Annual Report on

The Japanese Economy and Public Finance


- No Gains Without Reforms V -

Cabinet Office

Government of Japan

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Section 2 Points to Keep in Mind Regarding Economic Trends

    The business sector is maintaining good performance through constitutional improvement, and this renewed vitality is gradually spreading to the household sector, raising expectations of a sustained economic recovery. However, a consideration of forthcoming developments in the economy requires that two points be kept in mind. One is the impact of the sharp rise in crude oil prices. The other is the leveling off of exports since the latter half of 2004. The following is an evaluation of the state of the economy in light of these two developments.

1. The Sharp Rise in Crude Oil Prices

    Crude oil prices are on an upward trend, having risen from a level of 19.9 dollars per barrel in February 2002 (Dubai prices, the same hereafter) to a record of 54 dollars per barrel in June 2005. The effect on the economy of this rise in crude oil prices merits a close examination.

 Comparison with past oil crises
    To begin with, a comparison of the recent price increase and rises during the oil crises of the 1970s reveals the following characteristics:
(1) Oil prices have increased 2.6 fold in the present uptrend, and although this rise is below the 3.4-fold increase that occurred in the first oil crisis and the 2.9-fold increase in the second oil crisis, it still represents a substantial rise (Table 1-2-1).
Table 1-2-1 Comparison of crude oil price increases
(2) The present rise has continued over a period of more than three years, which is apparently longer than the first oil crisis (October 1973 - August 1974) and is about to reach the length of time experienced at the second oil crisis (December 1978 - April 1982).
(3) A major difference is that there has been no stoppage of supply, unlike in the oil crises when exports from oil producing countries came to a halt. That is, the two oil crises brought an alarming stoppage of supply (a major shift to the left of the total supply curve), whereas the effect on the total supply curve this time has been minimal.
    The principal factor of the current oil price increase is in supply and demand, as a background of these differences. Unlike the past oil crises, which occurred at the time of the Middle East war and the revolution in Iran, factors relating to economic structure have influences on the current price rise, namely rising demand not only from industrialized countries but also from high-growth countries such as China and India, as well as the restraints on increases in supply capacity among oil development firms due to drop in profitability.(16) As a result of the recent slowdown in the development of new oil fields, pressure is being exerted on OPEC's reserve crude oil supply capacity: The 26.5 million barrels actually produced relative to the daily production capacity of 31 million barrels recorded in the 1980s has tightened to 29.26 million barrels relative to the daily production capacity of 31.5 million barrels in May 2005.

 Impact of the increase in oil prices
    Attention will now turn to an examination of the negative impact of the crude oil price rise on the economy. Theoretically, the increase in crude oil prices can be cause the following: (1) Because of a deterioration of the terms of trade, income may be transferred to oil producing countries, causing a decline in domestic demand. (2) Increases in the price of raw materials may hold down total production output as a result of lower profits due to an increase in input costs. (3) The overall rise in commodity prices may reduce real disposable income and depress consumption.
    An analysis of this economic impact using the multiplier of an econometric model indicates that the effect is small. Comparing the magnitude of the effect on depressing Japan's real GDP if crude oil prices rose 20% reveals the following: (1) According to a global economic model of the Economic Planning Agency (1982), GDP would decline by 0.46% in the first year and by 1.24% in the second year. (2) According to the Cabinet Office's macro-econometric model of the Japanese economy (2005), GDP would decline by 0.11% in the first year and by 0.14% in the second year. Thus, the impact would be small.(17)
    This minor impact of crude oil price rises on depressing GDP will be taken into account in the following concrete analysis of present economic conditions.
(1) The deterioration of the terms of trade (the income transfer to oil producing countries due to the increase in crude oil prices) is 0.5% relative to GDP. This is small compared with the 3% income transfer at the time of the 1970's oil crises. Because of improved energy conservation and energy consumption efficiency, the amount of crude oil required per unit of nominal GDP today has declined substantially, to 1/6 of that of 1970. Consequently, the negative impact on domestic demand has been small.
(2) Because of the increase in input costs and the rise in real wages, the total supply curve shifted to the left, leading to a sharp rise in prices and a reduction in total production output at the time of the first oil crisis. With the current oil price rise, however, higher input costs have been absorbed to a significant degree thanks to factors including productivity improvements. In addition, with the moderate deflationary trend, cost increases do not immediately translate into inflation. For this reason, the shift in the total supply curve and the effect on production output have been small.
(3) In the first oil crisis, expectations of inflation climbed substantially upward, and though both nominal wages and real wages increased, the number of workers employed and real income slowed down. This time, however, expectations regarding inflation have not changed significantly and real wages have flattened out. With the recovery of employment, moreover, real income remains steady, and there has been no negative effect on consumption.

 Trends from now
    The characteristics of the current rise in crude oil prices as outlined above lead to expectations that the effect of the rise on depressing the economic growth rate will be small compared with the past. For the reasons given below, there is probably no need for excessive concern about negative effects on the economy.
    First, the deterioration of the terms of trade has been slight and the transfer of income to overseas has been minimal. So long as there is no stoppage of crude oil supply, the leftward shift of the total supply curve will be extremely small.
    Second, the economy is not currently in an inflationary phase. During the oil crises, a sharp rise in inflation was sparked by the boom in the plan to remodel the Japanese archipelago underway at the time and thus the oil crises helped to fuel the steep upturn in prices. In order to stabilize prices by dampening overall demand, monetary policy then was tightened substantially, and curbs were placed on fiscal policy. The current crude oil price rise, however, is taking place at a time when the economy is in a moderate deflationary phase, and a policy of quantitative easing is being implemented to draw the economy out of deflation.
    Third, the crude oil price increase up to now is most likely being affected by speculative moves amid the worldwide monetary surplus. To illustrate this point, in contrast with a 3.6% increase year-on-year in 2004 in the world crude oil one-day volume of demand, the one-day volume of trading in WTI crude oil futures on the New York Commodities Exchange increased by 16.4%.(18) However, it is expected that the worldwide money glut will gradually ease in response to tighter US monetary policy.
    Nevertheless, a protracted rise in crude oil prices could pose certain risks, as outlined below, requiring continued attention to crude oil price trends. (1) If, due to efforts to pass off price increases upstream, cost increases cannot be absorbed by productivity increases, management rationalization, and sales increases, pressure could be exerted on corporate profits. (2) If the increase in crude oil prices sparks uncertainties about the future, the business sector and the household sector may act with caution. (3) If the rise in crude oil prices causes an economic slowdown in the United States or in China, where energy consumption is high, the negative impact would spread to Japanese economy.

2. The Causes of the Slowdown in Exports

 Exports slowed despite the strength of overseas economies
    Since the latter half of 2004, Japanese exports leveled off, and exports to Asia, including China, turned downward (Figure 1-2-2). Products exported from Japan to Asia that have suffered noticeable declines include electric machinery and general machinery. Total imports of China increased 30% year-on-year in the period from October to December 2004 but fell to a little over 10% in the period from January to March 2005.
Figure 1-2-2 Export Volume
    An examination of overseas economies shows that the economies of Japan's principal export markets, Asia and the United States, are expanding. In China, investment in fixed assets since the latter half of 2004 increased dramatically by nearly 30%, and the economy grew strongly at 9.5% year-on-year in 2004. Thus, China's current economic trends do not adequately explain the slowdown in exports to China. It would be instructive to consider what sort of changes are occurring.

 Slowdown in exports to Asia due to softening of IT-related supply and demand
    The slowdown in Japanese exports to Asia and China is particularly pronounced in the electric machinery and general machinery sectors. The background of this slowdown is the worldwide softening of IT-related supply and demand. Growth in worldwide sales of semiconductors has slowed, and weakness appeared in supply and demand for semiconductor manufacturing equipment in both North America and Japan in the latter half of 2004 (as reflected by the Book-to-Bill Ratio). Japanese shipments also flattened out from the middle of 2004 (Figure 1-2-3).(19)
Figure 1-2-3 Book-to-Bill Ratio of Semiconductor Manufacturing Equipment and Shipment Index
    China and other Asian countries are becoming production bases for IT-related products, and exports from Japan, particularly exports to Asia, of electronic parts/materials such as semiconductors slowed from the latter half of 2004 in response to the softening in IT-related supply and demand (Figure 1-2-4). Exports from Japan of digital electronics (flat-screen televisions, DVD recorders and digital cameras), particularly to the United States, have also been sluggish since the middle of 2004. In addition to this softening of IT-related supply and demand, other factors could also be playing a part in the slowdown of exports to Asia from Japan, as follows.
Figure 1-2-4 Export of digital electronics and electronic parts such as semiconductors
    First, as for factors operating in Japan, the reserve export capacity of steel and other raw materials industries could be declining. Because raw materials industries have been cautious about capital investment in recent years, supply has been restricted, leading to a slowdown in exports to Asia. In crude steel production, priority has undoubtedly been given to domestic shipments because of buoyant domestic demand, and export shipments are declining. However, exports by other raw materials industries such as chemicals have not been limited by a lack of reserve supply capacity, and the impact on exports to Asia should not be significant.

 Trend in exports to China
    Of the countries of Asia, China, in particular, is a pertinent factor in the export slowdown. First of all, imports by China have slowed down since the latter half of 2004, especially in areas such as iron ore, steel, electronic micro IC parts, and auto parts (Figure 1-2-5). The causes of this slowdown that have been identified include (1) measures to dampen overheated investment and excessive supply; (2) an increase in self-sufficiency in procurement and export capacity by China; and (3) a rise in the proportion of supplies procured locally by Japanese companies in China. These factors are discussed in greater detail below.
Figure 1-2-5 Trends of Chinese imports
(1) Efforts by the Chinese authorities to curb investment to prevent an overheating of the economy are depressing Japanese exports. Because corporate investment and real estate investment in urban areas have overheated, authorities are formulating measures to curb these excesses. The slowdown in China's import of iron ore is also attributable to the decline in investment growth by the ferrous metal refining industry. Meanwhile, the prices of auto parts have sagged due to excessive competition, and expectations of further price falls have delayed auto purchases, leading to a decline in the growth in sales of passenger vehicles to about 10% year-on-year. As a result of these developments, the overheating of investment is thought to have subsided for the time being, except for some investments in infrastructure. In addition, a number of fields have probably experienced a build-up of inventories. Overproduction of cellular phones has necessitated adjustments to reduce production of micro IC parts, leading to a slowdown in parts imports.
(2) As China's economy develops, self-sufficiency and export capacity are increasing in both quantitative and qualitative terms. With respect to steel, China may, on a volume basis, temporarily take the role of a pure exporting country, and for Japan's steel industry, the competitive relationship in exports with China and other Asian countries would intensify, possibly causing exports to level off.
(3) Japanese companies that have set up local operations in China are gradually increasing the proportion of supplies procured locally.(20) Initially, Japanese companies with operations in China procured parts and materials exported from Japan and elsewhere to support production in China, but as China's economy develops, local procurement is tending to increase.
    The three developments outlined above are probable factors behind the slowdown in Japanese exports to China.

 Future export trends
    Since export trends have an impact on Japan's production activity, close attention must be paid to emerging trends in Asian economies, especially China's, and the US economy. However, the ongoing recovery of the world economy should fuel a continued increase in external demand. Attention will focus on the following three export trends:
    First, if the US economy remains on its present favorable course, exports to the US should generally be strong. Automobile exports should become steady, and it is expected that exports of digital electronics, which slowed down from the middle of 2004, will recover.
    Second, exports to China are currently slow due to the combination of factors mentioned above, and therefore exports will probably vary depending on the product. The impact of policies to curb overheating of the economy is cyclical, but enhancements in self-sufficiency and export capacity and increases in the proportion of supplies procured locally are structural and ongoing.
    Third, the penetration rate of IT-related products is still low. Therefore, if prices of digital electronics decrease to the popular price range, potential demand would emerge as actual demand and lead to an expansion of worldwide demand. In addition, the base of demand for IT-related products is broadening. Formerly, the principal products of the IT industry were personal computers and cellular phones, but the base has now broadened to include car navigation systems and other automotive uses, and consumer electronics such as liquid crystal televisions and digital cameras. If this trend continues, and demand for specific product groups changes, the negative impact on Japan's exports due to the factors discussed above will be dispersed and equalized to some extent.

3. Evaluation of the Present State of the Economy

    An evaluation of the state of the economy taking account of the points outlined above leads to the conclusion that an exit from the current slowdown is in sight and that moderate recovery will continue. The sharp rise in crude oil prices appears at this point not to be having a direct impact that would turn the economy downward.
    Although this subject will be taken up in detail in the following section, the nearly complete assimilation and disposal of the negative legacy left by the collapse of the bubble economy assures economic recovery. This refers specifically to the consistent pattern of improvement in structural factors that support economic recovery, such as the strengthening of corporate structure due to higher profits and other factors, and a more favorable supply and demand environment for labor as seen in the higher rate of job offers.
    However, attention must be also paid to cyclical factors. The present economic recovery is in its fourth year and signs of a maturation of the economy have begun to emerge. Important elements in the relationship between economic recovery and the business cycle are inventories and capital investment. With regard to the inventory cycle, the 45degree line was intersected in the first quadrant in the period from January to March, 2005 (Figure 1-1-2 above). This development can be attributed to the uptrend in inventories of transportation machinery, chemicals, general machinery and others, although there has been progress in the adjustment of IT-related producer goods inventories. The difficulty in chartering ships has resulted in an increase in automobile inventories, which means movements in shipments must be watched from now to determine whether or not this difficulty will lead to a prolongation of inventory adjustments. The capital investment cycle is, at present, characterized by an ongoing a maturation of the balance in flow and stock: although increases in capital stock have been low, investment has grown for nearly three years (Figure 1-2-6). Since increases in companies' expected growth rate are accompanied by rises in the desirable level of capital stock, corporate optimism is the key element in this relationship.
Figure 1-2-6 Capital investment cycle (manufacturing industry)

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