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 3

   Issues for Vitalizing Japan' s Economy

Section 1 Construing Concern over "Hollowing Out of Industry"

   Concern over the hollowing out of industry has recently been growing in Japan. Behind this concern, people have perceived that Japan' s manufacturing industry might have lost international competitiveness. Specifically, they fear that Japan' s goods and services trade could plunge into deficit as the manufacturing industry shrinks on a rapid increase in imports from China, that jobs could be lost as the manufacturing industry shrinks, and that Japan could lose its base for future economic growth as the manufacturing industry declines after having led the nation' s economic growth.
   In considering the concern in this section, we will analyze changes in trade structure changes in the first part and those in industrial structure the second part. In the third part, we will discuss how to construe the hollowing out of industry. These analyses will reveal that structural changes in the international division of labor have been behind the concern over the hollowing out of industry in Japan. They will also show that Japanese people view such changes as negative because Japan has had structural problems and lagged behind other countries in implementing structural reforms.

1. Structural Changes in Trade

   The concern over the hollowing out of industry includes a fear that Japan' s manufacturing industry may shrink due to the rapid increase in imports from China. We here would like to analyze the controversial fast increase in imports from China and consider how to construe this fact.
   As a matter of fact, imports from China have increased rapidly over the recent years. Increasing imports from China include not only labor-intensive goods but also electric machines that are considered to be knowledge- and technology-intensive goods. When we break down imports from China, however, we find that labor-intensive goods, among them electric machines, have increasingly flowed from China into Japan against the background of the modularization (to be discussed later) and rising direct investment in China by Japanese firms, while on the other hand Japan has been exporting knowledge- and technology-intensive electric machines to China. Therefore, Japan' s trade relations with China have not been special, but have met the principle of comparative advantage just as Japan' s trade relations with other Asian countries.
   But we have to pay attention to China' s rapid economic development and great structural change in the international division of labor. Japan now has to create an economic structure that can promptly respond to such changes meeting the principle of comparative advantage. To this end, Japan should vitalize its economy and promote structural reforms.
Concern over hollowing out of industry--Fast-rising imports from china
   Japan' s recent trade developments indicate that exports continued to grow from the January-March quarter of 1999 then turned down in the latter half of 2000 on the global economic slowdown that stemmed from the collapse of the U.S. information technology bubble (see Figure 3-1-1). Exports have begun to recover in 2002. On the other hand, imports continued increasing as from the April-June quarter of 1998 then began to decline in late 2000 on slowdown of domestic demand. Since early 2002, imports have turned up on domestic production recovery. But import growth has remained moderate.
   Product-by-product and region-by-region breakdowns of Japan' s exports and imports indicate that great structural changes have been going on. Among products, semiconductors and other electronic devices, and personal computers have grown fast, signaling IT-related goods' rising contribution to Japan' s foreign trade(1). IT-related goods' share of Japan' s exports rose 2.8 percentage points from 1990 to 20.8% in 2000, while their share of imports jumped from 5.1% in 1990 to 15.4% in 2000. Among regions, Asia has increased its share of Japan' s foreign trade, especially in IT-related goods. China has rapidly expanded its share of Japan' s exports and imports. In 2001 when Japan' s total exports in value declined 5.2% from the previous year, exports to China alone expanded 14.9%. In the same year when the nation' s total imports in value increased 3.6% from the previous year, Chinese imports jumped to 18.3%. As a result, China' s share of Japan' s exports rose to 7.7% and that of imports to 16.6%. China' s share of Japan' s imports has grown close to the U.S. share, indicating China' s rising presence in Japan' s foreign trade. Behind the recent concern over the hollowing out of industry in Japan may be the rapid increase in imports from China.
Figure 3-1-1 Changes in Japan' s Exports and Imports in Volume
Relationship between import growth and domestic production
   How have rising imports from China affected domestic production? We here use two indicators to consider the influence.
   The first indicator is the import penetration rate that measures imports' share of total domestic supply (domestic output and imports). The import penetration rate of Japan' s mining and manufacturing industries has been rising gradually since the 1980s, coming to 6.8% in 1990 and to 13.1% in the April-June quarter of 2002. Among manufacturing industry sectors, the textile and electric machinery have seen rapid increases in their import penetration rate since the 1990s. The import penetration rate soared from 8.3% in 1990 to 31.9% in the April-June quarter of 2002 for textiles and from 3.4% to 17.4% for electric machinery. In these sectors, imports from China have been outstanding. Chinese imports have had a great impact on the import penetration rate rises in the two sectors.
   The second indicator is the relationship between imports and domestic production. Here, we consider such relationships for precision machines, textiles and electric machines (see Figure 3-1-2). For precision machines and textiles, imports have been increasing with domestic production declining. In these sectors, Chinese imports have been rising against the background of cheap labor costs in China. In contrast, the electric machinery sector has seen rises both in imports and domestic production. In this sector, Chinese imports have been increasing while total domestic demand has been on the rise.
   Given these facts, we can conclude that rising Chinese imports have not necessarily worked to reduce domestic production in all sectors.
Figure 3-1-2 Relationship between Imports and Domestic Production
Japan' s trade specialization coefficients falling for areas where Japan has seemed to have comparative advantage
   Based the above data, we would like to analyze structural changes in trade more specifically.
   How is a country destined to export or import certain goods? Based on the principle of comparative advantage, any country may export goods for which it has relatively higher productivity (comparatively superior goods) and import those for which it has relatively lower productivity (comparatively inferior goods). But it is difficult to compare directly labor productivity data. Here, we view goods with higher labor productivity growth as comparatively superior goods and those with lower labor productivity growth as comparatively inferior goods.
   Let' s classify Japan' s tradable goods by labor productivity growth from the first half of the 1990s to the second half and look into changes in trade in each category of goods (see Appended Note 3-1). We describe goods featuring the highest labor productivity growth as "superior goods" including electric machinery, and those with the lowest labor productivity growth as "inferior goods" including textiles, foods and ordinary machinery. Goods ranked between the superior and inferior sectors are called "median goods" including chemicals, primary metals, precision machinery, metals and metallic products, and transportation machinery. On the other hand, whether labor productivity growth is higher or lower is closely related to whether total factor productivity growth is higher or lower. Therefore, "superior goods" can be described as "knowledge- and technology-intensive goods(2)."
   We would like to use these three categories of goods to construe changes in trade structure. To this end, we calculate Japan' s trade specialization coefficient for each category and track the moves of each coefficient. The trade specialization coefficient is the ratio of the trade balance to total foreign trade value for each good. The ratio ranges from -1 (fully imported) to +1 (fully exported). The closer to +1 the ratio for a good is, the more internationally competitive the good is(3).
   Estimated trade specialization coefficients for these categories are given in Figure 3-1-3. The coefficient was positive for superior goods and median goods, and negative for inferior goods throughout the 1990s. This basically meets the principle of comparative advantage. For superior goods for which Japan should be the most specialized in exporting, however, the coefficient declined gradually and slipped below that for median goods in and after 1998. Imports have thus been increasing for goods for which Japan should be specialized in exporting. This fact may be behind an argument that Japan' s tradable goods have been losing international competitiveness.
   Trade specialization coefficients have also been estimated for each product category for a more specific analysis of moves within each category of goods (see Figure 3-1-4). Here, we can see that the coefficients have been negative for textiles and foods that are inferior goods. The coefficient for automobiles, a median good, has remained positive, though moving up and down. In contrast, the coefficients for electric and precision machines have declined substantially. Specifically, the coefficient fell from 0.68 in 1990 to 0.28 in 2001 for electric machines and from 0.60 to 0.01 for precision machines. In detail, the coefficient fell from 0.60 to 0.01 for office machines and from 0.60 to 0.31 for semiconductors and other electronic devices. Substantial declines are seen in the coefficients for IT-related goods.
Figure 3-1-3 Trend of Trade for Each Group of Goods
Figure 3-1-4 Trade Specialization Coefficient for Each Group of Goods
Japan' s trade specialization coefficients for IT-related goods have turned negative in trade with China
   The substantial falls in the trade specialization coefficients for IT-related goods reflect structural changes in trade with China. We have estimated Japan' s trade specialization coefficients for each region. Our findings regarding Japan' s trade with China are (i) that imports from China have been rising despite a fall in total imports, and (ii) that China has outstripped newly industrializing economies (NIEs) and the Association of Southeast Asian Nations (ASEAN) in exports of knowledge-intensive goods.
   Remarkably high growth has been seen in textiles, foods and IT-related goods among imports from China. Japan' s trade specialization coefficients in trade with China (see Figure 3-1-5) have been noticeably negative for textiles and foods, and have turned negative for IT-related goods. Given the fact that Japan' s coefficient for IT-related goods has remained positive in trade with NIEs and ASEAN, the change in trade with China is worthy of attention. China has lagged behind NIEs and ASEAN in economic development and participation in the world economy. If the flying-geese theory for economic development(4) is valid, China should follow NIEs and ASEAN in foreign trade development. Japan' s trade specialization coefficient for IT-related goods should turn negative for NIEs and ASEAN ahead of China. In reality, however, the coefficient has turned negative for China ahead of NIEs and ASEAN. It seems that China has outstripped NIEs and ASEAN in economic development.
   Japan has long experienced pressure of competition from developing countries. The pressure included competition from NIEs and ASEAN in the 1980s, so such pressure is thus not necessarily new to Japan. Nevertheless, the pressure of competition from China has been emphasized conspicuously in Japan. This may be because China' s economic development has had the above unique features.
   However, we cannot necessarily conclude that China has really skipped some economic development phases. Let' s consider this point next.
Figure 3-1-5 Trade Specialization Coefficient by Goods in trade with China
Explanations from viewpoint of intra-industry trade development
   How should we construe Japan' s falling trade specialization coefficients for superior goods and its negative coefficient for IT-related goods in trade with China? We now would like to consider this question from the viewpoint of intra-industry trade development.
   Recent foreign trade features development in intra-industry trade. The intra-industry trade means that a country exports and imports the same category of goods. Based on the theory of comparative advantage, a country may be specialized in exporting some goods and importing others to maximize its and others' benefits. In reality, however, a country exports and imports the same category of goods. We now would like to use the intra-industry trade theory to look into reasons why imports have been increasing in IT-related goods where Japan has conceivably had a comparative advantage. We have calculated the intra-industry trade index to indicate development of intra-industry trade. The index ranges from zero to 100. An index closer to 100 indicates a greater intra-industry trade(5). Figure 3-1-6 shows the intra-industry trade indexes of semiconductors and other electronic devices and office machines, for which trade specialization coefficients are negative in trade with China, are very high.
   Intra-industry trade between industrial countries is seen mainly in high-value-added products. It represents the horizontal division of labor emerging from fine discrimination among products for trade, backed by the diversification of consumers' demand. For example, passenger cars that do not differ from each other in function and performance are discriminated by brand or design for international trade.
   On the other hand, industrial countries' intra-industry trade with developing countries represents a vertical division of labor. Within the same category, industrial countries export luxury goods and developing countries low-value goods. As for knowledge- and technology-intensive goods, developing countries undertake labor-intensive production steps and industrial countries technology-intensive steps. For example, Japan exports knowledge- and technology-intensive semiconductors to China and imports personal computers assembled in China using these chips.
   Factors behind such division of labor include the following:
   First, the recent technological development has allowed a product to be broken down into high-value-added components and enabled the production of each component to be separated from the final assembly of the product. The so-called modularization of products has contributed to the vertical division of labor.
   Second, foreign direct investment has led to overseas production bases. Japan' s direct investment in China increased in the latter half of the 1990s. Chinese firms' competitiveness is so limited that mainly non-Chinese businesses export goods from China. Japanese businesses are heavily involved in trade with China.
   Let' s consider these factors in detail next.
Figure 3-1-6 Intra-industry Trade Index by Goods
Modularization and division of labor between production steps
   The modularization means that a complicated product is broken down into smaller units (modules) that are respectively designed and produced with their standardized interfaces developed, and are easily assembled. Modularization has been positively developed in the computer industry that has grown more complex with memory capacity and computing speed increasing fast. Each company in the computer sector is now specialized in certain modules, like chips and displays, to flexibly respond to demand changes(6). Each module is produced by the most appropriate company in the most appropriate country. This means developing countries produce labor-intensive modules and industrial nations manufacture technology-intensive modules. Japan' s intra-industry trade with China has thus stemmed from modularization.
   In order to confirm this point, we classify IT-related goods by a nine-digit code on the Japan Exports & Imports and look into the relevant trading structure. We discuss here a pre-mounted semiconductor chip as a component and a finished desktop personal computer. Trade in chips and computers are illustrated in Figure 3-1-7. In trade in pre-mounted chips with the United States and the European Union, Japan posts an excess of imports. In such trade with the rest of Asia, Japan logs an export surplus. As for desktop computers, however, Japan registers an export surplus in trade with the United States and the EU, and an excess of imports with the rest of Asia. To sum up trade in IT-related goods, development of intra-industry trade has led to growth both in Japan' s exports and imports. In detail, the rest of Asia imports components from Japan and export finished products using these components. This tendency is clear for ASEAN and China.
Progress in overseas production shift
   A factor that has allowed production of knowledge- and technology-intensive goods in China has been electric machinery manufacturers' and other Japanese firms' positive foreign direct investment since the latter half of the 1980s, which has been concentrated in Asia, including China. Japan' s imports from and exports to Japanese companies operating in the rest of Asia have been increasing.
   According to the foreign direct investment report by the Ministry of Finance, Japan' s direct investment in the rest of Asia began to increase in 1994 and peaked in 1997 before declining since the Asian economic crisis (see Figure 3-1-8). In fiscal 2001, however, Japan' s direct investment in the rest of Asia turned upward. China has been the largest investment target.
   In the first half of the 1990s, the textile sector was dominant in Japan' s direct investment in China. Direct investment in China peaked in fiscal 1995 and then continued to decline for four years until fiscal 1999. But it turned up in fiscal 2000 and 2001 mainly in the electric machinery sector. China' s share of Japan' s direct investment compared with the rest of Asia in value came to 16.8% in fiscal 2000 and 23.3% in fiscal 2001.
   Foreign direct investment reflects an overseas production shift. To see this, we use the Survey of Overseas Business Activities by the Ministry of Economy, Trade and Industry to find changes in Japanese companies' overseas production share, or their overseas units' share of their total sales. The share for the whole manufacturing industry stood at 6.4% in fiscal 1990 and has maintained an upward trend since fiscal 1993. It stood at 13.4% in fiscal 2000. The highest shares among manufacturing sectors include 31.1% for transportation machinery and 21.9% for electric machinery.
   Such an overseas production shift has had some important effects on the Japan' s economy. As far as the domestic economy is concerned, important effects are on business investment. We frequently hear about fears that a rise in foreign direct investment may lead to a decline in domestic business investment. But overseas investment does not necessarily replace domestic investment. Recently, both foreign direct investment and domestic business investment have been declining (see Column 3-1). As far as the theme of this chapter is concerned, effects on trade are more important. Especially, export-inducing and import effects are important to intra-industry trade(7).
   An export-inducing effect emerges as Japanese companies expand exports of capital goods (including machinery) and intermediate goods (such as semi-finished products) in accordance with their establishment of overseas units and production facilities. As a percentage of Japan' s gross domestic product, intermediate goods procurement from Japan by overseas units of Japanese manufacturers rose from 1.3% in fiscal 1990 to 2.1% in fiscal 1995 and to 2.8% in fiscal 2000, indicating an upward trend.
   A reimport effect comes as products manufactured at Japanese firms' overseas units and facilities are imported into Japan. Such products' share of Japan' s total imports in value, which indicates the reimport effect of the overseas production shift, has been increasing almost persistently since fiscal 1990, standing at 14.8% in fiscal 2000.Especially from the rest of Asia, reimports account for more than 80%. Electric machinery captures some 60% of such imports. By sectors, electric machinery accounts for some 60%.
Figure 3-1-7 Trade with U.S., EU, and Asia
Figure 3-1-8 Trend of Japan' s Direct Investment in Asian Countries
Response to new international division of labor
   Based on the above analysis, we summarize our views responding to the concern that China, after its rapid economic development, may now be competing with Japan even in IT-related and other goods that dominate Japanese exports.
   First, imports from China have increased in the area of IT-related goods subject to Japan' s export specialization, based on the division of labor between production steps against the background of modularization. China undertakes relatively labor-intensive steps and depends on Japanese exports for supply of intermediate and capital goods for such steps. In short, a rise in imports from China coincides with that in exports to that country.
   Second, firms exporting products from China into Japan are mostly those that have been founded by Japanese companies through direct investment. This means that Japan' s increasing trade with China has resulted from Japan' s response to a new international division of labor.
   Such developments can be considered to be the changes in the international division of labor that has come from the changing comparative advantage. Since trade benefits all trading partners, Japan may be required to make a positive response to such developments.
   As indicated by a fast increase in IT-related imports from China into Japan since the mid-1990s, China has achieved rapid economic development and the international division of labor has been changing structurally and dramatically. Unless Japan promptly creates an economic structure that can quickly respond to such dramatic change, readjustment costs will be huge for Japan. In this respect, Japan should vitalize its economy to step up structural reforms.

Column 3-1
   Relationship between Foreign direct investment and Domestic Business Investment
   It is widely believed that foreign direct investment symbolizes the hollowing out of industry in Japan as it may replace domestic business investment and result in a decline in domestic production capacities. What is the real relationship between foreign direct investment and domestic business investment?
   According to the "Foreign Direct Investment Report" by the Ministry of Finance(1), Japanese firms' outward direct investment expanded substantially in the second half of the 1980s as manufacturers stepped up investment in Europe, North America and East Asia in response to the a rapid appreciation of the yen after the Plaza Agreement in 1985 and Japan-U.S. trade friction, and as banking, insurance, real estate and services sectors increased overseas investment against the background of their domestic business expansion. However, such investment peaked in fiscal 1989 and continued a sharp downturn until fiscal 1993 due to the collapse of the bubble economy in Japan. From fiscal 1994 to 1997, Japanese manufacturers increased outward direct investment, mainly in East Asia, in order to reduce production costs and explore new markets. But the East Asian economic crisis from the latter half of 1997 led to a downturn in Japan' s foreign direct investment in fiscal 1998. Foreign direct investment rose again thanks to large deals reflecting global industrial reorganization, before falling in both fiscal 2000 and 2001.
   The trend of Japan' s outward direct investment has thus been linked to the developments in domestic and overseas economies, as well as the exchange rate. A correlation between outward direct investment on the vertical axis and domestic business investment on the horizontal axis, as shown in Figure 1, indicates that domestic business investment and outward direct investment increase or decrease almost simultaneously, although large deals can result in some irregular moves. As such, we can see that outward direct investment and domestic business investment are not necessarily in a "zero-sum" relationship.
   The above explanations cover only Japanese parent companies' outward investment. But their overseas subsidiaries use not only direct investment from their parent companies but also their own final procurement such as borrowings from the local bank and profits from local operations (so-called "Reinvestment" ) to implement business investment. When examining the relationship between Japanese firms' outward direct investment and their domestic business investment, we must take account of their overseas subsidiaries' local borrowings and reinvestment. Looking at the relative size of overseas subsidiaries' investment, which includes investment implemented using self-raised funds, to total domestic business investment, i.e., "overseas business investment ratio" , for the manufacturing sector, the ratio has been rising slightly (See Figure 2). In other words, Japanese firms' overseas subsidiaries have been autonomously expanding their business sizes through business investment using their own internal reserves and overseas-raised funds. This has been contributing to a raise in the overseas production ratio for Japanese companies.
   Figure 1 Relationship between Outward Direct Investment and Domestic Business Investment (for All Industries)
   Figure 2 Ratio of Overseas Business Investment (Manufacturing Industry)

   Note: (1) Outward investment is defined as investment that a resident (a direct investor) in a country makes to a firm in another country (a direct investment destination) in order to acquire a permanent business interest. Statistically, outward direct investment is deemed an acquisition of a stake of 10% or more in an overseas business. Therefore, we must note that outward direct investment figures cover not only Japanese companies' investment in their overseas subsidiaries but also business transactions involving Japanese firms' minor stakes in foreign companies. In interpreting outward direct investment results in the MOF' s "Foreign Direct Investment Report" , we should acknowledge (i) that the results cover deals exceeding ¥100 million and do not include smaller deals, and (ii) that the results are based on reports submitted upon investment and fail to exclude investment returns or deals that were suspended after reporting.

Japan required to enhance competitiveness in services trade
   As the international division of labor changes structurally, Japan will have to pursue its comparative advantage not only in knowledge and technology intensive goods but also in services. But Japan has lagged far behind other industrial countries in services trade. We now review the current state of Japan' s services trade.
   Services trade covers transactions in travel, transportation, communications, financing and other services. Most services had been deemed non-tradable in the past. But services trade has expanded recently on the globalization of business activities, the development of traffic and transportation means, the advancement of information and communications technologies, and the rising presence of service industries amid economic growth. From 1991 to 2000, the global services trade grew at an annual average pace of 5.6%. In 2000, global services trade totaled $1,476.2 billion equivalent to 23.4% of merchandise trade.
   The main exporters in services trade are industrialized countries where economies are more services-oriented and have achieved higher technological levels than others. The 23 countries that are defined as industrialized by the International Monetary Fund account for 71.7% of global services exports. The five most industrialized nations--the United States, United Kingdom, Germany, France and Japan--alone capture 42.5% of global services exports. The United States is distinct among them in services exports, accounting for 20% of the global total.
   Japan was the fifth largest services exporter with $69.2 billion in 2000. But it has lagged far behind the United States, the largest services exporter. On the other hand, Japan' s services imports totaled $116.9 billion in the year, the third largest following figures for the United States and Germany. As a result, Japan posted a services trade deficit of $47.6 billion. Japan runs the largest merchandise trade surplus in the world, while posting the second largest services trade deficit following that of Germany.
   Of Japan' s services trade deficit in 2000, travel accounted for the largest share, at 60%, followed by 19.9% for transportation. This is because departures from Japan totaled 17.82 million, far more than 5.27 million visitors to Japan, and Japanese travelers' average overseas consumption at ¥198,000 (excluding fares) was far more than foreign travelers' average consumption in Japan at ¥76,000 (excluding fares). These differences reflect higher income for Japanese. Irrespective of income levels, however, Japan should provide more attractive tourism facilities and services and implement more positive campaigns in order to attract more foreign visitors.
   Japan has been less competitive in "other services" that have recently been contributing a lot to global services trade expansion. "Other services" include communications, construction, insurance, financing, information, patent royalties, business services, cultures and entertainment. Japan has run trade deficits in all of the "other services" excluding construction and financial services. We here use the revealed comparative advantage index(8) to measure Japan' s comparative advantage in these services. Japan' s RCA index slips below 1 for many of the "other services" including financing, insurance, information and communications (see Figure 3-1-9). The index exceeds 1 for construction and patent royalties. But Japan has lagged far behind the United States in patent royalty income. In contrast to Japan, the United States and United Kingdom have a high comparative advantage in financing, patent and other advanced services as well as cultural and entertainment services and run big services trade surpluses.
   Competition from the rest of Asia is expected to reduce a range of goods for which Japan maintains its comparative advantage. Therefore, it is important for Japan to improve its comparative advantage in services trade. Services are knowledge-intensive and some services in Japan are still under official regulations to limit competition. Japan is now required to improve services industry productivity and services trade competitiveness by promoting research and development to upgrade technological levels and by implementing deregulation to step up competition.
Figure 3-1-9 Revealed Comparative Advantage Index for Service
Concern over hollowing out of industry--Shrinking surplus in goods and services trade
   People' s concern over the "hollowing out of industry" in Japan may partly come from the fact that Japan could plunge into deficit in goods and services trade. Japan' s goods and services trade surplus peaked in fiscal 1998 and fell to a seasonally adjusted ¥115.3 billion in June 2001. This has led some people to worry that Japan may be losing its export competitiveness. We now would like to consider how we should construe Japan' s shrinking surplus in goods and services trade.
   In 2001, imports in value continued to increase until the January-March quarter before turning down in the April-June quarter and retaining a downtrend until the October-December quarter. On the other hand, exports in value turned down in the January-March quarter and retained a downtrend until the October-December quarter. Exports declined faster than imports.
   The decline in Japan' s goods and services trade surplus was attributable primarily to a temporary export fall stemming from the global economic slowdown. In fact, Japan' s exports ceased its downtrend with the trade surplus turning up in the latter half of 2001 as the world economy, including the United States, halted deterioration and began to recover(9).
   Therefore, the shrinkage of Japan' s goods and services trade surplus in June 2001 alone cannot be interpreted as indicating Japan' s loss of export competitiveness.
Structural changes in current account balance
   Although the shrinkage of the goods and services trade surplus may not necessarily mean the hollowing out of industry in Japan, whether Japan' s current account surplus will continue in the future is an issue that we should consider. The current account covers income and current transfers in addition to goods and services trade.
   Over a short term, the goods and services trade surplus is susceptible to the global economic trend and the domestic economic cycle, as explained above. During a domestic economic expansion when domestic demand including personal consumption and business investment is strong, imports increase to lower the goods and services trade surplus. During an economic contraction when domestic demand weakens, however, imports decline to boost the goods and services trade surplus. In fact, the past goods and services trade surplus has had a negative correlation with domestic demand growth (see Figure 3-1-10). In the future, Japan could post a goods and services trade deficit temporarily on a steep fall in exports amid a global economic slowdown or on substantial growth in domestic demand. External shocks like the oil crisis could also result in a goods and services trade deficit for Japan.
   But a merchandise and service trade deficit does not necessarily lead to a current account deficit. This is because Japan has had fast-growing net income from abroad. In 2001, the income balance posted net income from abroad at ¥8.4 trillion, almost equivalent to a ¥8.5 trillion trade surplus. Reflecting Japan' s substantial current account surplus sustained over the long term, the nation' s net overseas assets have been expanding. (At the end of 2001, Japan' s net overseas assets totaled ¥179,257 billion, a 3.5-fold increase from a decade ago.) Growing interest and dividend receipts on overseas assets have led to the expansion of net income from abroad. This is expected to remain a long-term trend. In future, rising net income from abroad is thus likely to boost Japan' s current account surplus while the goods and services trade surplus fluctuates on domestic and overseas economic changes. The rising weight of net income from abroad in Japan' s current account surplus means that Japan is shifting from "an immature creditor nation" to "a mature creditor nation" in terms of the current account structure under the balance of payments development theory.
   The investment-savings balance is expected to determine the medium- or long-term trend of the current account. The IS balance approach points to the possibility of Japan' s current account plunging into deficit (see Column 3-1).
Figure 3-1-10 Relationship between Goods and Services Trade Balance and Domestic Demand Growth

Column 3-2
   Medium- and Long-Term Prospects for the Current Account
   Will Japan' s current account sustain a surplus in future? From the macroeconomic viewpoint, the current account balance roughly matches a gap between domestic investment and savings, or the IS balance. Excess domestic savings may be invested overseas and equal to the current account surplus permanently(1). This indicates that behind a change in the current account is a relevant macroeconomic savings and investment change (a private sector investment-savings gap and a government budget balance). The current account balance makes short-term changes in response to exchange rates and domestic and overseas economic trends. In order to shed light on long-term changes in the current account balance, we should look into a medium- and long-term trends of domestic savings and investment.
   Japan' s IS balance has featured a savings excess in the household sector and an investment excess in the business and government sectors. Reflecting a remarkably high savings ratio in the household sector, Japan has sustained a substantial current account surplus corresponding to the domestic savings excess. Since the 1990s, as explained in Section 2, an investment excess in the business sector including non-financial corporations and financial institutions has declined and turned into a savings excess. The private sector IS balance has shown expanding savings excess while the government sector has posted expanding excessive investment reflecting a budget deficit. As a result, Japan' s overall savings excess has remained at more than 2% of nominal gross domestic product on average since the 1990s, allowing the current account to sustain a surplus. Even at present, Japan has a substantial savings excess as economic activities remain stagnant with actual GDP slipping far below potential GDP. Therefore, the current account is expected to retain a surplus for the immediate future.
   What about Japan' s longer-term current account? Generally, Japan' s current account surplus is expected to shrink as the falling birthrate and the aging population work to reduce the household savings ratio and overall population. The household savings ratio on a 93SNA (system of national accounts) basis declined from 14.8% in 1991 to 10.3% in 2000. As baby-boomers, now the core of Japan' s workforce, become pensioners from 2010 to 2015, some people argue, that the private sector savings ratio is expected to decline fast and lead the current account to plunge into deficit(2).
   National income as the source for savings and investment may have to contract on a decline in the working population amid the falling birthrate and the aging population if all other conditions remain unchanged. But such decline could be offset if productivity growth accelerated on structural reform and technological innovation. If so, the IS balance could see a sustained savings excess.
   The government sector' s savings and investment (budget deficit) are also an important factor when we analyze possible changes in the future current account. At present, the government is trying to promote fiscal structure reform by improving spending quality and holding down spending in order to prevent general government spending as a percentage of GDP from rising above the current level. In its Structural Reform and Medium-term Economic and Fiscal Outlook, as decided on by the Cabinet in January 2002, the government expects that the fiscal structure reform and private demand-led steady economic growth would allow the central and local government primary budget deficit as a percentage of GDP to shrink to half the current level (4.3% in fiscal 2000) by around fiscal 2006. Japan is expected to achieve a primary budget surplus in the early 2010s if efforts to improve the budget balance continue at the same pace as in fiscal 2002-2006 and if private demand-led steady economic growth is sustained.
   Japan' s future IS balance and current account trends will depend on how these factors will change(3). A current account deficit, if prolonged, could force Japan to dip into its overseas assets and cause net dividend and interest payments to foreign countries. Therefore, the general view is that any current account deficit should be avoided. If a current account deficit resulted from domestic demand expansion through economic vitalization, domestic and overseas confidence in the Japan' s economy would be enhanced to allow a stable inflow of investment into Japan. Even a current account surplus, if stemming from a fall in domestic demand amid a prolonged economic slowdown, would be undesirable. What is important for Japan is to achieve sustained economic growth. To this end, Japan should increase the productivity of its economy through structural reform. Any current account balance would be the result of such efforts. We should hold such viewpoint.
(1) This means domestic savings - domestic investment = net overseas investment = current account surplus. This can also be described as private savings-investment gap + government budget balance = current account balance.
(2) Other people are opposed to this argument, noting (i) that people accumulate savings for their children and do not necessarily dip into savings after their retirement, (ii) that as the employment rate increases for aged people and women, the aging population will not necessarily lead to any rapid decline in the savings ratio, and (iii) that the IS balance may avoid any sharp change as the labor-capital ratio falls on a decline in population to lower the domestic business investment ratio. The falling birthrate and the aging population can work to lower the household savings ratio. But we must note that no consensus has been formed on how much these social changes could work to reduce the savings excess.
(3) According to the macroeconomic picture as estimated by the Cabinet Office for discussions on the Structure Reform and Medium-term Economic and Fiscal Outlook, Japan' s savings excess is projected at 2.4% of GDP in fiscal 2010. Japan' s current account is thus expected to remain in the black at least for the 2000s.

2. Changes in Industrial Structure

   The concern over the hollowing out of industry in Japan may be based on a perception that Japan' s manufacturing industry has been reducing jobs and eliminating the base of economic growth. Is this perception right? Is the manufacturing industry really shrinking? How should we think of any shrinkage of the manufacturing industry?
   It is a fact that the manufacturing industry' s shares of nominal GDP and employment have been declining. This is because labor productivity of the manufacturing industry has persistently improved. On the other hand, the non-manufacturing industry, while limiting its labor productivity growth, has been growing more important for employment. But it is undesirable for the labor productivity of the non-manufacturing industry to remain low. Any low productivity for the non-manufacturing industry can prevent the macroeconomic productivity from growing and affect the improvement of living standards for the people. Unless the labor productivity growth is accelerated in the non-manufacturing industry, prices in the industry will remain high and affect the competitiveness of the manufacturing industry. In the future, Japan should look to increase the productivity of the non-manufacturing industry as well as the manufacturing industry.
Concern over hollowing out of industry--Shrinkage of the manufacturing industry
   Let' s confirm whether or not the manufacturing industry has been shrinking. According to the National Accounts by the Cabinet Office, the manufacturing industry' s share of nominal GDP stood above 30% in the 1970s, slipped below 30% in 1990 and fell to a level below 25% in 2000 (see Figure 3-1-11). A breakdown of the manufacturing industry indicates even electric machinery manufacturers that have better performed than others accounted for only 4-5% of nominal GDP throughout the 1990s. Shares for other manufacturers have been declining. In contrast, the non-manufacturing industry has been boosting its share of nominal GDP, including the services sector, whose share rose from a little more than 10% in 1970 to levels close to 20%.
   Next, let' s look at an industry-by-industry breakdown of employment (see Figure 3-1-12). The manufacturing industry' s share of employment fell from about 27% in the 1970s to about 24% in 1990 and to about 20% in 2000. Within the manufacturing industry, shares declined for steel, chemicals and textiles. On the other hand, the services sector boosted their employment share from about 15% in the 1970s to about 28% in 2000.
   As can be seen, the manufacturing industry has been shrinking with the services industry(10) expanding as far as their shares of nominal GDP and employment are concerned. This indicates the economy' s increasing shift to services. These changes may be behind the concern over the hollowing out of industry in Japan.
Figure 3-1-11 Industry-wise Breakdown of Nominal GDP
Figure 3-1-12 Composition of Employment by Industry
Remarkable productivity growth in the manufacturing industry
   But industry-by-industry shares of real GDP provide a different picture (see Figure 3-1-13). The manufacturing industry' s share of real GDP has declined from the 1970s at a far slower pace than its share of nominal GDP. Especially, electric machinery manufacturers have even increased their share of real GDP. In contrast, the non-manufacturing industry including services has seen its share of real GDP increasing at a slower pace than that of nominal GDP. The shares of real GDP thus indicate that the manufacturing industry has retained great contributions to overall production, which is contrary to the perception of concern over the hollowing out of industry.
   The manufacturing industry includes many sectors where import penetration has been rising. We can expect some effects of rising import penetration. But rising import penetration does not necessarily lead to a decline of domestic production, as described earlier in respect to trade structure changes (see Figure 3-1-2). In textile and other labor-intensive sectors that have lost their comparative advantage, imports have exceeded exports with domestic production declining. In electric machinery and other sectors where intra-industry trade has developed, however, both imports and exports have been increasing with domestic production expanding.
Figure 3-1-13 Composition of Real GDP by Industry
High labor productivity growth in the manufacturing industry
   The manufacturing industry features higher labor productivity growth than other industries. This explains why the manufacturing industry has kept its share of real GDP almost at a solid level while allowing its shares of nominal GDP and employment to decline. Higher labor productivity growth of the manufacturing industry apparently has had two effects.
   First, relative prices have dropped for products turned out by the manufacturing industry. As a result, the deflator, which is used to remove the effect of inflation from nominal GDP to determine real GDP, has posted smaller growth for the manufacturing industry than for other industries. This has allowed the manufacturing industry' s share of real GDP to remain bigger than its share of nominal GDP.
   Second, higher labor productivity growth has enabled the manufacturing industry to produce products with fewer workers. In other words, the higher productivity growth has allowed the manufacturing industry' s share of real GDP to be greater than its share of employment.
   In this way, the manufacturing industry' s shrinking shares of nominal GDP and employment can be interpreted as reflecting its better performance.
   What have been the factors behind higher labor productivity growth for the manufacturing industry? Direct factors include (i) the rising capital equipment ratio and (ii) the rising total factor productivity. The manufacturing industry has increased its labor productivity by stepping up capital spending aggressively to expand capital stock per worker. The industry has also taken advantage of production efficiency improvement and aggressive investment in research and development to accelerate growth of total factor productivity. The two factors have apparently led the manufacturing industry to achieve higher labor productivity growth. But gaps have existed between components of the manufacturing industry. Among them, electric machinery manufacturers have enjoyed remarkable growth in labor productivity.
   But one reason why the manufacturing industry has successfully increased labor productivity is that the industry has had incentives to improve its efficiency, including a large number of competitive companies within Japan and the pressure of competition from abroad through external trade. These incentives have prompted the Japanese manufacturing industry to accumulate cost-cutting efforts including (i) the adjustment of employment to reduce personnel cost, (ii) outsourcing indirect operations to lower general administration cost, and (iii) the promotion of technological development(11).
   On the other hand, labor productivity growth has remained low for the services industry for the apparent reasons (i) that the industry is labor-intensive, (ii) that the industry includes power utilities and others that are characteristically not allowed to have inventories and are forced to have equipment meeting demand peaks in consideration of daily and seasonal changes in demand, and (iii) that the industry includes many sectors subject to government regulations.
Demand increasing for the non-manufacturing industry
   On the other hand, the non-manufacturing industry' s lower labor productivity growth is not the only reason for its rising share of nominal GDP. In fact, demand for the services industry has increased.
   First, the rising national income and the aging population have worked to increase demand for services. A breakdown of family consumption (on a real and nominal GDP basis) indicates that spending on services has had an increasing share of total family consumption since 1990 (see Figure 3-1-14). Behind this might have been not only declining prices of durable and other goods but also a real increase in demand for services.
   Second, regulatory reform has led new goods and services to be provided, giving consumers a wider range of choices and expanding overall demand.
   Third, companies have stepped up outsourcing of non-core operations in efforts to reduce cost. Outsourcing can lead to the emergence and growth of leasing, temporary staffing, information and other services. The inter-industry relations table indicates that business services growth meeting a one-unit rise in output of the manufacturing industry has been accelerating persistently.
   Fourth, women' s increased participation in society has led to their household services to be provided commercially by restaurants, convenience stores, cleaners, etc.
Figure 3-1-14 Services Expenditure's Share of Domestic Final Consumption
Non-manufacturing industry required to raise total factor productivity
   The manufacturing industry has featured high labor productivity growth and has retained its importance for production of added value. In the meantime, the non-manufacturing industry may have to play a growing role in providing employment opportunities. If so, it would be undesirable for the non-manufacturing industry to keep its labor productivity at low levels. This is because the non-manufacturing industry' s low productivity can adversely affect growth of the macroeconomic productivity and improvement of living standards for the people. Unless the non-manufacturing industry accelerates its labor productivity growth, a productivity gap between tradable and non-tradable goods will expand further making it difficult to eliminate the gap between domestic and overseas prices. Furthermore, prices of non-tradable goods will relatively rise to affect prices of Japan' s tradable goods and hurt their price competitiveness. In this sense, low productivity growth in the non-manufacturing industry may have adverse effects on the manufacturing industry and the competitiveness of tradable goods.
   Labor productivity growth will become more and more important for the non-manufacturing industry as well as for the manufacturing industry.

3. Dealing with Structural Changes in International Division of Labor

   Behind the growing concern over the hollowing out of industry in Japan, the international division of labor involving Japan has made structural changes on the development of the world economy and technological innovation. Japan' s trade and industry are now required to make their structural changes. Structural changes required in Japan should shrink labor-intensive sectors losing comparative advantage while expanding knowledge- and technology-intensive sectors. Such structural changes are desirable since they can lead to production of more goods and services with fewer resources and to the improvement of living standards. But those concerned over the hollowing out of industry in Japan are worried about negative aspects of structural changes. More specifically, they are worried about (i) the cost of short-term restructuring, and (ii) the possible loss of the long-term growth base. Let' s consider these points.
Short-term adjustment cost
   The short-term adjustment cost includes a rise in unemployment. The manufacturing industry' s employment capacity has gradually declined as discussed earlier. Therefore, we must find employment opportunities in other industries. Employment has tended to increase in the services industry. There will be no problem if workers who cannot be employed in the manufacturing industry can promptly shift to the non-manufacturing industry. Workers' failure to promptly shift jobs could lead to a rise in unemployment.
   Let' s look at the relationship between prefecture-by-prefecture manufacturing industry ratios (ratios of added-value production by the manufacturing industry to prefectural income) and prefectural unemployment rates (see Figure 3-1-15). According to the figure, the higher the manufacturing industry ratio is, the lower the unemployment rate is. This indicates that the manufacturing industry, though seeing its share of employment falling persistently, is important for regional employment. At the same time, it indicates that a rise in unemployment could become a serious problem for any regional economy unless the non-manufacturing industry provides employment opportunities in place of the shrinking manufacturing industry or workers shift from the manufacturing industry to the non-manufacturing industry.
   Growth of sectors to provide new jobs and the prompt shift of labor and other production factors should thus accompany structural changes.
Figure 3-1-15 Manufacturing Industry' s Share and Unemployment Rate
Long-term growth base
   The recent economic trend indicates that those expected to expand in the future are the non-manufacturing industry including services, as well as knowledge- and technology-intensive sectors in the manufacturing industry. The "hollowing out of industry" theory presents a fear that the Japan' s economic growth potential could decline as resources shift from the manufacturing industry with high productivity to the non-manufacturing industry with lower productivity. In order to avoid such decline, Japan will have to (i) eliminate obstacles to the distribution of more production factors to sectors with higher total factor productivity and (ii) make efforts to improve productivity in every industry. Such efforts may allow Japan to even increase the growth potential of the Japan' s economy as a whole.
   If these efforts for the Japan' s economy are named restructuring, restructuring will be the task for the government and private sectors to vitalize the Japan' s economy.
Comparison with past restructuring
   Such restructuring has not been unknown to the Japan' s economy.
   Japan was faced with great difficulties when oil prices quadrupled during the oil crisis in the 1970s. Responding to the difficulties, however, Japanese companies stepped up slimming-down and energy-saving efforts. Though being forced to continue low growth after the oil crisis, the Japan' s economy later overcame the slowdown and saw its real growth recover to above 5% with its labor productivity rising in 1978. By 1980, Japan' s energy consumption efficiency rose by some 13%. Japan thus became one of the most energy-efficient economies in the world.
   In the mid-1980s, the yen' s two-fold appreciation seriously affected the international competitiveness of export-oriented companies in Japan. Imports increased explosively and Japanese manufacturers shifted their production bases overseas. Concern over the hollowing out of industry in Japan emerged then for the first time ever. As the yen' s appreciation improved the terms of trade, however, Japanese companies promoted cost-cutting, rationalization and labor-saving efforts, took advantage of business diversification to stimulate domestic demand, and established a new division of labor with other Asian countries.
   The past successful restructuring experiences can lead Japan to be confident in tackling the current restructuring facing its economy. In fact, however, Japan is required to implement the current restructuring under unprecedented circumstances.
   First, Japan is now forced to step up the current restructuring under deflation. In this sense, the current restructuring is far different from past restructuring that was promoted while prices were rising. As a matter of course, Japan must restructure and vitalize its economy in order to reverse deflation. But deflation exerts downward pressures on the economy, as discussed in Chapter 1. Various difficulties accompany restructuring under deflation. When price declines are unstable, deflation can increase uncertainties, leading households and companies to grow more cautious about spending and investing. This could make it difficult for restructuring to be facilitated.
   Second, the current restructuring is about to reform Japan' s traditional economic systems including the main bank system and unique employment practices. The past restructuring did not require any fundamental economic system reform but based adjustments to new external circumstances on the given economic systems. In a sense, the past restructuring was a quantitative adjustment, not qualitative adjustment. But we are now required to change employment and other economic systems that had been considered to be strong points of the Japan' s economy. In this sense, the current restructuring is a great challenge for Japan.

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