Annual Report on the Japanese

Economy and Public Finance


- No Gains Without Reforms IV -

July 2004

Cabinet Office

Government of Japan

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Section 6 Future Economic Prospect

    As observed from the previous sections, the current process of economic recovery is backed up by a stronger corporate sector, which benefits from the advancement to some extent in the disposal of non-performing loans and the reduction of excessive debt and labor costs by companies. If employment gradually improves, and consumption stays on the upturn, the economic recovery is expected to continue, unless it is disrupted by a setback in the international economy or an emergence of geopolitical risks. However, in the future event of deceleration in the economies of the US, China or another foreign economy, the recovery of Japanese economy could decelerate. Furthermore, the outlook of the economy is still threatened by the risks outlined below. This section discusses points of caution with regard to the future economic trends(41).
Impact of external demand
    The current process of economic recovery is driven by private demand through increase in capital investment, but the contribution of external demand to GDP growth in FY2003 remained at 0.8%, and any slowdown in overseas economies or drastic appreciation of the yen would to some extent accordingly affect the Japanese economy in a negative fashion. Regarding the contribution level of each industry to capital investment, for instance, export-related manufacturing industries occupy a significant share (an average of approximately 60% in FY2003) and could be affected by the trend in overseas economies (Appended Figure 1-29). In fact, an examination of the changes in the coefficient of correlation between exports, and domestic production and capital investment reveal that domestic production and capital investment tend to be correlated closely with exports (Appended Figure 1-30). Regarding the impact of exchange rates, on the other hand, as will be seen in Chapter 3, the volume of exports is very sensitive to the changes in the exchange rate because of the increased number of overseas bases of Japanese companies. Despite these developments, the impact of exchange rates on the corporate profitability is decreasing.
    An examination of the overseas economies by region, from the perspective of their impact on Japan's economy suggests that Japan is increasingly dependent on exports to the US and China, and it must pay attention to the economic prospects of these regional economies. However, at present the global economy is on the path of steady recovery and the risks of deceleration of this recovery are perceived as low. The US is witnessing a powerful boost to its economy, and even the employment situation, where improvement was slightly delayed, is on the upturn. In China as well, consumption-, investment- and export-driven economic expansion is under way, and some sectors are displaying symptoms of economic overheating. However, if the US and China continue to implement measures to restrict such economic overheating, the pace of economic expansion in these countries might decline slightly, possibly triggering a slight slowdown in the growth of Japan's economy.
    Moreover, as a result of an impulse response analysis in order to examine the impact of interest rates in the US on interest rates in Japan, almost no impact was observed with regard to short-term (three-month) interest rates, partly due to the quantitative easing policies of the BOJ. As for long-term interest rates, although the US interest rates might have impacted interest rates in Japan, the results of the analysis showed that the impact was statistically insignificant (Figure 1-6-1 and Appended Note 1-7). Yet, developments of the US interest rates need to be watched with a certain degree of caution.
Figure 1-6-1 Response of Japanese Interest Rates to US Interest Rate Shocks
    Starting in the spring of 2004, crude oil prices have been rising, triggered by the increased demand by the US and China, but the impact of these developments on the Japanese economy is believed to remain low compared to before due to the streamlining of energy consumption and the decreasing ratio of crude oil imports in the overall economy.
Spreading improvement in domestic demand
    Even in the event that external demand weakens, the economic recovery will continue uninterrupted as long as the demand of the private sector maintains its stable growth. Also, if the private demand-led economic recovery underpinned by the high growth in consumption and investment becomes reality, the improvement trends will spread further to cover even the regional economies, which at present still vary widely in terms of state of recovery, and small and medium enterprises, for which the recovery is delayed. Thus, the sustainability of the economic recovery will improve significantly. Spreading the effects of the improvement in the corporate sector to the households in the form of increased employment and increased wages is an indispensable prerequisite for achieving such a sustainable private demand-led economic growth. In this regard, as already observed, the economic recovery is expected to be accompanied by a certain increase in the wages of full-time employees in the form of overtime pay and bonuses, but as the proportion of part-time workers and dispatched workers with relatively lower wages will increase, it is likely that the growth in the employees' income on a macro-economic level remains moderate compared with past periods of recovery. However, the savings rate of households is likely to decline moderately in the future, reflecting the aging population and the recovery in consumer confidence backed by improved employment conditions. In summary, consumption is expected to also grow constantly in the future, against the backdrop of the projected gradual improvement in the income and employment environment. In order to improve the sustainability of consumption, it is important to supplement the improvement in the employment environment with development of latent demand through expanded supply of goods and services required by the aging society.
Low level of inventory and capital stock
    From the perspective of sustainability of the current economic recovery, one significant difference between the current economic recovery and past ones is that despite the continuous increase in production and capital investment, there has so far been almost no excessive accumulation of inventory or capital stock (Figure 1-6-2). That is why even a slight fallback in demand during the course of economic recovery is unlikely to immediately lead to substantial stock adjustments and setback in the economic recovery.
    According to the examination of the time-series changes in the variables such as inventory ratio, production capacity and operation rate, in 2001 after the collapse of the IT bubble, companies reduced their operation rate in order to adjust the accumulated stock, and also significantly shrank their production capacity. Since such trends toward reduction continued even after production started to increase, companies are now responding to the increase in demand by raising their operation rate and liquidating inventories (Figure 1-6-3). Some technological factors, such as the introduction of the method for comprehensive management of the product flow (supply chain management) have had some implications on the trend toward curbing the amount of stock, but in principle companies remain very cautious with regard to demand prospects. The same applies to capital investment, and, as already observed, companies carry out capital investment, but at the same time advance disposal of existing facilities, resulting in restraining production capacity.
Figure 1-6-3 Trends in Inventory Ratio, Operating Ratio and Production Capacity Index

Impact of higher pension premiums
    Following is a survey of the impact of the rise in pension premiums for Employees' pension from October 2004 (the increase in premiums for National Pension is scheduled to start in April 2005) from the viewpoint of economic effects. The annual margin of rise in pension premiums at this time is small, at 0.354% to the total payment for Employees' Pension (in equal shares by employer and employee, the amount covered by an average insured employee with a monthly income of 360,000 yen is 650 yen per month, and 1,150 yen for bonuses twice a year), and at 280 yen per month for National Pension (as of FY2004), but this increase is different from past increase measures in that insurance premiums will be raised incrementally not only for National Pension but also for Employees' Pension.
    A survey conducted by the Cabinet Office found that over 80% of the respondents (1,200 persons) were aware (albeit to different degrees) of the rise in pension premiums (Figure 1-6-4). Among them, some 50% responded that the increase in premiums could force them to reduce spending, while the remaining 50% said that the increase will have no effect on their spending. However, even among those who said they might reduce spending, over 40% said the timing of the reduction would depend on the state of their household income after the increase in premiums. Therefore, even if the rise in pension premiums is likely to have some impact, the extent to which it constrains consumption will depend on the income situation at the time. Also, most of the respondents who said that they would cut spending were either young people or people with low income. The 1,200 samples of the respondents in the survey were analyzed, and the impact of the economy, income, employment and price trends as well as pension premiums on the future spending were estimated using the probit model. The results of the estimate showed that the greatest impact was of income trends, followed by the impact of pension premiums and the impact of economic trends (Appended Table 1-31). Taking into account all of the above findings, it can be concluded that the scope of the impact of higher pension premiums will depend on the future income and employment trends, but some caution will be needed as nearly half of the respondents may cut spending, responding to such a slight increase in premiums.
Figure 1-6-4 Results from Survey on Increased Pension Premiums
    By comparison, the macro-economic situation now is quite different from back in 1997, when pension premiums were increased and certain events such as the Asian financial crisis and the collapse of major financial institutions in Japan had a heavy psychological impact on consumers.
Projected shape of the recovery
    In conclusion, although there are some external risks, such as overseas economic developments and exchange trends, as long as those risks become significant, it is assumed that the Japanese economy is building the foundations of continued recovery based on private demand.
    First, by substantially reducing some vulnerabilities of the corporate sector such as excessive debt and excessive employment, the economy is strengthening its financial health to withstand some shocks. Also, the cautiousness of companies, demonstrated by the level of inventory ratio much lower than recorded in the past and by the limited increase in capital stock, is further strengthening the resistance to shocks.
    Second, the harsh corporate restructuring seen in the recent years is gradually coming to a halt, and the employment situation is improving, thus boosting consumer confidence. In the period of recovery after the collapse of the bubble economy, the improvement in the economic climate eventually did not result in improvement of the employment situation accompanying lower unemployment rates. This time around, involuntary unemployment is decreasing, and against this backdrop, the unemployment rate is falling, and households are gradually feeling more secure in terms of employment prospects. These developments have stimulated improvement in spending, despite the relatively moderate increase in incomes.
    Third, rather than having a temporary impact, technological innovation is expected to stimulate further expansion in the future of demand for digital electronics and others as replacement for existing models. Japanese companies already possess a significant share in the manufacturing of components for such products, and the trend of manufacturing high added-value products domestically will trigger a virtuous cycle in the domestic economy.
    On the other hand, the pace of recovery might slightly slow as the increase in external demand becomes moderate, as the current rapid economic recovery of the US and China is expected to be curbed following some tightening measures. If such factors reduce the growth rate of exports, capital investment might also be affected.
    As for the prospects for overcoming deflation, consumer prices, which are currently flat, are eventually likely to move in the direction of mild increase, given that the economic recovery continues unabated. However, a number of challenges remain to be solved before deflation can be completely overcome, and the risks of its recurrence minimized. In the financial sector in particular, it is necessary to further advance the disposal of non-performing loans, including non-performing loans of regional banks, and to restore the soundness of the sector through improving its profitability. Also, a more effective monetary policy operation is necessary in order to truly overcome deflation.

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