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 3 Direction of the Economy

   As was described in Section 1, the economic recovery that started in the spring of 1999 was short and the economy turned downward again in the beginning of 2001. The main factors that caused the downturn in 2001 are that exports and business investment that had been the engines for the economic recovery were weak, that consumption remained stagnant, and that the settlement of the problem of non-performing loans was delayed. Section 2 analyzed that deflation is having adverse effects on the Japanese economy. In forecasting the direction of the Japanese economy on the basis of the above analyses, how to analyze the following points is important.
(a) When will exports recover?
(b) When will inventory adjustment that affects short-term economic performance end? And when will manufacturing output begin to increase?
(c) When will business investment recover?
(d) How long will stagnant consumption last?
(e) When will the problem of non-performing loans be resolved?
(f) When will deflation be dispelled?
   As will be described in detail below, the main scenario is that the Japanese economy will begin to recover in the second half of FY 2002 on the strength of the effects of the "Front-Loaded Reform Program" and other structural reforms in addition to recovery of exports and the Japanese economy' s autonomous recovery power (completion of inventory adjustment, completion of capital stock adjustment, etc.). However, the recovery will remain weak for some time to come, as the potential growth rate of the Japanese economy has dropped to about 1%, which will be analyzed in Chapter 2, and as it takes time before corporations and consumers begin to have higher expected growth rates.
   It is generally believed that recovery of the U.S. economy will be delayed due to the effects of a series of terrorist attacks in the United States and the subsequent military actions taken by the U.S. and other countries (hereinafter to be referred to as "series of terrorist attacks, etc." ). However, the above main scenario is based on the premises that the effects of the series of terrorist attacks, etc. on the U.S. economy and the global economy will not last long and that the U.S. economy will recover in the first half of 2002(28).
   However, the adverse effects of the series of terrorist attacks, etc. may last long, prolonging the depressed consumer confidence, and the recovery of the U.S. economy may not come until the second half of 2002 or later. If the world economy slows down further due to the effects, Japanese exports may decline further, causing adverse effects on production, corporate profits and business investment. It is also feared that promotion of structural reforms may put downward pressures on the economy in the short term, causing a rise in unemployment and bankruptcy and a decrease in public investment.
   When we forecast the future direction of the Japanese economy, it is necessary take the above risks fully into account. If such risks become tangible, the above main scenario may collapse.
   In this section, the main points for surveying the economy will be examined and the future movement of public investment and housing constructions that had so far supported the economy will be analyzed, in order to provide materials helpful in forecasting the future direction of the Japanese economy(29).
   Since the outlook for the economy in specific terms, including figures of economic growth rate in FY 2002, is to be published in the "Government' s Economic Growth Forecast" that will be approved at a cabinet meeting in late 2001, this section will provide only information and points that will be helpful in forecasting the future direction of the economy from the viewpoint of economic analysis.

1 Supply-side Weakness

 Decline of potential growth rate
   In order to forecast the future direction of the Japanese economy, it is necessary to analyze both supply-side and demand-side developments. As supply-side factors, how the potential growth rate will move is important. As will be analyzed in detail in Section 3, Chapter 2, the potential growth rate has dropped to around 1% due to slow economic growth in the past 10 years and is expected to stay around that level over the next 2~3 years. Therefore, the growth of the Japanese economy will inevitably be slow for some time to come due to the supply-side weakness.
   However, since demand is smaller than supply in the current Japanese economy on the whole, the actual economic growth rate can be higher than the potential growth rate provided by the supply-side until the gap between supply and demand is dissolved. (According to the analysis made in the next chapter, the current supply-demand gap is 3~4% of GDP, the same level as in the 1998 recession.) From this respect, some argue that demand-side developments are important when we forecast the short-term direction of the Japanese economy and that we don' t need to consider the supply side. How should we respond to this argument?
   As will be studied in detail in the next chapter, the Japanese economy has been stagnant for as long as ten years not because of a shortage of demand but basically because of supply-side weakness caused by a decline in potential growth rate. It was for this reason that the government was unable to shore up the stagnant economy despite its repeated efforts to create demand by implementing stimulus packages, such as huge amounts of public investment. Therefore, in order to increase growth, it is necessary to enhance the growth potential of the Japanese economy. To this end, it is necessary to promote structural reform that will raise the productivity of the Japanese economy as a whole. Structural reform will enhance the growth potential of the Japanese economy as it shifts Japan' s precious economic resources, such as labor, management resources, capital and land, to fields of higher productivity. The structural reform that will enhance the supply potential of the Japanese economy will also be accompanied by a sustainable expansion of private demand. This is because it increases private investment in highly profitable fields and because it brightens consumers' future prospects and thus results in a sustainable recovery of consumption.
   In view of the above, in forecasting the short-term direction of the Japanese economy, it is necessary not only to discern demand-side developments but also to fully take accounts of supply-side developments, or the outlook for the potential growth rate.


2 Future Demand Trends

   As a demand-side analysis, several positions and outlooks on the future trends of main demand items, such as exports, business investment, and consumption, and of inventory adjustment will be discussed below.
(1) Future exports
 U.S. economic trend with increasing impact
   As was described in Section 1, an increase in exports that was brought about by economic expansion in the U.S. and other countries played a big role in the economic recovery that started in the spring of 1999. Therefore, the slowdown of the U.S. economy that started in the second half of 2000 had a big adverse effect on the Japanese economy.
   The economies of Asian countries, except China, have slowed down sharply since the beginning of 2001. An analysis of the economic interdependence of Japan, the U.S. and Asia shows that the impact of U.S. economic developments on Asian economies in the second half of the 1990s was bigger than in the second half of the 1980s(30). This suggests that the main cause of the economic slowdown in Asia was the slowdown of the U.S. economy that started in the second half of 2000.
   Reflecting the fact that Japanese exports to Asia have been on an expanding trend, the impact of Asian economic developments on the Japanese economy has been increasing. Therefore, a slowdown of the U.S. economy not only reduces Japanese exports to the United States but its impact on Japan via stagnant Asian economies has also been increasing. Reflecting the increased inter-regional relationship of IT trade, a slowdown in IT demand in the United States has a significant impact on Japanese exports via trade between Asian countries and Japan.
   As can be seen from the above, developments of the U.S. economy exert a significant impact on the Japanese economy directly and indirectly. Therefore, analyzing the future directing of the U.S. economy is extremely important in forecasting the recovery date of Japanese exports. It is also one of the important points in forecasting the future direction of the Japanese economy.
   The growth rate of the U.S. economy has slowed down due to a sharp decrease in business investment caused by worsening corporate profits (Figure 1-3-1).
   It is generally believed that the series of terrorist attacks, etc. will have a negative impact on the U.S. economy in the short term (at least until the end of 2001). But its impact thereafter is uncertain, as it all depends on the developments of the military actions taken by the U.S. and other countries and on whether terrorist attacks take place again or not. The fact that it is quite uncertain may reduce economic activity. On the other hand, the tax cut that has been in place since July 2001 and the stimulus package now being deliberated in Congress are positive factors for the U.S. economy.
   The future direction of the U.S. economy largely depends on (a) personal consumption and developments of consumer confidence and (b) timing of recovery in business investment. These points will be studied below.
 Outlook for U.S. consumption
   U.S. personal consumption, though its growth rate has slackened since the second half of 2000, held steady compared with a slowdown of the economy as a whole and kept supporting the economy until the middle of 2001.
   Under the circumstances, we need to pay attention to the trend in the savings rate, which has so far remained at an extremely low level (about 1%). If consumer behavior becomes defensive and the savings rate rises, it is feared that not only weak business investment but also consumption will put downward pressures on the economy. (The savings rate rose to about 4% from July to August 2001. But this was partly due to an increase in disposable income brought about by tax rebates.)(31)
   Moreover, there are several negative factors for the future of U.S. consumption. The first negative factor is that there is a risk that consumers may become cautious about their spending due to uncertainty about the future that was caused by the series of terrorist attacks, etc. There are concerns that, just as consumption decreased due to a sharp decline in consumer confidence during the Gulf War (1990), the latest series of terrorist attacks may aggravate consumer confidence and that this may lead to lower consumption.
   The second negative factor is the movement of stock prices(32). If stock prices remain at a low level, growth of consumption may further decline due to a fall in the value of assets held by households (negative wealth effect).
   The third negative factor is deterioration of the employment situation. The unemployment rate began to rise in the autumn of 2000 and hit 4.9% in August 2001, the highest level in nearly four years. Moreover, the number of employees posted the sharpest decrease in nearly 10 years. If concerns about future employment increase, it may aggravate consumer confidence and slacken the growth in employee compensation, lowering the growth in consumer spending.
   On the other hand, there are positive factors. Among them are the tax cuts that went into effect in July 2001 (with total tax cuts from FY 2001 to FY 2011 amounting to about $1.35 trillion) and the package of economic stimulus measures adopted following the series of terrorist attacks and now being deliberated in Congress(33). It is hoped that these measures will increase consumers' disposable income and thus have a positive impact on consumption. We have to keep watching to what extent they can eliminate the above negative factors.
 Outlook for U.S. business investment
   In order to study the movement of business investment in the United States, we will analyze the relationship between business investment and expected growth rate (Figure 1-3-2) just as we did with regard to the Japanese economy (Figure 1-1-5). Corporations' expected growth rate (future economic growth rate forecast by corporations) rose to about 3.5% in the second half of the 1990s from about 3.0% in the first half, while the depreciation rate rose to about 9% in the 1990s from about 6% in the 1980s due to an increase in investment in fast-replaced information-related equipment(34). Therefore, it can be said that business investment posted steady growth after the middle of the 1990s in order to accumulate capital stock commensurate with the rises in the expected growth rate and the depreciation rate and that there was no excessive accumulation of capital stock until around 1998. In 1999, however, there may have been an accumulation of capital stock in excess of the rise in the expected growth rate and in the depreciation rate. Therefore, it can be said that the growth of business investment slowed down in and after the second half of 2000 because the excess capital stock accumulated by high growth of business investment entered an adjustment process (stock adjustment process).
   As we have seen in the analysis of the Japanese economy in Section 1, the length of a stock adjustment process depends on the movement of corporations' business outlook (expected growth rate). If the expected growth rate declines, the stock adjustment period may be extended and the recovery of business investment delayed. However, if the expected growth rate remains at the middle of the 3% level, the adjustment pressure on excess capacity will not become large. And if demand begins to rise again, it will provide corporations with incentives to increase investment and, as a result, the recovery of business investment may come relatively early.
(2) Outlook for inventory adjustment and industrial production
 Inventory that is entering a phase of adjustment
   We have just studied the outlook for Japanese exports and the future direction of the U.S. economy that has a great impact on Japanese exports. Now, we will analyze the prospects for inventory adjustment and industrial production that have significant impacts on short-term business cycles. Inventory adjustment means a process by which corporations restrain production in order to reduce inventories that have become excessive due to an increase in unsold inventories.
   Manufacturers' inventories had remained at a low level since the spring of 1999 due to a steady increase in shipments. However, inventories of electronic components began to increase sharply around the end of 2000 due to depressed IT demand worldwide caused by a slowdown of the U.S. economy and "unintended accumulation of inventories," especially of producer goods (electronic components, chemical goods, etc.), began in the spring of 2001. Therefore, manufacturers are expected to reduce production for some time to come in order to slash accumulated inventories. When the phase of inventory adjustment to reduce accumulated inventories will come to an end is an important point in forecasting the outlook for production.
   In order to study this point, let' s take a look at an inventory cycle (Figure 1-3-3). There were four phases of inventory adjustment since the 1980s and it took from one and half years to two years (5~8 quarters) to get out of each of phase(35). A comparison of changes of the industrial production indexes during adjustment phases show that the adjustment phase that started in the October-December quarter of 1997 was accompanied by a sharp decrease in production. However, the current adjustment phase is accompanied by an even sharper decrease in production (Figure 1-3-4). This suggests that manufacturers, especially of electric machinery, are responding quickly to unintended accumulation of inventories in the current adjustment phase. The adjustment phase that started in the October-December quarter of 1997, during which a quick response, which is similar to the response in the current phase, has been made, ended in five quarters, the shortest period of four phases.
   As for contribution of goods-by-goods inventory and shipment to total inventories and shipments, the inventory of all but production goods has accumulated significantly and the shipment of production goods has decreased greatly since the beginning of 2001. Such an extreme movement was not seen in the past inventory adjustment phases and is one of the characteristics of the current phase of inventory adjustment.
   A comparison with past inventory cycle patterns suggests that the end of the current inventory adjustment is likely to come by the middle of 2002, but it still depends on the future movement of domestic demand and the U.S. economy.
   We must also pay attention to the fact that there are differences in the timing of recovery by type of industry. While the inventory of production goods in the electric machinery industry has been decreasing since the spring of 2001 due to a sharp production decrease made earlier, the inventory of some production goods in the basic material industry (steel, paper and pulp, etc.) has remained at a high level despite a production reduction. Although the inventory adjustment of IT-related items has been making progress, a new unintended accumulation of inventory of items other than IT-related items has been going on since the spring of 2001, suggesting that it may fall into a "two-stage adjustment" situation. If the inventory adjustment of items other than IT-related items is prolonged, a rebound in industrial production as a whole may be delayed. Moreover, if the diffusion of new products, such as the next-generation mobile phones and personal computers, that are to be marketed in and after the autumn of 2001 is slow, there is a risk that the inventory adjustment of IT-related items will also be delayed.
(3) Outlook for business investment
 Movement of capital stock circulation
   With the capital stock adjustment by the manufacturing industry coming to an end, business investment kept increasing in 2000. However, as was analyzed in Section 1 of this chapter, the process of stock build-up by new investment does not last long unless corporations' expected growth rate rises consistently, or unless corporations' business outlook improves. Corporations' expected growth rate estimated from capital stock circulation had remained low at around zero percent since the second half of the 1990s. As a result, the cycle of capital stock circulation continued to be short. Since the expected growth rate also remained depressed at a low level in 2000 and 2001, capital stock circulation appears to be unable to get out of the short cycle.
   However, the fact that the cycle of capital stock circulation is short means that stock adjustment will also be short as long as the current low level of corporations' expected growth rate does not decline further. First of all, since capital stock entered an adjustment process without being fully built up, the stock in terms of "volume" would not have strong downward pressures. In addition, since the fact that capacity-increasing investment was restrained due to stagnation of corporations' expected growth rate is one of the characteristics of the current recovery phase of business investment, the "quality" of the built-up stock would not have strong adjustment pressures either. Should capacity-increasing investment be made actively in the process of stock build-up, the stock adjustment period would be prolonged because, in such a case, it would be necessary to raise the utilization rate of the capacity-increased capital stock before new business investment was to be made. However, the current recovery phase of business investment is not in such a situation.
   Judging from the above, although business investment may enter a stock adjustment process again in the second half of 2001 and manufacturers' business investment is likely to suffer a year on year decline, the adjustment process is not likely to last long. However, since the chances of business confidence rebounding sharply and corporations' expected growth rate posting a sharp increase are slim for the time being, even if business investment got out of the adjustment process and began to pick up, the recovery would be a weak one. The time when business investment will actually rebound depends on the movement of corporations' expected growth rate as well as on the cycle of capital stock circulation.
 Factors that determine business investment
   The estimated business investment functions that take into account such factors as cash flow and corporations' expected demand (Appended Note 1-3) show that a change of cash flow and business outlook tend to influence business investment in a time lag of 2~3 quarters.
   According to the BOJ' s Tankan, Business Conditions have continued to decline since the March 2001 survey and, in the September survey, the percentage of corporations saying their business outlook is "better" was still smaller than the percentage of corporations saying the outlook is "worse." In addition to the aggravation of Business Conditions, the growth of corporate profits has continued its decline. Since a change of cash flow and business outlook tend to influence business investment in a time lag of 2~3 quarters, their downward pressures on business investment are expected to remain in place at least until the first half of 2002.
 Movement of leading indicators and business investment plan
   In order to supplement the above analysis, We will take a look at the movement of machinery orders, a leading indicator of business investment.
   Machinery orders (private-sector machinery orders, excluding volatile ones for ships and those from electric power companies), a leading indicator of business investment 2~3 quarters ahead, have been on a downward trend, especially in the electric machinery industry, since the January-March quarter of 2001 (Figure 1-3-5). As for construction investment, the Current Survey on Orders Received from Construction (private; non-housing) that covers the 50 largest construction companies is also on a decreasing trend both in the manufacturing and non-manufacturing industries. The movements of these leading indicators of business investment also show that the decrease in business investment will continue at least until the first half of 2001.
   According to the BOJ' s Tankan (conducted in September 2001), business investment planned for FY 2001 will post a year on year decrease of 3.9% in the manufacturing industry and 6.5% in the non-manufacturing industry.
(4) Outlook for consumption and employment
 Outlook for consumption
   Consumption has moved sideways. Since movements of employees and wages are likely to remain weak, the future movement of consumption, as will be described below, is expected to remain weak.
   If the scenario that the Japanese economy will move toward recovery in late 2002 is realized, consumption will also begin to improve along with an increase in income. However, if the Japanese economy does not pick up quickly, the improvement of consumption will be weak, as the number of employees and wages are not likely to increase significantly and the improvement of consumer confidence is expected to be slow.
   As for consumer confidence, according to the Cabinet Office' s Consumer Behavior Survey, the consumer behavior index (seasonally adjusted) deteriorated for two consecutive quarters starting in December 2000. It also shows that consumer confidence in "employment environment" six months ahead deteriorated for three consecutive quarters starting in December 2000. According to Nihon Research Institute' s Consumer Sentiment Index survey conducted in August 2001, the "livelihood uncertainty index" that indexes the outlook for "livelihood in the next one year" hit the lowest level since the survey was first conducted (April 1977).
   In order to achieve a sustainable recovery of consumption, it is essential to have consumers brighten their future prospects and to enhance consumer confidence by promoting structural reforms.
 Number of employees likely to continue its weak movement
   The future course of consumption depends largely on the future developments of the employment situation. As was described earlier, employment remained severe and the increase in the number of employees was moderate during the recovery phase that started in the spring of 1999. With the perception of excess employment among corporations having been deteriorating since the beginning of 2001, the number of employees is likely to continue its weak movement.
   According to the BOJ' s Tankan, the diffusion index (D.I.) for the perception of excess employment, though it had been improving since June 1999, deteriorated for three consecutive quarters starting in March 2001 (Figure 1-3-6). By type of industry, the perception of excess employment improved significantly in the manufacturing industry in the current phase of recovery. However, since the beginning of 2001, the perception among small and medium-sized enterprises has deteriorated sharply against the background of decreasing production. Meanwhile, the perception of excess employment in the non-manufacturing industry as a whole continued to deteriorate from June to September 2001 due to a rise in the perception in the real estate and communications industries, although the service industry still had a perception of employment shortage in September. However, the magnitude of deterioration in the perception of excess employment in the non-manufacturing industry remains smaller than that in the manufacturing industry.
   Manpower reduction, especially of employees in administrative divisions, is expected to continue. According to the Cabinet Office' s "Questionnaire Concerning Corporate Activities (January 2001 survey), large corporations plan to slash the number of their employees by 0.6% over the next three years (a decrease of 4.0% in the manufacturing industry and an increase of 0.8% in the non-manufacturing industry). Although the margin of decrease is smaller than in the previous year' s survey (a decrease of 1.7%), the move to slash manpower is continuing. Although the number of employees in manufacturing and sales divisions decreased only 0.1%, showing signs that the downtrend has come to an end, the number of employees in administrative and planning divisions decreased 1.8%.
   Another factor that has adverse effects on employment is corporate bankruptcy. The number of corporate bankruptcies declined sharply from October 1998, when the government introduced a special loan guarantee system for small and medium-sized enterprises, until early 1999. After remaining at a low level for some time, the number began to rise gradually and moved at a high level of about 1,500 cases a month after the spring of 2000. In September 2001, the number came to 1,592 (Figure 1-3-7)(36). From February 2000, bakruptcies of large enterprises, such as listed companies and life insurance companies, began to increase and the liabilities left by failed companies increased sharply. As a result, the number of corporate bankruptcies in FY 2000 came to about 19,000, the third largest on record, and the total liabilities hit an all-time high of about ¥26.1 trillion. Corporate failures are likely to increase further, as financial institutions dispose of their non-performing loans. Even when a financial institution agrees to give up its credit, the debtor corporation has to prepare a reconstruction plan, including personnel cuts, and implement it(37). In this respect as well, the employment situations will remain severe for some time to come.
   The movement of wages has been slow since the beginning of 2001 due partly to a decrease in overtime hours worked. The growth rate of the wage increase agreed to at labor-management negotiations in the spring of 2001 was lower than in the previous year and, according to the Monthly Labour Survey (Business establishments with a workforce of five or more) of the Ministry of Health, Labour and Welfare, summer bonus payments decreased 1.1% from the previous year.
   Although corporate profits stand at a high level comparable to those during the period of the bubble economy thanks to sharp increases in 1999 and 2000, they hit a peak in 2001 and began to decrease thereafter. Reflecting this, the growth of wages is expected to remain slow.
   Judging from the above analysis of the future movement of employment situations, consumption is expected to continue its lackluster performance for the time being.
(5) Outlook for public investment
 Public investment is expected to remain sluggish
   Public investment played a major role in supporting the economy amid a decline in private demand in and after the second half of FY 1998. Despite the relatively high level of public investment in FY 1998, public fixed capital formation (real) posted only a marginal year on year decrease of 0.7% in real terms due partly to a decline in prices.
   In FY 2000, although a supplementary budget was compiled, the total public works-related expenditure of the initial budget and the supplementary budget combined for the national government decreased 7.1% from the previous fiscal year. The investment expenditure of local governments also decreased from the previous fiscal year, reflecting severe fiscal conditions. As a result, the public fixed capital formation (real) of the national and local governments combined fell 6.1% from the previous fiscal year.
   In FY 2001, although the initial budget of the national government was almost the same amount as the initial budget of the previous fiscal year, the investment expenditure of local government decreased. As a result, public investment as a whole is expected to remain sluggish.
   In the "Structural Reform of the Japanese Economy: Basic Policies for Macroeconomic Management" (or "Basic Policies" ) that was decided at a cabinet meeting in June 2001, the government has declared that it aims to restrict the issues of new government bonds to a maximum of ¥30 trillion in FY 2002 and slash public investment-related budget by reviewing national government' s expenditure without leaving any sanctuary. Based on the Basic Policies, the government intends to slash FY 2002 budget requests for public investment-related expenditure (public works-related expenditure and facility expenditure) by 10% from the previous fiscal year. Since local governments are also likely to further slash investment expenditure, public investment is expected to post a year on year decrease in FY 2002.
   A decrease in public investment has indirect negative impacts, as well as direct impacts, on employment and investment and it may put downward pressures (so-called "fiscal drag" ) on the economy. However, in "Basic Policies," the government has declared that it will review the contents of public investment, promote efficient establishment of social infrastructure, and make focused investment in fields that are effective in spurring private demand. Such improvement of the quality of public investment will be effective in easing the downward pressures of public investment in terms of quality in the medium term. Therefore, it is all the more important to drastically improve the contents of public investment in next year' s budget.
(6) Outlook for housing construction
 Sluggish movement of housing construction continuing
   Private housing investment (real) on the National Accounts basis supported the economy in 1999 and 2000 (up 1.1% year on year in 1999 and 1.3% in 2000), when the economy was in a recovery phase. But it posted a decline for two consecutive quarters in 2001 (down 5.2% year on year in the January-March quarter and down 8.8% in the April-June quarter).
   According to Housing Construction Started, Ministry of Land, Infrastructure and Transport, construction of owner-occupied houses (construction of houses for one' s own residence. So-called custom-built houses) in 1999 increased 10.2% (on a unit basis) from a year earlier. In particular, construction of owner-occupied houses financed by loans from the Housing Loan Corporation increased sharply, thanks to housing construction promotion measures, including tax incentives for housing loans and low interest rates on loans provided by the Housing Loan Corporation. However, construction of owner-occupied houses financed by loans from the Housing Loan Corporation began to decrease in the second half of 1999 due to a series of hikes of the basic lending rate in 1999. Meanwhile, construction of owner-occupied houses financed by loans provided by private financial institutions increased, as interest rates in that sector became relatively low. All told, construction of owner-occupied houses remained almost flat from the middle of 1999 to 2000.
   What propped up housing construction during this period was construction of condominiums for sale and rental houses (those build with private funds alone). Factors behind this were, in addition to the same policy effect as in the case of owner-occupied houses, the progress in the use of idle or underdeveloped land in urban areas and conversion of office/commercial buildings into houses. Construction of private rental houses is firm, reflecting moves to replace older rental housing stocks.
   Housing construction had moved at an annual rate of about 1.2 million units since 1999, but it posted decreases for two consecutive quarters in 2001, declining to an annual rate of about 1.15 million units in the April-June quarter of 2001. This is due to the fact that a sharp drop in 2001 in the construction of owner-occupied houses financed by loans provided by the Housing Loan Corporation decreased construction of owner-occupied houses as a whole, in addition to the fact that the construction of condominiums, that had propped up housing construction, slowed down. Behind this is the fact that consumers are less willing to purchase houses due to (1) severe employment/income environment and (2) difficulty of replacing houses caused by the long-term downward trend of real estate prices. As seen in the above, there are factors that decrease housing construction, such as continued sluggish movement of the number of employees and wages.


3 Future Price Movement

 Prices to remain under downward pressures
   As was seen in Section 2, the Japanese economy is now in a mild deflationary phase. There are three factors behind this: (a) "Supply-side structural factors" such as increase in low-priced imports, (b) "Demand factors" caused by a lack of strength of the economy, and (c) Financial factors.
   As for structural factors, since the proportion of Chinese-made products to Japan' s total imports has increased as a result of the progress of local production of electric appliances and other machinery in China, the downward pressures of low-priced imports are likely to remain for some time to come.
   As for demand factors, since both business investment and personal consumption are expected to remain sluggish for some time to come as was described earlier, downward pressures on prices from the demand side are likely to remain for some time to come.
   As for financial factors, we have analyzed in Section 2 of this chapter that the drastic monetary easing policies implemented by the Bank of Japan have yet to lead to sufficient increases in bank lending and money supply and are unable to eliminate the deflationary pressure because of the strong power of the structural and demand factors and because of the excessive debts that saddle corporations and a decline in banks' intermediation function. As will be analyzed in detail in Chapter 2, such mechanism cannot be eliminated in the short run, if the prolonged problem of non-performing loans is taken into account.
   As was mentioned above, the deflationary pressure is not likely to be eliminated in the short run and a mild decline in prices will continue in 2002. Therefore, it is important for the government to promote drastic disposal of non-performing loans in order to restore banks' intermediation function. It is also important that the Bank of Japan, for its part, positively considers further measures to ease deflationary pressures.
   As can be seen from the above study, the economy is expected to remain stagnant for some time in 2002 for the reasons that inventory adjustment and capital stock adjustment began only in the second half of 2001 and that consumption lacks strength due to weak employment. However, our main scenario is as follows: the Japanese economy will begin to recover in the second half of FY 2002 on the strength of the effects of the "Front-Loaded Reform Program" and other structural reforms in addition to a rebound of exports in line with the recovery of the U.S. economy and Japanese economy' s autonomous recovery power (progress in inventory adjustment, capital stock adjustment, etc.). This is our main scenario.
   Aside from the cyclical perspective, there are structural downward pressures on the economy that cannot be eliminated in the short run. They are visible in the form of a decline in potential growth rate. Since it is difficult to eliminate such structural problems in the short run and raise expected growth rate and corporations' expected profit rate significantly, a recovery of the Japanese economy, if any, will be weak for some time to come. It is necessary to promote drastic settlement of the problem of non-performing loans and resolutely carry out structural reforms, such as deregulation and fiscal reform that will draw out the strength of the Japanese economy, in order to eliminate the structural downward pressures as early as possible and realize strong recovery of the Japanese economy(38).


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