corresponding to a low expected growth rate. (That is, the circulation circle in Figure 1-1-5, lower figure, becomes smaller and an increasing phase of business investment becomes shorter.) This suggests that a decline in corporations' expected growth rate and their pessimism about the future of the Japanese economy constitute one of the major reasons why an increase in business investment did not last long in the second half of the 1990s.
   According to the Cabinet Office' s Questionnaire Concerning Corporate Activities (conducted in January 2001), corporations' forecast of real growth rate of industry demand (manufacturing industry, over next one year) remained below 2% during the period from the second half of the 1990s to FY 2001. Moreover, since the economy deteriorated thereafter, it is believed that corporations' expected growth rate estimated from the circulation of capital stock is staying at a low level in 2001. Therefore, business investment is expected to be in a stock adjustment process in the second half of 2001. As a result, business investment by manufacturing industries is expected to continue decreasing for some time to come under the pressure of adjustment of excess capital stock.
   In fact, the Bank of Japan' s short-term survey on business sentiment (Tankan) shows that the proportion of corporations, mainly manufacturers, feeling they have excess capacity increased in the March 2001 survey, although the proportion was on a downward trend from the April-June quarter of 1999 to the end of 2000. This indicates that the proportion of corporations feeling they have excess capacity began to increase without declining to the level of the previous bottom (March 1997 survey).
   Judging from the results of the above analysis, in order to achieve a sustainable, steady increase of business investment, it is essential to raise corporations' expected growth rate. For that to happen, it is important that the government raises the potential growth ability of the Japanese economy and makes corporations confident of their growth in the medium term by achieving structural reforms.
 Cutback on capacity-increasing investment
   The low level of corporations' expected growth rate has brought about another outstanding characteristic of the latest phase of business investment increase, that is, manufacturers in various types of industry have slashed investment to increase capacity.
   The Ministry of Economy, Trade and Industry' s Production Capacity Index shows that although both business investment and production capacity increased in certain IT-related industries (electric machinery, and non-ferrous metal used in electronic devices), production capacity decreased in other industries and, on a year-on-year monthly basis, it keeps decreasing in the industry as a whole. This means that many corporations have kept slashing capacity-increasing investment, except in some industries, such as IT-related electric machinery that were supported by brisk demand.
   As was described earlier, it is generally believed that the stock adjustment pressure was dissolved in 2000. Therefore, it was expected that investment to boost capacity would begin again. However, corporations did not raise their expected growth rate and have kept slashing capacity-increasing investment due to the presence of supply-demand gaps in the macro-economy.
   Since the start of 2001, the feeling of excess capacity has increased sharply in the electric machinery and non-ferrous metal industries that had been increasing production capacity. Therefore, capacity-increasing investment is likely to be slashed drastically in these industries as well. Meanwhile, production capacity shows signs of stopping declining in the steel and paper/pulp industries but it is still in a downward trend in the textile, general machinery, and transportation equipment industries. It is, therefore, expected that the manufacturing industry' s move to slash capacity-increasing investment will continue for some time.

Column1-1
   Mechanism by Which Stock Adjustment Curbs Business Investment
   In order to analyze capital stock adjustment, one of the important factors that determine the movement of business investment, the following diagram was prepared to show the movement of capital flow (business investment) and stock (capital stock, or total of production equipment owned by corporations). Corporations set a desired capital stock level in line with a production level to be targeted (hereinafter to be called "targeted production level" ) and try to adjust the current stock level. Since it takes a certain time to achieve the desired stock level, the growth of business investment and the growth of capital stock usually construct a circulation diagram. The following is an explanation of the "capital stock circulation."
   When economic outlook improves, corporations raise the targeted production level and try to build up capital stock in line with it. As a result, the growth rate of capital stock that has been stagnant enters a rising phase. (This turning point is A in the diagram.) As the buildup of capital stock continues until it reaches the desired level corresponding to the targeted production level, the growth of business investment (flow) rises much faster than the growth of capital stock in the initial stage.
   As the buildup comes close to the desired capital stock level corresponding to the targeted production level, the corporations begin to restrain the growth of business investment and soon the growth of capital stock and the growth of business investment will be balanced (point B in the diagram). It is desirable if the corporations can keep the growth of capital stock at the equilibrium point without changing the targeted production level. In reality, however, it is difficult to do so. This is because a slowdown of the growth rate of business investment is one of the causes that trigger an economic recession and because the corporations, in response, lower the targeted production level. As a result, the capital stock that has been built up becomes excessive. In order to bring down the capital stock to a level corresponding to the lower targeted production level, the corporations reduce business investment at an accelerated speed.
   As the capital stock comes close to the desired level corresponding to the lower targeted production level, the magnitude of decline of the business investment shrinks and the capital stock returns to the point A and begins a new circulation.
   The circulation that is repeated like this is called "capital stock circulation." The process from point B to point A in the circulation ((2) in the diagram) is called "stock adjustment phase" and it is the process through which corporations slash business investment to adjust the capital stock that has become excessive as a result of lowering the targeted production level.

(3) Business investment by non-manufacturing industries to remain sluggish
   We have just observed characteristics of manufacturing industries' business investment activities from 1999 until recently. The Report disclosed that behind the weak undertone of business investment lies the facts that the recovery of investment was limited to IT-related industries, that capacity-increasing investment was slashed, and that corporations' forecast for economic outlook is worsening.
   Then, what is the situation of business investment by non-manufacturing industries? A notable characteristic is that there was no clear movement that showed a recovery of business investment even after the economy started to recover in the spring of 1999. The following are the main reasons for that.
(a) The business investment by the service industry, which accounts for a large portion of business investment by non-manufacturing industries, did not show any clear increase, as consumer services slackened due to sluggish consumption.
(b) Business investment remained slow in such deregulated industries as electric power and transportation/communications(6).
(c) Since many corporations in non-manufacturing industries are saddled with excessive debts, they used most of the income that had increased sharply in 1999-2000 for repayments of debts. They were unable to use funds sufficiently for new business investment.
   In the following, the Report examines income trends and the problem of excessive debts in non-manufacturing industries.
 Corporate profits of non-manufacturing industries increased under deflation
   Corporate profitability improved sharply in non-manufacturing industries as well. According to the Ministry of Finance' s Financial Statements Statistics of Corporations by Industry, Quarterly (nominal value), corporate profits posted a sharp increase for eight consecutive quarters from the January-March quarter of 1999 to the October-December quarter of 2000 (year-on-year increases of 8.4%~34.5%). Though corporate profits decreased in the January-March quarter of 2001, they increased again in the April-June quarter.
   A factor analysis of increases or decreases of corporate profits by scale of enterprise shows that large non-manufacturers had increased corporate profits by slashing the cost of sales and since the April-June quarter of 2000 they have maintained the rise in profits by increasing sales. (Figure 1-1-4 (3)) However, with consumer prices falling faster than wholesale prices since the middle of 2000 and expanding the magnitude of decline, it has become difficult for large non-manufacturers to increase profit margins(7). For this reason, the sales cost ratio (cost of sales / sales) began to rise in mid-2000, suggesting that large non-manufacturers have been forced to adopt a low-margin, high volume strategy in order to secure profits. As a result, the purchase cost factor (cost of sales factor) has been putting a downward pressure on profits since the middle of 2000 and the growth of corporate profits has slowed down. The degree of profit squeeze by the cost of sales factor is large in the wholesale and retail industries that are especially vulnerable to a decline in consumer prices.
   Meanwhile, small and medium-sized non-manufacturers, for whom the sales factor had consistently contributed as a factor to increase corporate profits, have slashed personnel expenses and sales management cost and maintained an increase in profits since the April-June quarter of 2000. However, their profits turned downward in the January-March quarter of 2001, as the minus contribution of the purchase cost factor has increased just as in the case of large enterprises and as their flexibility to slash personnel expenses has diminished just as in the case of manufacturers. (Figure 1-1-4 (4)) Although their profits increased again due to a rise in sales in the April-June quarter of 2001, the contribution of a rise in personnel expenses (personnel expense factor) to reduce profits has begun to increase.
 Repayment of loans to continue
   Although non-manufacturing enterprises saw their corporate profits decrease in the January-March quarter of 2001, their profits are still above the level seen during the bubble economy and they increased cash flow (retained earnings + depreciation cost). However, with the problem of excessive debts staying as it is, non-manufacturing enterprises used the cash flow for repayment of debts and may have been unable to use funds sufficiently for new business investment. Wholesalers and retailers aggressively made last-minute business investment ahead of the expiration of the special measures of Law concerning the Adjustment of Retail Business Operation in Large-Scale Retail Stores. But, since they made little progress in unwinding their excessive debts, the problem of overhand debts is likely to continue restraining business investment by non-manufacturing enterprises in and after 2001.
   The slow progress in unwinding excessive debts may also have something to do with the fact that many enterprises used their funds to make up for the shortage of reserves for retirement benefit obligation in connection with the introduction of a retirement benefit accounting system that became effective in the business year starting in April 2000. Although enterprises may make up for the shortage of reserves for retirement benefit obligations in 15 years, most of them apparently decided to make up for the shortage early in order to show the soundness of their balance sheet in response to market requests.
   We will sum up the results of the analyses concerning recent trends of business investment. In the recovery phase that began in the spring of 1999, there was a movement in which an increase in production led to an increase in corporate profits, with production, mainly of the manufacturing industry, beginning to pick up in around the spring of 1999 and then exports beginning to contribute to the recovery from the second half of 1999. Business investment also began to pick up in late 1999. Although business investment began an upward trend in the beginning of 2000, it was mostly limited to IT-related manufacturing industries and hit a peak in the beginning of 2001 without spreading to non-manufacturing industries and then turned downward. A slowdown of corporate profits, which could become a factor to restrain business investment, was also observed.
   The following points can be cited as reasons why the latest recovery of business investment was weak and turned downward in the beginning of 2001.
(a) It was a recovery driven by IT-related demand at home and abroad and mainly concentrated in the manufacturing industry. When IT-related demand slowed down worldwide, production, corporate profits, and business investment also slowed down.
(b) In non-manufacturing industries, corporate profits improved due to cutbacks on sales costs and personnel expenses, but business investment by the non-manufacturing industries as a whole remained weak, as electricity and the communications industry basically slashed business investment and as consumption remained sluggish.
   The analyses made so far suggest that preconditions to recovery of business investment are (a) raising corporations' expected growth rate by achieving structural reforms and (b) making cash flow available for business investment by solving the problem of excessive debts (especially of non-manufacturing enterprises).


3 Sluggish Consumption

(1) Why is sluggish consumption continuing?
   While the economy was heading for recovery in and after the spring of 1999, consumption remained flat, a movement not seen before. Real private final consumption expenditure (National Accounts base) rose 1.5% in FY 1999 but remained unchanged in FY 2000. In the April-June quarter of 2001, it posted an increase of 0.5% compared to the previous year. In the past, consumption rebounded along with an economic recovery. However, since the last cyclical trough (April-June quarter of 1999), consumption has remained almost flat, a stark contrast to the steady recovery in the corporate sector, such as business investment, production and corporate profits. (Figure 1-1-6)
   This sluggish recovery of consumption, which accounts for about 60% of GDP, is one of the causes that brought the latest phase of economic recovery to an end in a short period of time(8).
   Why is sluggish consumption continuing? Analyses below will explain that the potential for recovery of consumption is weak because of the following two reasons.
(a) Improvement of household income was moderate throughout the period of economic upturn that started in 1999 and the period of economic downturn thereafter.
(b) Households are cutting back on consumption due to concerns about their future work and income.
   In addition to these basic reasons, another reason for sluggish consumption may be that households, saddled with the heavy burden of housing loan repayments, are further reducing consumption.
   While consumption as a whole remains sluggish, there is a steady movement of consumption in some sectors. Consumption by the aged, in particular, is brisk. By item, information and communications-related consumption, such as mobile phones, DVDs, digital cameras and communication expenses, are increasing sharply along with sales of high-priced overseas brand products.
   Let' s examine these points in detail.
 Basic factors behind sluggish consumption
   One of the main reasons for sluggish consumption is that the improvement of income remains moderate. Reflecting severe employment situations, the movement of households' real wage after the cyclical trough in the spring of 1999 remained weak as it did during the previous recovery phase (1993 IV~) and it further slackened at the beginning of 2001. Since the increase in the number of employees is also moderate, the improvement of income of the economy as a whole is moderate (Figure 1-1-7). The severe employment situations that lie behind will be examined in (2) Employment situations to remain in severe conditions. As was described above, the fact that the improvement of household income remains moderate is one of the basic factors behind sluggish consumption.
   In the previous recovery phase (1993 IV~), consumption increased, albeit moderately, in line with a weak growth of income (Figure 1-1-6). But in and after the spring of 1999, consumption as well as income remained weak. Up until the mid-1990s, the propensity to consumer (ratio of income used for consumption) rose when income growth slackened and it supported consumption. However, the propensity to consume has remained almost flat since FY 1997, depressing consumption, as the improvement of income also remains moderate (Figure 1-1-8).
   Next, in order to see how concerns about future work as a restraint on present consumption, we will examine the factors that cause concerns about the future to affect propensity to consume. Many households determine their present consumption level after considering not only their present income but also their future income. Therefore, even if there is no change in the present income, a change in the expectation of future income affects present consumption. In order to see how it works, we will take a look at the relationship between the consumer sentiment index regarding income and employment conditions six months ahead (Consumer Behavior Survey, Cabinet Office) and the propensity to consume. In the phase of economic recovery that started in the autumn of 1993, the propensity to consume (on the National Account base) rose in line with improvement of the outlook for employment conditions (Figure 1-1-9). In the phase of economic downturn that started in the January-March quarter of 1997, as the outlook for employment conditions deteriorated rapidly, increasing households' concerns about future, the propensity to consume also declined slightly. Although the outlook for employment conditions improved around the middle of 1998, it has been deteriorating since the autumn of 2000. The propensity to consume also improved slightly but then leveled off, failing to show any clear upward trend (Figure 1-1-9).
   According to the National Life Monitoring Survey conducted by the Cabinet Office in September 2001, many (about 20%) of the households replying that they spent less on consumption than in the previous year cited "Increased concerns and uncertainties about future work/income" and "Income is expected to decrease in the future" as the reasons for the decreased consumption. This suggests that increased concerns about future work and income are depressing present consumption (Figure 1-1-10).
   The above analyses show that the slow improvement of income and concerns about future work and income are the basic factors behind sluggish consumption.
 Housing loan burden restraining household consumption
   In the same National Life Monitoring Survey, about 19% of the households replying that their consumption spending decreased compared with a year earlier cited "Have to pay housing loan and income did not increase as expected." Given the fact that about 30~40% of workers' households have housing loans, this is a figure that cannot be ignored. We will study the relationship between housing loans and consumption from the Family Income and Expenditure Survey (Workers' households). Up until the mid-1990s, consumption spending by households having housing loans and those not having housing loans showed the same movement. But from around 1999, consumption by households having housing loans decreased significantly (Figure 1-1-11 (1)). As for the propensity to consume, while the propensity to consume of the households not having housing loans began to pick up in the first half of 1999, that of the households having housing loans has been on a downward trend (figure 1-1-11 (2)). This seems to suggest that the consumption-restraining power of a slow improvement of income worked more strongly on the households saddled with repayment of housing loans that have a nature of "forced savings." We have to keep in mind that housing construction has a major effect on consumption, as it often involves purchases of furniture and other durable consumer goods.
   As will be described below, the Japanese economy is in deflation, with price declines continuing and nominal wages showing weaker movement compared with real wages. In FY 2000, per-capita nominal wage (total cash earnings) came to ¥355,000, down 4.3% from FY 1997 (¥371,000). Since amounts due are determined by nominal value, the stagnant nominal wage appears to be increasing the burden on households having housing loans.
 Bright movement in some items
   Although consumption as a whole remains sluggish, there are relatively steady movements in consumption of some items, such as (1) consumption by the aged, (2) information and communications-related consumption (sales of digital equipment, such as mobile phones, DVDs, and digital cameras, and communication expense), and (3) sales of high-priced overseas brand products.
   First, as for consumption by the aged, consumption spending by people aged 60 or over, whose loan payment burden and concerns about the future are relatively small, shows a firm movement compared with those in other age brackets (Figure 1-1-12)(9).
   Second, there are many products whose consumption has increased sharply. Among them is information- and communication-related consumption. For example, in 2000 (FY 2000), domestic shipments of digital still cameras increased 89% over the previous year, sales of DVDs increased 66%, sales of mobile phones increased 59%, and domestic shipments of car navigation systems increased 29%(10). Reflecting the spread of mobile phones and the Internet, communication expense (consumption of communication services) also posted a sharp rise of 8.0% in FY 2000 (on the Family Income and Expenditure Survey base).
   Third, sales of high-priced overseas brand products (such as clothes, bags, and accessories) are increasing, suggesting that those having no concerns about the future are steadily increasing consumption. Meanwhile, sales of low-priced products are brisk, reflecting recent deflationary trends. This suggests a bipolarization of consumption.
(2) Employment situation to remain in a severe condition
   The employment situation has a major effect on consumption. Throughout the economic recovery that started in the spring of 1999 and an economic downturn that followed, the employment situation remained in a severe condition. A severe employment situation depresses consumption through two different routes: slow improvement of income and concerns about the future. The recent severe employment situation has the following two characteristics.
(a) Since the structural unemployment rate is on an upward trend as a result of expanded mismatch of employment, the unemployment rate tends to resist declining regardless of the strength or weakness of economic conditions. Of the 5% unemployment rate in recent months, close to 4% is estimated to be structural unemployment(11).
(b) Growth of wages is slow because corporations are slashing personnel expenses in order to reduce excessive debts left since the collapse of the bubble economy.
   These points are examined below.
 Unemployment rate remained at a high level despite the economic recovery
   Despite the progress of an economic recovery that started in the spring of 1999, the unemployment rate remained at a high level. When the economy turned downward from late 2000 to the first half of 2001, the unemployment rate hit the previous high of 4.9% several times before rising to 5.0% in July 2001, the first 5% level ever.
   In and after the spring of 1999, there was seemingly an unusual movement in which, regardless of strength or weakness of economic conditions, shortage of labor (vacancy) increased, while unemployment stayed at a high level.
   Figure 1-1-13 show the relationship between "the degree of labor shortage (vacancy rate)" and unemployment rate. Labor shortage here means unfilled vacancies (number of jobs offered minus cases of employment) and "degree of labor shortage (vacancy rate)" is the ratio of (unfilled vacancies) to (number of employees + unfilled vacancies). The unemployment rate here refers to the unemployment (employment unemployment rate) of employees and does not include the self-employed.
   In the actual economy, labor shortage (vacancy) and unemployment take place at the same time because there is often a mismatch of corporations' needs and workers' needs due to the difference of the type of job, the type of industry, experience and skill required and because it usually takes time for unemployed workers to find a new job. The Report calls unemployment caused by mismatch of employment and unemployment due to job changing or job finding structural unemployment in that they take place independent of business cycle and are embedded in the structure of the labor market.
   An analysis of the relationship between "the degree of labor shortage (vacancy rate)" and unemployment rate (UV Curve) shows how high the structural unemployment has risen (For how to read UV Curve, see the diagram in Column 1-2). Specifically, the following points are clear.
(a) From the 1970s to the 1980s, structural unemployment rose slightly.
(b) Structural unemployment rose further in the second half of the 1990s.
(c) Although labor shortage (vacancy rate) rose during the phase of economic recovery from 1999 to 2000, the unemployment rate stayed at a high level, suggesting that the structural unemployment rate is high.
   Most of the rise in structural unemployment in recent years can be accounted for by mismatches of employment.

Column1-2
   How to Read UV Curve
   Generally speaking, if corporations' labor shortage increases due to a pickup of the economy, the corporations increase employment and unemployment decreases. In the diagram below, this is expressed by the movement from upper left to lower right on the UV curve. On the other hand, if mismatch of employment and inefficiency of job finding increase, the possibility of the coexistence of unemployment and labor shortage increases and this in turn raises the structural unemployment rate. In the diagram, this is expressed by the shift of the UV curve to upper right.

 Most of the recent unemployment is structural unemployment
   We will estimate how much of the actual unemployment can be accounted for by the structural unemployment rate on the basis of the analysis above.
   The basic idea behind estimating structural unemployment rate is as follows. When the number of workers in short supply (number of vacancies) and the number of unemployed workers are the same, all of the unemployed workers would be employed, barring structural factors such as mismatch and frictions involved in job changing. Therefore, we consider the unemployment rate at a time when the number of workers in short supply (number of vacancies) and the number of unemployed workers are the same as the structural unemployment rate and unemployment that occurs in other occasions as the cyclical unemployment rate that occurs in connection with a fluctuation of economic cycle(12).
   The structural unemployment rate estimated on the basis of the above idea has been rising consistently since the middle of the 1990s (Figure 1-1-14). The cyclical unemployment rate also rose in 1998, when economic situations were particularly severe. The unemployment rate stayed at a high level even when the economy turned upward in the second half of 1999, because the structural unemployment rate kept rising despite a decline in the cyclical unemployment rate.
   Of the 5% unemployment rate in the latest reporting month, close to 4% is structural unemployment and about 1% is cyclical unemployment rate.
 Employment shortage in the specialty/technical jobs and service industries
   In what jobs and industries has mismatch of employment increased? In order to study this point, The Report examined the characteristics of corporations' perception of employment excess/shortage by type of jobs/industries. By all industries and by all jobs, corporations' perception of employment excess was high in the initial stage of the economic expansion that started in the spring of 1999, because the economy was in deep recession in 1998. Then, the perception of employment excess kept declining in line with the improvement of the economy until the end of 2000, when it began to increase again.
   The perception of employment excess/shortage differs greatly from one type of job to another and from one type of industry to another. By type of job, the perception of shortage has declined sharply in craftsmen in line with the deterioration of the economy since late 2000, but the perception of shortage still remains high in professional/technical jobs. On the other hand, the perception of employment excess remains high in managerial, official and clerical-related jobs, showing a mismatch of employment among different types of jobs (Figure 1-1-15 (1)).
   By type of industries, almost all industries had a perception of employment shortage in and after the spring of 1999, reflecting the economic performance of the time, but they began to have a perception of employment excess in and after late 2000. But, the perception of employment shortage is high in the transportation/communication and service industries and the perception of employment excess is high in the manufacturing and construction industries. In the service industry, whose perception of employment shortage is always high, the magnitude of decline in the perception of shortage has been small since late 2000, while in the manufacturing and construction industries, whose perception of employment excess is always high, the perception of excess increased sharply, reflecting a decline in production and public works (Figure 1-1-15 (2)).
 Improvement of wage income is slow
   Amid a severe employment situation, the improvement of wage income remains slow. Wage income affects consumption through a change of household income. Compensation of employees on the National Accounts base (real) rose 2.4% in FY 2000, after falling 0.5% in FY 1999. In the April-June quarter of 2001, it posted a gain of 1.0% over a year earlier. Since wage income of the economy as a whole is the number of employees multiplied by per-capita wage, We will study in detail the slow improvement of wage income from the movements of the number of employees and per-capita wage.
   First, the improvement in the number of employees in the latest phase of economic recovery was slow compared with past phases of economic recovery. It remained on a downward trend when the economy entered a recovery phase in FY 1999 and finally posted a year-on-year increase as late as May 2000 (Figure 1-1-7, lower figure). The number of employees has remained almost flat since the beginning of 2001. By type of industry, the number of employees has been increasing in the service industry but has been on a downward trend in the construction and manufacturing industries.
   The growth of per-capita wage is also slow. Per-capita cash earnings (total of pre-tax salary including bonus and overtime pay; nominal) decreased 1.7% in FY 1998 and 0.8% in FY 1999, before increasing 0.4% in FY 2000. In real terms after adjusting for price changes, the per-capita wage increased 1.1% in FY 2000 (decreased 0.2% in FY 1999) due to a decline in consumer prices, but the growth is slower than in the past phases of economic recovery (Figure 1-1-7; upper figure). The per-capital wage has been continuing its weak movement in 2001 due mainly to a decrease in overtime hours worked. Monthly Labour Survey (Business establishments with a workforce of five or more), Ministry of Health, Labour and Welfare, shows that summer bonus for 2001 decreased 1.1% from a year earlier.
   Behind the slow growth of wage lies the fact that corporations are slashing personnel expenses in order to cope with a rise in personnel expenses caused by aging of their employees. Although corporate profits increased sharply in 1999 and 2000, personnel expenses remained almost unchanged (Figure 1-1-16).
   The following methods can be used to restrain wage: (a) restraint on bonus payments and (b) use of part-timers and day workers. As for causes of changes in per-capital cash earnings, a decrease in bonus payments had the largest effect on the decrease of total compensation in 1998 and 1999. This shows that corporations restrained wages mainly by decreasing bonus payments. Moreover, as was described earlier, the improvement in the number of employees has been slow in recent years. An increase in employment of part-timers and day workers had the largest contribution to an increase in the number of employees, and the number of regular male employees, other than part-timers, continued to decrease even after the economy had entered a recovery phase. In the service industry, which is an important contributor to the recent increase in the number of employees, the proportion of part-timers and day workers has been increasing(13). The increase in the number of part-timers and day workers, whose wages are lower compared with those of regular employees, other than part-timers, has an effect of lowering average wages.
   Household income includes income of self-employed/family employees, in addition to wage income. The fact that the number of self-employed/family employees decreased 1.6% in 1999, 3.5% in 2000 and is decreasing in 2001 depressed the total income for the economy.
   The above analysis reveals that the improvement of wage income is slow because the movement of both the number of employees and wage is weak. This constitutes one of the main reasons for sluggish consumption.
   We have analyzed the causes of the weak recovery of business investment and consumption, the two major items that should support the Japanese economy. The analysis has revealed that a decline in corporate and consumer confidence is a major factor behind the fragile recovery. In other words, the Japanese economy is now caught in a vicious circle, in which corporations and consumers are unable to brighten their future prospects as a result of prolonged economic stagnation and this "bearish mood" of corporations and consumers, in turn, is making the economy weak.
   In order to realize sustainable economic growth, it is necessary to dispel concerns held by corporations and households about the future and brighten their future prospects (expected growth rate). To that end, it is necessary to implement structural reform, such as deregulation, fiscal reform and reform of pension/medical insurance systems, in a tangible way.


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