Section 2 Current Situation of Structural Adjustment and Tasks for Economic Vitalization

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Factors behind falling labor productivity growth

The Japan' s economic structural problems can be clearly seen in the trend of macro labor productivity. The Japan' s economic average macro labor productivity growth declined by 1.7 percentage points from 3.7% in the 1980s to 2.0% in the 1990s (see Figure 3-2-1)(12).

Figure 3-2-1 Trend of Labor Productivity

In a bid to look into factors behind the lower labor productivity growth, we will analyze here the contributions of the capital equipment ratio growth and the total factor productivity (TFP) growth to the overall labor productivity growth(13).

The capital equipment ratio represents capital stock per unit labor input. As the ratio rises on progress in mechanization, labor productivity is expected to increase. The TFP growth indicates contributions made to productivity growth by labor and capital that are the most fundamental productive factors for economic growth. The TFP growth stems from 1） productivity growth accompanying an increase in overall economic efficiency through regulatory reform and other measures, and 2） productivity growth accompanying technological progress. In this sense, TFP growth is the most fundamental factor behind economic growth. Looking at the two factors' respective contributions to labor productivity growth, we can find that the capital equipment ratio growth has contributed to increasing labor productivity and that the TFP growth' s fall of 1.4 percentage points from 1.6% in the 1980s to 0.2% in the 1990s was the cause of the slowdown in labor productivity growth. Dividing the 1990s into two halves, we find that labor productivity growth declined by 0.2 percentage points from 2.1% in the first half to 1.9% in the second half (see Figure 3-2-2)(14). In contrast, the United States accelerated its labor productivity growth in the second half of the 1990s. U.S. labor productivity growth rose from 1.4% in the first half of the 1990s to 2.6% in the second half(15). As a result, Japan' s superiority over the United States in labor productivity growth was reversed. The United States outdid Japan in labor productivity growth. The slowdown in Japan' s labor productivity growth in the second half of the 1990s was basically attributable to the TFP growth' s fall of 0.3 percentage points from 0.4% in the first half to 0.1% in the second half, since the capital equipment ratio growth remained flat after adjustment for the impact of the operating ratio. This point represents a major difference between Japan and the United States. The U.S. TFP growth rose from 0.4% in the first half of the 1990s to 1.4% in the second half.

Figure 3-2-2 Factor Decomposition of Labour Productivity Growth

Let' s break down TFP growth by industry (see Figure 3-2-3). This breakdown indicates that TFP growth remained positive for the manufacturing industry and negative for the non-manufacturing industry throughout the 1990s(16).

Within the manufacturing industry, the textile, ceramic, clay and stone product, and transportation machinery sectors positive growth slowed in their TFP from the first half of the 1990s compared to the second half. The electric machinery sector continued to grow at high levels. On the other hand, most components of the non-manufacturing industry posted negative growth in the first half of the decade. Positive growth was limited to the wholesale and retail, and transportation and communications sectors. In the second half, however, the wholesale and retail sector saw its TFP growth turning negative. Posting positive growth in the second half were transportation and communications, financing and insurance, power, gas and water utilities, and services. But the positive growth was not so high.

Figure 3-2-3 TFP Growth

In this way, Japan' s labor productivity growth has declined substantially as TFP growth dropped sharply. For some sectors, TFP growth rates slowed substantially and turned negative. This is a noteworthy phenomenon. Economic vitalization, through increased overall economic efficiency and technological development, must contribute to accelerating TFP growth. To this end, Japan must review its economic systems and create new systems.

There are three basic ways to do so: First, the efficiency of corporate management should be enhanced for each company. From this viewpoint, Japanese firms' management, as symbolized by low return on assets, has not necessarily been efficient. This indicates limits on Japanese-style corporate governance as well as slow business renewal, as represented by low rates of firm start-up and closure.

Second, productive factors should promptly shift from low-productivity sectors to high-productivity sectors. The current sector-by-sector allocation of labor and capital that are key productive factors indicates the concentration in sectors with lower TFP, representing the inefficiency of the Japanese economy. Lower-TFP sectors mostly have abundant non-performing loans.

Third, each sector should promote technological development. Japan' s research and development spending levels are not low. The high R&D spending levels had led to some achievements until the 1980s. In the 1990s, however, R&D spending weakened its contributions to TFP. Japan has failed to take full advantage of the potential of information technology that has helped to accelerate labor productivity growth in the United States. With these basic ways in mind, we now would like to look into the current state of structural adjustment and tasks for economic vitalization in respect to 1） corporate management efficiency, 2） labor allocation efficiency, 3） resource allocation efficiency, and 4） R&D efficiency.

1. Improvement of Corporate Management Efficiency

^note-1)

Low profitability has frequently been cited for explaining the inefficiency of Japanese companies. In terms of return on assets, Japanese companies have been very inferior to U.S. firms, indicating that Japan has made less efficient investment than the United States (see Figure 3-2-4). Various factors behind the failure are conceivable. We focus here on the limit of Japanese-style corporate governance, and low rates of start-up and closure.

Figure 3-2-4 Comparison between Japanese and U.S. ROA Data

(1) Corporate governance

Decisions on how to use productive factors for companies' production form the core of corporate management. How to use productive factors basically depends on production technology, companies' business goals and ways to achieve such goals.

Corporate management discussions have recently focused on corporate governance. Corporate governance indicates coordination of interests among shareholders, managers, employees, creditors and other stakeholders to maximize business efficiency. Key factors of corporate governance are: 1） how business decisions are made, 2） how shareholders control managers' decision making, and 3） what incentives are given to stakeholders to achieve business goals.

From these viewpoints, Japanese companies' sluggish business performances since the 1990s are taken by some people to indicate that Japanese-style corporate governance has been failing to work effectively. We now would like to consider Japanese-style corporate governance and its limits.

Performance gaps stemming from corporate governance

How can corporate governance affect business performances? We will compare here Japanese companies with foreign affiliates in Japan whose corporate governance gives priority to capital efficiency. Using the Survey of Trends in Business Activities of Foreign Affiliates by the Ministry of Economy, Trade and Industry and the Annual Report on Financial Statements Statistics of Corporations by Industry by the Ministry of Finance, we compare various indicators of Japanese firms and foreign affiliates in Japan(17).

The comparison brings about the following findings: First, the payout ratio (=dividend/profit) has been stable for foreign affiliates while moving up or down in accordance with profit changes for all corporations including Japanese firms and foreign affiliates (see Appended Note 3-3 (1)). This apparently indicates that foreign affiliates give priority to payouts to shareholders meeting profit levels.

Second, foreign affiliates have higher returns on assets than all firms in the electric machinery, and wholesale and retail sectors (see Figure 3-2-5).

In the oil sector, however, ROAs for all firms and foreign affiliates are almost the same. In the transportation machinery sector, foreign affiliates' ROAs are lower. Given the possibility of special factors(18) affecting the transportation machinery sector, we can perceive that foreign affiliates' ROAs are at least the same as or higher than those of Japanese companies.

Third, higher ROAs lead to more value-added production. In the electric machinery, and wholesale and retail sectors where ROAs are higher than in other sectors, valued-added output' s ratio to assets is higher (see Appended Note 3-3 (2)). Even if value-added output is consistent, companies can boost ROAs by raising capital shares. In fact, foreign affiliates are raising capital shares to lift ROAs. At the same time, however, they effectively exploit productive resources for relatively higher value-added production to increase ROAs. This indicates that companies' efforts to increase capital efficiency can lead to higher macroeconomic growth. Fourth, foreign affiliates have increased labor productivity in order to boost value-added production. In the electric machinery, and wholesale and retail sectors where foreign affiliates have achieved higher value-added production, labor productivity is higher (see Appended Note 3-3 (3)). This indicates that companies should give priority not only to ROAs but also to the efficient exploitation of labor.

Figure 3-2-5 Comparison of ROA

Traditional Japanese corporate governance

Let' s review traditional corporate governance in Japan, which has had the following features:

First, shareholders' control over business decision making has been weak. Business decisions have been made by a board of directors that is identical to an executive organ. Therefore, shareholders have failed to supervise business execution. Behind that, companies within a keiretsu (business group) have held shares in each other. Corporate shareholders have thus remained stable and dominant shareholders, making general meetings of shareholders meaningless.

Second, incentives to achieve business goals have been based on long-term interdependent systems including lifetime employment, seniority-based wages and company-wise labor unions, where employees have received long-term employment security in exchange for their loyalty and contributions to companies. Under the main bank system, banks have provided long-term loans to companies while continuously monitoring business performances of client borrowers. They have bailed out client borrowers faced with financial difficulties. Such bailouts have met the interests of shareholders in banks.

Traditional corporate governance reaches an impasse

There had been no major problems with Japanese corporate governance until the 1980s. Rather, Japanese corporate governance had been praised for giving priority to longer-term viewpoints and being superior to U.S. and other foreign styles of corporate governance. However, we have found that Japanese corporate governance failed to check accumulation of excessive equipment, employment and debts amid the bubble economy. It has allowed the resolution of these problems to be delayed, falling short of playing effective roles after the collapse of the bubble economy (19) (20). But we do not deny that some Japanese companies have maintained good business performances. They are called excellent companies(21) and have enjoyed high profit ratios. But the problem is that Japanese companies as a whole are inefficient as indicated by falling ROAs, despite the presence of some outstanding companies. Therefore Japanese corporate governance must now be reconsidered.

In future, direct financing' s weight will increase with companies being required to give higher priority to the interests of shareholders, as economic globalization makes further progress to boost competition pressure. Under such circumstances, the problem is that Japanese corporate governance is failing to effectively exploit assets. ROAs, which indicate how efficient asset exploitation is, have been very low for Japanese companies, as discussed earlier.

Reflecting on the problem, Japanese companies are increasingly trying to improve their capital efficiency. According to a survey on corporate actions for 2002 conducted by the Cabinet Office, only 6.8% of responding companies gave priority to profit-to-capital ratio and capital efficiency as business targets in the past, while 71.2% cited absolute amounts of sales and profits as the priority. For the future, however, 36.5% give priority to profit-to-capital ratio and capital efficiency, outweighing 29.3% maintaining close attention to absolute amounts of sales and profits. The tendency to look at profit ratio and capital efficiency is stronger among larger-capital companies. Japanese firms are now apparently shifting to capital efficiency improvement as their priority business target.

Corporate governance reform

Japanese companies are now reforming their governance while the traditional Japanese corporate governance has reached an impasse.

First, shareholders have enhanced their influence over business decision-making. A growing number of companies have named chief executive officers, separated boards of directors from business execution organs and invited outside directors to their boards. Shareholders have boosted their supervision of business management. Companies have activated mergers and alliances beyond boundaries between keiretsu business groups. They have also been unloading cross shareholdings.

Second, long-term interdependent systems have begun to collapse. In employment, companies have increasingly been forced to reduce regular employees while increasing non-regular ones. A rising number of companies have adopted performance-based wage systems. The main bank system has weakened as big companies have increased their dependence on direct financing with banks curtailing lending.

Third, Japanese companies have been upgrading accounting and disclosure systems to international levels. While introducing consolidated accounting, cash flow accounting, mark-to-market accounting and evaluation loss accounting systems, they are stepping up investor relations and other information disclosure activities.

The direction where Japanese firms' corporate governance reforms are going is close to U.S.-style corporate governance. But U.S.-style corporate governance has not necessarily been comprehensive, as indicated by the confusion that has emerged over business accounting since last year. U.S.-style governance reportedly contains the following problems:

1） Auditors have failed to find problems with financial statements.

2） Conflicts of interest have emerged as auditors have undertaken consulting services and analysts have had dubious relations with auditors.

3） Financial statements have failed to reflect business realities as firms have taken advantage of special purpose companies to undertake massive transactions off the books.

4） Increasing stock option rewards have raised incentives to chase short-term gains. Since stock options have failed to be booked as costs, corporate profits have been exaggerated.

The prosperity and decline of Japanese and U.S. corporate governance styles indicates that corporate governance has no fundamentally correct style and that optimum corporate governance differs from time to time, from circumstance to circumstance, and from industry to industry. Given these indications, corporate governance reforms should not simply replace the traditional Japanese style with a different style, but develop an environment allowing companies to choose their respective best governance styles from various alternatives in consideration of their respective industrial features and market situations.

Agenda for enhancing corporate governance

As discussed earlier, the improvement of corporate management efficiency, as well as resource allocation and R&D efficiency, is expected to contribute to boosting labor productivity. Structural reform is an attempt to tackle these agenda through restructuring of the economy. Structural reform policies and measures are spelled out in the "Basic Policies for Economic and Fiscal Policy Management and Structural Reform 2002" as decided on by the Cabinet in June 2002. As reforms progress, a reform for increasing the efficiency of resource allocation may contribute to an improvement in corporate management efficiency. Reform progress in one area may thus work to contribute positively to solving various problems simultaneously. Taking note of this point, we now would like to summarize basic views on the agenda for enhancing corporate governance.

System to provide various alternatives

In order to enhance corporate governance, Japan revised the Commercial Code in 2002 to allow any company to separate management control from execution and introduce a management committee of which outside directors account for a majority. Legal systems are thus being developed for corporate management reforms. Companies are expected to take advantage of such new legal frameworks and to positively reform corporate management.

Individual companies should change their management setups in order to implement their respective optimum management. In a bid to meet circumstantial changes and characteristics of their production operations and products, they may take such measures as reorganization, overseas production and downsizing.

Vitalization of direct financing market

The enhancement of corporate governance is closely related to the vitalization of the direct financing market. As companies raise more funds in the direct financing market, corporate control through the market is toughened. Their managers are expected to become conscious of such control and consider aggressive management reforms.

In order to vitalize the direct financing market, it is effective to develop corporate information disclosure rules to increase the transparency of corporate information. This is expected to contribute to improving creditworthiness of companies as investment targets and promoting cash flow to companies. Specific measures to vitalize the direct financing market include the promotion of quarterly information disclosure and tougher standards for companies' exit from securities markets.

Globalization and investment in Japan

Globalization of corporate activities can enhance corporate governance. Overseas investment and direct financing are expected to help Japanese companies develop corporate management discipline. Expansion of foreign firms' direct investment in Japan can vitalize the economy through creation of jobs and promotion of competition and help diffuse their business know-how in Japan. The promotion of foreign firms' investment in Japan and the expansion of foreign knowledge inflow into Japan are important for the improvement of corporate management efficiency.

(2) Promotion of firm formation

In order to ensure the development of sectors featuring high total factor productivity growth, productive factors should promptly shift to such sectors and should be exploited efficiently to contribute to production. In this respect, firm start-up and closure should be stepped up to renew the economy. Efficient firms should be created to participate in the economy, while inefficient firms should be prompted to exit from the economy. But Japan' s firm start-up and closure rates have been very low.

Current situation of firm start-up and closure

Firm start-up and closure can play a key role in improving productivity. Specifically, firm start-up and closure can lead to a prompt shift of business resources and increase competition pressures. If firm start-up expands high-productivity sectors with firm closure shrinking low-productivity sectors, overall productivity will be increased. American experiences indicate that venture businesses play a great role in non-apparatus-based sectors including the globally growing IT-related sectors. Therefore, it is important to take measures to promote firm start-up and closure. The Organization for Economic Cooperation and Development has found that positive correlations exist between firm start-up and GDP growth (see Figure 3-2-6).

Based on the Establishment and Enterprise Census by the Ministry of Public Management, Home Affairs, Posts and Telecommunications, Japan' s firm start-up rate stood at 4.1% for the 1996-99 period. The firm closure rate came to 5.9% for the period, exceeding the firm start-up rate. Based on the Employment Insurance Office Statistics by the Ministry of Health, Labor and Welfare for fiscal 2000, the firm start-up rate was 4.9% and the firm closure rate 4.0%(22). These figures are far lower than the firm start-up rate of 14.3% and the termination rate of 12.0% in the United States in 1997 on an employment insurance basis.

Figure 3-2-6 Start-up Rates and GDP Growth

Figure 3-2-7 Enterprise Start-up and Closure Rates and TFP

Industry-by-industry firm formation and termination trends

Let' s look at industry-by-industry firm start-up and closure trends in Japan. The non-manufacturing industry has had a higher firm start-up rate than the manufacturing industry, while the firm closure rates are almost the same for these industries. As a result, the number of firms has been increasing in the non-manufacturing industry. This apparently reflects the industrial structure' s shift from the manufacturing industry to the non-manufacturing one.

Looking at firm start-up and closure, and TFP growth, we find no general relations between firm start-up and TFP growth. But the manufacturing industry alone indicates some positive correlations between firm start-up and TFP growth (see Figure 3-2-7). This apparently suggests that firm start-up is concentrated in high-productivity sectors. Firm start-up may be boosting competition pressures to increase productivity in these sectors. In the non-manufacturing industry of which a large portion is made up by public utilities, firm start-up and closure have been difficult irrespective of productivity growth. On the other hand, the firm closure rate has had weak positive correlations with TFP growth for all industries and for the manufacturing industry in particular. This means that a higher termination rate for better industry renewal accompanies higher productivity. As a matter of course, the above points indicate that it is important to increase firm start-up and closure rates generally. They also suggest that lifting the firm start-up rate in the non-manufacturing industry is especially important.

Venture capital

One of the keys to stimulating firm start-up is the activation of venture capital. Firms that develop and commercialize new technologies and business models are generally expected to feature high productivity. They are thus important for Japan' s recovery of productivity growth after a slowdown in the 1990s.

Funds that invest in privately held companies are called private equity funds, including venture capital funds that invest in firms in the startup (idea) stage. Venture capital funds invest in and foster startup companies with new technologies in order to get returns on their eventual initial public offerings. Such funds usually include unlimited and limited liability investors. Unlimited liability investors collect limited liability investors. Japan enacted a law for limited partnerships for investment in small businesses in 1998, allowing investors to establish venture capital funds similar to those seen in the United States that is known for active venture investment.

Let' s look at features of Japan' s venture capital in comparison with U.S. venture capital. Venture capital investment in Japan over the past several years has been limited to far less than one-tenth of U.S. investment. In the United States, venture capital investors include pension funds, industrial corporations, university and foundation funds, and individual investors. But individual investors are engaged primarily in direct investment in venture businesses, which is larger than venture capital investment. In Japan, venture capital investors include industrial corporations and financial institutions. Venture capital funds are mostly affiliated with banks or securities companies. Individual investors make little direct investment in venture businesses in Japan.

In the United States, an average venture capital investment amount for one deal is 10 times as much as an average Japanese amount. U.S. venture capital funds usually send directors and take part in the management of investment targets. They help entrepreneurs start up and manage new companies. In contrast, Japanese venture capital funds feature smaller and more dispersed investment and refrain from taking part in the management of investment targets. Until the second half of the 1990s, lending was dominant in venture capital investment in Japan and such investment focused on firms in the latter part of the startup stage, rather than in the initial part.

In this sense, Japan' s venture capital funds can afford to further expand investment. Important for stimulating venture formation is not only investment by venture capital funds but also activation of engineers and other venture founders, and academia-industry cooperation and other bridges between investors and ventures, as discussed in "4. Promotion of R&D Efficiency."

Agenda for stimulating firm formation

The number of people who are willing to form new firms is not small in Japan, however the firm start-up rate is low. According to the Basic Survey of Job Structure by the Ministry of Public Management, Home Affairs, Posts and Telecommunications, more than one million people have been willing to start up companies since the second half of the 1970s. But those who actually start up firms number 300,000 to 400,000, or 30 to 40% of those willing to do so. The problem in Japan is that business startup plans cannot be put into practice easily. In order to solve the problem, Japan should ease regulations, develop an environment for helping those interested in starting up firms and secure funds in proceeding with structural reform.

Promotion of regulatory reform

Regulated industry sectors usually restrict entries and exits. In the absence of an effectively working competition principle, these sectors remain inefficient. They should promote regulatory reform to allow greater entries and exits. In this respect, the introduction of special structural reform zones is worthy of attention. This is the plan to designate certain regions for deregulatory reform in a bid to gain the momentum for structural reform and trigger nationwide reform (see Column 3-3).

Facilitation of firm formation and revival

In order to vitalize firm start-up, it is important to examine tax and other systems. For example, minimum capital regulations could be revised to lower firm start-up costs and a system could be created to easily use business partnerships for starting up new firms. Systems should thus be revised to facilitate firm start-up procedures.

Procedures for business failures are also important. Upon business failures, prompt action must be taken to minimize deterioration of assets after failures and facilitate possible reconstruction of firms. Moreover, if necessary, the survival of the executives of bankrupt companies would be very useful to revitalize the resources of bankrupt companies effectively. From this point of view, it is very important to make use of the Civil Rehabilitation Law and to eliminate the barriers of business closure by improving the bankrupt legal system.

Financing

In considering financing for risky attempts to start up new companies, we should look at smooth supply of risk money. The formation of new firms is based on their forecast superiority over existing companies and expected to take advantage of initiation to produce relatively higher returns. We expect financing to come for firm start-up as funds are efficiently allocated in a manner where risks match returns, as discussed later.

As discussed earlier, it is expected to expand risk money supply for ventures having new technologies through venture capital funds as well as other channels. In this respect, Japan should vitalize a private bond market. At the same time, Japan should develop human resources for corporate management. If advanced technologies fail to lead to real business activities, it would be a social loss. Ventures should receive fund supply while enhancing their corporate governance through the promotion of information disclosure and the acceptance of managers from venture capital funds.

Climate where entrepreneurs are easily accepted

There is a view that Japan' s business climate is cool to failed businessmen. If penalties for failures are too harsh for entrepreneurs to form companies again or maintain their living standards, entrepreneurs may be discouraged from starting up new businesses. Entrepreneurs should be allowed to take advantage of failure experiences for starting up businesses again for the sake of the economy as a whole. In order to eliminate obstacles to the promotion of firm start-up and closure, Japan should review creditors' collections of claims from defaulters, personal guarantees and other practices to prevent penalties for failures from being too harsh.

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2. Improvement of Labor Allocation Efficiency

^note-2)

Behind the declining productivity of the Japanese economy has been inefficient allocation of productive factors. Expansion of high-productivity sectors can increase the total factor productivity for the whole of the economy. In order to allow such sectors to expand, productive factors should be able to smoothly move to these sectors to meet and support their expansion.

Excessive employment and equipment mean that Japan has so far failed to allocate productive resources in such an efficient way.

Let' s analyze how labor is allowed to move to high-productivity sectors. Specifically, we will look into whether employment has been increasing in high-productivity sectors or whether employment has remained excessive in low-productivity sectors. Capital allocation is discussed later.

Changes in industry-wide labor allocation

Employment has been wildly fluctuating in all industries in Japan recently. In the 1980s, employment had been increasing both for the manufacturing and non-manufacturing industries. In the 1990s, employment declined in the manufacturing industry and increased in the non-manufacturing industry. Employment declined for all sectors of the manufacturing industry throughout the 1990s. As for the non-manufacturing industry, employment continued to rise for all sectors until 1996 and began to decrease in 1997 for sectors other than services, wholesale and retail, and transportation and communications.

This means that the overall labor allocation picture has been changing. Now we would like to look into some sectors that have received more labor allocation than others. In this respect, Figure 3-2-8 is given to indicate relations between industry-wide productivity growth and employment changes.

Our findings regarding labor allocation are as follows:

First, the manufacturing industry has seen productivity growth and employment decline simultaneously. This is because the manufacturing industry has raised labor productivity by implementing the improvement of production efficiency, positive R&D investment and cost-cutting efforts, including employment curtailment to save personnel costs. Such relations have been detected for most of the manufacturing industry components. On the other hand, the non-manufacturing industry has increased employment in the absence of productivity growth. An employment increase in the non-manufacturing industry has roughly offset a drop in the manufacturing industry.

Second, we look into sector-by-sector employment for the non-manufacturing industry that has absorbed workers. The transportation and communications sector has increased employment while boosting productivity. This reflects the expansion of communications services through technological development and deregulation, as discussed earlier. In contrast, the construction, real estate, and power, gas and water utility sectors increased employment while seeing declining productivity in the first half of the 1990s. The services sector has achieved the fastest employment rise while seeing little productivity growth, indicating the expansion of its size on increased demand for services.

Third, a comparison between the first half of the 1990s (1990-1996) and the second half (1997-2000) indicates that productivity-falling sectors were attempting to reduce employment. But the wholesale and retail sector continued to increase employment in spite of a downturn in productivity. The finance and insurance sector increased productivity in the second half after reducing employment in view of the falling productivity in the first half.

Based on the above, we can divide sectors into four conceptual groups in respect to relations between TFP growth and employment changes: 1） sectors featuring productivity growth and employment expansion (growth sectors), 2） sectors seeing productivity growth in the absence of employment expansion (restructuring sectors), 3） sectors seeing productivity decline and employment expansion (restructuring-delayed sectors), 4） sectors seeing productivity and employment decline (declining sectors)(23). In order to enhance the Japan' s economic growth potential, low-TFP-growth sectors should shrink and high-TFP-growth sectors should expand. Labor should be available for the expansion of the high-growth sectors. Low-growth sectors may be expected to play a role in absorbing employment at a time when unemployment is high. As Japan is predicted to face labor shortages over the medium or long term, however, we should now give priority to high TFP growth.

Figure 3-2-8 Growth of Total Factor Productivity (TFP) and Change of the Number of Employed by Industry

Three channels for labor stock adjustment and reallocation

There are three channels to adjust and reallocate labor stock in the external labor market: 1） adjusting the number of new accessions, 2） adjusting the number of separations from employment, and 3） adjusting the number of job-hopping accessions(24).

Labor stock adjustment through these three channels is indicated in the Survey on Employment Trends by the Ministry of Health, Labor and Welfare (see Figure 3-2-9)(25). From 1991 to 1993, accessions declined as both new and job-hopping accessions decreased. This indicates that companies were adjusting employment by restricting accessions during the period. On the other hand, separations declined faster than accessions. As a result, regular employees increased during the period. From 1994 to 2001, both new and job-hopping accessions increased. On the other hand, separations increased faster than accessions. This indicates that companies increased retirees while securing necessary personnel.

New accessions continued on a downward trend until 1994 before rising continuously until 2001. But new accessions in 2001 were still some 10% less than in 1991, accounting for only 5.8% of regular employees. Companies apparently reduced employment of new graduates in the period. Although new graduates are decreasing in number by decreasing in the birthrate and aging, the accession rate for new graduates fell from 81.3% in 1990 to 56.9% in 2002 for university graduates and from 87% to 60.3% for junior college graduates. Therefore, the increase in new accessions since 1993 was apparently led by part-timers.

Next, the number of those who couldn' t find employment after separation has basically kept increasing since 1991, reaching about 3.16 million in 2001, one million more than in 1991. There are much those who format the un-labor force focusing on those who reached at retirement age (see Column 3-4). However, others might have remained in the job market as jobless people.

Lastly, we would like to consider the trend of job-hopping accessions, which kept falling until 1994 before continuously increasing. As a result, job-hopping accessions totaled some 3.85 million in 2001, accounting for 9.3% of all regular employees. The share for those leaving jobs within three years after graduation from school has been increasing. In 1998, they accounted for 70.8% of junior high school graduates, 46.8% of senior high school graduates and 32.0% of university graduates. This apparently reflects the fact that people have been trying to change jobs while they are young(26).

Both employees and employers have had reasons to cause an increase in job changes.

First, a growing number of workers are willing to change jobs. The Labor Force Survey by the Ministry of Public Management, Home Affairs, Posts and Telecommunications looks into workers who are willing to change jobs while being employed. According to this survey, workers willing to change jobs accounted for 10.5% of all employed in 2001, up from about 8% in 1995. Among them, the number of engineers is greater than administrative workers, attesting to an increase in demand for skilled specialists. An increase in involuntary job losers amid companies' business reorganization has also contributed to expanding labor supply in the job-hopping market.

Second, companies have positively promoted mid-career hiring. According to the Survey on Employment Management by the Ministry of Health, Labor and Welfare, the most cited reasons for hiring of mid-career managers and officials are that they are immediately useful and that a diversity of experienced personnel can invigorate organizations. Frequently cited reasons for employing mid-career clerical and related workers include replacement of retirees and utilization of immediately useful personnel. Reasons for hiring mid-career engineers and researchers also include utilization of immediately useful personnel and replacement of retirees. Positive reasons such as exploration of new business areas and expansion of existing businesses are cited less frequently. Large companies with more than 1,000 employees tend to cite positive reasons for mid-career hiring

Figure 3-2-9 Changes in Numbers of Job Accessions, Job Separations and Job-hopping Accessions

Diversification of Employees

Employees include regular employees, non-regular employees (such as part-timers) and outside employees (such as temporary staff). The recent employment trend features an increase in non-regular employees including part-timers and temporary staff.

First, part-timers have been increasing. While the regular employment indices in the Monthly Labor Survey of the Ministry of Health, Labor and Welfare leveled off in the second half of the 1990s, full-time employees began to decline with part-time employees increasing in and after 1998. As a result, the rate of part-time workers has exceeded 20%(27). According to the Labor Force Survey by the Ministry of Public Management, Home Affairs, Posts and Telecommunications temporary or daily employees under less than one-year contracts have increased while regular employment has decreased. Their share of temporary or daily employment is close to 13%(28).

The reason part-timers have been increasing is that companies can benefit from an increased weight of part-timers while women have increasingly participated in society. According to a survey on part-timers conducted by the Tokyo metropolitan government in October 2001, frequently cited reasons to employ part-timers included lower wage costs, simpler jobs and responses to daily and seasonally busy periods.

Second, temporary staffs have also been increasing. Thanks to the revised Worker Dispatch Law, the number of temporary staffs rose from some 600,000 in 1995 to 1.4 million in 2000(29). The number increased further in 2001, according to industry statistics. According to a temporary staff service survey by the Ministry of Health, Labor and Welfare in January 2001, the most frequently cited reason for firms to accept temporary employee was prompt employment of necessary personnel to fill vacancies and new posts, followed by cheap personnel costs, temporary employment of supplementary personnel for daily operations, and needs for special knowledge or skills(30). Reasons for firms to accept temporary staffs instead of part-timers included prompt employment of necessary personnel, needs for special knowledge or skills, and lower employment management costs. These reasons indicate that companies expect temporary staff to be immediately useful for jobs requiring high-grade knowledge and skills.

Such non-regular employees had tended to serve as a buffer for employment adjustment and decline upon economic deterioration. In the current recession, however, they have been increasing. This reflects a structural change where a market (demand and supply) for non-regular employees has expanded. For the labor side, factors behind the increase include women' s growing participation in society and changes in people' s views on working, including a shift of priority to leisure. On the other hand, there may be people who are forced under the severe employment situation to work as non-regular employees such as part-timers while being willing to become regular employees(31)1. For employers, factors behind the increasing number of non-regular employees may include personnel cost reductions and responses to risks(32) (33).

Expanding employment mismatches

As indicated by increasing job changes, the labor force has grown more fluid in Japan. But job changes are not necessarily smooth because of mismatches between job offers and seekers.

Employment mismatches are a phenomenon where vacancies and unemployment coexist as job offers fail to satisfy job seekers even under a macro equilibrium between labor demand and supply.

Employment mismatches are indicated by the unemployment-vacancy curve' s upward shift on the right (see Figure 3-2-10). The UV curve indicates the relationship between the unemployment rate and the vacancy rate (the extent of labor shortages for employers).

Without structural changes, the curve should go up on the left or down on the right. But structural changes can cause the curve to go up on the right or down on the left. The figure indicates some structural changes occurring since the second half of the 1990s.

It apparently indicates that job seekers' requests are increasingly failing to match job offer conditions regarding occupations, skills, ages, wages, contract periods or working periods. Let' s look at employment excesses or shortages by sector. Manufacturing, construction, and wholesale and retail sectors face employment excesses, while transportation and communications, and services sectors face an employment shortage. By occupation, employment excesses are seen for management and administration jobs, and shortages for specialized and engineering jobs.

Behind such a situation may be the following changes:

First, technologies have been developing rapidly. This means that skills and knowledge can become obsolete rapidly.

Second, business restructuring has led to a massive number of middle-aged and older people seeking jobs in the labor market. These people have difficulties finding jobs and tend to find jobs similar to their former ones. If they were to find different jobs, they might have to remain unemployed longer.

Third, a growing number of people are calling for diversification of employment conditions regarding contract periods and working hours. Let' s estimate structural unemployment as indicated by the UV curve' s upward shift on the right. The structural unemployment rate has persistently increased to the present level of around 4%, accounting for a greater part of the high unemployment rate.

Existing employment mismatches mean that job seekers are failing to take advantage of potential employment opportunities. If employment mismatches remain, demand shortages and unemployment will be prolonged. This may lead to the existing skills of job seekers becoming obsolete, reducing their employment potential(34). It is necessary to enhance efforts to eliminate employment mismatches.

Figure 3-2-10 UV Curve

For improving labor allocation efficiency

In order to take advantage of growing job changes (mid-career hiring) for restructuring the Japan' s economy, Japan will have to develop an environment that can ensure the job market' s fulfillment of its functions, quickly eliminate employment and refrain from impeding the liquidity of labor.

Enhancing functions of the job market

If labor mobility is facilitated in the job market, existing companies and entrepreneurs will be able to promptly get personnel for launching new businesses and workers will be allowed to shorten their unemployment periods before finding jobs matching their requests. But employment mismatches can emerge to affect labor mobility 1） if information is limited on job details, workers' skills, their willingness to work and other matters, 2） if job seekers and job-offering employers differ over contract periods, working hours and other working conditions, or 3） if job seekers' skills fail to meet conditions.

We should consider the expansion of placement services to solve the information shortage problem, the revision of institutions to tackle working condition problems, and the development of knowledge and skills and improvement of vocational training to address the working skill problems.

In tackling the information shortage problem, the public sector should take more advantage of private-sector placement services through closer cooperation. The private sector has already been expanding placement services as private placement firms are introduced and job information is disseminated through the Internet.

In addressing working condition problems, we should consider fixed-term employment contracts, discretionary labor and other systems to allow workers to choose from a diversity of conditions.

In vocational development, a rising number of adult graduate schools are expected to play a greater role as demand is increasing for specialized and skilled workers amid the structural shift to technology and knowledge-intensive industries. Scholarship expansion and other measures are required to support adult graduate schools.

Other institutional changes are also important for enhancing the functions of the job market. Such changes should include the expansion of a range of jobs for temporary staffs.

Furthermore, the maintenance and improvement in employment potential power are also important. Prolonged unemployment can reduce reemployment potential. The work-sharing system, which is increased to allow a wider diversity of working styles, is expected to contribute to the maintenance of working skills.

Regulation reform to which mobilization dose not become disadvantageous

Environment where the change of occupation dose not become disadvantageous is also important for ensuring labor liquidity. Specifically, pension, retirement allowance and other financial conditions benefiting lifetime employment may impede job changes.

In order to help ensure the portability of pension insurance, the fixed-premium pension system was established in 2001 for corporate pension programs. The system fixes premiums during employment instead of pension money after retirement and may be neutral to job changes. In line with an increase in job changes, companies are growing interested in an environment that does not put job changers at a disadvantage. A greater number of companies are expected to give consideration to this point.

A rising number of part-timers, temporary staff and other non-regular employees indicate that working styles should be diversified. In order to support such diversification, it is important to review working conditions for non-regular employees and expand social insurance coverage for them.

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3. Improvement of Fund Allocation Efficiency

Another factor behind falling labor productivity growth is the inefficiency in allocation of capital stock that is a productive factor as important as labor. Financial markets, especially bank lending as the main money source to enterprises, have failed to efficiently provide companies with funds from the macroeconomic point of view(35). From a wider viewpoint, we can conclude that money flow centering on indirect financing has been inefficient. We now would like to consider these two problems regarding fund allocation.

Inefficient allocation of bank lending and its correction

In order to check whether bank lending has been provided to high-productivity sectors from the macroeconomic point of view, we will first look into the relationship between bank lending, the mainstay fund-raising means for companies, and TFP. See Figure 3-2-11 that illustrates the relationship between bank lending and TFP on a sector-by-sector basis.

While outstanding bank lending from 1994 to 1997 leveled off or declined for most sectors, those to the construction and real estate sectors with falling TFP remained steady. These two heavily indebted sectors have been plagued with massive debts. Nevertheless, bank lending to these sectors continued to increase due apparently to loan rollover without much scrutiny. Bank lending has been inefficient, as indicated by the massive loans to sectors with low TFP growth between 1994 and 1997. Bank lending allocation has been inefficient while outstanding bank lending as a whole have leveled off.

In the late 1990s, however, moves emerged to correct such inefficiency. Since 1998, bank lending to the real estate and construction sectors declined while those to the electric machinery sector increased. Loans have thus begun to contribute to TFP growth generally. But a decline in bank lending to some sectors mainly reflects bad loan disposal. While the decline can be viewed as a step to improve the efficiency of bank lending, we cannot decisively conclude that bank lending efficiency has been improved generally.

Figure 3-2-11 Correlation Between TFP and Loans (by Industries) Structural changes in money flow

As discussed above, fund allocation through bank lending has been inefficient in some areas. But not only bank lending has been inefficient. Overall money flow including bank lending has indicated structural changes. The financial system has failed to sufficiently respond to economic changes.

Looking into Japan' s overall money flow seen until the first half of the 1990s, households then had been the only stable fund-surplus sector. Households had provided the non-financial corporate and general government sectors with savings for investment. Savings had also been used to cover fund shortages in the overseas sector (corresponding to the current account surplus in the international balance of payments) (see Figure 3-2-12)(36). Financial institutions had served as financial intermediaries to transfer household savings to non-financial corporations(37).

This framework began to collapse in the latter half of the 1990s. Non-financial corporations became a fund-surplus sector. This may be because companies with excess capacity and debts reduced capital investment and land holdings in order to reduce debts. They took such action inevitably since they were required to restructure themselves. As a result, however, non-financial corporations became an excess-savings sector after using household savings, and financial institutions failed to serve as financial intermediaries between households and non-financial corporations. Financial institutions thus came to a turning point.

Let' s look into details of the changes in the household, non-financial corporate and banking sectors.

Figure 3-2-12 Changes in Fund Surplus and Shortage

Household sector' s financial asset holdings

The household sector' s financial asset holdings have been concentrated in safe assets. Risk assets' share of the holdings has been very low. Household financial asset holdings totaled some ¥1,400 trillion (at the end of FY2001). Cash, deposits and other safe assets increased their share of household financial asset holdings to 54.4% at the end of FY2001 (see Figure 3-2-13). Risk assets, including bonds, equity shares and investment trusts that are exposed to market risks, saw their share falling to 13.2%. The risk asset share is far lower than 55.5% in the United States. It is even lower than in Germany, which had a risk asset share as low as in Japan once. In the second half of the 1990s, the risk asset share rose to 37.1% in Germany on the government' s promotion of people' s equity investment(38).

The reasons for the household sector' s risk-avoiding asset holdings, where a risk asset share is low, may include the following:

1） Stock investment has been inconvenient as large minimum investment lots have made small-lot investment difficult and convenient investment products including settlement services have been absent.

2） There are maruyu for aged people (non-tax system for small savings) and other tax incentives savings.

3） People fail to understand the characteristics of risk assets under investment information shortages.

4） Aged people who usually prefer low-risk assets are increasing their share of the population.

Recent reasons follow:

5） The stock market slump has led people to be more conscious of stock investment risks.

6） People are increasing reserve savings since they have grown more uncertain about the future of the economy and the social security system.

Let' s look at the impact of the fourth reason--aged households' rising share of Japan' s households. The Survey on Savings Trends by the Ministry of Public Management, Home Affairs, Posts and Telecommunications indicates that assets held by households whose householders are 60 years or older have been increasing their share of total household assets, standing at 54% in 2000. This is because the number of households with householders aged at or above 60 is increasing and their financial assets are relatively abundant. A breakdown of household assets by householder age shows that average household assets total ¥4.32 million for householders aged under 30, ¥17.98 million for those aged 50-59, and ¥26.41 million for those aged 60 or older. Deposits, savings and other safe assets account for most of the financial assets held by aged people, and stock and other risk assets are limited(39).

In this way, the household sector' s financial asset holdings are concentrated in safe assets, meaning that the household sector, while being a major fund provider, has refrained from supplying risk money directly. This does not necessarily match rising weight on direct financing in large companies' fund-raising operations as discussed next.

Figure 3-2-13 International Comparison of Household Financial Assets

Corporate sector' s dependence on indirect financing

The corporate sector (non-financial companies) has heavily depended on indirect financing for raising funds. The sector' s outstanding liabilities (funds the sector raised) totaled ¥1,258 trillion at the end of FY2001. Borrowings accounted for 38.7% of the total, while equity shares, capital, bonds and other securities captured 40.8%. The sector' s dependence on indirect financing, or borrowings, is relatively heavy (see Figure 3-2-14).

The borrowings percentage of 38.7% is far higher than 14.1% in the United States and the securities percentage of 40.8% is far lower than 65.8% in the United States. As for Germany that is said to have industrial and financial systems similar to Japan' s, the borrowings percentage is lower at 37.6% and the securities percentage is higher at 50.2%. The corporate sector in Japan thus depends on direct financing less than in other major industrial nations and on indirect financing more.

But borrowings peaked in 1995 before following a downward trend due to disposal of non-performing loans and the bad debt problem for financial and non-financial corporations. At the end of FY2001, borrowings totaled ¥487 trillion accounting for 38.7% of total corporate sector liabilities(40). On the other hand, equity shares and capital continued a downward trend from 1989, coming to ¥392 trillion accounting for 31.1% of total liabilities at the end of FY2001.

Among companies, large ones have increased their dependence on direct financing. But small and medium enterprises are still heavily dependent on indirect financing. Let' s look at corporate fund-raising operations by size. According to the Financial Statements Statistics of Corporations by Industry as published by the Ministry of Finance, large companies gradually reduced interest-bearing debts throughout the 1990s (see Appended Note 3-4). Bond issues account for some 10% of their liabilities. But small and medium enterprises have made few bond issues and depended only on borrowings for raising funds.

Large companies have thus been shifting from indirect financing through banks to direct financing through equity and bond issues. The first apparent reason for such a shift is that they can take advantage of their growth potential and profitability to reduce fund-raising costs. Second, they can disperse risks by diversifying fund-raising means. Third, they can raise funds even without real assets since equity shares can be issued without any collateral.

There are several reasons for small and medium enterprises failing to utilize direct financing. First, their assessment on the direct-financing market is problematic since their earnings are difficult to assess. Second, information disclosure costs for using direct financing can become a great burden on them. Third, many SMEs believe that they can raise sufficient funds through indirect financing. Fourth, they want to maintain good relations with financial institutions. Fifth, they want to maintain their present management rights and setup.

Figure 3-2-14 International Comparison of Corporate's Financing Activity

Declining financial intermediation function As discussed earlier, households have continued to deposit funds at banks, while companies have had a cash surplus. This may be because financial intermediation function has declined while companies' demand for funds has dropped on an economic slump and debt repayments as financial institutions' risk-taking capacity has decreased on a stock market fall and non-performing loan disposal.

Domestic banks' balance sheets, as given in the Flow of Funds by the Bank of Japan, indicate that total liabilities in FY2001 declined from the early 1990s. Among the liabilities, deposits and their share of liabilities have been increasing.

On the other hand, banks' gross assets also declined from the early 1990s to FY2001. Among the assets, loans growth slowed from the high levels of the early 1990s and began to decline. Their share of gross assets soared, peaking in the mid-1990s before declining(41) (see Figure 3-2-15).

The share for stocks and capital has also been falling since the second half of the 1990s. In contrast, the share for government bonds and bills, and local government bonds has been rising since the mid-1990s.

A breakdown of bank assets by bank category, as based on the principal thoughts of financial institutions, indicates that domestic banks' outstanding loans have recently been falling by 4% to 5% annually. Especially, city banks' loans posted lower growth than other banks and turned down in the 1990s in reaction to a substantial expansion in the second half of the 1980s. Their loans in March 2002 fell 4.5% from a year earlier. On the other hand, city banks increased their bond holdings' share of gross assets in the second half of the 1990s as financial institutions' bond holdings as a whole increased.

While financial intermediation between households and companies reducing, banks have increasingly purchased public bonds to funnel household savings to the general government sector.

Figure 3-2-15 Breakdown of Financial Assets at Japanese Banks

Financial system reform

Indirect financing system providing household savings via banks to companies' investment, had worked effectively under the fast-growing, stable economy. As the bubble economy collapsed to force balance sheet adjustment at financial institutions and non-financial companies, however, companies' falling demand for funds has led banks' financial intermediation to decline. Under the slow-growth economy exposed to various risks, the dependence on indirect financing alone can make fund allocation rigid and inefficient. This could become a constraint on future economic growth. Japan is now urgently required to shift to a financial system where indirect financing is well balanced with direct financing to overcome growing uncertainties. Agenda that Japan should tackle to this end are as follows:

Recovery of banks' financial intermediation function

Banks must accelerate non-performing loan disposal in order to recover their financial intermediation(42). If net operating profit for disposing non-performing loan small, however, such disposal can result in a depletion of capital. In order to promote non-performing loan disposal, therefore, banks must step up profitability-boosting efforts including setting profit margins to match risks involving borrowers. In order to improve profitability, banks may have to not only expand profit margins but also cut costs through rationalization and expand other high value-added businesses, such as investment banking.

For the immediate future, banks need to boost their capacity for examinations of borrowers and set interest rates matching risks involving individual loans in order to expand profit margins as a whole and improve earnings. But wider profit margins can serve as increased burdens on borrowers. The impact of rising burdens on borrowers cannot be ignored. The impact is serious especially on small and medium enterprises. Tougher lending terms could lead to criticisms against a credit crunch. Such criticisms are attributable to the limited objective standards on lending terms meeting conditions of borrowers. Therefore, banks should build databases of borrowers, process them statistically and use such databases for explaining reasons for raising profit margins. They should also explain efforts to rationalize management and secure profit to depositors.

While banks must make efforts to improve their profitability, Japan must urgently reconsider functions of public financial institutions and promote the diversification, specialization and division of financial intermediation in order to increase the efficiency of indirect financing.

Improving functions of direct financing

Direct financing has been less developed than indirect financing in Japan. In order to ensure the development of a well-balanced financial system, however, Japan must attempt to improve the functions of direct financing. To this end, Japan should expand and develop money flow channels through markets based on the risk-return relationship and should increase the efficiency of money flow amid the highly uncertain economic environment. Japan' s securities market has been developed and expanded under the Japanese version of the financial Big Bang launched in 1997. In order to solve the problem of limited investors, however, Japan must ensure the market' s transparency through further improvements in information disclosure and enhance market surveillance functions.

On the other hand, some problems remain regarding fund-raisers' access to direct financing markets. A serious problem is how best to improve access to direct financing markets for small and medium enterprises and venture companies as fund-raisers. For some outstanding SMEs, the initial public offering market has been developed and financial assistance through venture capital funds are available (see Column 3-5). SMEs may have potential demand for direct financing. But disclosure and other institutional requirements have increased effective burdens on SMEs, discouraging them from promoting use of direct financing. Private bond issues to a limited range of investors would be facilitated, and efforts would be stepped up to increase liquidity of and securitize the liabilities of SMEs(43).

Risk money supply

It is important to secure risk money supply while direct financing is expanded. In order to increase risk money supply from households whose investment has so far been concentrated in safe assets, Japan should increase returns to match risks, or increase risk-diversifying means. On the other hand, the growth of specialized investment knowledge has led to institutionalization of fund management. Giving consideration to such phenomenon, Japan should expand a direct fund flow from fund suppliers to markets but also an indirect flow from suppliers to markets via institutional investors.

To this end, Japan should review savings incentives and taxes on financial products, develop and provide new financial products and a diversity of sales channels, spread defined-contribution pension plans and develop investment advisory services. Through these efforts, Japan should develop indirect and direct financing in a balanced manner in order to allow the efficient fund supply required for economic growth.

4. Improvement of R&D Efficiency

Importance of technological progress

Total factor productivity growth is productivity growth that is independent from any increase in capital or labor input. The most fundamental factor behind TFP growth is technological progress stemming from research and development investment(44). East Asian countries are enhancing their competitiveness amid economic globalization. If Japan is to maintain its competitiveness under such circumstances, it will have to increase its economic productivity through technological progress. On the other hand, the declining birthrate and aging population in Japan are expected to continue faster than in any other country. Constraints on labor force and capital supply are likely to emerge in Japan. Therefore, the promotion of technological progress through research and development operations is important for maintaining medium and long-term economic growth in Japan.

However, a study by the Organization for Economic Cooperation and Development indicates the possibility that Japan' s R&D investment has failed to boost TFP effectively. Looking at the cross-country relationship between the R&D investment ratio (the ratio of R&D investment to GDP) and TFP growth (average growth from the 1980s to the 1990s) in the OECD countries, we can find that higher growth in the R&D investment ratio accompanies higher TFP growth on the whole. In spite of a rise in the R&D investment ratio from the 1980s to the 1990s in Japan, however, its TFP growth has been declining to deviate from below the general trend line (see Figure 3-2-16). This means that R&D investment growth has not necessarily led to productivity growth in Japan(45).

We would like here to put Japan' s R&D problems in order and consider how best to effectively link R&D investment to productivity growth.

Figure 3-2-16 Cross-country Correlation between R&D Intensity Ratio and Total Factor Productivity (TFP)

Current situation of R&D investment

Before considering the relationship between R&D investment and technological progress, we would like here to review the current situation of R&D investment in Japan. Japan' s R&D investment features 1） a large size, 2） private companies' dominance and 3） concentration in applied and development research.

Let' s look at Japan' s R&D spending in fiscal 2000 according to the Survey of Research and Development by the Ministry of Public Management, Home Affairs, Posts and Telecommunications. The year' s nominal R&D spending totaled ¥16,289.3 billion, up some 25% from a decade ago. In real terms, fiscal 2000' s spending was up some 22% from a decade ago. As a result, the ratio of R&D spending to GDP rose from 2.90% in fiscal 1990 to 3.18% in fiscal 2000, the highest among major countries (see Figure 3-2-17).

Figure 3-2-17 Evolution of R&D Expenditure Relative to Nominal GDP

As for R&D spending, industry accounted for 66.7% or a majority of, universities for 19.7%, the government for 9.3%, and private research institutes for 4.3%. The government contributions totaled 21.7% of Japan' s total R&D expenses. This share is slightly lower than in other major countries(46). Most of the government contributions are spent by public organizations including state and other public research institutes, research arms of special public corporations for advanced and fundamental R&D, and state and other public universities. Government R&D subsidies to industry including private companies in Japan are less than in any other major country.

Among industrial sectors featuring massive R&D spending are electric machinery, chemicals and transportation machinery manufacturers. These three sectors alone account for 64.4% of industrial R&D spending. R&D spending' s ratio to sales, an indicator of relative spending size, is high at 5.65% for electric machinery, 6.34% for precision machinery, 5.36% for chemicals, and 5.79% for software.

Let' s look at the characteristics of R&D. Generally, R&D investment is grouped into three categories--1） basic research, 2） applied research and 3） development research. Of corporate R&D investment in fiscal 2000, basic research accounted for 5.8%, applied research for 21.3% and development research for 73.0%. Applied and development research thus has a dominant share of the total. The public sector, which is expected to undertake basic research, spends relatively less on R&D. As a result, basic research' s share of total R&D spending in Japan is lower than in any other major nation. Japan' s R&D spending thus concentrates in applied and development research.

To summarize, R&D investment in Japan is one of the highest levels in the world and dominantly covers development and applied research. Basic research' s and government spending' s shares of total R&D investment are limited.

Relationship between R&D investment and TFP

How does R&D investment lead to TFP growth? In considering the question, we look here at corporate R&D investment that accounts for the majority of Japan' s total R&D spending.

Corporate R&D investment produces technologies and knowledge to make real contributions to productivity growth after a certain incubation period from the spending implementation. As time goes by, technologies and knowledge lose value (or become obsolete) on the emergence of new ones. Considering this, let' s estimate R&D investment adjusted to a certain time lag as "technology and knowledge flow" and the accumulation of technology and knowledge flow based on a certain rate of obsolescence as "technology and knowledge stock(47)."

The estimated technology and knowledge flow declined between fiscal 1994 and 1996 in response to an R&D spending fall amid the economic slowdown after the burst of the economic bubble. But the flow increased in fiscal 1997. On the other hand, technology and knowledge stock slowed its growth in and after fiscal 1994. It has remained slow in recent years. This may be because corporate R&D spending has slowed growth in the severe economic situation after the burst of the economic bubble. Another reason may be that existing technology and knowledge stock has become obsolete faster as technological innovation has accelerated to shorten life cycles of products in recent years (see Figure 3-2-18).

In order to find the technology and knowledge stock accumulation' s contributions to actual productivity growth, we would now like to look into the cross-industry relationship between technology and knowledge stock and TFP. Although certain extent of dispersion is observed from sector to sector, we see moderate positive correlations between the stock and TFP, indicating that a sector that has larger R&D investment and faster knowledge and technology stock growth than others can achieve higher productivity growth (see Figure 3-2-19).

Next, let' s estimate the production function that gives explicit consideration to technology and knowledge stock, in order to find how technology and knowledge stock growth has contributed to economic growth(48). This indicates that technology and knowledge stock has significantly contributed to economic growth and that technology and knowledge stock accumulated through R&D can work to accelerate technological progress (see Figure 3-2-20).

But technology and knowledge stock' s growth slowdown lowered the stock' s contributions to economic growth in the 1990s. Furthermore, if we estimate the production function for both the 1980s (1981-1990) and the 1990s (1991-2000) periods, in order to look into the elasticity of technology and knowledge stock to added value, the elasticity of technology and knowledge stock declined to 0.13 in the 1990s after rising to 0.43 in the 1980s. Technology and knowledge stock growth had greater difficulties in leading to productivity growth in the 1990s. These factors may be behind the fact that Japan' s R&D investment growth from the 1980s to the 1990s failed to lead to productivity growth, as indicated in the above-cited nation-by-nation comparison by the OECD.

Figure 3-2-18 Changes in Technology and Knowledge Flow and Stock (Real, Fiscal 1990 as Base Year)

Figure 3-2-19 Cross-Industry Correlation between Knowledge & Technology Stock and Total Factor Productivity (TFP)

Figure 3-2-20 Technology and Knowledge Stock' s Contribution to Added-value Growth

Japan' s problems with R&D

While close relations are detected between R&D investment and productivity, R&D investment has had difficulties in leading to productivity growth since the 1990s, as discussed above. Since Japan' s economic slowdown has continued on non-performing loan and other structural problems since the burst of the economic bubble, however, this cannot be attributed totally to problems with R&D. In fact, however, some people argue that Japan' s massive R&D investment has failed to lead to productivity growth because problems have existed with R&D quality and effective uses of R&D achievements. We would now like to consider problems with Japan' s R&D from the viewpoints of 1） quality of R&D, and 2） utilization of R&D achievements.

Quality of R&D

It is frequently noted that Japan' s R&D achievements are less than indicated by its R&D spending. Specifically, following issues are often cited as examples to support that view. Namely, 1） the citation index for Japanese research papers is low, 2） the citation index for Japanese patents and knowledge intensity for Japanese patents are low, and 3） Japan suffers technology trade deficits in strategically important areas while running an overall technology trade surplus.

First, if the quality of research papers as R&D achievements is higher, their citations are expected to be more frequent. According to the U.S. "Science Citation Index: Science and Technology Literature Database," U.S. was dominant in the SCI database for the six years from 1994, followed by Japanese reports. However, Japan' s Relative Citation Index (RCI),(49) which gauges the quality of research paper production has remained below the international average of 1. Furthermore, the Japanese RCI has leveled off while RCIs for other major countries have been rising (see Figure 3-2-21). Japan' s RCI is below 1 for every research area. Especially, Japan' s SCI is remarkably low at 0.39 for the computer science area, which is closely related with IT technology.

Second, a similar tendency is seen for patents. U.S. patent data indicate that Japan' s share of patent applications is the second largest after the U.S. share, although it has been on a downward trend since the 1990s due to other Asian countries' rising shares. But Japan' s relative science citation index(50) for patents remained under the international average of 1 throughout the 1990s before starting an upward trend and surpassing 1 in 2001. Furthermore, Japan' s science linkage(51), which indicates the strength of relations between patents and science reports (or the intensity of knowledge for patents), is the lowest among the five major countries (Japan, the United States, United Kingdom, Germany and France), and its gaps with the other major countries have been expanding. Especially in biotechnology and some other areas, Japan' s science linkage is far lower than in the other major countries.

Third, let' s look into technology trade (international transactions in patents, utility model rights, etc.). According to the Survey of Research and Development by the Ministry of Public Management, Home Affairs, Posts and Telecommunications, Japan has maintained a technology trade surplus since fiscal 1993 after technology exports began to rise remarkably in the early 1990s(52). The ratio of technology exports to imports has been rising specifically for automobile and some other sectors. But the ratio has remained below 1 for IT-related sectors (communications, electronics and electric measurement equipment) and the non-manufacturing industry. In technology trade with the United States, automobiles and other mature sectors have run surpluses, but advanced technology areas, including communications, electronics and electric measurement equipment, have seen deficits.

To summarize, Japan' s abundant R&D spending has led to its large share of global R&D research papers and patents and its technology trade surplus. Reflecting the heavy emphasis on applied and development research and the light emphasis on basic research, however, the influence and knowledge intensiveness of Japanese R&D research papers and patents have been limited. In IT and other areas closely related to basic and advanced research, Japan' s technological levels have been lower than in other major countries. As symbolized by the fact that Japan lagged behind other major countries in IT development in the 1990s, the lower quality of R&D and the low technological levels in strategically important areas might have worked as constraints on the improvement of the Japan' s economic productivity.

Figure 3-2-21 Changes in Relative Science Citation Indexes of Major Countries

Utilization of R&D achievements

R&D achievements are expected to contribute to productivity growth through their effective utilization. In Japan, however, some people argue that many R&D achievements have remained within universities and companies' research laboratories and have failed to be effectively utilized. Universities and research institutes are expected to provide the society with fundamental and advanced research achievements that are difficult for companies' applied and development research to make. However, Japan has failed to develop mechanisms for these achievements to be authorized as rights for supply to society. Under legislation in the late 1990s, technology licensing organizations, known as TLOs, have been established to facilitate the transfer of research achievements at universities and research institutes to companies. As a result, there has been much progress in patent acquisitions of universities and research institutes, as well as their technology transfer to industrial sector. Since TLOs have just been created, however, actual technology licensing in fiscal 2000 was limited to only 98 cases, far less than 3,306 in the United States(53). The number of university-based ventures, founded through such technology licensing, totaled 263 firms in Japan at the end of 2001, against a total 2,624 firms as established in the Untied States by fiscal 2000(54).

It is also said that even private companies have failed to commercialize promising R&D achievements amid the promotion of business selection and concentration. A poll to private companies has found that 76% of respondent firms have had research achievements that had failed to be commercialized. While only 15% of such firms have sold these achievements to others, 68% of them have left their research achievements frozen within the company(55).

In this way, Japan has just launched efforts to promote effective utilization of R&D investment achievements. This may be a factor behind the failure of abundant R&D investment in leading to productivity growth in Japan.

Improving effectiveness of R&D

What should Japan do in order to link its massive technology and knowledge stock to productivity growth effectively? We would like to consider this question from several viewpoints: 1） enhancement of basic research, 2） expansion of R&D in the services industries, 3） roles of universities and government, 4） promotion of industry-academia-government cooperation, 5） enhancement of international cooperation, 6） establishment of intellectual property rights, and 7） enhancement of knowledge management at companies.

Enhancement of basic research for product innovation in the manufacturing industry

Technological progress includes product innovation to produce new epoch-making technologies and products, and process innovation to improve production process for upgrading product quality or lowering product prices. Generally, product innovation is a risky challenge requiring massive funds. Once product innovation is triggered, however, its versatile effect may spread throughout the whole economy.

Japan has so far taken advantage of process innovation to improve its productivity. In process innovation, Japan has introduced basic technologies developed in Europe and the United States for applied and development research. As Japan has been catching up with Europe and the United States in the technology area, however, Japan now has less room to depend on European and U.S. technologies and knowledge for increasing productivity. On the other hand, Japan has lagged behind other industrial nations in biotechnology, information, communications, and other cutting-edge technology areas, which require a solid foundation of basic research and given priority for future innovation, as discussed in respect to R&D quality.

Therefore, Japan should step up basic research to stimulate product innovation.

Expansion of R&D in services industry

Amid the growing presence of services in the economy, the services industry should promote R&D with consideration given to the diversity of its products. In fact, the United States and United Kingdom have seen R&D spending increasing for financial services, insurance, computer services, R&D services and other services. In future, Japan may have massive room to improve the intensiveness of technologies and knowledge in the services industry.

Roles of universities and government

Basic research that is important for product innovation is too versatile to allow developers to get insufficient returns. Private companies hesitate to invest in basic research whose achievements can be copied and lead to technological spillovers. As corporate R&D spending growth slows amid the prolonged economic slump, private companies tend to give less priority to basic research that takes much time to produce achievements for commercialization.

In such circumstances, universities and the public sector have key roles to play in promoting basic research. Therefore, Japan has been implementing measures to invigorate universities and improve their international competitiveness. For example, state universities are promoting reorganization and consolidation and introducing private-sector management ideas such as incorporation for enhanced independence and autonomy, and exemption of university officials from the government bureaucracy. In order to make universities internationally competitive, the government must prioritize public assistance while introducing competition principles through third-party assessment.

In order to vitalize R&D investment by private companies, the government should review and improve tax incentives for R&D promotion (see Column 3-6) and aggressively implement assistance including the Japanese version of the U.S. Small Business Innovation Research System(56).

Promotion of Industry-Academia-Government Cooperation

It is important for technologies and knowledge produced in research at universities and research institutes to be utilized smoothly for developing new products and exploring new markets. As discussed above, however, Japan' s process has failed to work to commercialize new technologies. On the other hand, private companies have been forced to limit R&D spending amid the severe economic environment. In addition, private companies' existing human resources, technologies and know-how have difficulties in tackling advanced technology areas. Private companies might then have potential expectation of cooperation with academic and government sectors. In order to commercialize cutting-edge achievements at universities and research institutes, Japan should develop and promote TLO and other systems to act as a bridge between basic research and applied research. It should also promote the public sector' s joint research with private companies and develop mechanisms (including the expansion of the Japanese-version Bayh-Dole system(57)) for transferring technologies from the government and universities to private companies in order to enhance industry-academia-government cooperation. The government should help frozen R&D achievements to be commercialized and give assistance to venture businesses willing to take advantage of new technologies(58).

Enhancement of international cooperation

Technological innovation has accelerated and R&D costs have ballooned for such innovation. It is now difficult for one country alone to implement necessary, effective R&D operations. Therefore, domestic and international R&D alliances have grown more important. Under these circumstances, cross-border R&D cooperation has been invigorated. From the 1980s to the 1990s, the number of international strategic technological alliances increased substantially. But Japanese firms' international technological alliances declined in the period, leaving Japan to deviate from the global trend(59). At present, each research area has a global network with a center to create new technologies. One example is a network spreading from Silicon Valley for IT. Isolation from such global networks means a deviation from the global trend of technological innovation. Japan should enhance cooperation with research institutes in foreign countries through international joint research, promotion of international exchanges of researchers, and international technological alliances.

Establishment of intellectual property rights

The intellectual property right policy is a very important infrastructure to support technology and knowledge production in R&D activities linking companies, governments and universities. Any delay in development of such policy can increase the possibility of technologies or knowledge being copied and reduce incentives for R&D investment. Some exclusive rights to R&D achievements should be given through patents. Japan has implemented reforms to enhance the patent system, but it must further promote such reforms. On the other hand, excessive monopolies through patents could increase social costs including impediments to the spread of technologies. While comparing social benefits of R&D promotion and social costs stemming from technology monopolies, we must design an optimum patent system. There are some problems with Japan' s patent system. It is often argued that too much time is consumed for screening patent applications and that the present damages compensation system is not a sufficient deterrent to patent infringements. Japan should consider faster screening of patent applications and improving the legal system.

Enhancement of knowledge management at companies

Apart from R&D problems, patents, know-how and other intellectual properties as R&D achievements have been growing more important for corporate management. A general view at present is that intellectual properties are a source of competitiveness and corporate value. Nevertheless, there is a complaint that Japanese companies have given less strategic considerations than European and American firms to acquisitions and management of intellectual properties. In order to respond to international competition involving intellectual properties, Japanese firms should step up selection and concentration of intellectual properties from the viewpoints of improved profitability and business strategy.

Since Japanese companies have failed to sufficiently disclose their intellectual property information, investors remain unable to base their assessment of firms' profitability and value on intellectual properties. Companies should sufficiently disclose intellectual property information for assessment of property value. If such assessment becomes a key factor behind decisions on profitability and value of companies, these firms may be able to establish their intellectual property strategies that should enhance their fund-raising capacity and improve their business strength. In this respect, Japan should promote firms' intellectual property disclosure through the introduction of intellectual property accounting and reports for explicit assessment of patents, copyrights, brands and other intellectual properties. This would allow companies to base their management strategies on intellectual properties.

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