Annual Report on the Japanese

Economy and Public Finance


- No Gains without Reforms II -

November 2002
Cabinet Office

Government of Japan

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Chapter 1

   Overview of the Capacity for Economic Recovery

Section 1 Background of the Bottoming out of the Economy

   The Japanese economy entered a recession phase after hitting a peak in October 2000(1). Later, the economy continued deteriorating throughout 2001, with production posting a sharp decrease and the unemployment rate hitting a record high. The Real GDP had negative growth in and after the April-June quarter of 2001. With deflation progressing, there were even concerns that the Japanese economy might descend into a deflationary spiral. However, exports began to increase and production stopped decreasing in early 2002. The economy is believed to have bottomed out in the January-March quarter of 2002(2).
   Viewed from the standpoint of business cycles, if the economy picks up from the bottom, it will be the third economic recovery phase since the 1990s. Since the economy, as measured by GDP deflator, has been posting negative growth since the second half of the 1990s, it will also be the third recovery in the deflationary phase(3). The two previous recovery phases(4) shifted to recession phases without achieving strong recovery led by private demand due to slowdown of the world economy and financial system unrest. The question is how to view the strength of the latest economic recovery.
   This section will focus on the background to the latest bottoming out of the economy, its characteristics as compared with the previous recovery phases, and the current state of deflation.

1. Bottoming out of the Economy
(1) Current state of the economy

From deterioration to bottoming out
   The latest economic recession was caused by a sharp decrease in exports, as the U.S. economy decelerated rapidly in and after the second half of 2000 and triggered a global economic slowdown.
   Changes in Real GDP (See Figure 1-1-1) show that net exports and business investment led the growth of the economy until the first half of 2000 but that net exports began to decrease in the October-December quarter of 2000. This led to an inventory increase and a resultant decrease in production and the economy moved to a recession phase in October 2000. With Private consumption falling slightly in the April-June and July-September quarters of 2001 and Private non-residential investment continuing to decrease, Real GDP posted minus growth for four consecutive quarters from the April-June quarter of 2001 to the January-March quarter of 2002 and the Real GDP growth rate for FY2001 fell 1.9% from the preceding fiscal year. Meanwhile, the employment situation deteriorated drastically. The unemployment rate, which had been on a rising trend, rose above the 5% level in July and hit a record 5.5% in December. On the other hand, Domestic wholesale prices and Consumer prices continued declining along with asset prices such as land and stock prices. Since people became concerned about a deflationary spiral, a second supplementary budget was compiled and further quantitative monetary easing measures were adopted in order to avoid such a spiral.
   In the beginning of 2002, exports stopped decreasing and began to increase. As a result, shipments stopped decreasing and production also began to stop decreasing against the background of progress in inventory adjustment. Business sentiment, mainly of big corporations, began to stop falling and corporate profits also showed signs of ending their decline. Meanwhile, a pause was seen in the rise of the unemployment rate and Domestic wholesale prices stopped declining and began to move sideways.
   Assuming that the trough of the latest recession was the January-March quarter of 2002(5), the length of the recession phase would come to about five quarters. Since the average length of the recession phases that took place after the second oil shock was about nine quarters, it can be said that the bottoming out of the economy this time came in a relatively short period of time.
Figure 1-1-1 Real GDP Growth and Contribution of Components
Background to the bottoming out of the economy
   --External factor: Export growth
   The background that led to the bottoming out of the economy this time can be divided into external factor and domestic factor. As an external factor it can first of all be pointed out that exports, which decreased drastically during 2001, stopped decreasing in the beginning of 2002 as described earlier and began to increase sharply, mainly to Asia, in the middle of the year. The factors that led to the increase in exports are as follows.
   First is the recovery of the U.S. economy. The U.S. economy began to slow down in the middle of 2000 following the collapse of the IT bubble and posted negative growth for three consecutive quarters starting in the January-March quarter of 2001. However, individual consumption began to show firm movement following the adoption of positive fiscal and monetary policies, including tax cuts and monetary easing, and rapid progress in inventory adjustment, especially of IT-related goods. As a result, the growth rate of Real GDP increased in the October-December quarter of 2001 and the January-March quarter of 2002 (See Figure 1-1-2, upper figure). It can be said that the U.S. economy entered a recovery phase in the January-March quarter of 2002.
   Second, the Asian economy has also recovered. The Asian economy recovered earlier than the U.S. economy, led by exports of IT-related goods. In South Korea, domestic demand turned firm as individual consumption and construction investment increased.
   Incidentally, the increase in Japanese exports, mainly to Asia, can be attributed to the recovery of the U.S. economy. This is because exports to the U.S. contribute greatly to production increases in Asian countries. It can be said that against the backdrop of the progress in inventory adjustment of IT-related goods and the steady consumption in the U.S., Japanese exports of parts to Asia are increasing sharply. The parts are assembled and processed in Asian countries for exports to the U.S. In fact, the sharp increase in U.S. imports since the beginning of 2002 (See Figure 1-1-2, middle and lower figures) can largely be attributed to imports from Asia.
   Third, the yen depreciated against the dollar. The exchange rate of the yen against the dollar, which stood at 109.82 during the October-December quarter of 2000, depreciated to 118.09 in the January-March quarter of 2001 and since then basically remained weak and depreciated to 132.46 in the January-March quarter of 2002. The yen' s depreciation is believed to have strengthened the price competitiveness of Japanese exports and contributed to an increase in Japanese exports. According to an estimate, Japanese export volume in the April-June quarter of 2002 increased over 2.6% (or raised the quarterly growth by an average of over 0.4%) more than in the case where the yen-dollar exchange rate would have remained unchanged at the level of the October-December quarter of 2000 (See Appended Note 1-1).
Figure 1-1-2 Trend of U.S. Economy
Background of the bottoming out of the economy
   --Domestic factor: End of inventory adjustment
   The above external factor undoubtedly contributed to the bottoming out of the economy through exports. However, the early bottoming out would not have been possible with such a factor alone. We have to take a look other factor, namely, domestic factor. What is of particular importance is the rapid, broad production adjustment in the corporate sector. Faced with a sharp decrease in shipment due to deterioration of the economy and the resulting large increase in inventory, the corporate sector carried out production adjustment rapidly and drastically. The inventory adjustment came to an end swiftly only because the production adjustment was carried out and shipments stopped decreasing thanks to an increase in exports.
   However, the domestic sector as a whole remained under strong adjustment pressure. The corporate sector aggressively promoted balance-sheet adjustment, capital stock adjustment, and wage/employment adjustment, etc. from a medium-term viewpoint. The banking sector, plagued with a huge amount of non-performing loans, remained unable to regain its financial intermediation function. The household sector had no choice but to take a cautious stance on consumption and residential investment amid the severe employment and income environments and uncertainties about the future. All these worked to put downward pressure on the economy.
   In the meantime, fiscal and monetary policies were implemented flexibly in order to dispel fears about a deflationary spiral. As to fiscal policies, the FY2001 budget was made from the standpoint of fiscal structural reforms. In December 2001, the government worked out "Immediate Action Program for Structural Reform" against a deflationary spiral and made a second supplementary budget. As to monetary policies, the target level of the quantitative monetary easing measures which were adopted in March 2001 to control the outstanding balance of current accounts at the Bank of Japan was raised several times. The macro-economic impact of the fiscal and monetary policies will be examined in detail in Section 3.
(2) Characteristics of the latest bottoming out of the economy
Comparison with the previous recovery phases: Expected growth rate drops further
   If the economy picks up from the bottom, it will become the third recovery phase since the early 1990s. The two previous recovery phases shifted to recession phases without achieving strong recovery led by private demand due to the slowdown of the world economy and financial system unrest. In order to survey the strength of recovery, we would like to review the characteristics of the current phase by comparison with the two previous recovery phases.
   As we have seen earlier, the latest recession and the bottoming out thereafter can largely be attributed to a slowdown of the world economy and its subsequent recovery. Consequently, the margin of fluctuation in production, etc. this time was larger than in the previous two recovery phases. Comparison of exports, production, and operating ratios (See Figure 1-1-3) based on the assumption that the latest bottoming out of the economy took place in the January-March quarter of 2002 shows that its characteristic is that the slump to the trough and the subsequent rebound were significant.
   Next, let' s take a look at trends of private demand (See Figure 1-1-4). During the recession phase of the current business cycle, business investment continued to decrease at the same pace as in the previous phases. During the recovery phase since the autumn of 1993, business investment remained on a downward trend for some time due to deeper adjustment of capital stock after the collapse of the bubble economy. Business investment began to increase clearly from FY1995. Subsequently, business investment posted a relatively high growth rate until 1997 thanks to the spread of mobile phones and personal computers. It began to decrease again, however, in the beginning of 1998, reflecting the Asian crisis and financial system unrest. In the next recovery phase that started in the beginning of 1999, business investment recovered relatively fast and IT-related investment began to increase, as stock adjustment pressure was smaller than at the time immediately after the collapse of the bubble economy. However, business investment lacked momentum as compared with investment during the 1995-1997 recovery phase and decreased sharply in FY2001, affected by the falls in exports and production caused by economic slowdown in the United States and some other countries.
Figure 1-1-3 Comparison of Business Aspects (1)
Figure 1-1-4 Comparison of Business Aspects (2)
Figure 1-1-5 Comparison of Business Aspects (3)
   Meanwhile, individual consumption during the latest recession phase posted a solid quarter-to-quarter increase as it did during the first recession phase. This compares with the consumption decline during the last (second) recession phase that was triggered by consumers' growing unease against the background of financial system unrest. However, the level of consumption remains depressed, as consumer concern about the future, which began to heighten in the autumn of 1997 has not been dispelled to any great extent.
   The above are movements of the real economy. Lastly, let' s compare how economic entities see their future (See Figure 1-1-5). Business sentiment and consumer confidence, as measured by the business sentiment D.I. and the consumer behavior index, though still remaining at a low level, have improved to the same levels as in the two previous phases. On the other hand, corporations' expected growth rate has dropped further. This shows that although corporate and consumer sentiment has bottomed out, corporations and consumers still maintain a slightly more cautious or pessimistic view of the strength of economic recovery(6)
   What is characteristic of the current bottoming out of the economy is that industrial production has picked up from the fast and sharp decline against the background of increased exports. At the same time, however, it also suggests that economic recovery in the future will lack strength, as the expected growth rate has dropped further from past levels. Based on these characteristics, the trends and future outlooks of each economic entity will be analyzed in detail in Section 2.

2. Current State of Deflation

   Deflation continued to progress along with the movement of the bottoming out of the economy this time around. Since the GDP deflator has been on a downward trend from the second half of the 1990s, if the economy keeps picking up, the current phase of the business cycle will become the third recovery phase under deflation. Deflation has adverse effects on the economy. Here, we would like to review the current state of deflation and its impact on the macro-economy as the basis for study in the next section and after.
(1) General price deflation
   The trend of goods and service prices shows that the deflation is still continuing in that prices are continuously declining. Let' s examine it by using three indicators (Domestic wholesale prices, Consumer prices, and the GDP deflator) (See Figure 1-1-6).
Figure 1-1-6 Trend of General Prices
Movements of Domestic wholesale prices and Consumer prices are slightly different
   First, let' s take a look at the year-to-year changes of Domestic wholesale prices. It is evident that Domestic wholesale prices were on a downward trend between 1992 and 1999, except for the period when the impact of the increase in the consumption tax was observed. In 2000, Domestic wholesale prices rose temporarily over their year earlier level due to the impact of higher import prices caused mainly by a hike in crude oil prices. However, Domestic wholesale prices widened their margin of decline in 2001, reflecting an aggravation of the demand-supply balance. As a result, on a yearly basis, Domestic wholesale prices dropped 1.1% in FY2001, after falling 0.1% in FY2000. In the beginning of 2002, however, Domestic wholesale prices narrowed their margin of decline due partly to the yen' s depreciation and partly to an improvement in the demand-supply balance, and have been moving sideways on a month-to-month basis.
   Next, let' s take a look at year-to-year changes of Consumer prices (General, excluding fresh food). Although Consumer prices showed temporary declines(7) after 1995, the decline has become consistent since the autumn of 1999(8). Even when Domestic wholesale prices rose in 2000, Consumer prices kept declining. On a fiscal year basis, Consumer prices fell 0.4% in FY2000 and 0.8% in FY2001. They remain declining slightly in FY2002.
   The movements of Domestic wholesale prices and Consumer prices differ because of the following reasons. Domestic wholesale prices are sensitive to changes in import prices and supply-demand balance (See Figure 1-1-7)(9). On the other hand, Consumer prices, though influenced by Domestic wholesale prices, reflect competitive pressure at the retail stage and therefore even the same "Consumption goods" show a different movement from their Domestic wholesale prices. In particular, the recent increase in import penetration has become a major downward factor on Consumer prices (10) (See Figure 1-1-8).
Figure 1-1-7 Factors behind Changes in Domestic Wholesale Prices
Figure 1-1-8 Import Penetration and Price Changes
GDP deflator remains on a downward trend
   Domestic wholesale prices and Consumer prices come under the direct influence of import price fluctuations. Therefore, in order to understand underlying domestic price trends, it is important to see values added that exclude the direct influence of the fluctuations of import prices. In this sense, the GDP deflator is an important indicator.
   The GDP deflator can be obtained from the ratios of Nominal GDP and Real GDP. Nominal GDP is the aggregate of value added produced and mainly consists of nominal wage and nominal profit. On the other hand, Real GDP is an aggregate of real value added produced. In this sense, it can be said that the GDP deflator is an indicator that shows the trends of unit labor costs and unit profits. A decline of the GDP deflator indicates that prices are declining due to domestic factors that are different from exogenous factors like import prices. The GDP deflator is an indicator for judging whether deflation is home-made or not(11).
   A study of year-to-year changes of the GDP deflator shows that it has been on a downward trend since FY1994, except for the period during which the deflator was affected by the consumption tax hike. The GDP deflator fell 1.9% in FY2000 and 0.9% in FY2001. This means that the contribution of domestic factors to the deflation was large.
Factors behind the general price deflation
   The factors behind the deflation, such as those mentioned above, were analyzed in last year' s edition of the "Annual Report on Japan' s Economy and Public Finance." Specifically, they are (i) "Supply-side structural factors" such as the increase in low-priced imports, IT and other technological innovation, and the distribution revolution, (ii) "Demand factors" caused by the lack of strength of the economy, and (iii) "Financial factors" caused by disintermediation of bank-system lending.
   Since these factors are not likely to be resolved at an early date, general price deflation is likely to continue for some time to come.
(2) Asset price deflation
   Deflation is advancing not only in goods and service prices but also in asset prices, such as land and stock prices. According to Published Land Prices by Ministry of Land, Infrastructure and Transport, posted land prices across the country have been continuing their decline after hitting a peak in 1991. Stock prices have also been weak, with the TOPIX in 2002 standing at about 30-40% at the end of 1989. We would now like to review the present state of the land and stock price deflation and its background.
Factors behind land price decline
   Land prices, which posted a rapid rise in the second half of the 1980s, have been continuing their decline since 1991. A study of the ratio of land assets in the National Accounts to GDP shows that land prices have kept declining for more than 10 years since hitting a peak in 1990, or shortly after the 'burst' of the economic bubble. At present, the ratio of land prices to GDP to all is at the same level as in the first half of the 1980s.
   The question is why land prices are falling. Let' s study land price trends by using the earnings discount model. Under the earnings discount model, land prices can be explained by (i) profits currently produced by land and its future prospects, (ii) changes in the rate of returns on risk-free assets (interest rate trends), and (iii) the anticipated rate of return on land investment exceeding the rate of return on risk-free assets(12). Here, we use office rentals as profits produced by land for the current term, the anticipated growth rate of the real estate industry as the anticipated growth rate of profits, and the nominal long-term interest rate (10-year government bonds) as returns on risk-free assets (See Attached Note 1-3). As to risk premiums, we used two different cases: one that assumes that risk premiums will remain constant, and the other that calculates risk premiums by working backward to make theoretical land prices agree with real land prices.
   Let' s take a look at the movement of each indicator. Current-term profits have been a factor behind the decline of land prices since the burst of the economic bubble. Office rentals across Japan have turned downward after hitting a peak in 1991. Though they moved sideways in 1997, office rentals continued their decline until 2001(13). Office rentals in Tokyo had also continued to decline until 2001(14). As to the vacancy rate that affects rental trends (a rise in the vacancy rate indicates drop in rentals), the rate in Tokyo' s 23 wards, though lower than in other urban cities, has continued to rise for five consecutive quarters since the April-June quarter of 2001. The vacancy rates in other big cities have also been on an upward trend.
   The anticipated growth rate of profits has also been contributing to the decline in land prices. The anticipated growth rate of the real estate industry ( "Questionnaire Concerning Corporate Activities" Cabinet Office) turned downward after hitting a peak in 1989 and dropped sharply in 1993 and 1994. Though it picked up slightly in 1999, the rate turned downward again in 2000.
   The interest rate is a factor that raises land prices. The nominal long-term interest rates (10-year government bond) continued to decline from 1980 to 1987, then turned upward before declining again after hitting a peak in 1991. Since then, the interest rates have remained on a downward trend.
   The theoretical land price, which is calculated on the basis of the above land-price determining factors and on the assumption that risk premiums remain constant, shows almost the same movement as real land prices. However, the margin of fluctuation of the theoretical land price is smaller than that of real land prices and the rate of its rise during the bubble economy and the rate of its decline thereafter were both smaller than those of real land prices. The risk premium, which is calculated by working backward to make theoretical land prices agree with real land prices, shows a sharp rise after the burst of the economic bubble.
   The results of the above estimation can be interpreted as follows: Due to greater uncertainties and higher risk aversion after the collapse of the bubble economy, the risk premiums demanded by investors may have been rising.
   However, since the risk premium calculated by working backward shows a sharp rise even compared with the time before the economic bubble, the decline in land prices cannot simply be explained by a rise in the anticipated profit rate demanded by investors. Among the reasons why it cannot be explained by factors based on only the earnings discount model are the drastic changes of the environments surrounding the land market. Until the economic bubble, the "myth of ever-higher land prices" remained strong and the risk of land holding was considered low. Recently, the emphasis has shifted from "ownership to utility value." Previously, land prices were determined based on the transaction prices of neighboring land. Recently, the emphasis has increasing shifted to the convenience and profitability of land. Moreover, a land liquidation market has been established(15). As a result, it can be said that the prices of land with low convenience and low profitability have declined and that this in turn has pulled down the average price of land(16).
   Moreover, supply-side factors, such as land disposal through corporate restructuring and liquidation of non-performing loans after the burst of the economic bubble, may be putting downward pressure on land prices(17). However, since such supply pressures mean that the reallocation of land to economic entities that can enhance the utility value of the land has been making progress, it can be seen as a move to enhance the productivity of land. This will lead in the medium and long run to the enhancement of the productivity and profitability of land. Therefore, once the supply pressures have run their course, they will have a favorable impact on land prices.
Region-by-region characteristics of land-price decline
   That land prices are increasingly determined by their profitability can also be observed from region-by-region land price tends.
   A year-to-year comparison of the characteristics of region-by-region land price (commercial land) trends (See Figure 1-1-9) shows that while the margin of decline in land prices has narrowed in the Tokyo area, it has widened in the Osaka area and local areas. In the central part of Tokyo, the higher a location' s land price is, the smaller the margin of its land price decline, and the land prices in some areas there are rising. On the other hand, in most of the central parts of prefectures, the higher a location' s land price is, the larger the margin of its land price decline.
   The difference in land price trend by region or location reflects the difference in the profitability of land. In Tokyo, for example, where the margin of land price decline is narrowing, the vacancy rate that shows the strength of demand for office buildings is remaining at a low level, as most of such buildings are located in central Tokyo and as demand for high-quality large office buildings remains strong. This indicates that the profitability of office buildings has been increasing (See Figure 1-1-10). According to "Annual Report on Civil, Litigation, and Human Rights Statistics" of the Ministry of Justice, although the number of land transactions has been on the decrease nationally, it is increasing sharply in Tokyo. On the other hand, in big cities other than Tokyo, demand for office buildings remains sluggish, reflecting corporations' relocation of their head offices and restructuring. The higher the rate of a vacant room is, the larger the decline of such city' s land price tends to be. In local cities, such as prefectural capitals, the rate of land price decline is larger in central parts of the cities where land prices are high. This may be because the urban shopping areas of such cities have hollowed out due to the establishment of large-scale retail stores in suburban areas and corporations' move to abolish or merge their branch offices.
   As seen in the above, while the prices of commercial land have been declining on average, the move to determine land price in accordance with the profitability of the land has been gradually gaining momentum.
Figure 1-1-9 Recent Land Price Trends (Commercial land)
Figure 1-1-10 Changes of Vacancy Rate
Factors behind stock price decline
   After the bubble burst, stock prices followed on a downward trend, accompanied by occasional upward fluctuations. In February 2002, stock prices, as measured by TOPIX hit a low of 922 points, the lowest level since February 1985, or before the collapse of the bubble economy.
   As in the case of land prices, the factors behind the decline of stock prices appear to be sluggish corporate earnings and their low growth prospects. Corporate earnings, which will be examined in detail in Section 2, have remained sluggish since the collapse of the bubble economy and net profits plunged into the red in FY2001. The expected growth rate has also been on a downward trend, according to Cabinet Office' s "Questionnaire Concerning Corporate Activities." On the other hand, declines in nominal long-term interest rate (10-year government bond) have worked to prop up stock prices.
   Another factor behind the decline of stock prices is a rise in credit risk, such as corporate bankruptcy. A study of stock price movement by industry shows that although electrical machinery and transport equipment staged a comeback after the collapse of the bubble economy, stocks of such industries as real estate, construction, and banking, have fallen to less than half of their levels in the early stage of the bubble economy. This difference basically reflects the disparity in profitability among the industries. But as for those industries and corporations whose stock prices fell extremely, it can be said that their declines also reflect a rise in credit risk.
   As to stock price movements in and after the second half of the 1990s, it is necessary to examine the impact of stock sales by financial institutions in connection with their unwinding of cross shareholdings. In fact, a study of the relationship between the stock price decline of a corporation and stock sales by financial institutions shows that they are positively correlated (See Appended Note 1-4).
   Even if a financial institution sold its stock in a corporation to unwind its cross shareholdings, it should not have any impact on the price of the stock, since it only means a shift of the holder of the stock from the financial institution to others and does not cause any change in the value of the corporation. Nevertheless, there is a positive correlation between the stock price decline of corporations and stock sales by financial institutions. Several reasons can be cited for this.
   First, it may be that a financial institution sells the stock of a company around the same time as when the market evaluation of the company declines. Moreover, massive sales of the stock of a corporation may tip the supply-demand balance of the corporation' s stock.
   Moreover, a corporation' s cross shareholdings with a financial institution may have affected the market value of the corporation. In other words, a corporation and a financial institution may have promoted their cross shareholdings in the belief that it is beneficial for both of them in terms of business relations and stabilizing business management, and thus enhanced the market value of the corporation as expressed by its stock price(18). Furthermore, there was a strong view in the market that the financial institution, in particular the main bank, would not let a corporation with which it has dealings go bankrupt. However, financial institutions began to review their cross shareholdings in and after the second half of the 1990s, as it became necessary for them to sell their shareholdings due to a rise in the costs and risk of holding shares against the background of the needs to dispose of non-performing loans, a decline in their business strength, and introduction of market-value accounting(19). Moreover, following a series of bankruptcies of big corporations, the market view that main banks would not let their important corporate customers go bankrupt has receded. Consequently, it appears likely that the stocks whose ratio of shareholdings by financial institutions is higher dropped more steeply.
   Since banks are mandated to limit their stockholdings within the equity of them, they are expected to continue to release their stockholdings on the market and this in turn is likely to put downward pressures on stock prices(20). In order to help banks reduce their stockholdings, Banks' Shareholdings Purchase Corporation was established in 2002. Under the scheme, banks can sell stocks to the corporation, if they desire to do so. It is hoped that impact of banks' stock sales on the stock market will be limited to a minimum(21). In September 2002, the Bank of Japan announced that it would study purchasing stocks held by financial institutions in order to stabilize the financial system.
Huge amounts of capital loss caused by asset price deflation
   From a macro-economic view, let' s consider the size of the impact of the asset price deflation, by taking a look at the National Accounts.
   Since the burst of the economic bubble in 1990, combined capital losses on stocks and land in Japan have amounted as a whole to 1,158 trillion yen (See Figure 1-1-11). Losses on land amount to 734 trillion yen and those on stocks to 424 trillion yen. The cumulative total is about this much, as land has consistently produced capital losses since 1991, while stocks had upward phases(22).
Figure 1-1-11 The Capital Loss of Land and Shares
   By economic entity, the sector that has the largest capital losses is households at 437 trillion yen, with most of the losses accounted for by land(23). Non-financial corporations have the second largest capital losses at 357 trillion yen, with most of the losses also accounted for by land. Financial corporations have capital losses of 231 trillion yen. It is believed that financial corporations are plagued not only with the direct impact of the capital losses but also with the indirect impact of an increase in non-performing loans.
   If we limit capital losses to those in 2000, the losses on stocks came to 105 trillion yen and those on land to 81 trillion yen. Households had large capital losses, while corporations and financial corporations s had large capital losses on stocks in that year. As both land prices and stock prices have been declining sharply since 2001, capital losses are estimated to have increased further.
   Let' s study what impact the huge amount of capital losses had on the real economy.
Deflation restrains the real economy
   Deflation has adverse effects on the real economy in various ways. Last year' s "Annual Report on Japan' s Economy and Public Finance" made an analysis on the impacts of the goods and service price deflation on the real economy. The conclusion of the analysis can be summarized as follows.
   First, deflation increases the real debt of corporations. Therefore, it restrains new business investment.
   Second, in the case where prices decline but nominal interest rates and nominal wages do not decline as much, the real interest rates and real wages will increase, depressing corporate profits and restraining business investment.
   Consequently, the question is what impact the asset price deflation has on the real economy. The asset price deflation affects the real economy in the following two ways: (i) by deteriorating balance sheets, as the value on the liability side is fixed, while the value on asset side decreases and (ii) by making it difficult to raise funds, as the value of collateral decreases and stock prices decline.
   As to the deterioration of balance sheets, economic entities try to improve their balance sheets by reducing the debts. In the case of corporations, for example, they will use their cash flow not for forward-looking expenditure, such as business investment, but for repaying debts. In the case of households, if real assets erode, it will restrain household expenditure and instead increase savings, causing potential postponement of replacement house purchase. Even if households do not have debts, a decline in the value of assets caused by stock price declines, etc. would produce a negative wealth effect and restrain consumption. Accordingly, the deterioration of balance sheets puts downward pressures on the real economy.
   As to the decrease in the value of collateral, corporations may be asked to put up additional collateral for existing loans. This also puts downward pressure on the real economy. If the corporations become unable to repay loans from banks, the banks' non-performing loans will increase and the banks' financial intermediary function will decline. If unrealized capital gains decrease due to asset price deflation, funds for the disposal of non-performing loans will decrease. Moreover, if stock prices decline, it will make corporate financing difficult.
   Due to the above reasons, the asset price deflation restrains the real economy by adversely affecting business investment and individual consumption and by increasing the non-performing loans of financial institutions through deterioration of balance sheets and increased difficulty in corporate financing. At the same time, the weakness of the real economy causes general price and asset price deflations.
   Under the strong downward pressures, each economic entity--corporations, banks, households--were forced to take difficult measures. In the next section, the activities of each economic entity will be examined in detail.

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