Annual Report on

The Japanese Economy and Public Finance

2005

- No Gains Without Reforms V -

Cabinet Office

Government of Japan


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Chapter 1

Japanese Economy Aims for Long-term Growth

    The Japanese economy continues to recover. The economic expansion phase which commenced at the beginning of 2002 is now approaching its fourth year, surpassing the average length (33 months) of previous expansionary periods during the post-World War II era. Although the economic recovery has brought positive developments to the business sector, these gains have been slow to spread to the household sector. Nevertheless, an unfolding of the benefits of the expansion has finally come into view in 2005 with improvements in employment and the income environment, raising expectations for further steady growth.
    The expansionary phase up to now has not been a uniform process. Rather, it has included two temporary adjustment phases. The first phase was the early half of 2003, when the war in Iraq got underway. The second phase began in the latter half of 2004 when IT-related sectors underwent a worldwide adjustment. In the first adjustment phase, uncertainty about the future faded upon conclusion of the initial invasion of Iraq, stimulating a return to recovery in the domestic and international economies. The second adjustment phase is gradually coming to an end thanks to progress in inventory adjustment of IT-related producer goods and steady growth in private demand spurred by strong performance in the business sector.
    This chapter will clarify the characteristics of the current economic recovery and examine the recovery's long-term potential, specifying points to keep in mind. Attention will first focus on the household sector, where growth is strengthening, and the business sector, which is succeeding in advancing reforms. This will be followed by dealing with the negative legacy left by the main causes of the Japanese economy's slide into long-term stagnation after the collapse of the bubble economy in order to show how the economic structure is acquiring secure underpinnings. Analysis will then zero in on the impact of changes in the overseas economy on Japan's exports, particularly in the IT sector, and the effect of rising oil prices on depressing the economy, etc. Next, the discussion will turn to the state of progress of structural reform and economic results in the intensive adjustment period, and then examine challenges associated with the period of strengthening efforts regarding priority issues that begins this fiscal year. The chapter will also evaluate fiscal policy, which promotes integrated reform of expenditure and revenue, and monetary policy, which continues to focus on quantitative easing.

Section 1 Current Temporary Slowdown will come to an end

    The Japanese economy remains in the economic recovery phase which began at the start of 2002. Real growth in FY2002 reached only 0.8% because of the low starting position that negative growth in FY2001 established due to the collapse of the IT bubble, but the growth rate rose steadily thereafter, reaching 2.0% in FY2003 (Figure 1-1-1). Although the latter half of FY2004 saw a slowdown in the economy, the growth rate nevertheless reached 1.9%. The current economic recovery phase, which is now in its fourth year, is characterized by (1) steady support of growth from private consumption and corporate investment (2) restrained government spending, and (3) a steady decline in the unemployment rate.
Figure 1-1-1 Real GDP and its breakdown

1. Major Slowdown in Economic Growth Rate in Latter Half of 2004

    The contrast between economic growth in the first and second halves of 2004 was striking. In the first half, annual growth was high at 4% thanks to the positive contribution of external demand along with strong private demand in the form of consumption and investment. On the other hand, in the second half, the growth rate dramatically dropped to nearly zero due to the negative contribution of external demand, reflecting the worldwide adjustment in IT-related sectors and the temporary adverse effect of the warm weather and typhoon in the fall season on private demand.

 High growth in the first half of 2004
    In the current economic recovery phase, which emerged from a trough in January 2002, the average growth rate has reached 1.8% (annualized, as with figures below). In contrast to that, the periods from October to December, 2003 and from January to March, 2004 consecutively witnessed high growth exceeding 5%. The following three factors can be identified as the spurs to this high growth rate: (1) steady growth in household consumption due to improved consumer confidence encouraged by the completion of employment restructuring, (2) higher capital investment in manufacturing industries, particularly IT-related sectors, and (3) a positive contribution from external demand thanks to strong exports, particularly of consumer electronics, steel and iron and chemical products, etc.

 Zero growth in the second half of 2004
    Despite robust growth in the first half of 2004, the economy in the latter half turned to be at a temporary pause and growth approached near zero. The following factors can be identified as the cause of this decline: (1) the slowdown in growth of exports, particularly to Asia and the US, of IT-related producer goods such as electronics components and devices and digital electronics, (2) the negative impact on consumer consumption and capital investment in non-manufacturing industries (particularly real estate, etc.) stemming from the frequent typhoons in the fall of 2004, and (3) slow consumption of winter clothing and home heating appliances due to high temperatures at the end of the year.
    Of the abovementioned factors, (1) was, in particular, associated with inventory adjustments of producer goods. This can be explained as follows. Production of digital electronics such as flat-screen televisions increased sharply in companies due to the expectation of stronger domestic demand spurred by the Athens Olympics and expanding sales in the US market. However, the rise in oil prices and interest rates in the period from April to June 2004 caused a temporary downturn in consumption in the US. Sales of digital electronics did not grow as expected and growth in worldwide semiconductor demand in the latter half of 2004 became sluggish. For this reason, unintended increases in inventory occurred throughout the worldwide IT market, leading to an accumulation of inventories of the core components of digital electronics: electronics components and devices (ICs, liquid crystal elements, etc.). Following the period from July to September, inventory adjustments of producer goods exerted a negative effect on production. The growth rate of the industrial production index in the period from October to December 2004 dropped 0.9% year-on-year, with the electronics components and devices accounting for 0.9% of this decline.
    Factors (2) and (3) above were of a transitory nature, but they clearly tended to suppress consumption in comparison with the rise in consumption in the first half of the year. According to a household survey for the period from October to December 2004 (all households), year-on-year growth fell to by 2.4%. The Cabinet Office estimates, however, indicate that a 0.8% portion of this decline was due to transitory factors, which exerted a negative impact on spending for clothing and recreation.

 Differences between the slowdown at the present time and at the time of the collapse of the IT bubble in 2001
    A prominent feature of the current slowdown is the fact that the inventory adjustment of producer goods occurring in the electronic components and device industry has not been linked to inventory adjustments in overall industrial production. This is a major difference from past recessionary phases (Figure 1-1-2).
Figure 1-1-2 Inventory adjustment of IT-related producer goods
    In 2001, production declined severely upon the collapse of the IT bubble. The reason being that this collapse led to a major accumulation of product and components inventories, requiring broad production cutbacks in order to overcome the problem. However, the current inventory adjustment of producer goods exhibits several differences from the one in 2001, as follows, and it is expected that the current production adjustment could be minor and short-lived:
(1) The current increases in production of electronics components and devices have been comparatively modest, and so the level of inventories accumulated has been relatively low. In contrast, excessive forecast-based production during the IT bubble left manufacturers with huge inventories.
(2) The current increases in shipments of products such as steel and iron and chemicals continue as before, which means the ripple effect from production adjustments in the electronics components and devices has not extended to overall industrial production. In contrast, the production adjustments focusing on computers in the previous adjustment phase affected the industry as a whole.
(3) Even with sluggish demand for flat-screen televisions, overall demand for IT-related producer goods is holding steady as a whole, facilitating the progress of inventory adjustments for ICs and liquid crystal elements. In the previous adjustment phase, however, computer inventories were primarily made up of those for Internet uses, and thus demand for computers for other uses did not hasten the progress of inventory adjustments.
    The above analysis indicates that although there are structural differences within the field of industrial production, major differences also exist in the macroeconomic environment. In 2001, corporate structure remained fragile, and the environment surrounding private consumption was beset by harsh conditions as employment restructuring continued. The result was a slowdown in investment and consumption accompanying the deterioration of the external environment. Developments such as these have not appeared this time, allowing continued strength in the business sector and steady growth in the household sector.

 Moderate recovery will continue into 2005
    The arrival of 2005 has been accompanied by a gradual appearance of developments that promise the emergence from the temporary pause of the economy.
(1) Consumption is rebounding due to factors including the substantial increase in household consumption in January brought on by the return of winter weather. The principal features of this consumption will be discussed later.
(2) In investment, building construction started rising, despite the prolonged economic recovery phase. These increases include the construction of distribution and commercial facilities, as well as buildings for manufacturing industries.
(3) Inventory adjustment of electronic components and devices is moving forward. In addition, Indices of Industrial Production in the period from January to March increased year-on-year for the first time in three quarters.
(4) Although exports to Asia have been weak, exports to other regions, particularly the US, have begun to brighten, promising an upturn in overall export volume.
    Economic growth during the period from January to March grew at a high annual rate of about 5%. Although this growth could partially be explained as a reaction to the decline in consumption and investment caused by temporary factors in the previous term, it most likely reflects the ongoing moderate recovery of the economy as a whole.
    In order to see economic developments up to now in a different light, the GDP gap (percentage of real GDP relative to potential GDP) will be adopted as the perspective of analysis (Figure 1-1-3, Appended Note 1-1).
Figure 1-1-3 GDP gaps since the 1990s
(1) At the start of 2004, the GDP gap shrank to about -0.7% because of high growth.
(2) Afterward, the gap expanded again reflecting the economy at a temporary pause. During that period, market expectations for an exit from deflation were put on hold.
(3) In the period from January to March 2005, the gap returned to the level of a year ago reflecting high growth.
    From the above, it can be concluded that although the GDP gap has made a great improvement of about 4% points from about -4.7% recorded in the period from January to March 2002, the economy is still in recession.

2. Further Steady Growth in the Household Sector

    Household consumption has supported the economy during the current economic recovery phase, showing particularly high growth in 2004. Although growth flattened out due to temporary factors in the fall of 2004, it rebounded afterward. The background of this trend in consumption will now be considered.

 Steady movement in household consumption
    Since fall 2003, private consumption has clearly turned upward (Figure 1-1-4). The following factors form the background of this steady growth in household consumption. First, there has been an ongoing improvement in consumer confidence since the beginning of 2003. Second, although household income bottomed out in the second half of 2003, and it has been recovering in 2005. These could be explained by the improvement in employment conditions, such as the decline in the unemployment rate since 2003 owing to the completion of employment restructuring, which have had a positive impact on the income environment. Areas of consumption where growth has been particularly strong include purchases of durable goods, such as digital electronics, and spending on such services as domestic and international travel, Internet connection fees, and cellular phone charges. The household penetration rates of major digital electronics are, as of March 2005, 56.9% for personal computers, 44.1% for DVD players (combination video players and recorders), and 10.4% for flat-screen televisions (Consumer Confidence Survey, Cabinet Office, based on all households including single households).
Figure 1-1-4 Private consumption, real employee's income, and consumer confidence

 Consumption supported by the ratchet effect
    Although the present economic recovery phase includes two adjustment periods, a prominent characteristic of the recovery is the steady growth of consumption during these periods. The following discussion analyzes the background of this growth.
    In the period from the latter half of the 1990s, wages declined for seven consecutive years for the first time since the end of the Second World War. Since FY2001, moreover, the total unemployment rate has exceeded 5% for a record three consecutive years, the worst since the end of the war. These and other developments brought extremely harsh conditions to the household income environment. However, a major feature of the current economic recovery phase is that, despite this harsh income environment, private consumption has held steady and has helped to support the economy. Considered from a macroeconomic perspective, the correlation between GDP and household consumption has declined, and compared with the past, consumption no longer declines to the same extent as GDP.
    This weakening correlation could possibly be explained by consumption's ratchet effect. Looking at the relationship between disposable household income growth (X-axis) and the average change in consumer propensity (Y-axis), the slope of the trend line has steepened since 1999 compared with the past (Figure 1-1-5). The figure shows that when incomes are falling, consumer propensity moves upward and thus tends to support the level of consumption. In other words, consumption works to equalize economic trends. Although Chapter 3 will provide an analysis of trends in the household savings rate, the decline in the household savings rate in recent years can also be explained looking from the above perspective.
Figure 1-1-5 Ratchet effect in consumption
    Possible factors relating to the strengthening of this ratchet effect in recent years include:
(1) Despite the harsh conditions imposed by the hitherto unheard of drop in nominal wages, the level of consumption has been maintained.
(2) Most of household consumption is accounted for by services such as travel and healthcare (49.5% in 1980, 53.4% in 2003, SNA base), consumption of which remains stable regardless of changes in income.
    This trend, whereby an increase in consumer propensity, even when growth in household income is declining, serves to maintain the level of consumption, can be seen in other countries. An example is Canada, where in recent years consumer propensity has fluctuated widely compared with the past. In the United States, however, this trend is not clearly visible.
    The role of the ratchet effect as seen in the economic recovery phase since the beginning of 2002 will now be considered. Household income during this phase has been improving moderately. During phases of falling income, the ratchet effect plays a role in supporting the economy, but during phases of rising income, it probably does not increase consumption as in the past. That is to say, if households' expectations concerning increases in income extending into the future are pessimistic, it is likely that consumption increases will only be modest. However, an analysis of movements during the immediately preceding three years, estimating the data for the year up to the period from January to March 2005, indicates that the slope of the trend line is fairly gentle, which means that households' income expectations have become somewhat brighter through improvements in employment conditions. Evidently, this suggests that consumer propensity relating to income growth will probably not decline to the same extent that it has up to now. Therefore, it can be expected that continued improvement in the income environment and consumer confidence will be associated with an increase in consumption.

3. Advancement of Reforms in the Business Sector and Increases in Capital Investment

    Corporate restructuring efforts since the 1990s have helped the business sector to achieve strong performance during the current economic recovery period, and the moderate increase in capital investment in this sector has supported the economic recovery. The business sector enjoys the benefits of high profits, which it owes to an advancement of reforms provided by the eradication of the problem of the "three excesses," to be explained below.

 Achieving higher profits and its factors
    Ordinary profit from sales has reached a level surpassing that of the era of the bubble economy in the 1980s. Among large corporations in the manufacturing industry, this ratio reached a particularly high 5.6% in FY2004, the highest level since 1974 (Figure 1-1-6). In industry as a whole, moreover, ordinary profit has increased for three consecutive years. The factors behind this profit growth differ from growth factors operating during the bubble period as follows: (1) A major factor that sparked the rise in corporate profits was labor and other cost reductions; (2) Although growth in sales amounts consistently contributed to profit growth during the bubble era, sales growth in the current phase is not such a strong contributing factor.
Figure 1-1-6 Factors for increased profits for corporate sector
    Amid this continuing rise in profits, the retained earnings of corporations are at a high level, and free cash flow(1) has risen to a level unheard of the past. An analysis of the savings and investment balance of the business sector shows that although non-financial corporations already held excess savings in FY2001, excess savings expanded even after FY2002 as corporate profits grew, and climbed to the high level of 3% relative to GDP in FY2003 (Figure 1-1-7). The reasons behind these continued excess savings include (1) the level of capital investment remaining low following the collapse of the bubble economy, and (2) increased repayment of borrowing by corporations.
Figure 1-1-7 Balance of saving and investment
    Among the trends likely to emerge from now, appropriation of profits by corporations will have a major impact. The possible methods that corporations may choose from to appropriate profits include returning profits to stockholders through higher dividends, distribution to employees, investment in business reorganization through M&A, and increases in capital investment. Of these methods, an increasing number of corporations are actively pursuing measures to return profits to stockholders.(2) This approach is being stimulated by a currently prevailing mid-to-long term trend toward a major decline in the ratio of crossholding shares among corporations. In response, corporations are seeking to increase earnings per share by raising or resuming dividends on the strength of their favorable performance, or by increasing share buybacks made possible by such institutional measures as the lifting of the ban on treasury stock (2001). The second approach of distributing profits to employees as a method of appropriation of profits is one that has an impact on the consumption sector. As will be seen later, the strength of the business sector, having implemented adjustments to eliminate over-employment, is gradually spreading to the household sector through employment and wage opportunities, establishing a link to the stability of household consumption. Capital investment, on the other hand, is increasing only moderately, and remains at a modest level. However, domestic and overseas investment activities aimed at generating future profits are the key to achieving a sustained expansion of sales and operating profit. As the excessive capital stock and excessive debt have been largely eliminated as will be described later, it is expected that aggressive investment in new growth fields will be conducted.

 The "three excesses" have largely been eliminated
    After the collapse of the bubble economy, the problem of excesses in employment, capital stock and debt placed a major constraint on growth of the Japanese economy. These excesses are now thought to have largely been eliminated. The present high level of profits will be considered from this perspective.

 Over-employment
    Over-employment refers to the situation where the actual level of employment exceeds the employment level the company considers appropriate. One cause of over-employment is the fact that companies have difficulty in making major employment cuts, even when business results decline due to economic recession because of long-term employment commitments. In addition, over-employment can generate inordinate wage costs for reasons including the difficulty of lowering nominal wages during a deflationary period and the excessive rise in the labor cost burden due to the increasing age of persons employed under a wage system based on seniority. As a result, companies have tried to cut back on wage costs by placing curbs on new hiring and shifting to atypical employment.
    Adjustments in staffing became widespread from 1998, and after that, growth in the number of persons employed declined up until 2003. At the same time, wage adjustments were implemented for seven consecutive years from 1998 through 2004, resulting in a decline in total cash earnings. Over-employment was gradually eliminated through these employment restructuring efforts. With the economic recovery beginning in 2002 and the gradual retirement of elderly employees, over-employment as judged by companies was probably eliminated by the end of 2004(3). (Figure 1-1-8 (1)).
Figure 1-1-8 (1) Over-employment

 Excessive capital stock
    The problem of excessive capital stock stems from the boom in investment by companies beginning in the bubble period from the end of the 1980s to the early 1990s. When the bubble collapsed, the resulting economic recession led to an over-accumulation of capital stock. This excess included idle unprofitable capital stock acquired during the bubble period, as well as excessive stock generated by the downward shift in the level of required capital stock due to the substantial decline in the expected growth rate. In the 1990s, companies had to face the sluggish sales amounts and deal with the depreciation burden of capital investment, putting further pressure on profits.
    Adjustments to reduce excessive capital stock basically took the form of postponing new investment or disposing (retiring) of idle or aging capital stock. On the accounting side, companies still generating strong profits began to take their own initiative in impairing capital stock, and it was decided that accounting for the impairment of assets(4) would be applied in the business year to commence April 1, 2005. These moves hastened the adjustment of excessive capital stock, and by the start of 2005, the sense that there was excessive capital stock had virtually faded out, and the problem essentially ended. (Figure 1-1-8 (2)).
Figure 1-1-8 (2) State of excessive capital stock

 Excessive debt
    The problem of excessive debt originated during the bubble period from the end of the 1980s to the beginning of the 1990s when companies increased their borrowings from financial institutions in order to implement business expansion and aggressive investment. This wave of borrowing produced massive debt that weighed heavily on companies' balance sheets when the bubble economy collapsed. The liability side of balance sheets swelled due to borrowings, corporate bond issues and other debt, while the assets side suffered price declines in items such as land and marketable securities, making the repayment of loans difficult. Consequently, the repayment of principal and interest on liabilities put pressure on profits, and in some instances led to damage to companies' own capital and a descent into a real excessive debt. Thus, the excessive debt of business corporations became the bad debt of the lending financial institutions.
    To reduce excessive debt, the business sector had to allocate a substantial portion of profits to the repayment of debt and to repay loans through disposal of assets. As a result, the interest-bearing debt/cash flow ratio declined to pre-bubble economy levels (Figure 1-1-8 (3)). From the beginning of 2005, the non-performing loan ratio of major banks dropped to 2.93% (first quarter), and the lending attitude of major banks continued to improve. Thus, adjustments to reduce excessive debt are approaching a conclusion, both from the point of view of companies and financial institutions.
Figure 1-1-8 (3) Interest-bearing debt/cash flow ratio

 Strengthening corporate structure
    The elimination of the problem of the "three excesses" led to a strengthening and improvement of the corporate structure. An estimate of break-even points indicates that it has declined to the lowest level since the collapse of the bubble economy (Figure 1-1-9). A drop in the break-even point signifies that a company's structure has started to be strengthened to the extent that it can still generate profits even given such unfavorable developments as changes in sales amounts due to economic fluctuations, changes in industry conditions or economic structure, or slumps in sales prices or sales amounts due to deflation. Analysis of industry sectors reveals that chemicals and automobiles have led the way in lowering break-even points, although since 2004, there has been a noticeable decline in the break-even point in the steel industry against the backdrop of a favorable condition of the raw materials market. The prominent factors contributing to these lower break-even points include the firm stance toward curbing fixed costs adopted around 1999 and the contribution of the increase in sales from around 2004, while on the other hand labor costs and other fixed costs are factors pushing break-even points up.
Figure 1-1-9 Break-even point ratio

 Capital investment increasing moderately
    Private capital investment has increased for two consecutive years, with growth reaching about 5% year-on-year in FY2004. After an about 4% year-on-year increase in the period from April to June 2004, capital investment slowed as inventory adjustments of IT-related producer goods broadened, but managed a moderate increase in the period from January to March 2005.
    According to Short-term Economic Survey of Enterprises in Japan conducted by the Bank of Japan (TANKAN survey, June 2005), capital investment plans for FY2005 (all sizes in all industries) increased 5.4% year-on-year, and this, for the June survey, was the highest growth recorded since 1990. Although the contribution of electric machinery has declined, the contribution of sectors such as automobiles, chemicals and steel and iron has increased. With progress in inventory adjustments of IT-related producer goods and the high level of corporate profits, it is thought that capital investment will remain strong.
    Capital investment in the current economic recovery phase has displayed the following characteristics:
    First, the level of capital investment is modest in relation to the continued advancement of reforms in the business sector (Figure 1-1-10). A typical example is the steel industry. Capital investment there has remained in a downtrend from the 1990s and, in the current economic recovery phase, has not increased significantly relative to the significant improvement in profits. On the other hand, steel firms are taking active steps to retire (remove) capital goods whose economic value has declined. As a result, the increases both in capital stock in the capital coefficient (capital stock / added value) have been moderate. (Figure 1-1-11).
Figure 1-1-10 Capital investment and cash flow
Figure 1-1-11 Conditions of capital stock (all industries)
    Second, although investment has been modest, production efficiency is increasing. The replacement of capital stock is moving forward, and the vintage, or average age, of capital stock is increasing only slowly. These developments suggest that replacement of existing capital stock with advanced capital stock that offers high productivity and high profitability has made headway. In addition, the capital investment efficiency (added value / tangible fixed assets) of manufacturing industries has been increasing since 2003, leading to higher productivity. (Figure 1-1-12).
Figure 1-1-12 The changing factors for capital investment efficiency (Contribution breakdown)

 Capital equipment ratio is important from mid-term perspective
    Thus, although corporations are making increases in capital investment, they are also removing aged capital stock, maintaining, as they give priority to repaying interest-bearing debt, a firm investment stance that seeks to restrict capital investment to within the scope of cash flow. Reflecting these moves, corporations continued, until the latter half of the 1990s, to increase their capital equipment ratio, a measure of the amount of capital stock per worker, but in recent years, this indicator has flattened out. A comparison of manufacturing and non-manufacturing industries shows, amid the long-term shift in industrial structure from manufacturing to services, that manufacturing industries have sought to reduce their number of employees since the mid-1990s and thereby have succeeded in maintaining a high capital equipment ratio. Non-manufacturing industries, on the other hand, have leaned toward increasing employees, and their capital equipment ratio has consequently risen at a sluggish pace (Figure 1-1-13).
Figure 1-1-13 Changes in the number of people employed and capital equipment ratio
    The trend in Japan toward lower birthrates and an aging population will lead to a decline in the labor force, and the resulting increase in the capital equipment ratio will itself work to raise labor productivity. An approximate mathematical relation formula can be devised pooling the various sectors of manufacturing industries in order to describe labor productivity in terms of the capital equipment ratio. The formula indicates that a positive relationship between the capital equipment ratio and productivity has continued since the 1980s. (Appended Note 1-3). Therefore, it is expected that an increase in new capital investment resulting in increases in capital equipment ratios will be advantageous not only in non-manufacturing industries, but in manufacturing industries as well.

 Proactive capital investment based on expected growth rate
    When companies anticipate a rise in demand in the future, a reasonable response is to increase production capacity through proactive capital investment. According to the Cabinet Office's "Annual Survey of Corporate Behavior (2005)," the capital investment plans for the next three years for all industries target growth of 4.7% (fiscal year average), the highest growth since the 5.0% figure given in the FY1996 survey. However, if a model is devised to describe capital investment plans in terms of the real expected growth rate using a special calculation based on the 2005 survey, a relationship is shown to exist in which those companies with approximately a 1% higher expected growth rate have 1.7% higher capital investment plans (Figure 1-1-14). Further, if capital investment is divided into "proactive investment," which includes investment for increasing capacity and saving labor, and "other investment," which includes investment for maintaining capacity or replacing capital stock, companies with a high expected growth rate demonstrate a tendency to increase proactive investment.
Figure 1-1-14 The impact of the expected growth rate of enterprises on capital investment
    As noted above, the capital equipment ratio of companies is slowing down, and the question arises as to whether this is due to a contraction of assets or whether there is scope for raising the capital equipment ratio. Even companies that proclaim the improvement of capital stock efficiency as one of their management goals have positioned the method of introducing advanced capital stock as a particularly important priority, and, significantly, do not simply assume that a contraction of assets will bring efficiency(5). This suggests that if companies increase their expectation for growth, they still have ample scope for increasing capital stock focusing on highly efficient capital.

4. Improving Employment Conditions and the Adjustment of Labor Share

    Amid the steady improvement of the business sector, a comparison of the current economic recovery phase and the recovery phase of the 1990s reveals the following characteristics of the employment situation (Figure 1-1-15). 1) The unemployment rate did not decline in the 1999 recovery phase and the one preceding that, but the current economic recovery has been accompanied by a drop in the unemployment rate. 2) Although the number of workers employed is a lagging indicator relating to the economy, the current rise in the number of workers employed has been modest, despite the passage of a full three years since the start of economic recovery. 3) There has been little growth in wages despite improvements in employment conditions. 4) The effective ratio of job offers to applicants has risen conspicuously. Moreover, looking at the number of job offers and the number of jobseekers, as in previous recovery phases, the number of job offers has been rising in the present recovery, but, unlike previous recovery phases, the number of jobseekers has been falling.
Figure 1-1-15 Comparison of improvements on employment situation

 Non-regular employment such as part-time workers increasing sharply
    The number of workers employed as described in 2) above has probably been affected by companies' efforts to reduce over-employment. As pointed out previously, because employment was excessive up to now, companies were cautious about increasing the overall number of persons employed. Dividing workers into regular workers and non-regular workers as part of their efforts to reduce over-employment, companies are trying to curtail regular employment. Meanwhile, part-time and other non-regular employees are increasing, as companies move to hold down rises in overall labor costs. Because these efforts are congruent with the current trend among young workers and female workers to choose part-time or flexible work, companies have continued to increase non-regular employment since 1995.
    The number of workers employed has not increased to the extent that would be indicated by the improvement in the effective ratio of job offers to applicants, for the reasons suggested below. Although the effective ratio of job offers to applicants showed the highest growth during the 1990s, an analysis dividing job offers from job-seeking reveals a differing pattern: (1) Although the number of job offers is increasing to the same extent as in previous economic recovery phase, the number of jobseekers is heading downward in the current recovery phase. This probably means that the situation is being affected by the lower number of involuntarily unemployed persons, the reduction in the labor force population, and the decline in the labor participation rate (two factors in this are the movement of persons in the active generation into non-employment and the exit of the generation of retirees from the labor market). (2) The increase in the number of job-changers as the market for job-changers grows and expanded hiring of mid-career workers is probably boosting the number of job offers.
    The wage movements described in the 3) above have been strongly affected by the downtrend in wages caused by the rise in the ratio of part-time workers, which increased from 21.1% in 2001 to 25.3% in 2004. Consequently, average regular salary per employee (contractual cash earnings, not including bonuses) is being dragged down as a result of the increase in low-paid part-time workers. However, the ratio of part-time workers peaked at the beginning of 2005, and, with the increase in the hiring of new college graduates, full-time workers increased year-on-year for the first time in seven years. These and other developments have led to a steady rise in regular employment and have favorably affected wage trends.

 Adjustment of high labor share
    Movements in the number of workers employed and wages will now be considered from the perspective of labor share adjustments. A long-term trend in labor share movements has been the upswing since the 1960s. (Figure 1-1-16). This upward trend was especially prominent in the mid-1970s following the first oil crisis and in the first half of the 1990s after the collapse of the bubble economy. High labor share means that the share of workers is rising while the share of companies is declining. Labor share was especially hovering at a high level in the latter half of the 1990s due to stagnation of the Japanese economy as a whole, and worked to support income. On the other hand, it probably exerted a negative impact on corporate vitality. This high labor share was adjusted through employment restructuring, and has declined since the beginning of 2000. In more concrete terms, the number of workers employed and wages have been kept down, a trend which, as mentioned above, is expressed in the characteristics of the current employment index.
Figure 1-1-16 Labor share and labor productivity and real wages in Japan and the US

 Signs of change
    Signs of change in these adjustments of labor share began to emerge at the beginning of 2005. The number of workers employed was affected by two developments: (1) the improvement in the situation regarding the job recruitment of new graduates and (2) the virtual end of over-employment in fall of 2004. Looking at the diffusion index (DI) for judging employment conditions in "Short-term Economic Survey of Enterprises in Japan" conducted by the Bank of Japan (TANKAN survey, June 2005), it appears that there is an employment shortage among large and medium enterprises in the non-manufacturing industry. In addition, the following developments were revealed concerning wages: (1) The winter 2004 bonus marked the first year-on-year increase in eight years. (2) The start of 2005 saw a year-on-year drop in rises in regular salary to nearly zero, reflecting the peak reached in the ratio of part-time employees and the first year-on-year increase in the number of full-time employees in seven years. (3) Under employment conditions associated with new job offers, the average wage of job offers has increased steadily year-on-year since 2003.
    These developments basically stem from an improvement in the supply and demand circumstances of the labor market. With the expected retirement of large numbers of first baby boomer generation (hereinafter "Dankai generation") in 2007, the labor market is expected to change markedly (to be discussed in detail in Chapter 3).

 Theoretical examination of labor share
    The following is a consideration of future movements in labor share.
    Labor share represents workers' share of the allocation of national income.(6) Increase or decreases in the labor share represent increases or decreases in workers' share relative to the companies' share. There are two aspects of the relationship between labor share and the state of the economy that are now clear: (1) During an economic recovery phase, wages tend to rise slowly, and thus labor share declines. (Conversely, labor share increases during economic recessionary periods.) (2) When the economy entered a slump following the collapse of the bubble economy for the first time in the 1990s, labor share rose, but afterward, even during the economic recovery phase, it continued to increase. (The explanation is that wage adjustments led to a year-on-year decline in wages for the first time in 1998.)
    Therefore, if other conditions remain constant, the following relationships emerge: (1) a drop in real wages results in a decline in labor share; and (2) an increase in labor productivity results in a decline in labor share. A synthesis of (1) and (2) reveals the following relationship: When the rate of increase in real wages is less than the rate of increase in labor productivity, labor share declines. For example, comparing Japan and the US in terms of these movements beginning from 1990, it appears that in the US after 1990, real wages and labor productivity rose at roughly the same pace, and thus caused no large fluctuation in labor share (Figure 1-1-16 (2) above). In Japan, by contrast, the increase in labor productivity in the 1990s was relatively low, and as real wages continued to rise, labor share consequently increased. At the start of the 2000s, however, real wages flattened out, putting downward pressure on labor share. In addition, if the rate of increase in unit labor cost is less than the rate of increase in the GDP deflator (price fluctuation index), then labor share declines.
    The long-term-equilibrium level of the overall macro-economy can be pictured as the point at which the rate of increase in labor productivity and the rate of increase in real wages coincide. In other words, when the rate of increase in labor productivity and the rate of increase in real wages are equal, labor share does not change. If this relationship of equilibrium is assumed to be a long-term pattern, an estimate of the degree of deviation from this equilibrium relationship at each point in time reveals the following picture: For a period of more than 10 years following 1992, labor share deviated widely from the long-term equilibrium level, but with the arrival of 2004, it finally returned to the equilibrium level, which, in the period from January to March 2005, was 66.0% (Figure 1-1-17, Appended Note 1-4). Judging from past movements, then, labor share in 2005 appears to be at the equilibrium level, and so long as other conditions do not change, then there probably will be no major decline in labor share. With the improvement of the supply and demand circumstances of the labor market, the key to raise the certainty of economic growth will depend on an increase in employment and a rise in wages in this improvement of the labor market.
Figure 1-1-17 Labor share and equilibrium level

5. IT Demand and Economic Trends

    It has been pointed out that Japan's manufacturing industries suffered a decline in international competitiveness after the 1990s. For example, the Japanese semiconductor industry in 1988-89 commanded more than a 50% share of the world market on the strength of its competitiveness in DRAM chips (random access memory that must be refreshed to prevent data loss), but by 2004, the industry's share had declined to about 25%(7). Recently, however, the semiconductor industry has also been enjoying strong demand for system LSI and other components for the digital electronics market. Japan's manufacturing industries have long had a robust foundation, as demonstrated by their top rank position from 1982 to 2004 in the world in the value of machine tool production. Japan's manufacturing industries are also leaders in the cutting-edge technologies field and command half the worldwide production of solar cells.(8) Japanese firms also manufacture a variety of final products in the digital electronics field and maintain a major share of the worldwide market.(9) In raw materials for digital electronics, the strength of Japanese companies is also unmatched. For example, they boast overwhelming competitiveness in functional chemicals, which are materials used in semiconductors and displays.(10) They also hold down a majority share of the worldwide market for substrate glass, which is used for manufacturing liquid crystal and plasma display panels, magnetic disks of personal computers and servers, and integrated circuits and liquid crystal displays. Despite Japanese companies' global strength in the IT field, however, the Japanese economy has been at a temporary pause due to a global adjustment in the IT industry in 2004. The relationship between the IT sector and the economy is discussed below.

 Strong interrelationship between overseas economies and the Japanese economy
    The Japanese economy shares such a strong interrelationship with overseas economies that when overseas economies are strong, production in Japan also increases as practically a natural consequence (Appended Chart 1-1). Conversely, when the global economy slows down, exports from Japan will slow down even more, and domestic production naturally falls. This interrelationship is influencing the Japanese economic trend in the temporary adjustment that started from the latter half of 2004.
    The interrelationship is particularly manifest in the global IT-related industry, where buoyant demand worldwide for many products manufactured by Japanese firms has grown. In electric machinery, these include personal computers and liquid crystal televisions, as well as electronic components such as semiconductors and liquid crystal elements.(11) In general machinery, products include semiconductor manufacturing equipment and flat-panel display manufacturing equipment, and demand for digital electronics in this sector is also thriving.
    If worldwide IT demand changes, Japan's domestic production will be strongly affected by the fluctuation of exports, for the reasons given below.

 Japan as a production base for IT-related producer goods
    Compared with IT production in the US, Japanese production has a stronger interrelationship with world IT demand (Figure 1-1-18). This is because the weight of IT-related goods in overall production is, in Japan's case, higher than that of the US. For Japan, the production weight of IT-related goods is 18.5%, whereas for the US, the production weight among manufacturing industries is 7.3%.(12) Although the US is a major consumer of IT-related goods in terms of introduction and utilization, its demand is strongly characterized by a dependence on overseas IT production. In contrast, Japan, like Taiwan and other countries, can be characterized more as a production base for the supply of IT products to the US and other consumers of IT products. The percentage of intermediate IT-related goods such as electronic components accounted for by imports was, in 2000, 11.9% for Japan, as opposed to 47.1% for the US.(13)
Figure 1-1-18 World semiconductor sales and Japan-US production index
    These structural features of IT production strengthen the interrelationship between production in Japan and the world economy, which means that Japan is more susceptible to the impact of changes in IT demand than the US.
    However, a structural mechanism that could serve to disperse and equalize changes in demand has begun to emerge.
    First of all, among Japan's IT-related manufacturing industries, the production weight of consumer goods such as personal computers, liquid crystal televisions, and cellular phones, is high. Likewise, the production weight of producer goods, such as electronic components and devices such as semiconductors and liquid crystal elements, and the production weight of capital goods, including general machinery such as semiconductor manufacturing equipment and flat panel display manufacturing equipment, are also high. The 2000 benchmark weights of the industrial production index are as follows: 5.7% for electrical machinery and 4.8% for information and communication electronics equipment, as opposed to 11% for electronic parts and devices and 13% for general machinery.(14)
    In the case of consumer goods, if competitiveness between manufacturers or between countries changes in response to changes in the product cycle or consumer needs, then there most likely would be a direct impact on production. In contrast, in the producer goods and capital goods sectors in which Japan is superior, competitiveness is not easily challenged. That is, it is difficult for newly industrializing countries to imitate Japanese manufacturers simply by introducing the latest technologies and setting up low-cost production operations. The accumulation of knowledge and the development of integrated strength that encompasses several industries are the sources of superiority. Producer goods and capital goods are not easily affected by changes in the requirements of competition with rival companies or countries, and thus the impact on production is modest.
    Secondly, consumer goods in which components are used have diversified, and changes in final demand are not tied closely to changes in components production. A breakdown of domestic production of the major products that incorporate electronic components and devices in the period immediately after the collapse of the IT bubble (1999-2000) indicates that personal computers and cellular phones accounted for more than 80% of production, while other products accounted for less than 20%. For this reason, when demand for final products such as personal computers became sluggish, it was difficult to offset this with demand for other uses. At present, however, the share of production of personal computers and cellular phones is declining, while the shares of other products, such as car navigation systems and other automotive products and consumer electronics such as liquid crystal televisions and digital cameras have risen to about 30-40%. (Figure 1-1-19). By broadening the base of products that use electronic components and devices, the impact of changes in demand for specific products on the production and inventory of electronic components and devices is more easily dispersed and equalized than at the time of the IT bubble.(15)
Figure 1-1-19 Composition changes of products using electronic components and devices


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