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 1 Japanese Economy and Globalization

1. Significance of Globalization

Deepening relations with the overseas economy
    In general, globalization refers to the deepening of economic ties worldwide resulting from intensified cross-border movement of capital and labor force, increased transactions of commodities and services through trade and expanded overseas investment. This definition of "globalization" will be used throughout this book.
    The World Bank defines globalization as the "freedom and ability of individuals and firms to initiate voluntary economic transactions with residents of other countries."(2) In this definition, "freedom" means the lack of barriers in the cross-border movement of capital and labor force, among other things, and "capacity" means that there is the ability to provide commodities and services across borders or to conduct economic activities in other countries. Looking back at the past, it appears that globalization advanced as technology and information-carrying capacity for transport, communications, finance, insurance and other aspects developed and political barriers to the movement of trade, capital and other items were removed. These developments boosted income levels, which in turn further deepened economic ties. Hence globalization is a trend that brings about economic development.
    The process of globalization is basically the same as the process a country goes through in advancing a division of labor. Economic activity becomes more specialized due to the division of labor and generates economic growth while incorporating technological innovation. Growing income levels allow further division of labor, thereby creating a virtuous cycle of economic growth. As a result, this cycle will gradually include the world economy and people will be able to enjoy the benefits of the free economy. From the consumers' standpoint, they will be able to choose cheaper, better quality goods and services and their standard of living will improve.
    Globalization in recent years has been newly influenced by technological innovation in the area of communication, including information processing via computers and the Internet. Such technological innovation has enhanced various service functions such as finance. These technological transformations have reformed the previous approach to economic activities. They are believed to have expanded the possibilities of globalization mainly in the area of finance, such as allowing economic transactions to instantly take place on a global scale.
    In order to enjoy the benefits of globalization, it will be necessary to promote technological innovation in companies without delay and promptly adapt economic and social systems to respond to technological innovation, eliminate barriers and foster human resources that are able to carry out these changes.
Structural reform is important in Japan's relations with overseas economies
    Structural reform stimulates the domestic economy and is also important in the process of deriving benefits from globalization. In other words, the major objectives of structural reform are to ensure that the market mechanism fully functions, broadly enhance productivity and move labor and capital, among others, from low productivity areas to high productivity areas. This will also allow Japan to reap benefits from closer economic ties with overseas economies.
    In cases where regulations on investment, employment and production activities remain and structural reform is insufficient, or in cases where human resource development cannot deal with technological innovation, sometimes it will be impossible to derive benefits from globalization. Far from it, the economic situation may become increasingly severe, characterized by stagnating investments, factories moving overseas, rising unemployment and widening income disparities.
    Moreover, in addition to structural reform in Japan, it will be necessary to standardize products and regulations in cooperation with other countries and regions in order to promote global trade and investment. It will be also important to abide by contracts, protect intellectual property and strengthen competition policy, etc. in order to boost economic activity through the advancement of the international division of labor.
    To begin with, the following discussion will outline the situation after 1973 when Japan made the transition to a floating exchange rate system and identify the characteristics of globalization that have been evident in the Japanese economy particularly since the 1990s. Thereafter, the awareness of issues behind the analyses conducted in the following sections and the major conclusions will be described in advance.
2. Characteristics of the Economic Developments with Focus on the Period after the 1990s

Four characteristics
    There are four characteristics of globalization in the Japanese economy especially in the period after the 1990s, as explained below.
    The first characteristic is the changes in exchange rates and their economic impact. After making the transition to a floating exchange rate system, Japan was faced with a steep appreciation of the yen in the late 1980s as well as experienced a long-term appreciation of the yen, albeit modest, in the early 1990s. These exchange rate changes had a substantial impact on the Japanese economy.
    Secondly, with the advancement of Japan's industrial and trade structure, the focus on the US as a trading partner and direct investment destination gradually shifted to the East Asian region. These developments are the result of vigorous corporate activity which took place as Japan's relations deepened with overseas economies.
    Thirdly, regarding Japan's financial and capital transactions, equity investments from abroad have recently increased, but it cannot be said that Japan's international financial and capital transactions have accelerated, except in the bubble economy period. Financial and capital developments have been stagnant compared to those on the trade front.
    Fourthly, the Japanese economy's international ties are not as deep as those of European and North American countries. This means that even though globalization in Japan is presumably advancing, it may not be the case when compared to the European and North American countries.
    The following will explain the background of these four characteristics.
Transition to the floating exchange rate and significant changes in exchange rates
    In 1973, major countries including Japan shifted from the fixed exchange rate system to the floating exchange rate system. Since then, these countries have employed a system where exchange rates are decided in a foreign exchange market. The reason these countries shifted to the floating exchange rate system was because the trade imbalance in advanced countries had not been rectified and the circulation of speculative funds intensified, based on the assumption that exchange rates would change, which frequently led to cases of international currency instability. As such, it became difficult to maintain the fixed exchange rate system.
    After World War II, the international community sought to build a foundation for world peace by global economic development through nondiscriminatory and free trade. Based on such intentions of the international community, adjustments were made to eliminate various barriers to trade, such as tariffs and restrictions on exports and imports. As a result of these adjustments as well as the advancement of transport and communications technology, the trade volume among countries expanded and the economic level rose through exports in countries defeated in World War II such as Japan and former West Germany.
    As the basic economic conditions of countries began to change, these changes were manifested as the balance of payments disequilibrium due to the fixed exchange rate. More specifically, if a country's competitiveness declines comparatively and the exchange rate does not fall in response to the competitiveness, then its exports will be relatively expensive, while imports from other countries will be relatively inexpensive. The trade deficit will grow as a result of the decline in exports and rise in imports. Conversely, in cases where a country's competitiveness rises compared to other countries, the trade surplus will grow.
    Hence major countries began controlling their balance of payments disequilibrium using the market function and further reflecting the basic economic conditions in the exchange rate. At the same time, major countries tried to ward off the effects of shocks that occurred in other countries, which included economic fluctuations and rising prices, before they filtered into their own countries. It was under these circumstances that Japan also shifted to the floating exchange rate system. Therefore, in light of the fact that the international monetary system needed to be adjusted in order to respond to trade developments, it can be said that the transition to the floating exchange rate system is symbolic of the advancement of globalization.
    Following that, the exchange rate became increasingly volatile and did not necessarily reflect the basic economic conditions in the short term because of the growing number of foreign exchange transactions resulting from the liberalization of capital flows and financial technology, etc. This is also believed to be an impact of the increasing number of foreign exchange transactions.
    A look at trends in the yen/dollar exchange rate after the transition to the floating exchange rate system reveals that the exchange rate level changed dramatically in the mid-1980s (Figure 3-1-1). This change continued for about a year, between the signing of the Plaza Accord in September 1985 and the Louvre Accord in February 1987.(3) Looking at the yen/dollar exchange rate before and after this adjustment period, the yen appreciated by about more than 50%. The yen/dollar exchange rate was on average about 252 yen during the period beginning with the adoption of the floating exchange rate system in March 1973 and ending with the signing of the Plaza Accord. The yen/dollar exchange rate was on average about 121 yen from the signing of the Louvre Accord until April 2004. Furthermore, although the appreciation of the yen in the early 1990s continued for a long time, the appreciation rate of about 48% during this period is almost equivalent to the appreciation rate of about 46% between 1985 and 1987.
    How have these changes in exchange rates affected Japan since the 1990s? Considering the importance of exporting companies in the Japanese economy until then, these changes are believed to have affected Japan's economic structure through changes in corporate activity. Section 2 will examine this issue in detail.
Figure 3-1-1 Trends in the Yen/Dollar Exchange Rate

Increased significance of East Asia in terms of trade and investment
    Next, the changes in trade and outward and inward direct investment will be surveyed. Compared to labor migration, trade and direct investment is an area where globalization takes place relatively easily, but it is not advancing uniformly. The discussion will begin with a look at the relationship between Japan's economy and industry under these circumstances.
    One of the distinctive changes in trade in the past 30 years is that the biggest trading partner shifted from being the US to the East Asian region (Figure 3-1-2). Behind this shift is the rise of the Association of Southeast Asian Nations (ASEAN) and China. With respect to merchandise trade, or the total of exports and imports, Asia surpassed the US as a trading partner after 1988 and China by itself exceeded the US with respect to imports in 2002.
Figure 3-1-2 Changes in Export/Import Share by Region
    Next, as for traded commodities, a look at changes in import and export items shows that they reflect Japan's industrial advancement in the past 30 years (Figure 3-1-3). Regarding export items, the machinery and equipment-related share grew substantially as a result of increased exports of high value-added manufactured goods. Meanwhile, concerning import items, raw materials were replaced with intermediate goods and products, and imports consisted of products with relatively lower added value compared to exports.
Figure 3-1-3 Trends in Ratio of Export/Import by Item
    Deficits in services trade began increasing at the end of the 1980s (Figure 3-1-4). An underlying factor is the increase in the number of people who traveled abroad due to the appreciation of the yen in the latter half of the 1980s. In addition, Japan received greater payments from royalties and license fees, etc. as a result of improved technological development capacity of Japanese companies and increased number of licenses issued to businesses launched overseas. The net balance was positive in 2003.
    As explained above, it is evident that on the trade front, (i) Japan's merchandise trade has shifted its focus from the US to the East Asian region, and (ii) Japan's industrial structure has advanced in terms of the export and import items and technology trade, etc.
    With regard to outward direct investment, there was a shift from investment aimed at securing markets in the 1960s to 1970s to increased overseas expansion of manufacturing in response to the trade friction and appreciation of the yen in the late 1980s. Beginning in the 1990s, growth was evident in investment resulting from greater vertical specialization in the East Asian region, mainly in transport equipment and electrical machinery, as well as investment aimed at market reorganization, primarily in financial institutions (Figure 3-1-5). One feature in recent years has been that the amount of investment for each case has been rising.
Figure 3-1-4 Trends in Services
Figure 3-1-5 Trends in Direct Outward and Inward Investments
    On a regional basis, the amount of investment has been on a downward trend for the North American region since the 1990s and investment levels dropped after the Asian financial crisis even though the East Asian region's significance as a region has been growing. In contrast, investment in the European region has been on an upward trend since around 1999, especially in finance and insurance and transport equipment, but this is presumably investment toward an integrated European market and transport equipment exports to the Eastern and Central European regions.
    It is apparent that the amount of inward direct investment is extremely small compared to outward direct investment (Figure 3-1-5 cited above). In Japan's case, this is an indication that in many industries restrictions are imposed on investment from foreign companies.(4) Nonetheless, inward direct investment has been soaring as a result of considerable progress of deregulation since the late 1990s. Currently, the amount of inward direct investment is nearly half that of outward direct investment.
    On a regional basis, investment from the North American and European regions was significant throughout the 1990s and the amount of investment for each case has been rising. Although most of the investment is in the machinery and equipment industry, deregulation and financial reorganization in recent years have contributed to conspicuous growth in chemicals (pharmaceuticals), finance and insurance and telecommunications, etc.
    Bearing in mind the above, Section 2 will analyze the issues concerning the shift in the focus of trade and outward direct investment from the US to the East Asian region. Section 4 will examine the current situation and issues involving inward direct investment.
Japan's international financial and capital transactions that had been stagnant
    The liberalization of international current transactions and capital transactions advanced after Japan acceded to the Organisation of Economic Co-operation and Development (OECD) in 1964. Meanwhile, the liberalization of short-term money markets and capital markets, which leads to the lifting of bans on lending and borrowing in foreign currency, was delayed about 20 years and progress was finally achieved between the 1980s and 1990s.
    Nonetheless, it appears that international financial and capital transactions have not been fully activated in Japan except during the bubble economy period in the late 1980s. The reasons for the lack of dynamism are as follows.
    The first reason is because overseas asset management was not an option for Japanese households until quite recently. More than half of the financial assets directly held by households are maintained in the form of bank deposits and postal savings. Management using foreign currency deposits of recent years remains at a low level overall.
    The second reason is that the interest rate of borrowing from overseas was high and fund demand in the corporate sector was weak due to economic stagnation and the excess debt problem, etc.
    The third reason is that international activity appears to be dwindling overall. For example, financial institutions are withdrawing their overseas business centers in order to deal with the disposal of non-performing loans and other issues.
    The fourth reason is that domestic institutional investors including life insurance companies refrained from conducting international capital transactions. This was because of the high risk that the investment value would decline after foreign investment bonds were converted into yen given the continued appreciation of the yen beginning in the late 1980s. However, foreign bond investment has been increasing recently since domestic interest rates are low.
    Despite these circumstances in Japan, investment from overseas to Japan has soared. For instance, the percentage of foreign investors in Japan's stock market rose in the late 1990s. This percentage increased from under 10% in the early 1990s to 17.7% at the end of March 2003. This figure exceeds the percentage of foreign investors in the US stock market (7.8% at the end of June 2002) (Figure 3-1-6).
Figure 3-1-6 Composition Ratio of Foreign Investors on the Stock Markets in Japan and the US

    In contrast to the stock market, the percentage of foreign investors in government bond market was 3.6% at the end of March 2003. This is lower than the percentage of foreign investors in the US government bond market (40.7% at the end of June 2002). Furthermore, the proportion of yen-denominated trade in Japan rose for both exports and imports until around 1993. The proportion of yen-denominated exports has remained in the region around 35% in recent years after hitting a peak of 42.8%. The proportion of yen-denominated imports increased to around 20-25% and has stayed roughly flat since then.
    The major reason Japan's international financial and capital transactions, except for those in the stock market, have not been fully activated is due to the low interest rate, which is a result of the long-stagnant Japanese economy. Financial and capital transactions are closely linked to the level of economic activity, which in turn is reflected in interest rates. Therefore, it is important to revitalize the Japanese economy and ensure a high expected rate of return in yen asset investment. To this end, it is first crucial to put the Japanese economy firmly back on a path of sustainable growth.
The pace of globalization of the Japanese economy is somewhat slow compared to European and North American countries
    If trade and foreign investment including direct investment and securities investment are treated as major fields of globalization, and the ratios of gross domestic product (GDP) to the amount of exports and imports of traded commodities and to the amount of foreign accumulated investment are calculated, then these indicators both illustrate the importance of external economic activity based on economic size. The former indicator will be called "trade openness" and the latter "financial openness." The following characteristics are evident if the degree of progress in trade and capital flows are measured for Japan, US and Europe (Figure 3-1-7).
    Firstly, trade openness increased in Japan and Europe from 1979 to 1986. This was the effect of the second oil shock and the ensuing reverse oil shock. In other words, the amount of imports increased as a result of rising oil prices during this period. This was not because of any particular advancement of trade openness.
    Secondly, trade openness and financial openness increased in Europe beginning in 1993. This is believed to be the result of economic recovery and expanded trade and investment within Europe, brought about by the establishment of the European Union (EU) in 1993 with the Maastricht Treaty and the introduction of the single currency, the euro, in 1999.
    Thirdly, trade openness in the US rose gradually from the late 1990s. Meanwhile, the growth of financial openness appears to have been caused by the entry into force of the North American Free Trade Agreement (NAFTA) in 1994 as well as the boom in securities investment toward newly industrializing countries (NICs). Financial openness subsequently plummeted due to the Asian financial crisis that occurred in 1998 and the flow of funds to domestic IT investment in 2000.
    Fourthly, in contrast to European and North American countries, trade openness in Japan has continued to be generally flat at around 15% since the 1990s. Although the level of financial openness in Japan surpassed the level in the US during the bubble economy period in the late 1980s, economic activity was not as dynamic in Japan compared to European and North American countries after the collapse of the bubble economy. It appears that foreign bond investment in European and American countries, brought about by the lack of lucrative investment opportunities in the domestic markets, is contributing to the recent growth in financial openness.
    As far as these measures of trade openness and financial openness are concerned, it seems that Japan's globalization is not as advanced as in European and North American countries.
Figure 3-1-7 Level of Trade Liberalization and Promotion of Outward Investment in Japan, the US and Europe
    The 1990s was a period when Europe and the US boldly promoted regional measures in the fields of trade and investment. On the other hand, it is possible that Japan missed the opportunity to harness the benefits that can be reaped from globalization due to the prolonged economic stagnation resulting from the delay in dealing with the collapse of the bubble economy. It is only recently that steady economic recovery has finally been realized without the economy becoming more dependent on public spending. There is a need to consider how such missed opportunities in the 1990s can be regained in order to improve the sustainability of economic growth led by private demand. This is suggestive of how important it is for Japan to promote economic partnerships and structural reform in a manner consistent with economic partnerships so it can enjoy the benefits of globalization along with other relevant countries and contribute to global economic development. This issue will be addressed in Sections 3 and 4.

Analyses and conclusions in the following sections
    The content and conclusions of Section 2 and subsequent sections will be briefly summarized as follows, bearing in mind the developments in globalization described above.
    Section 2 will reveal that the macroeconomic response to exchange rate changes has altered after the 1990s and has had a greater effect on diminishing the surplus in the balance of payments for goods and services. Next, the focus will be on the overseas production development of exporting companies and the process of change in corporate activity will be specifically examined. As a result, it was discovered that vertical intra-industry trade within the East Asian region was established as a result of Japanese companies' overseas development centered on the East Asian region. Furthermore, as for the impact that globalization has had on households, prices of daily necessities dropped significantly due to the remarkable increase in imports, which benefited households. However, it is clear that the decrease in exports and increase in imports influenced the decline in employment in Japan.
    Section 3 will explore the question of whether to handle regional economic partnerships with a focus on East Asia. This section explains that it is important to further promote regional free trade agreements (FTA), considering the economic impact that FTA themselves generate, and the role they play in complementing the free, nondiscriminatory trade system that the World Trade Organization (WTO) aspires to establish.
    Taking the above aspects into account, Section 4 will incorporate an analysis from a global perspective on structural reform aimed at deriving the benefits of globalization. The first point to consider in addressing liberalization is Japan's agriculture. As a future direction, it will become apparent that considering the aging of farmers, taking an integrated response to farmers and land will be required in order to further boost productivity. The second factor is the expansion of inward direct investment. As Japan's regulations remain stringent, it is necessary to promote reform based on the Cabinet policy of doubling inward direct investment. The third point is the issue of foreign workers, which has gathered attention due to underlying factors including the aging society and declining birthrates. It explains that a comprehensive, forward-looking consideration on accepting more foreign workers is required. The fourth aspect is the concern that corporate competitiveness will decline as a result of the expected growth in the social security burden in Japan. The social security burden is believed to have had a limited direct impact on competitiveness until now, but the analysis proves that its negative impact on the entire economy cannot be underestimated in the future. The fifth point is the kind of competition policy required, taking into account international corporate activity. It describes that international harmonization is required in competition policy and that it is important to consider steps toward globalization and structural reform in fields that were previously regarded as unrelated to competition.
    This chapter aims to prove that structural takes into account the tendency for structural reform is deeply linked to the international economy, given that the reforms is often regarded as an issue concerning the domestic economy.

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