Economy and Public Finance
- No Gains without Reforms II -
Government of Japan
Overview of the Capacity for Economic Recovery
Section 4 Future of the Economy
The Japanese economy gradually reduced the pace of its
deterioration and bottomed out in early 2002, with some sectors showing
signs of improvement. As outlined in Section 1, the factors behind the
bottoming out of the economy were an improvement in the economic environment
of the United States and other countries and inventory adjustment progress
in Japan. Section 2 examined the activities of each economic entity--corporations,
banks, and households--under deflation and revealed that structural downward
pressures, such as excess liabilities and the problem of non-performing
loans, were still in place and that deflation and the sluggish real economy
were interacting with each other. Section 3 analyzed the trends of fiscal
and monetary policies taken under such circumstances.
In light of the above analyses, the following points are important when forecasting the future of the Japanese economy.
(i) The sustainability of the increase in exports and its strength
(ii) The timing of business investment recovery and its strength
(iii) The question of whether or not consumption will begin to pick up
(iv) The macro-economic impact of fiscal and monetary policies
(v) The question of whether or not deflation can be dissolved
In this section, the future of the Japanese economy will be addressed focusing on the above points(90).
As will be described in detail below, the expected scenario for the future course of the economy is that due to the influence of export growth and the upturn in production, corporate earnings and the employment/income environment will gradually improve, further spilling over to turn around private demand, and the economy will slowly recover. However, since adjustment pressures on the corporate sector, etc. are strong, it will be difficult for the effect to spread to private demand and therefore the economy will have a weak recovery capacity for a while. The economy is fragile, particularly to external shocks. Therefore, we need to keep a close watch on changes in the external environment.
The basic scenario presupposes that the United States and other economies will continue to make a slow recovery. However, stock prices in the United States began to fall at the beginning of FY2002, with the NASDAQ Composite Index and the Dow Jones Industrial Average in July falling below the low recorded after the Sept. 11 terrorist attacks. The plunge spread to Asia and Europe, triggering a worldwide fall in stock prices(91). The dollar also plunged, creating unrest in financial markets worldwide. Since the Japanese economy is largely export dependant, if the United States and other economies become sluggish and the yen appreciates sharply, Japan' s exports and the earnings of export companies are likely to be subject to downward pressure and the possibility that Japan' s economic recovery led by the corporate sector will stall cannot be ruled out.
1. The Sustainability of the Increase in Exports and Its Strength
Exports stopped declining and began to increase at the
beginning of 2002 and posted a sharp increase in the middle of the year.
As was described in Section 1, the increase in exports that was brought
about by the recovery of the U.S. and Asian economies was one of the main
factors behind this particular bottoming out of the economy. Therefore,
ascertaining whether the export increase is sustainable or not is one of
the important points when forecasting the future course of the domestic
In this light, it is important to assess the sustainability and strength of the U.S. economic recovery. This is because, as was described in Section 1, the recovery of the U.S. economy played a major role in the recovery of the Asian economy that lies behind the increase in Japanese exports starting at the beginning of 2002.
As we have seen in Section 1, the United States re-attained a high economic growth rate from the October-December quarter to the January-March quarter of 2002 due to progress in inventory adjustment and steady private consumption. However, the economic growth rate slackened in the April-June quarter of 2002.
A standard scenario for the U.S. economy in and after the second half of 2002 would be that, while the contribution of inventory investment is expected to decrease, private consumption will remain firm and business investment will recover gradually, putting the economy on a sustainable recovery track. If the recovery of the U.S. economy is sustainable, it will have a positive impact on the Asian economy and exports from Japan will continue to increase. However, the pace of recovery is likely to be moderate for a while, as the contribution of inventory investment is expected to decrease and corporate and consumer sentiment, as will be described later, has weakened. In this case, as for current exports from Japan, the growth rate will be smaller than that of the first half of 2002 as a result of the sharp recovery of inventory investment.
In order to confirm the above points, an analysis of the prospects of U.S. consumption and business investment, that are important in predicting the sustainability of the recovery of the U.S. economy, follows below.
Consumption outlook in the United States
In FY2001, although employment adjustment and a rise in the unemployment rate dragged down income, the solid performance of the household sector that was supported by tax cuts and lower interest rates (refinancing of housing loans) propped up the U.S. economy.
Although the additional effects of fiscal and monetary policies are expected to decrease gradually, a recovery in business investment, which will be brought about by an improvement in corporate earnings, is expected to lead the economy. This, in turn, is expected to improve the employment/income environment and shore up consumption.
Outlook for business investment in the United States
Business investment in the United States decreased for seven consecutive quarters from the October-December quarter of 2000 to the April-June quarter of 2002. However, the magnitude of decline has been shrinking drastically, with machinery equipment and software investment beginning to increase. Industrial production/Operating ratio and corporate earnings have seen a moderate upward trend since the beginning of 2002 (See Figure 1-4-1) and business investment is expected to begin a moderate recovery in the middle of 2002.
Figure 1-4-1 Business Investment, Corporate Profits, and Operating Ratio in the U.S.
The basic scenario presupposes that U.S. consumption will continue to grow steadily and that business investment will also recover. However there are causes for concern, the most prominent being the sharp decline in stock prices since the beginning of FY2002. As was described earlier, one of the factors behind the sharp decline in stock prices despite the fact that the real economy has been in a recovery phase is distrust in corporate accounting systems in connection with the collapse of Enron and others(92). A decline in stock prices may lead to adverse effects on household spending, corporate fund raising and business investment, as it aggravates consumer and business sentiment and produces a negative wealth effect(93).
There are also concerns that greater uncertainties about the future course of the U.S. economy might destabilize the exchange market. In fact, the dollar depreciated sharply from the beginning of FY2002 to early summer, triggered by a rise in uncertainties about the profitability of dollar assets caused by wider uncertainties over the future course of the U.S. economy in the wake of current account deficit expansion and the decline in stock prices. In the meantime, U.S. long-term interest rates have declined, narrowing the interest rate difference between Japan and the United States.
If these concerns become more pronounced, the mild recovery of the U.S. economy will come to a halt. In addition, if the dollar' s depreciation and the yen' s appreciation progress as a result, it will put downward pressures on exports and corporate earnings and the negative impact on the Japanese economy will increase. If we cannot expect an increase in exports, the main scenario for Japanese economic recovery will fall apart, as it presupposes that an increase in exports will raise industrial production/operating ratio, leading to a recovery of business investment.
2. Outlook for the Corporate Sector
Production stopped decreasing and began to pick up against
the background of an increase in exports and a completion of inventory
adjustment. As for its outlook, if export production continues to increase,
albeit at a slower pace, as was explained earlier, production as a whole
will continue to pick up at a slower pace, as an increase in corporate
earnings, which will be explained later, is expected to have spill-over
effects on private demand, such as business investment.
According to the Ministry of Finance' s "Financial Statements Statistics of Corporations by Industry, Quarterly," corporate earnings, especially in the manufacturing industry, which posted a sharp decrease in the second half of 2001, narrowed the margin of decline and stopped decreasing in the first half of 2002. As we have seen in Section 2, an analysis of earnings factors show that a decrease in unit sales, especially in the manufacturing industry, had a major negative contribution. With production beginning to pick up, however, the unit sales factor is expected to have a positive contribution. Moreover, as a result of fixed expense cutbacks, such as personnel costs, corporations' capacity to earn profits even when sales do not markedly increase, has been enhanced. According to the Bank of Japan' s "Short-Term Economic Survey of All Enterprises in Japan" (Tankan; September 2002 survey), the corporations surveyed forecast that their ordinary profits (on a year-to-year basis) would post a sharp increase in the second half of FY2002 after decreasing slightly in the first half. Moreover, they expect that extraordinary loss cutbacks as a result of restructuring progress will have a positive impact on their net profits(94). However, if the weaker dollar/stronger yen trend that was seen at the beginning of FY2002 intensifies, it would put downward pressures on corporate earnings, especially of manufacturers, in the second half of the fiscal year.
Corporate sentiment is also improving. According to Tankan' s diffusion index (D.I.) for business conditions, the number of corporations reporting unfavorable business conditions stopped increasing, especially among big enterprises, in the March survey, after increasing sharply, especially among manufacturing enterprises, in 2001. Business sentiment began to improve in all enterprises in the June survey and continued to show improvement, albeit slightly, in the September survey. As to the outlook for business conditions, many corporations expect a slight improvement. However, if the stock and foreign exchange markets continue their unstable movement, it would put downward pressures on corporate sentiment.
Reflecting improvements in production, corporate earnings, and business sentiment, it is expected that business investment, especially in the manufacturing industry, will begin to pick up in the second half of FY2002. Already, shipment of capital goods, which is a supply-side indicator of machinery equipment investment, stopped decreasing. Private machinery orders (excluding ships and electric power generating equipment), a leading indicator of corporate capital spending about two quarters ahead, posted a slight increase in the April-June quarter of 2002 (See Figure 1-4-2) after decreasing slightly in the preceding quarter. In particular, machinery orders placed by manufacturing enterprises appear to have stopped their trend of decline, as they posted slight increases in the January-March and April-June quarters of 2002. Business investment posted a sharp decline in the second half of FY2001. Therefore, business investment will decrease on a yearly basis in FY2002, even if machinery orders stop declining in the first half of FY2002 and pick up slightly in the second half on a quarter-to-quarter basis. In fact, BOJ Tankan (September 2002 survey) shows that business investment planned for FY2002 is smaller than that for the previous year.
Figure 1-4-2 Changes of Machinery Orders
The capacity for business investment recovery will be weak for a while because the expected growth rate is stagnant, and the adjustment of excessive debt as well as asset price deflation will serve as downward pressures, especially for the non-manufacturing industry and small and medium-sized enterprises. In the manufacturing industry, the transfer of production facilities abroad is expected to continue.
3. Outlook for the Household Sector
Private consumption and housing investment have been for
the most part flat. The employment/income environment has begun to show
signs of improvement in some areas since the beginning of 2002, as can
be seen from the increases in overtime work hours and job offers, a stop
of the decline of the number of employees, and an improvement in consumer
confidence. However, the spillover effect on the household sector of the
pickup in the corporate sector led by the manufacturing industries, (i.e.,
pickup in the exports and production,) is likely to be limited, not to
mention the uncertainty of the US economy. Private consumption and housing
investment are likely to recover extremely slowly, if at all, since the
reduction of regular workers is expected to compression and wages are expected
to decrease for the background of corporations' persistent efforts to cut
costs, as will be described below.
Wages have been decreasing. However, the decline is expected to slow as the corporate sector recovers. Non-scheduled cash earnings are expected to increase as production recovers. And if the upturn in corporate profits is confirmed, special cash earnings (bonus, etc.) are likely to decrease at a slower pace and would eventually begin to increase.
However, as was outlined in Section 2, an increase in part-time workers is restraining total cash earnings. Corporations are keen to curb scheduled cash earnings. Therefore, the wage recovery is likely to be slow.
Next, let' s take a look at the employment situation, as was described in Section 2, the number of employees decreased in 2001 due to strong employment adjustment in the manufacturing industry (especially large enterprises). The overtime work increases in the manufacturing industry and new job offers increase at the beginning of 2002, while production began to pick up. Although the number of employees in the manufacturing industry is not likely to increase for some time to come, we can expect the decrease to slow or come to a halt. On the other hand, the number of employees in the service industry continued to increase steadily despite a recession phase of the business cycle. The number of employees increased in industries serving business establishments and in those related to medical service/social welfare. With job offers in the service industry remaining steady, the industry is likely to continue to increase the number of employees. Since employment adjustment pressure in the manufacturing industry, which reduced the number of employees drastically in the latest round of recession, is expected to weaken and job offers in the service industry are expected to remain steady, the employee numbers are likely to begin picking up slightly. However, the growth in the number of employees in the non-manufacturing industries as a whole, including the service industry, may slow down in view of the fact that while manufacturers' sense of excess employment has improved relatively quickly, non-manufacturers' sense of excess employment has not improved much.
With the unemployment rate staying at a high level, the severe employment situation is likely to continue for a while due to the fact that: corporations are keen on reducing their numbers of regular workers and are likely to mainly increase their numbers of non-regular workers, such as part-timers; the effect of the second supplementary budget on the construction industry is expected to wane in the middle of the year; and that the number of bankrupt companies is likely to remain at a high level. Financial institutions are expected to step up the final disposal of non-performing loans as the amount increased further in FY2001. Since the disposal of non-performing loans, even if it does not result in bankrupt companies, is expected to intensify the move to cut jobs, it will put downward pressure on employment in the short term.
With wage restraint continuing and employment improvement expected to remain limited, the employment/income environment will continue to be severe and its improvement, if any, would be slow. In this environment, consumer confidence is likely to improve only slightly. Private consumption is expected to remain flat or improve extremely slowly, if at all.
With regard to housing investment, we can expect an increase in demand for rental houses from the number of households and second-generation baby boomers. As described in Section 2, the adjustment pressure on housing stock is believed to have weakened, as housing starts have remained sluggish. Moreover, housing acquisition capability is at a high level thanks to low interest rates. However, in view of the fact that the employment/income environment continues to be severe and that second home buyers remains difficult due to the continuing downward trend of real estate prices, a recovery in housing investment, if any, will be highly likely to remain at a low level.
4. Outlook for Government Spending
As discussed in Section 3, the consumption expenditure of the government is increasing due to a rise in expenditure pertaining to social security, while public investment is being slashed.
Public investment posted a year-to-year decrease in FY2000 and FY2001 (Year-to-year comparison in real terms: minus 7.4% in FY2000, minus 6.6% in FY2001). This is mainly because local governments slashed investment expenses to cope with severe fiscal conditions. A study of the recent trends of local public financial program and their actual public investment (See Figure 1-4-3) shows that public projects implemented with central government subsidies exceeded the plans due to the compilation of a supplementary budget by the central government, but projects to be undertaken by local governments on their own funding fell below the plans.
Although most of the national government' s second supplementary budget for FY2001 is to be implemented in the first half of FY2002, the initial national budget for FY2002 slashed public investment-related expenses, including facility expenses, by 10.7% from the previous year. Local governments also slashed FY2002 investment expenses for projects to be conducted under their own funding by 10.0%. Accordingly, public investment on the whole is expected to remain sluggish.
Figure 1-4-3 Changes of Public Investment
The "Structural Reform and Medium-Term Economic and Fiscal Perspectives" that was decided by the Cabinet in January 2002 (so-called "Reform and Perspectives" ) stipulates the government' s basic policy of "striving during the target period, the goal will be to hold the size of government (the ratio of general government expenditure to GDP) at or below its present level." It also details the government' s policy of restraining expenditure on main items, such as public investment. Based on the policy, the Cabinet adopted the "Basic Policies for Economic and Fiscal Policy Management and Structural Reform 2002" (so-called "Basic Policies Stage 2" ) in June 2002. Subsequently, the Council on Economic and Fiscal Policy prepared an "overall picture of the FY2003 budget" and the Cabinet approved "guidelines for budget appropriation request" for FY2003, which is in line with the "Basic Policies Stage 2" . Under the basic policy of keeping the size of FY2003 general expenditures and the FY2003 general account below the levels in FY2002, the guidelines are: (i) divide general expenditures into "public investment-related expenditures," "discretionary spending," and "mandatory spending" and (ii) reduce "public investment-related expenditures" and "discretionary spending" but accept requests for a budget increase of up to 20% in order to encourage government ministries and agencies to draw up new policy measures(95).
Curbing overall expenditure, however, will not lead to a dramatic decrease in overall fiscal spending, as social security expenditures are expected to inevitably increase due to the aging of the society. Moreover, as described in the "Basic Policies Stage 2," the reduction of public investment can have a negative short-term impact on the economy. Therefore, it is essential to promote the "improvement of the quality of expenditures" and structural reform in order to ease short-term negative impacts and increase medium- and long-term growth potential of the economy.
5. Outlook for General Prices/Asset Prices
General price deflation is very likely to continue for a while. Therefore, the government and the Bank of Japan must work together to continue taking measures to overcome the deflation.
As was discussed in Section 1, the yen' s depreciation and an improvement in the supply-demand balance eased deflationary pressure. As a result, import prices rose and domestic wholesale prices moved sideways. However, since the yen began to appreciate against the dollar in the beginning of FY2002, domestic wholesale prices are likely to drop again affected by a fall in import prices. Since the potential for recovery in demand is considerably weak, the supply-demand gap remains wide. Moreover, bank lending and money supply are not likely to increase sufficiently due to corporations' excessive debts and the disintermediation of bank-system lending. Accordingly, consumer prices and the GDP deflator are likely to continue their downward trend.
With regard to land prices, a large supply of office buildings in central Tokyo, which is expected in 2003, is likely to raise occupancy rates and lower average office rent. Land supply pressure in connection with the disposal of non-performing loans is also strong. On the other hand, the promotion of urban renewal and other structural reforms is likely to increase effective utilization of land. In any case, the difference in land prices by location/building is likely to widen depending on the land' s convenience and profitability.
As for stock prices, corporate earnings improvement is likely to have a favorable effect. On the other hand, downward pressure from the sale of stock holdings by financial institutions is likely to continue. If uncertainties about the global economy, including the movement of U.S. stock prices, increase, they will put downward pressures on domestic stock prices.
With regard to asset prices, such as land and stock prices, it is important to improve their profitability and enhance their medium and long-term growth potential by promoting structural reform. We need to keep a close watch on the sluggish movement of asset prices as it deteriorates the balance sheets of corporations and financial institutions and puts downward pressure on the economy.
Since general price deflation is very likely to continue for a while, the quantitative easing is expected to be continued(96).
As can be determined from the above analysis, the current situation of the Japanese economy is that production has picked up due to an increase in exports and the end of inventory adjustment and its effect is about to spread to corporate profits and the improvement of the employment/income environment. If it goes smoothly, the economy is expected to move towards an incipient recovery. However, since adjustment pressure on corporations is strong, it is likely to be difficult for the effect to spread. If the strength of recovery is fragile, the scenario is likely to fall apart due to external shocks. The possibility that Japan' s economic recovery will stall cannot be ruled out if the U.S. economy turns sluggish. For both Japan and the United States, the timing of the recovery of business investment and its strength are key points.
In order to link the cyclical recovery to a robust recovery, it is necessary to promote structural reform and revitalize the economy. The government considers FY2002~2003 as an intensive adjustment period to promote structural reform, such as the disposal of non-performing loans, in earnest. Promoting structural reform during the intensive adjustment period has two aspects: bringing about a deflationary pressure in the short term and enhancing the anticipated growth rate in the medium and long terms. If corporate and household sentiment is enhanced in the meantime, however, it will have a positive effect in overcoming the deflation in the short term.