Annual Report on the Japanese

Economy and Public Finance

2003-2004

- No Gains Without Reforms IV -

July 2004

Cabinet Office

Government of Japan


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Section 2 Business Sector Benefiting from Reform

    Since the balance sheets of companies and the employment and income situation remained fragile in the previous economic recovery, the economy entered a recession with foreign demand weakening. Based on this, structural reforms have been promoted in order to overcome fragility in the economy in particular areas such as strengthening the financial system and revitalizing the business sector, and harsh restructuring has been carried out in the business sector. With these reform and restructuring efforts, uncertainty about the future has diminished, encouraging companies in expanding their business. This section discusses the way in which fragility in the corporate sector has been reduced through progress in the disposal of non-performing loans, the extent to which excess labor, debt and capital equipment at companies has been eliminated, the extent to which the finances of companies have been strengthened through business reorganization such as M&A and the reduction in debt and labor costs, and the status of the mechanism through which capital investment is currently recovering.
   
Corporate profits: higher revenue, higher profits
    Corporate profits are increasing in almost every industry, and the source of these profits has been a gradual increase in demand which allows companies to gain higher profits through higher revenue. The recovery of profits in manufacturing industries in 2002 was mostly due to labor costs being suppressed through restructuring, while the recovery in profits in 2003 resulted from a pattern of higher revenue and higher profits, with increased sales leading to increased profits (Figure 1-2-1). Almost the same pattern could be seen in non-manufacturing industries, but the extent of the recovery in profits in non-manufacturing industries has been modest compared with that in manufacturing industries.
Figure 1-2-1 Recovery in Corporate Profits is a Pattern of Higher Revenue, Higher Profits
    Regarding trends by industry, a comparison between the peak of the previous recovery at the end of 2000 and the first quarter of 2004 shows that harsh restructuring took place during the previous recovery (2000), including continued reductions in labor costs even for industries in which sales were increasing, with the exception of real estate, while in the current cycle, some industries, such as transport machinery, services, and steel, are experiencing increase in both sales and labor costs (Figure 1-2-2). Thus, the trend of significant reductions in labor costs through restructuring seen over the past several years appears to be coming to a halt in many industries. Meanwhile, restructuring, such as reductions in labor costs, continue to take place in industries in which sales are not increasing.
Figure 1-2-2 Corporate Earnings and Restructuring
    In addition, while the input prices of companies are rising as a result of increases in the prices of materials and intermediate goods, the output prices of companies did not rise in almost all industries. As a result, the terms of trade (output prices divided by input prices) of companies worsened, and there are concerns about the impact that this will have on corporate profits. Regarding the situation by industry, in industries such as pulp, paper and wood products, and oil and coal products, a portion of the rise in input prices transferred to a rise in output prices, and downturns in profits (terms of trade) were relatively small, while in industries such as iron and steel, non-ferrous metals, chemicals and general machinery, the transfer of the rise in input prices to output prices was insufficient, and there were downturns in profits (Appended Figure 1-7). This point will be discussed in detail in Section 4. Regarding the effect on corporate profits, it appears that the phenomenon of output prices not rising as much as input prices (deteriorating terms of trade), which has also been seen during past recovery phases, is repeating itself (Figure 1-2-3). As such, although deteriorating terms of trade cause reductions in corporate profits, it appears that some of the effects of this are cancelled out by increased revenue as a result of economic recovery.
Figure 1-2-3 Current Profits (Manufacturing) and Terms of Trade (Year-on-Year)

Reduction of debt with disposal of non-performing loans
    The issue of the disposal of non-performing loans by banks will be discussed in detail in Section 5. This section examines the extent to which there has been progress in the disposal of excessive debt in industries generating non-performing loans, and the effect of this on rate of return in those industries. First, regarding the movements in the outstanding non-performing loans (risk-management bond basis) of major banks by industry, outstanding non-performing loans to real estate industries and construction industries decreased rapidly during the two years from the end of FY2001 to the end of FY2003 (Figure 1-2-4). Outstanding non-performing loans on the whole decreased steadily in other industries as well. On the borrowers' side, there has been a steady decline in outstanding debt in industries which have a high proportion of non-performing loans such as real estate, wholesale and retail and construction, and as of 2003, outstanding debts had been close to their level at the beginning of the 1990s (Figure 1-2-5). There has been a modest increase in the return on assets (ROA) of real estate, wholesale and retail and construction industries, reflecting a reduction of debt and a withdrawal of companies with low productivity. In addition, because of the improvement in rate of return and the gradual reduction of uncertainty concerning disposal of non-performing loans, stock prices in these industries as a whole either stopped falling or increased in the current recovery phase.
Figure 1-2-4 Trends in Balance of Non-performing Loans By Industry
Figure 1-2-5 Three Industries Cut Their Non-performing Loans, Increase Profits

Reduction of excessive debt, employment and capital equipment
    The improvement in corporate profits is partially a result of restructuring carried out by companies over the past several years. Excesses in debt, employment and capital equipment were not all reduced together, and rather, the reduction of debt came first followed by the reduction of excessive employment and capital equipment progressing gradually.
    First, with regard to the reduction of debt, calculation of the number of years worth of debt in terms of available cash flow shows that companies of all sizes in all industries had 8.3 years worth of debt in 2003. This is almost on the same level as in the middle of the 1980s before the start of the bubble economy, indicating a significant progress in the disposal of debt (Figure 1-2-6 (1)). However, a decomposition by company size shows that the debt of small and medium-sized enterprises is still above its level in the middle of the 1980s.
    Next, according to the diffusion index (DI) for judging employment conditions in the Bank of Japan's Short-term Economic Survey of Principal Enterprises in Japan (Tankan survey) by which excess in employment is often judged, large companies registered six points and small and medium-sized companies five points in the June 2004 survey, both improving to their levels in the early half of the 1990s, and excessive employment on the whole has been decreasing (Appended Figure 1-8). Looking at the burden of labor costs for companies in terms of labor share (labor costs as a percentage of value-added at companies), labor share for companies of all sizes in all industries was 66% in 2003, down 3.3 percentage points compared with its peak in 1998 (Figure 1-2-6 (2)). Nevertheless, although labor share is still at a higher level than compared with that of the early 1990s, this was partially caused by factors such as an increasing proportion of middle-aged and elderly people in the age composition of employees and an increasing number of employees with higher education(2). Regarding company size, with the overall labor share rate being restrained, labor share at small and medium-sized enterprises on the whole remained at a high level compared with labor share at large companies.
Figure 1-2-6 Changes in Improvements in Corporate Sector
    The DI for judging capacity in the Bank of Japan's Tankan survey, which is one of the standard measures of whether capital stock is excessive, shows that the situation has been improving in recent years (Appended Figure 1-8). The situation of excess in capacity can also be looked at in terms of the volume of sales generated through the use of a certain unit of asset (total asset turnover ratio). Total asset turnover ratio decreased throughout the 1990s in the long run but rose slightly in 2003. This trend appears to be almost the same for different industries and different company sizes (Figure 1-2-6 (3)). This trend also appears to be the same for the turnover ratio of only tangible fixed assets. Return on assets (ROA) decreased in the 1990s, but bottomed out at around 3% in 1998. In 2003, return on assets was 3.2%, rising slightly from the previous year (Figure 1-2-6 (4)). Regarding excess capital stock, as will be discussed in detail later on, the extent of excessive capacity has been slightly decreasing in recent years due to increases in the elimination of old equipment. This has not been enough, however, to lead to sufficient rise in the efficiency of capital.
   
Effect of corporate restructuring
    As explained above, restructuring by companies including reductions in debt, employment and capital stock have, in terms of the economy as a whole, had the effect of raising return on total assets in recent years. The improvement, however, is still not at a sufficient level. Nevertheless, effects can clearly be seen at individual companies which actually carried out corporate reorganization including restructuring and M&A. In order to verify this point, the effect on return on assets of movements in M&A, labor costs and interest-bearing debts carried out between 1999 and 2002 was examined with regard to 1,094 companies for which detailed sequential consolidated financial data was available.
    First, regarding the distribution of companies in the database by level of ROA, the majority of companies have an ROA of 4%, which is close to the mean, and moving away from the mean, the number of companies becomes lesser. There are, however, a substantial number of companies with an ROA of either less than 1% or more than 8% (Appended Note 1-1). Regarding the ratio of labor costs to sales of companies by level of ROA, the labor cost ratio of companies with low ROA rose between 1999 and 2002, while the labor cost ratio of companies with relatively high ROA declined (Figure 1-2-7). An examination of changes in the ratio of interest-bearing debt to sales between 1999 and 2002 shows that the ratio of debt of companies with relatively low ROA decreased greatly, while at the same time the ratio of debt of companies in almost all ROA classifications decreased. In addition, there appeared to be a correlation between the value of business sales and purchases as a ratio of capital and ROA in such a way that companies which experienced substantial business sales and purchases also tended to have a high ROA on the whole.
Figure 1-2-7 Relationship between Restructuring and Corporate Earnings (Listed Manufacturers)
    Next, the effect of movements in the scale of business sales and purchases, labor costs and interest-bearing debt on return on assets is estimated by using the database. The following results are obtained (Figure 1-2-7 and Appended Note 1-1):
(i) The profitability of companies which carried out business purchases and sales increased over time.
(ii) The profitability of companies increased when the ratio of labor costs to sales decreases.
(iii) The profitability of companies increased when the ratio of debt to sales decreases.
    These results show that companies which moved forward reinforced areas of strength and moved out of areas of weakness through business sales and purchases, had high profits. They also show that financial restructuring including the reduction of labor costs and debts also contributed to increasing profitability.
    Although simply comparing the ROA of these companies at two points in time, the ROA was somewhat higher in 1999 than in 2002, in terms of soundness of finance in changing the profit environment, the companies appear to be more robust in 2002. In order to show this, a stress test was carried out using the data of individual companies to estimate the extent to which a 10% drop in sales or a 1% rise in interest directly affects profit, assuming that the behavior of companies did not change. This estimate does not aim to calculate absolute amounts for decreases in profits, but rather, compares the relative size of decrease in profits at two points in time. According to the results, the degree to which profits decreased in both cases was less in 2002 than in 1999 (Table 1-2-8 and Appended Note 1-2). This appears to reflect that the reduction in outstanding debt and the ratio of labor costs has had the effect of lowering the break-even point.
Table 1-2-8 Impact of Changing Sales and Interest Rates on Profits

Sustainability of capital investment
    Real capital investment on an SNA basis increased for seven consecutive quarters from the third quarter of 2002 to the first quarter of 2004. This increase in capital investment, as mentioned earlier, partially resulted from improved corporate profits. The increase in capital investment is relatively modest, however, relative to extent of the increase in cash flow. While the ratio of cash flow to the amount of capital investment at companies continued to decrease in 2002 and 2003, the ratio of cash flow to the amount of decrease in debt rose, showing that companies continued as before to give priority to repayment of debt (Figure 1-2-9).
    A distinctive feature of the recovery of capital investment this time is that companies are making new investment, while being keen on elimination of old equipment. The vintage of equipment has been rising as a result of companies holding back on making new investments and on renewing existing equipment since the 1990s. According to an estimate, the average age of equipment was around 12 years as of 2003 (Figure 1-2-10). Companies, especially since 2000, have been boosting their elimination of old equipment, however, and the amount of disposed equipment has been increasing. As a result, the rate of growth of capital stock fell significantly in 2002 and 2003 and was 1.4% in 2003 (Figure 1-2-11). As such, even though the ratio of private sector capital investment to GDP is rising, the ratio of capital stock to GDP is falling, and there does not appear to be a buildup of excessive capital stock (Appended Figure 1-9). In addition, according to the output indicator, production capacity has fallen to the level it was at in the latter half of the 1980s (Figure 1-2-11).
    One apparent reason for the emergence of excessive capital stock, which was disposed of later, seems to be that the expected growth rate of companies declined during the 1990s. With regard to the recent situation, however, according to the Cabinet Office's "Annual Survey of Corporate Behavior (2003)," the expected growth rate of companies has been rising slightly, with the anticipated growth rate over the next five years rising above its level in the previous year's survey. Thus, assuming that companies have decided upon a level of capital stock to keep consistency with mid- to long-term expected growth, the decline in the growth of capital stock is likely to bottom out at some point in the future with increases in the expected growth rate. Concerning the sustainability of capital investment, it is expected to increase steadily for the time being based on such facts as that (i) the limited possibility that capital stock adjustment could be induced by a temporary fall in the level of production because the majority of the increase in capital investment currently taking place does not lead to increases in capital stock, and (ii) expectations of forward-looking capital investment in areas in which technological innovation is moving forward rapidly.
Figure 1-2-9 Capital Investment and Cash Flow
Figure 1-2-10 Trends in Equipment Investment and Elimination
Figure 1-2-11 Growth Rate of Capital Stock Declining


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