Annual Report on

The Japanese Economy and Public Finance


- No Gains Without Reforms V -

Cabinet Office

Government of Japan

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Section 5 Future Outlook for the Economy

    The disposal of the negative effects left by the collapse of the bubble economy as symbolized by the problem of non-performing loans has been completed. As a result, the condition of companies has grown stronger, and this renewed strength is now spreading to the household sector through improvements in employment. Amid these positive developments, the Japanese economy continues on a path of moderate recovery. An examination of the economic outlook also reveals the presence of negative factors such as the increase in crude oil prices and the leveling off of exports, but as the analysis up to the preceding section shows, these factors are unlikely to lead directly to an economic recession, and in all probability the economy will continue on its present course of moderate recovery. This section examines the shape of this economic recovery and its sustainability.

 Forces driving the economy
    The forces that are assumed to drive the economy forward include the following: (1) stable growth of the world economy; (2) the moderate recovery in production thanks to the completion of adjustments of IT-related producer goods inventories; (3) the sustained recovery of corporate profits against this backdrop; and (4) the moderate increase in private consumption.
    Concerning overseas economic trends, the tempo of economic expansion in the United States, Europe and Asia is expected to moderate to some degree in 2005, but the IMF predicts that growth in world GDP, which was recorded to be more than 5% in 2004, will be strong in 2005, securing growth with a range between 4.0-4.5%. At the present time, then, there is little risk of a major slowdown as was seen in the previous recessionary period of 2001 and in 1998 during the Asian currency crisis. (Between 2000 and 2001, world economic growth declined from the mid-4%-level to the mid-2%-level, while between 1997 and 1998, it fell from the lower 4%-level to the upper 2%-level.)
    With respect to IT-related producer goods inventories, adjustments aimed at reducing inventories were implemented over several quarters, resulting in a significant drop in inventory levels, and are now nearing the end. Thanks to this development, Japanese exports and production are expected to recover, even though growth will be moderate. If this growth in production is sustained, corporate profits are very likely to continue increasing at a moderate pace, even if margins are squeezed by the rise in the raw material prices. This point was taken up in the Bank of Japan's Short-term Economic Survey of Principal Enterprises in Japan (TANKAN survey, etc.), which forecasts that, in FY2005, ordinary profit will grow for the fourth consecutive year. These improvements in corporate profits are also expected to give a further boost to capital investment.
    Another force driving the economy is the moderate increase in private consumption that has resulted from higher employment and an improved income environment. Looking at employment, the number of workers employed is on a moderate upward trend, and though growth in part-time workers has slowed, full-time workers have begun to gain in number. In addition, according to the Monthly Labor Survey, bonuses increased for the first time in eight years with the 2004 year-end bonus, and the 2005 bonus is expected to be even higher. Therefore, as employment stabilizes and the income environment improves, private consumption is expected to show a continued moderate increase.
    The overseas economic environment is always associated with risk. However, with expectations that firm growth will continue in overseas economies, private demand should be a strong support for economic growth in 2005.

 A downward pressure on the economic development
    Even with the completion of adjustments of IT-related producer goods inventories and the end of the economic leveling off, factors remain that could continue to put pressure on the economic development, including: (1) the sharp rise in crude oil prices; (2) decline in corporate profits because of difficulties in implementing price-shifting; and (3) the possibility of an autonomous business cycle arising as the recovery reaches a mature stage.
    The downward pressure that the rise in crude oil prices is exerting on the economy is less than in the past because of the reduction in oil dependency. However, the rise in oil prices has become protracted, having continued into 2005. Although the future direction of oil prices is not clear, structural factors such as increasing demand for oil from China and restrictions on supply will not be eliminated immediately, leaving some possibility that crude oil prices will remain somewhat high.
    In addition, price increases have spread to intermediate producer goods such as steel due to higher raw materials prices, and these increases are not necessarily passed-through at the final product level. Both of these circumstances pose the risk of lowering corporate profits. Further, if worldwide supply and demand regarding raw materials continues to tighten, prices are likely to stay high. In that case, however, strong demand will propel sales upward, which means that the impact on corporate profits will be limited and the pressure on the economy may not be strong enough to change the tone of the economy.
    Finally, factors that could produce an autonomous business cycle merit attention. A natural result of the maturation of economies is an increase in inventories and capital stock. If, at such times, demand slows and expectations sag, the mechanisms of inventory adjustments and capital stock adjustment tend to engage. Once these mechanisms start to take effect, there is a cumulative forward progression in the economic adjustment process. These workings are a lesson for understanding the economic cycle up to now. Even without external shocks, autonomous domestic activities are an important ingredient of economic trends.

 Sustainability of the economic recovery
    As described above, forces that support or pressure the economy are both at work. Given this context, a scenario that envisions a continued moderate recovery of the economy has taken the central position in the economic outlook. From the perspective of the sustainability of the economy, there are different factors from those that operated during the 1990s after the collapse of the bubble economy.
    First, the strengthening of the financial condition of the business sector has a positive effect on sustainability. Corporations have virtually eliminated the problems of over employment, excessive capital stock and excessive debt. As a result, fixed expenses (labor costs, interest payable and depreciation expenses) as a percentage of sales (i.e. the break-even point) have declined substantially, returning to the level at the beginning of the 1990s (Figure 1-1-9 above). A breakdown of variations in the break-even point shows that during the economic expansion period at the beginning of the 1990s, declines in the break-even point were due entirely to the growth in sales amounts, while fixed costs worked almost consistently to push up the break-even point. At the beginning of the 2000s, by contrast, fixed costs consistently worked to push down the break-even point. In the 1990s economic expansion period, moreover, declines in the break-even point were small and, as a result, net sales growth fell due to a slowdown in demand, and this alone sparked an immediate rise in the break-even point, putting pressure on corporate profits and leading to economic recession. In the current economic expansion phase, the break-even point continues to decline due to the reduction in fixed expenses. Hence, even at the time of the Iraq war at the beginning of 2003 and in the latter half of 2004 when demand leveled off temporarily, the impact on corporate profits was limited. This strength of the corporate sector is boosting the sustainability of the economy.
    Second, the recovery of profits in the business sector has significantly affected the income of the household sector, which, through increased consumption, is contributing to the sustainability of the economy. Although the income environment of the household sector is improving at this time, the increase in consumption has been modest. The elimination of over-employment and the approaching retirement of the first baby boomer generation are two factors that will improve employment conditions. Moreover, corporations enjoy abundant cash flow, and this, should it lead to increases in employee incomes, can be expected to support the sustainability of the economy.
    An examination of the contribution of each category of demand relative to the real GDP growth rate reveals that, in the past, consumption growth accounted for more than half of the GDP growth rate (Figure 1-5-1). However, the role of consumption in the economic expansion period has tended to decline, and in the present cycle has dipped to about 30%. In its place, capital investment's role has grown relatively large, and its contribution to the GDP growth rate is now close to 40% as opposed to 20% in the past. Since capital investment has had a relatively high amplitude compared with consumption in the past, if consumption's contribution to GDP growth declines while investment's contribution increases, the amplitude of the GDP growth rate will also rise. This means that an increase in the role of consumption will probably contribute to a leveling-out of economic fluctuations. It is therefore important, from the perspective of the sustainability of the economy, to be attentive as to whether a further increase in income will be linked to consumption.
Figure 1-5-1 Contribution by category of demand for each economic expansion period
    It would now be instructive to consider the factors other than those described above that are likely to pose the risk of obstructing economic sustainability.
    First, there are possibilities that the overseas economy, including the US and China, slows down more than expected, and the international flow of funds could change rapidly. Though the US and Chinese economies are expanding, inflationary pressures are building amid the sharp rise in crude oil prices. In order to curb these pressures, policy measures that seek a moderate tightening have again been taken, and it would be inaccurate to say that there is no possibility that these policy measures will cause a slowing of the economy. In these cases, the Japanese economy is affected to some extent. Attention must be also be paid to what measures will be taken to adjust the huge fiscal deficits held by the US government and the imbalance in the international current account balance, and to the effect exerted on the international flow of funds. Another development to watch is the sharp rise in asset prices in the US.
    Second, domestic policy issues have an impact on the sustainability of the economy. With respect to fiscal policy, measures to curb expenditure increases such as reductions in public investments continued in FY2005. From 2006, proportional tax reductions of private income taxes will be cut from 20% of the income tax amount to 10%, and pension insurance premiums will be increased each year. Improvements in employment and the income environment are expected, but the impact on the economy should be limited. Regarding monetary policy, the Bank of Japan has promised to continue its present quantitative easing policy until the consumer price (overall nationwide, excluding fresh food) stably reaches zero or above. For this reason, short-term interest rates will continue to be stable. Long-term interest rates should also remain stable in light of these monetary policy trends, and when conditions allow a discontinuation of quantitative easing, close attention must be paid to the impact of changes in the framework of monetary policy on long-term interest rates.

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