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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Conclusion

Positive Signs Observed in the Japanese Economy
    The Japanese economy passed the trough in January 2002 and entered a recovery phase of the economic cycle. However, the recovery was somewhat bumpy, finally coming to a rest by the end of 2002. This was largely attributable to the gradual slowdown in export growth. In such a situation, however, positive signs continued to be seen in the business sector, mainly in corporate profits and business investment. These effects are further spreading to the employment situation, and are about to affect even the household sector. If the U.S. economy resumes growth and Japanese export to the United States starts to recover, there would be even stronger signs of economic improvement.
    On the other hand, deflation still lingers, exerting a downward pressure on the Japanese economy. Still, some changes can be observed. First of all, stock prices have turned up. This represents that economic prospects have brightened along with the positive signs in the business sector. It is hoped that this trend will have a favorable impact on the economy. Next, the fall of general prices has moderated, showing signs of leveling off. Although this trend is partly due to temporary factors, it also reflects the steadier condition of the commodity market.
    Amidst such economic conditions, fiscal structure reform is being promoted as fiscal policy. Nevertheless, although fiscal spending of the general government has remained on the same level, revenues have weakened, so the budget deficit has slightly increased. Accordingly, the general government-based fiscal policy is in fact not having a negative effect on the macroeconomic conditions despite the spending reform. It should also be noted that fiscal reconstruction could have a Non-Keynesian effect depending on the economic and financial situations. As for monetary policy, continuous quantitative easing greatly contributed to eliminating the concerns about the monetary system through the supply of abundant liquidity in markets. However, the quantitative easing is not exactly achieving the expected effect on the macroeconomic conditions. The underlying factor is that the process of spreading the monetary policy effects, intermediated by banks, is cut off by the problems of non-performing loans and excessive debts.

Moving Toward Economic Improvement
    These circumstances suggest that the economic conditions will gradually improve in the future. The positive signs in the business sector are expected to further strengthen in line with export recovery. Moreover, these positive signs would reinforce the changes observed in employment/wages and would eventually have a favorable impact also on the household sector. In addition, this process is expected to develop a clearer outlook toward the end of the deflation of general prices.
    This basic scenario, however, is largely dependent on a premise that the U.S. economy will grow. The U.S. economy itself is not necessarily solid, and if it shows its weak side, it could greatly affect the export growth necessary for Japan's economic improvement. The fact that the basic scenario still needs to assume export growth as the basis for economic improvement, instead of autonomous recovery driven by private demand, reveals the fragility of the current economic conditions.
    In order for the Japanese economy to not only improve, but to show autonomous recovery centered on private demand, the public sector needs to positively engage in spending activities. To this end, such impediments as the problems of non-performing loans and excessive debts, as well as the issue of reforming social security systems must be solved, so as to bring about brighter forecasts. Only then would the quantitative easing monetary policy demonstrate sufficient effects and serve as a powerful strength toward overcoming deflation.

Importance of Rebuilding Finance and Enterprises
    Japan's financial system is centered on indirect finance intermediated by financial institutions. However, the function of direct finance is declining. In order for funds to be efficiently utilized for economic growth, efforts must be made to improve the function of direct finance and normalize indirect finance.
    A factor behind the declined function of indirect finance is that financial institutions, loaded with non-performing loans, have become reluctant to extend loans due to their lower risk tolerance. At the same time, enterprises, which lack earning capacity while holding excessive debts, are subject to higher credit risks. In short, the problems of both finance and enterprises are having an adverse effect. This can also be identified by looking at the trend of business investment and the current state of SME finance. The most important thing in normalizing the function of indirect finance is to address both the disposal of non-performing loans and reduction of excessive debts.
    Disposal of non-performing loans is steadily making progress in the financial sector. Although new non-performing loans are still emerging, credits are being liquidated and debts are being renounced at a faster pace. In order to further promote disposal of non-performing loans, continuous efforts should be made to reduce credits to failed corporate borrowers and corporate borrowers with a possibility of failure, while striving to dispose of the non-performing loans that still remain as loans needing careful monitoring, and preventing healthy loans from becoming non-performing. In addition, it is necessary to set risk-matching interest rates and raise the earning capacity also from the viewpoint of securing financial funds for disposing of the non-performing loans. Furthermore, in order to prepare the conditions for allowing sufficient demonstration of the financial function, it is essential to make financial institutions capable of extending loans not on an enterprise basis, but on a project basis, to facilitate liquidation of credits, and to review policy-based finance.
    Meanwhile, restructuring efforts have made progress in the business sector. In line with the increased capacity to create cash flow, excessive debts have been steadily reduced. However, there are still enterprises that need to adjust their balance sheets mainly in the construction, real estate, and wholesale/retail industries, as well as small and medium non-manufacturing enterprises. In particular, those enterprises that have a weak revenue base while holding large amounts of debts are facing considerable difficulties. Some of such enterprises are moving toward reconstruction step by step by utilizing business revitalization schemes that are currently being developed, and this trend needs to spread to other enterprises as well. At the same time, enterprises are required to go beyond reducing excessive debts and revitalizing business, and make continuous efforts to secure the earning capacity necessary for surviving in a highly competitive environment. Part of such efforts can be seen in the increase in the number of M&As that also utilize corporate reorganization means for which legislation has been developed in recent years. It is hoped that such trend will become even stronger.
   

New Challenges Facing Enterprises
    In order to increase their earning capacity, enterprises need to tackle any new challenges that come their way.
    With the development of information and communications means and the increased frequency of direct investment and transfer of management resources, Japanese companies have come to develop closer relationships with overseas companies, and are required to respond to the expanding and intensifying globalization trend. In addition, as R&D findings are not effectively resulting in new products or new businesses, "technology-based management," which places technology at the core of business development, is becoming more and more important. Moreover, some enterprises are moving to make environmental problems their business opportunities by taking advantage of the current rise in environmental awareness.
    Enterprises' positive efforts to address these issues would also lead to activation of the Japanese economy.

Evaluation of Corporate Reconstruction and Business Revitalization
    Corporate reconstruction and business revitalization are gaining importance in disposal of non-performing loans and excessive debts. These are methods for carrying out disposal by reconstructing the enterprise through selling off unprofitable operations or downsizing personnel. Such a trend is observed from the increased cases of non-performing loan disposals through reconstruction of the enterprise, and the increased creditor-led workouts through renouncing of debts with regard to disposal of excessive debts.
    Utilization of these means is significant in that the accumulated capital stock, human resources, and management resources of the enterprise can continue to be utilized without being scattered.
    Nevertheless, disposal through reconstruction merely means that the very first step has been taken toward reconstruction. Whether or not renouncing of debts and formulation of a reconstruction plan will actually bring about reconstruction of that enterprise solely depends on the content of the reconstruction plan and the ability to surely perform that plan. Since corporate reconstruction only bears its actual meaning when it is achieved, if the corporate reconstruction ends in failure, the current disposal through reconstruction will also end up being mere "postponement." Further efforts need to be exerted in order to achieve corporate reconstruction.

Concept of the "Pains Accompanying Structural Reform"
    Structural reform means shifts of resources, such as capital and work force from less productive divisions to more productive divisions. In the area of work force, structural reform could result in more people leaving their jobs. Therefore, the job turnover rate was expected to increase considerably with progress in disposal of non-performing loans and reduction of excessive debts. Looking at the recent trend, however, the number of job-leavers has not dramatically grown despite the progress in non-performing loan disposals and excessive debt reductions. This is due to the moves toward reconstructing the enterprises rather than liquidating them, as mentioned above.
    Nevertheless, a person who has left a job cannot necessarily find another job smoothly. Instead, job-leavers are very likely to remain in the labour market as the unemployed, partly due to employment mismatch. A recent characteristic is the increased number of young unemployed persons and the long-term unemployed. If such losses that derive from adjustments were to be called adjustment costs, it is important to make efforts to minimize the adjustment costs. In that sense, employment policy has become more important than ever, and it is particularly essential to strengthen proactive employment policy centering on education and training in order for people to raise skills for getting a job.
    One thing to note in considering such a trend is that adjustment costs in that sense are not necessarily "new pains created by structural reform." Various problems have been revealed in the Japanese economic and social systems in the course of experiencing the emergence and collapse of the bubble economy. In addition, with the catching-up of developing countries and advancement of technology, there have been calls for a change to systems that can sufficiently adapt to such developments. However, reforms of systems have been put off so far. That is the biggest reason for the stagnation of the Japanese economy since the 1990s. Based on such circumstance, the current structural reform aims to finally put the long-postponed reforms into practice. Therefore, the adjustment costs to be borne at present are the costs that should have been borne at a much earlier stage, in which case the costs would probably have been much lower than they are now. They are the inevitable costs for building systems that meet the demands of the times.

Impact of the Aging and Declining Population on Economic Growth
    One of the long-term challenges facing the Japanese economy is to address the aging and declining population. The aging and declining of population are phenomena seen mainly in industrial nations in line with economic development. However, the pace of the aging and the decline in Japan is not only beyond Japan's experience, but is unprecedented on a worldwide scale. Therefore, their impact on the Japanese economy is highly opaque. The aging and decline of population alone would mean a decrease in labour input and capital input, so they would have a negative impact on macroeconomic growth. There would even be a possibility of negative growth depending on the future trend of birth rate and the extent of the population decline.
    Yet the impact does not necessarily have to be viewed pessimistically. This is because income per capita is expected to continue increasing and there are also mechanisms that would offset impacts that drastically slow down macroeconomic growth. Progress in the decline of population will promote educational investment in individuals and advancement of labour-saving technology. In addition, although a declined savings rate may restrain accumulation of capital stock, it can be supplemented if capital flows in smoothly from overseas. Furthermore, even the decline in labour input itself could be eased if more women and elderly who are eager to work come to join the labour market.
    However, the problem is that many of the factors that offset the negative impact of the aging and declining population are dependent on future efforts. They greatly dependent on constant endeavors of enterprises, individuals' eagerness to work, and government policy to support such movements. If such efforts are made sufficiently, the economic growth can be sustained. However, if the efforts are insufficient, it could lead to negative growth. How we address the aging and declining population is now being called into question.

Toward Establishment of Sustainable Public Finance and Social Security Systems
    The aging and decline of population are also having various impacts on economic and social systems. Particularly serious is the impact on public finance and social security systems.
    The basic frameworks of the present public finance and social security systems were formed at a time when the population was composed of younger generations and the economic growth rate was high. If such a time had continued, there would be no problem. However, with progress in the aging and decline of population as well as the slowdown of economic growth, it will become difficult to sustain the existing systems if the current benefit-burden structure were maintained. With regard to public pension, for example, citizens' burden of premiums is expected to double in the future if the current system were maintained, giving rise to concerns that the system would no longer be sustainable due to excess burden on future working generations. Such problems has long been recognized, and measures have been taken to keep the systems sustainable, but partly because the speed of the decline and aging of the population was faster than originally expected, the reform is still halfway through. Facing such a reality, a surging number of young people are not paying pension premiums from concerns toward the pension system. In this manner, people are holding great concerns about the sustainability of the public finance and social security systems and are calling for implementation of drastic system reforms as soon as possible.
    There are two points that should be considered in system reforms. One is to build sustainable and stable public finance and social security systems, taking into account a certain range in the prospects of population decline and the uncertainties in economic growth. Only then will stable and reliable systems be established. The other is that system reforms should not be implemented independently for pension, healthcare or other systems, but by also achieving compliance with public finance and taxation. Only through such reforms will it be possible to prevent passing on an enormous burden to future generations and to build sustaining social security systems.

Incentives That Promote Institutional Reforms
    Financial/corporate restructuring and the addressing of the aging and declining population have been recognized as important tasks, and efforts to this end have been ongoing for quite some time. Why is it, then, that sufficient results have not been achieved despite such efforts?
    This lack of results cannot always be attributable to irrational behavior by households, enterprises, and financial institutions, because they have no reason to behave irrationally. Rather, the "postponement" that in effect occurred may have resulted from none other than behavior rational to the individual economic agents. For instance, those presently concerned may well find it a rational choice to pass on all their burdens to future generations if possible, without bearing it them themselves.
    If this is the case, the real problem is that behavior rational to those presently concerned is not always rational for the entire society. In other words, the problem lies in the incentive structures that serve as the premises for-and have a significant impact on-the behavior of those presently concerned. It should be concluded that the incentive structures surrounding households and enterprises within the present economic and social systems are not suitable for solving the problems facing the Japanese economy.
    In the area of finance, for instance, if policy measures or shareholders' pressure for prompt disposal of non-performing loans were weak, difficult disposals would tend to be postponed. In addition, when loans are basically to be made to companies and when such loan assets cannot be liquidated, disposal of the non-performing loans would tend to be off-putting, as it will lead to the liquidation of the debtor company itself. With respect to the pension system as well, there would be an incentive to postpone drastic reforms and pass on the burden to future generations as long as the deteriorated budget does not immediately affect the premiums and benefits of the current working generation. Conversely, if excessive burden is imposed on future generations as a result of postponing the reforms, they would not be able to find meaning in paying the premiums and supporting the social security system.
    Therefore, when reforming an old system or establishing a new system, an effective incentive structure that is consistent with the purposes of the system in question must also be established. The key to success for future institutional reforms will be to properly reform and design systems by giving sufficient consideration to what incentives should be provided.


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