Annual Report on the Japanese

Economy and Public Finance

2002-2003

- No Gains Without Reforms III -

October 2003

Cabinet Office

Government of Japan


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Section 4 Economic Outlook

    As analyzed in Section 1, positive signs are emerging mainly in the business sector. The prospects for economic improvement are starting to look brighter.
    In this section, we will set out the economic outlook based on such current situation.(57) First, we will present the basic scenario about the economic prospects. In this part, we will indicate that economic improvement can be expected as positive signs spread from the business sector to the household sector. In addition, we will prospect the future of the deflation. Then, we will discuss the risks involved in this main scenario and the weakness of economic recovery. Lastly, we will summarize the tasks to be tackled toward self-sustaining economic recovery.

1. Main Scenario for Economic Recovery
    In the current economy, positive signs are observed mainly in the business sector. These signs imply that preconditions for future economic improvement are gradually being met. If export resumes growth and production recovers, the positive movements in the business sector will be further enhanced and result in economic recovery.

(1) Business Sector Sustains Positive Moves
    The positive moves in the business sector are seen in the trends of corporate profits and business investment.
    Firstly, corporate profits indicated high growth in FY 2002 and continued to grow in FY 2003. According to the BOJ's September Tankan survey, ordinary profits increased by 16.4% over the previous fiscal year for companies of all sizes and industries in FY 2002, and are expected to further increase by 10.4% in FY 2003. The profit increase is not only expected for large manufacturing companies, but also non-manufacturing companies and SMEs. In addition, the ordinary profit on sales is expected to rise to the highest level since the beginning of the 1990s for large manufacturing companies. Such sustained improvements in corporate profits will have a favorable impact on the trends of business investment and employment/wages.
    Secondly, business investment is also growing. Business investment passed the adjustment phase in the beginning of FY 2002 and entered a growth phase, which is still continuing in FY 2003. Business investment for companies of all sizes and industries increased by 2.2% over the previous fiscal year in the BOJ's September Tankan survey. Being a figure as of the September survey, this growth matches that in FY 1996 and FY 2000, which are past business investment recovery phases. Dramatic growth is particularly expected for large manufacturing companies, while it also has a strong showing for non-manufacturing companies and SMEs. Immediate indicators, such as machinery orders, are also compliant with such a growing trend.
    These signs of recovery in the business sector indicate that the preconditions for improvement of the entire economy are gradually being met. If production increases in the future, the recovery in the business sector will become more robust, and its effect is expected to spread to the household sector.

(2) Global Recovery and Increase in Japanese Exports
    The key to production growth is increase in exports. Export growth had been leading the movements toward recovery since the bottoming out in the beginning of 2002, but with the weakening of the global economic resilience as the main cause, the growth stopped from the end of 2002 to mid-2003. Yet, even in such a situation, signs of change could be observed. In the United States in particular, economic resilience has been gaining strength since the April-June quarter of 2003, and a rise in the real growth rate is expected in the second half of 2003.

Rise of real growth rate in the United States
    In the U.S. economy, the real growth rate is rising, posting a 3.3% increase from the previous quarter (seasonally adjusted) in the April-June quarter of 2002. The growth can be characterized as follows.
    First, as to the details of the growth, personal consumption continued to make steady increases along with an increase in business investment. The business sector, which had been lagging behind the household sector, contrary to the situation in Japan, is finally showing signs of recovery.
    Second, continued improvements in corporate profits are seen mainly in IT-related businesses. While this serves as a factor that boosts business investment, it also serves as a factor that supports personal consumption through a rise in stock prices, since many stocks are held by households.
    Thirdly, flexible macroeconomic policy is expected to support the economic resilience. U.S. monetary policy has been supporting the economy through flexible interest rate reductions, and effective monetary policy operation can also be expected in the future toward achieving a sustainable economic recovery while averting deflation. In addition, measures on income tax reduction from the tax cut package(58) adopted in May 2003 have been retroactively applied from January 2003 and implemented from the end of July. These policy efforts in fiscal and monetary areas are expected to contribute greatly to supporting the economy.

Economic recovery's spread to Asia and Europe
    Such rise in the growth rate of the U.S. economy will have a favorable impact on the recovery of the Asian and European economies. While the growth of the Asian economy had stagnated due to a decline in exports to the United States and the impact of SARS, exports to the United States are showing signs of recovery, so the economy may regain growth in line with the cessation of the impact of SARS. The European economy has slowed down due to the impact of the strong euro, and is facing a severe situation. However, recovery of exports to the United States would have the impact of supporting the economy.

Export growth and production recovery
    The rise in the growth rate in the United States and the ripple effects to Asia, etc. will have an effect of boosting Japanese exports as well. The increase in industrial production stopped in the April-June quarter of 2003 since export growth stopped while no dramatic increase was observed for domestic shipment. Since inventory is low and there is no pressure to adjust inventory, export growth is expected to bring about corresponding production growth.
    Production growth would further encourage the positive signs that are already observed in the business sector.

(3) Recovery's Spread to Household Sector
Recovery in employment/wages
    The positive signs in the business sector are gradually spreading to employment and wages.
    The number of employees has shown an increase since the end of 2002, led by an increase in job offers from the beginning of 2002. One of the background factors is that a pause is being observed in the drastic restructuring efforts. The positive movements in the business sector would make the increase in the number of employees steadier.
    With regard to wages as well, if production recovers, overtime work allowances will continue to increase accordingly. In addition, improvements in corporate profits would lead to better bonuses. The summer bonus in 2003 remained at the same level as the previous year, becoming flat. Basic wages will continue to be subject to downward pressure due to the review of the seniority wage system and other factors, but as a whole, it is likely to show gradual recovery.

Recovery in personal consumption
    Despite the severe income environment, personal consumption has indicated a moderate increase on a GDP basis. The possible reasons are that elderly households have come to make greater contribution to consumption in line with the aging of the population, and with the increased purchasing power of the financial asset balance due to the deflation, it is possible to use part of such assets for personal consumption.
    Future recovery in employment and wages means improvements in the income environment of households. In line with this, consumer confidence will improve and personal consumption is expected to gradually show signs of recovery.
    In this manner, if export grows and production resumes growth based on the positive signs already observed in the business sector, these positive movements will become steadier and will have a favorable impact on improvement of personal consumption through increase in employment and wages. With this, the whole economy is likely to make a gradual recovery.

(4) Prospects for Overcoming Deflation
    Although the economy will move toward recovery, the mild deflation is expected to continue for a while. Consumer prices (general; excluding perishables) have been flat in terms of month-on-month changes since the fall of 2002, while domestic corporate goods prices also remained at the same level except for a limited period in 2003. However, these have resulted from temporary factors such as a rise in crude oil prices, and the deflation is basically continuing.
    However, some signs of changes have also been observed in the area of deflation. In particular, domestic corporate goods prices are rising for material-type products, such as iron & steel and petroleum & coal products, reflecting the firm commodity markets. The prospects for overcoming the deflation is expected to become more concrete as the economic recovery becomes steadier.
    There are also signs of changes in the deflation of asset prices, such as stock prices and land prices. Stock prices have shown recovery after posting a record low since the collapse of the bubble economy at the end of April. On the one hand, it is a rise pertaining to improvements in corporate profits and decline in concerns over monetary system, which has resulted from expectations for signs of recovery of the Japanese economy in the future. On the other, such an increase in stock prices would support the recovery of the Japanese economy by having the following effects: (i) asset effect on personal consumption; (ii) improvement in companies' fund procurement environment; (iii) improvement in companies' and households' business confidence; and (iv) improvement in the balance sheets of companies and financial institutions.
    Meanwhile, the fall in land prices has accelerated again, particularly in rural areas. The downward trend is likely to continue for a while.

(5) Economic and Fiscal Policy Stance
    In order to strengthen the vitality of the Japanese economy and to achieve economic recovery led by private demand, it is vital to address structural reform toward economic revitalization.
    The "Reform and Perspectives-2002 Revision" compiled in January 2003 sets forth that reform should be accelerated centering on structural reform with focus on expansion of private demand and employment, and that comprehensive measures should be taken in the monetary area during the concentrated adjustment period until FY 2004, based on the awareness that the most important task is to overcome deflation including asset deflation. Based on the concept of this Revised Reform and Perspectives, the government will implement powerful and comprehensive measures toward overcoming deflation together with the BOJ. Bold and flexible policy measures will be taken in accordance with the economic conditions.
    Upholding this idea, the government will continue to implement the four pillars of structural reform, which are regulatory, financial, tax system, and government expenditure reforms, in an integrated and consistent manner based on the Basic Policies 2003 compiled in June. Thereby, it will establish an environment in which private demand will be created in a sustaining manner. In other words:
(i) in the regulatory area, the government will conduct thorough reform in fields that are directly linked with people's lives and arouse potential demand in growth fields, using special structural reform areas as a breakthrough;
(ii) in the financial area, the government will recover the financial intermediary function and enable a smooth shift of resources to new growth fields, by steadily implementing the measures based on the program for financial revival with an aim of resolving the NPL problem in FY 2004, and it will prevent emergence of any concerns over the monetary system in the future;
(iii) in the tax system area, the government will continue to promote reform toward a tax system that ensures that the people have sense of reassurance for the future, aiming at a sustainable revitalization of the economy and society; and
(iv) in the government expenditure area, the government will boldly implement prioritization focusing on creation of private demand, and along with reform of the social security system, it will eliminate citizens' concerns for the future as well as spur consumption and investment.
    With regard to monetary policy, it is expected that quantitative easing will be continued and more effective monetary easing will be studied and implemented based on the Reform and Perspectives-FY 2002 Revision, with the objective of overcoming deflation as early as possible. While prospects of ending the deflation are expected to gradually open up, as mentioned above, the quantitative easing policy is to be continued until the consumer price index (excluding perishables, on a nationwide statistics) resisters stably a zero percent or an increase year on year.

2. Risks in Main Scenario and Vulnerability of Economic Recovery
    As discussed above, the main scenario of the future economy is that if export resumes growth and production also improves, the positive signs currently observed mainly in the business sector will strengthen further, and will lead to economic recovery. The possibility of this scenario is considered to be increasing. At the same time, however, it is essential to recognize that this scenario still involves risks. In addition, it should be confirmed that even if the main scenario were realized, economic recovery will be vulnerable for a while.

(1) Risks in Main Scenario
    The risks in the main scenario are divided into external risks and internal risks.
    First, external risks include the risks faced by the U.S. economy. As mentioned above, in the U.S. economy, both personal consumption and business investment are gaining strength, so economic resilience has become stronger, and the real growth rate is also very likely to see gradual growth. However, in such a situation:
(i) employment situation still has not improved, with the number of employees continuing to decline, so improvement of consumer confidence lacks robustness and growth in personal consumption may stagnate;
(ii) when the economy does not recover as expected, deflationary concerns intensify again, and when it becomes obvious, it serves as a downward pressure on the economy; and
(iii) under this situation, the current account deficit expanded considerably due to an expansion in the budget deficit. In the future, we cannot overlook the risks relating to expansion of the current account deficit, while the economy makes a sustainable recovery.
    In addition, the exchange rate trend where the appreciation of the yen advanced is another risk to be taken into account.
    Second, internal factors include risks pertaining to domestic stock prices and long-term interest rate. Stock prices are recovering, and it is important that the recovery trend continues. The rise in the long-term interest rate, which is observed in parallel with this trend, would only have a small impact if the increase suits the actual state of the economy. However, if not, it may have an adverse impact on the Japanese economy through its influence on the interest rate, housing loans and the balance sheets of financial institutions, etc.

(2) Vulnerability of Economic Recovery
    In the main scenario, export growth led by recovery of the global economy is to play a significant role. The reason that the main scenario assumes economic improvement led by foreign demand is that the economy's power to achieve self-sustainable recovery is still vulnerable. The vulnerability is specifically observed in the following aspects.
    First, the improvement in corporate profits was largely attained by the restructuring efforts of mainly large companies, and this serves as a sales restraining factor for SMEs. Thus, unless it is offset by export growth, progress in restructuring leads to a restriction in the corporate profits aspect.
    Second, while business investment is in a growth phase, the extent of growth is largely affected by companies' future demand forecast. Companies are still considered to prospect the future cautiously, so business investment recovery may become limited. Furthermore, companies that have excessive debts are still not in the stage of making active business investment.
    Third, with regard to an increase in employment and wages, companies are still cautious about increasing the personnel costs. If so, improvement in the income environment of households would be limited. In addition, even if jobs were offered, the offers may not lead to actual employment due to the "employment mismatch," and the income environment may be restrained in that respect.
    Fourth, personal consumption is basically largely affected by the trend of income to be gained in the future and uncertainties over it. At present, people view the employment situation and the social security system cautiously and have concerns over them, so there seems to be not much room for growth of personal consumption.
    Fifth, the continuing deflation is exerting a downward pressure on the economy. In particular, the fall in land prices will continue to serve as a great aggravating factor for balance sheets.
    Due to these vulnerabilities, self-sustainable economic recovery cannot be achieved smoothly. Thus, contribution of foreign demand to the economy becomes greater and the Japanese economy will face the external risks.

3. Obstacles to Self-Sustainable Recovery
    If exports grow, the economy is expected to gradually improve according to the main scenario. However, there are some obstacles to tackle in order to head toward a more self-sustainable economic recovery.
    First is that, due to the presence of NPLs, financial institutions' risk tolerance has lowered, and they are reluctant to increase loans and other risk assets. Therefore, in the monetary policy, the essential effect of quantitative monetary easing, which is to expect effects originating from financial institutions, has not been observed. In addition, while companies are appropriating cash flow and conducting restructuring to reduce their excessive debts, which have an inseparable relation with the NPLs of financial institutions, this is serving as a factor restraining business investment and employment/wages. Unless these problems are solved, resources will remain in low productivity sectors. Accordingly, companies will be unable to have confidence in the future of the Japanese economy, and the expected growth rate will remain low.
    Second is that Japan's productivity growth has declined since the 1990s. In the background, there are such factors as the inefficient allocation of the basic production factors, capital and labor, and the fall in the power to raise productivity by technological progress. The sense of economic stagnation is also affecting companies' and households' views on the future. The future medium-term growth rate expected by companies and households has dropped even below 1%. In such a situation, companies and households would take a cautious attitude toward active spending in the business investments or personal consumptions.
    Third, there are concerns about the future because the economic and social systems are not fully corresponding to the changes in the present economic and social environments. With regard to public finance and the social security system, there will be a problem of sustainability if the current systems were maintained while the declining birthrate and the aging of the population were causing a decrease in population. Nevertheless, the reform has been only half implemented. Therefore, concerns are arising as to how the fiscal deficit will be reduced in the future and the whether pensions will be provided without fail, and this is likely to be leading to the cautious spending of the households and corporations.
    If the reasons for the slow progress in the self-sustainable economic recovery can be summed up as above, the action to be taken to achieve self-sustainable recovery of the economy is to remove all such factors. The structural reform tries to address such matters. Chapter 2 and 3 below deal with such problems. Chapter 2 examines restructuring of public finance and companies. Finally, Chapter 3 analyzes the problems in finance and social system policy under the aging population and declining birthrate. (59)


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