Section 1 Present State of Economy and Positive Signs

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The recent economic recovery phase that started in the beginning of 2002 has been prompted by the recovery of industrial production originated from export growth. This has brought about improvements in corporate profits and an increase in business investment, and as a result, positive signs are being observed mainly in the business sector. The effect is also gradually extending to the employment and pay situations, though sure signs of improvement have yet to be seen, while no movements have been observed yet in the household sector.

In the following part of this section, we will first overview the economic trends after the bottoming out, and then analyze some signs of improvement in the business sector, the employment situation, and the household sector in detail.

1. Economic Trend After the Bottoming Out

blackcircle Signs of improvements after the bottoming out

Since November 2000, the Japanese economy had been in a recession phase due to the influence of the collapse of the global IT bubble. However, originating from the upturn in exports that has been backed by the start of a recovery by the U.S. and Asian economies and the depreciation of yen, bright signs gradually began to emerge, with the economy finally bottoming out in January 2002. (1) After the economy bottomed out, signs of improvement were observed mainly in the business sector. These signs emerged in the business sector in the form of industrial production growth, improvement in corporate profits, improvement in business outlook, and business investment recovery, as well as in relation to employment such as an increase in new job offers. If this trend continues steadily, it should eventually bring about an increase in employment and wages, and lead to signs of improvement in the household sector.

blackcircle Recovery comes to a halt before moving toward improvement again

However, due partly to the escalation of tensions over Iraq from the second half of 2002 and the subsequent outbreak of the Iraq War, as well as the increase in the number of people infected by Severe Acute Respiratory Syndrome (SARS) and the increase in the number of infected areas, Japanese export growth lagged in line with the economic slowdowns that occurred in the United States and the Asian region-Japan's main export markets. Because of this, production growth in the business sector also stopped, and the positive signs in the business sector began to moderate. In the household sector as well, personal consumption weakened at the end of 2002 due to cash earnings downturn, particularly for bonuses, and the drop in consumer confidence, and it remained at the same level after that.

From that point to the middle of 2003, exports have shown signs of recovery as the Iraq situation and the SARS issue began to settle down and the sense of uncertainty faded. With clear positive signs indicated in the business sector, the economy has begun to show movements toward improvement again.

blackcircle Characteristics of the recent economic recovery phase

The economic recovery did not intensify smoothly after the bottoming out, but rather temporarily weakened from the end of 2002 to the beginning of 2003.

This trend can be observed in the changes in the diffusion index (DI) (Figure 1-1-1). The DI, which came to exceed 50% after the bottoming out, dropped below 50% in December 2002 and April 2003. However, it has stayed above 50% since then.

The same trend can also be observed in the real GDP growth rates in the April-June quarter of 2002 (Figure 1-1-2). After marking a 0.9% increase over the seasonally adjusted rate of the previous quarter in the April-June quarter of 2002, the rise of the real GDP growth rate slowed, indicating a 0.8% increase in the July-September quarter, a 0.6% increase in the October-December quarter, and a 0.6% increase in the January-March quarter of 2003. However, it picked up again in the April-June quarter of 2003, posting a 1.0% increase.

Taking a look at the breakdown of the real growth rate, external demand is seen to be making a large contribution. External demand made a 0.5 percent point contribution to the real growth rate in the January-March quarter of 2002 when the real growth rate had increased by 0.2%, and also made a 0.4 percent point contribution in the subsequent April-June quarter. After the July-September quarter, too, it again made a 0.4 percent point contribution in the October-December quarter. As a result, external demand achieved a contribution of 0.8 percent point to the 1.6% real growth rate increase in fiscal 2002. This suggests that the recent economic recovery phase has been lead by exports and that the export trend has been an important factor in the bottoming out and the subsequent trend of the economy.

What, then, is the current situation of the economic recovery of the Japanese economy? We will examine this issue separately below for the business sector and the household sector. The analysis illustrates a situation where, despite the positive signs observed mainly in the business sector, the cycle toward economic recovery has not yet to be fully set in vigorous motion.

Figure 1-1-1 Diffusion Index (Coincident Index) and Real GDP Growth Rate

Figure 1-1-2 Changes in Real GDP Growth Rate

2. Positive Signs in Business Sector

The current economic recovery has originated from the rebound in exports and its effect has spread gradually in the business sector. As export growth subsequently took on a weak tone, production weakened accordingly. Owing to continuing improvements in corporate profits and business investments as well as recovering export growth, however, positive signs in the business sector are beginning to solidify. We will now give a category-by-category outline of the economic trends in the business sector.

(1) Slowdown in export growth

blackcircle Export trends

Export trends have significantly affected the bottoming out of the economy in 2002 and subsequent economic trends. According to the export volume indexes based on the customs statistics, Japanese export volume started to increase in the January-March quarter of 2002, and continued to increase until the end of the April-June quarter of 2002, at a higher pace than in the two previous recovery phases (see Figure 1-1-3). The factors behind this export growth were the sharp rise in exports to Asia along with the recovery in the conditions of the IT market, and the recovery in exports to the U.S.

However, export growth started to slow down in the July-September quarter of 2002, which seems to be due to the following factors: 1) growth in exports to Asia decelerated in the July-September quarter of 2002 and the growth took a downward turn in the April-June quarter of 2003; 2) exports to the U.S. dropped sharply in the January-March quarter of 2003; and 3) exports to the EU also decreased considerably in the April-June quarter of 2003 (see Figure 1-1-4).

Figure 1-1-3 Trends in Export Volume in Recovery Phases

Figure 1-1-4 Changes in Japan's Exports Volume

blackcircle Economic trends in the major trading partners

Such export trends in Japan outlined above are closely related to economic trends in the trading partners. In other words, Japanese economic trends depend on the economic trends of its trading partners. This is revealed by the fact that the correlation between Japan's GDP and its major trading partners' GDP has recently intensified (see Appended Figure 1-1.) Of overall Japanese exports, about 30% is to the United States, about 40% to Asia and about 15% to the EU. We will now outline the economic trends of these regions.

Of all Japan's major trading partners, the trends of the U.S. economy are particularly important. Since entering a recovery phase in November 2001, the U.S. economy achieved a high growth rate of 5.0% per annum in the January-March quarter of 2002, driven by increased consumer spending (see Figure 1-1-5). Subsequently, however, there was delay in improvements in business investments, and the rise in consumer spending, which had been driving economic growth, slowed down as tensions escalated over Iraq. As a result, the real growth rate decelerated from 4.0% in the July-September quarter to 1.4% in the October-December quarter. It remained at 1.4% in the January-March quarter of 2003 during the period of the Iraq War, staying at a lower level below 1% for two consecutive quarters. (2)

These trends in the U.S. economy also had an impact on the Asian economy. In Asia, domestic consumption improved after the Asian Financial Crisis. However, as exports to the U.S. decelerated due to the slowdown in U.S. economic growth, economic growth in Asian countries also decelerated (see Figure 1-1-6). In the Republic of Korea and other Asian countries where the dependency on exports to the U.S. had been relatively low, consumers cut back on their spending and therefore domestic consumption growth dropped, which brought about a slowdown in economic growth.

High growth in the Chinese economy made up for the slow growth in the U.S. Economy. The Chinese economy-growing 7 to 8% every year-achieved a high growth rate of 4.0% in the January-March quarter of 2003 (17.0% per annum). Accordingly, China's total import volume has been increasing, reaching $87.3 billion in the January-March quarter, up about 50% over the previous year. Asian countries have become increasingly dependent on China as their importer. In the total export volume of Japan, China (including Hong Kong) has an increasingly larger share, accounting for the second largest share at 16% in 2002, following the U.S. (29%).

However, the outbreak of the SARS epidemic at the beginning of 2003 had a significant influence on China and other Asian countries. China's real growth rate was negative in the April-June quarter of 2003, down by 0.6% over the previous quarter, and Singapore also registered negative growth in the same quarter, down by 3.0%.(3)

The economy was generally stagnant in EU countries. By country, economies slowed down in all euro members, with an outstanding economic recession seen in Germany. The U.K., one of the non-euro members, sustained a relatively strong economic performance before its growth gradually began to slow.

As outlined above, economic slowdown in the major trading partners, and the U.S. and China in particular, seem to have acted as a significant factor inhibiting Japanese exports.

Figure 1-1-5 Real Growth Rate of U.S. GDP

Figure 1-1-6 Economic Growth Rates of Asian Countries

blackcircle Exchange rate trends

Exchange rate trends also have affected Japan's regional export trends. In particular, one of the recent trends was the depreciation of the U.S. dollar against other currencies (see Figure 1-1-7). According to the trend in the yen/dollar exchange rate, the U.S. dollar weakened from its 120-yen level in the April-June quarter of 2002 to the 110-yen level in the July-September quarter. This exchange fluctuation weakened Japan's export competitiveness not only for its exports to the U.S. but also for those to Asian countries, because many Asian currencies are linked with the U.S. dollar in some way. (4) On the other hand, the euro continued to appreciate against other currencies. According to the trend in the yen/euro exchange rate, the yen has been weak since the October-December quarter of 2002, which seems to have supported the base of Japanese exports to Europe.

The nominal effective exchange rate, which is an average of the exchange rates in these regions weighted by the share of each trading partner, has been scarcely fluctuating. This implies that the trend in the nominal effective exchange rate has not significantly affected the overall export trend.

The yen has been appreciating since it became stronger against the euro in June 2003 and against the dollar ($1=110 yen) in late September.

Figure 1-1-7 Trends in the Yen Exchange Rate

blackcircle Export trends by item

Looking the export trends by item, automobile and IT-related products made significant contributions, accounting for about 17% and about 22% of the export volume in 2002 respectively (see Figure 1-1-8). The trend in automobile exports is greatly affected by exports to the U.S. (5) Automobile exports to the U.S. increased significantly in the first half of 2002 when the U.S. automobile industry enjoyed good sales due to the zero-interest campaign launched by the Big 3 Automakers and other automobile companies. Subsequently, as local stock started to pile up after the sales hit the ceiling, the inventory adjustment started and Japanese exports decreased. However, inventory declined to an appropriate level in the beginning of 2003, and Japanese automobile exports are expected to increase in the future in line with the trend of automobile sales in the U.S. Among IT-related products, exports of electronic parts such as semiconductors, office appliances and scientific and optical devices increased significantly. The majority of these products were exported to Asian countries with which Japan had established relationships for the division of labour in production steps, and the high export growth in the first half of 2002 was supported by the high growth in the Asian economy. (6) However, along with the slowdown of the Asian economy, the export growth decelerated with respect to all these products in 2002 and the export volume dropped sharply in the January-March quarter of 2003.

Figure 1-1-8 Analysis of Contribution of Each Item in the Export Volume

blackcircle Trends in the second quarter of 2003 and thereafter

Since the April-June quarter of 2003, the momentum of economic recovery has been strengthening both in the U.S. and Asian economies. In the U.S., the GDP increased by 3.1% per annum in the April-June quarter of 2003 over the previous quarter, surpassing the 1%-mark. The Asian economy also seems to be breaking free of the influence of SARS as it subsides. These movements will bring about a favorable environment for future Japanese exports to these regions. We will address what these movements will mean for the future prospects of the Japanese economy in Section 4.

(2) Upward Trend of Industrial Production Also Slowing Down

From the beginning of 2002, industrial production continued to increase backed by export growth. However, the output stopped rising from the end of 2002 on a slowdown in export growth due to lack of any powerful increase in domestic demand. Because industrial production is a core element for the overall economic trend, a steady increase in industrial production is essential for achieving a sustainable economic expansion.

blackcircle Trend of industrial production

After industrial production also turned up in the January-March quarter of 2002 supported by the export increase, its growth accelerated, marking a 2.8% increase over the previous quarter in the April-June quarter and a 2.0% increase in the July-September quarter (Figure 1-1-9). Similar to export growth, the growth in industrial production at this time was much faster than in the past two economic recovery phases. Nevertheless, the growth slowed down from the end of 2002 to the beginning of 2003, and leveled off in the middle of the year.

blackcircle Cause of the slowdown in the upward trend

Such changes in industrial production have been largely affected by the export trend. While production is conducted in response to the shipment trend, the breakdown in shipments reveals that export shipments achieved high growth. In particular, the shipment growth in the January-March quarter of 2002 was basically attributable to export shipments (Figure 1-1-10). After that, the contribution of export shipment declined, and domestic shipment began to make larger contributions instead. However, as domestic shipment is likely to partly include shipments that have been induced for export, the influence of exports is still considered to be great. By item, IT-related goods and transport equipment, such as electronic parts/devices, electric equipment, and information and communications equipment, have made significant contributions, coinciding with the export trend.

Indeed, calculating the correlation coefficient between exports and industrial production shows that the coefficient has exceeded 0.9 since the end of 2001, which demonstrates the strong influence of the export trend (see Appended Figure 1-2).

Figure 1-1-9 Industrial Production Comparison with the Past Recovery Phases

Figure 1-1-10 Industrial Shipment by Destination

blackcircle Reasons for the lack of inventory accumulation

The present phase can be illustrated as in Figure 1-1-11 based on the inventory level. According to this, the inventory adjustment phase ended in the January-March quarter of 2002, and an inventory accumulation phase started in the July-September quarter. However, production growth has not gone with shipment growth, so the inventory level has remained at the lowest levels recorded since 1988. Furthermore, shipment growth is slowing down. As a result, the inventory is moving to the right and downward on the inventory cycle, as if the inventory accumulation phase is going to end (Figure 1-1-12).

Why is no inventory accumulation observed?

Inventory is considered to be decided by the following factors. First of all, the factors for increasing inventory are: 1) trying to keep inventory in order to meet long-term demand growth and prevent any loss of opportunities from going out of stock; and 2) trying to keep inventory as a buffer to hold down adjustment costs related to the production line by leveling production as much as possible when short-term demand growth is expected.

On the other hand, factors for decreasing inventory are: 1) seeking to raise asset efficiency by cutting inventory holding costs, such as interest; and 2) limiting the inventory valuation loss pertaining to deflation to the minimum (see Appended Figure 1-3).

It hardly needs mentioning that inventory could also fluctuate due to an erroneous demand forecast irrelative to the company's intention. The inventory decreases if the actual shipment exceeds the forecast level, and increases if it fails to reach the forecast level. It is also an important factor that creates cyclical changes in inventory. (7)

Figure 1-1-11 Production/Shipment/Inventory Indices

Figure 1-1-12 Inventory Cycle

Therefore, in order to identify the contributing factors, we quantitatively analyzed the factors that decide the inventory (For details, see Appended Figure 1-1). According to this, factors such as the expected growth rate of demand, the expected price fluctuation rate, and forecast errors are found to have a significant influence. This result indicates that the expected price fluctuation rate has a considerable impact, while the impact of forecast errors is relatively small at present. Therefore, we can see that the inventory trend in the recent inventory accumulation has been defined by economic motives to hold down inventory based on deflationary expectations.

blackcircle Requirements for production growth

These analysis results reveal the requirements for achieving future production growth. In order for current production to grow, a recovery in exports is the first requirement. In particular, it is necessary for the U.S. growth rate to rise and for that to have an impact on the entire global economy as well as improve the Japanese export environment. Second, domestic demand needs to increase dramatically. A particularly important point is that an increase in personal consumption and business investment will induce production of consumer goods and capital goods. Third, inventory must be accumulated. To this end, the demand forecast needs to be corrected upward in the future based on growth of final demand. Furthermore, if the deflation comes to an end, the limiting of inventory from a concern for valuation loss is likely to be eased.

When these requirements are gradually met, production growth will become sustainable and it will be possible to achieve a solid economic recovery.

(3) Continuous improvements in corporate profits

Shipment growth acts as a profit-boosting factor for corporate profits (ordinary profits). In addition, companies made restructuring efforts to raise their earning power. As a result, corporate profits, which had seen a profit decline in FY 2001, increased in profits in FY 2002. Nevertheless, deflation means a severe earning environment for companies. Also, cost reduction by large companies causes earnings deterioration for small and medium-sized companies, such as subcontractors. Therefore, corporate performance differed by type of business and company size.

blackcircle Environment surrounding corporate profits

The FY 2002 environment surrounding corporate profits can be summed up as follows.

First, it was hard to increase sales in the deflationary environment. Deflation served as a factor that reduced corporate profits, because even if sales increased in quantity, sales amounts would be restrained due to falls in unit sales prices. However, if a company was highly dependent on exports, it could achieve high growth in terms of sales quantity and the overall sales could increase in some cases. Moreover, if the unit purchase cost also declined under the same deflationary environment, it could have the effect of supplementing the decreased sales amount.

Second is the impact of restructuring. Since the end of the 1990s, companies had been strengthening their restructuring efforts to cut fixed costs. Specifically, these were various measures to reduce personnel costs, as well as sales costs and sales administrative expenses. As a result, the break-even point was lowered and the business structure was changed to enable profit to be made even without growth of sales amounts. However, restructuring of large companies meant a decline in sales amounts for small and medium enterprises, such as subcontractors.

blackcircle Significant increase in profits in the manufacturing industry

We will now look at the status of corporate profits in FY 2002 under the above circumstances based on ordinary profits reported in the "Financial Statements Statistics of Corporations by Industry, Quarterly."

Companies' overall corporate profits (ordinary profits) took a favorable turn from the 19.6% decline from the previous fiscal year marked in FY2001 to a 7.2% increase in FY 2002 (see Figure 1-1-13). However, the breakdown reveals different results by type of business and company size.

The manufacturing industry increased its profits dramatically in FY 2002. Ordinary profits marked a 42.5% decline from the previous fiscal year in FY 2001, but recorded a 32.8% increase in FY 2002. The underlying factors are as follows (see Figure 1-1-14).

The first factor was that sales amounts increased by 1.9% over the previous fiscal year in large companies despite the deflation. This was mainly attributable to export growth. At the same time, sales costs increased and offset part of the profit-boosting factors brought about by increased sales amounts. Overall, however, large manufacturing companies were able to prevent the impact of deflation from affecting corporate profits to a certain extent.

Meanwhile, sales amounts declined for small and medium enterprises. This is because SMEs were less dependent on exports, and the cost-cutting efforts of large companies led to fewer orders being placed with SMEs. However, part of such an impact was offset as a result of a decline in sales costs achieved by the cost reduction efforts that had been promoted as part of restructuring measures. Though not as much as for large companies, the impact of the deflation was also limited to some degree for small and medium manufacturing enterprises.

Figure 1-1-13 Corporate Profits

Figure 1-1-14 Factors Contributing to Improvement of Corporate Profits (Manufacturing Industry)

The second factor was a decrease in personnel costs, which came as the result of powerful restructuring efforts. Such decrease was particularly obvious for large companies. The figures suggest that thorough restructuring measures have been implemented, because not only personnel costs, but also sales administrative expenses and "Others" (a decline in financial charges) were found to be contributing to the increase in profits. Because sales amounts are increasing, that alone would be sufficient to stop the decline in profits, but they are likely to be engaging in restructuring in order to further raise their corporate profits. Thus, this restructuring could be called "aggressive restructuring." Consequently, the break-even points of large manufacturing companies were lowered and we can confirm that restructuring has served as a factor to raise corporate profits.

Personnel costs were also reduced considerably in SMEs, and restructuring efforts have been made. In addition, the break-even points of SMEs have notably lowered. However their restructuring was intended more as a measure to offset the impact of the declines in sales evident during the period. In that sense, the restructuring carried out by SMEs had the quality of "defensive restructuring."

blackcircle Non-manufacturing industry managed merely to halt the decline

The ordinary profits of the non-manufacturing industry declined in FY 2002. Again, according to the "Financial Statements Statistics of Corporations by Industry, Quarterly," the ordinary profits declined by 1.3% from the previous fiscal year in FY 2001 and declined further, by 4.6%, in FY 2002.

The first underlying factor was the impact of the decrease in sales amounts (see Figure 1-1-15). Sales costs also decreased, and served as a profit-boosting factor, but it contributed largely to the fall in sales amounts, indicating the impact of the deflation.

The second factor is a decline in personnel costs and sales administrative expenses and progress in restructuring. The break-even points lowered both for large companies and SMEs. Nevertheless, it did not manage to offset the decline in corporate profits caused by the fall in sales amounts.

These characteristics are particularly noticeable in SMEs. It should be noted that, in their case, the fall in sales amounts serves as a particularly large profit-reducing factors. On the other hand, in the case of large companies, the decline in sales amounts is small, but not so much restructuring effort has been observed. In this sense, non-manufacturing companies' restructuring was also "defensive restructuring."

Figure 1-1-15 Factors Contributing to Improvement of Corporate Profits (Non-manufacturing Industry)

blackcircle Current income also turning profitable for the first time in two years

Current income, which is obtained by adding extraordinary gains or losses to ordinary profits and deducting tax payable, showed a loss of 2 million yen in FY 2001, but it returned to the black for the first time in two years in FY 2002, posting a surplus of 2.8 trillion yen (see Figure 1-1-16).

Figure 1-1-16 Changes in Corporate Profits (Extraordinary Gains and Losses)

The underlying factors in terms of extraordinary gains and losses were the decline in costs related to retirement benefits, which had been posted in large amounts until the previous fiscal year, and the decrease in asset impairment processing conducted ahead of schedule. This indicates that restructuring passed its peak in FY 2001. The effects of this restructuring showed up in the ordinary profits for FY 2002 as discussed above. On the other hand, valuation losses of securities have remained at the same level, revealing that price falls are continuing.

Such increase in cash flow contributed to promoting companies' balance sheet adjustments. As discussed later, companies' cash flow exceeds business investment. When we analyze the cash flow statements of listed companies to identify uses of cash flow other than business invention, we can see that the major part of it is used to repay debts (see Figure 1-1-17). In the background, there are positive movements to reduce excessive debts. As a result, companies' outstanding liabilities with interest have decreased(8) (see Figure 1-1-18). We can also see that they are buying their own shares. This trend is notable for companies whose debt ratio is not particularly high. It is considered to be not only for extinguishment of stock, but also because purchase of one's own shares has become easier with the lifting of the ban on treasury stock in October 2001. (9)

Figure 1-1-17 Cash Flow Management of Listed Companies

Figure 1-1-18 Changes in the Balance of Interest-Bearing Liabilities of Companies

blackcircle Profit increase continues in FY 2003

Corporate profits are expected to continue to improve in FY 2003. According to the "Financial Statements Statistics of Corporations by Industry, Quarterly," ordinary profits for the April-June quarter of 2003 marked a 13.6% increase over the same quarter of the previous year. In addition, according to the 2002 plan of ordinary profits for companies of all industries and all sizes based on the September survey of the Short-term Economic Survey of Principal Enterprise in Japan (Tankan), following a 16.4% profit increase over the previous fiscal year, an increase of 10.4% over the previous fiscal year is expected in FY 2003 too.

(4) Increasing business investment

Following the capital stock adjustment phase since 2001, business investment turned up in the first half of 2002 as the economy hit bottom. Conditions that will support this trend have been put in place, such as increasing operating ratio and improving corporate profits. However, as companies' outlook for the future is cautious, it is difficult to expect any drastic increase in business investment.

blackcircle Upturn in FY 2002

According to the quarterly GDP statistics, real business investment turned up in the July-September quarter of 2002 and continued to increase for the fourth consecutive quarter (see Figure 1-1-19). The pace of this increase is almost the same as or slightly higher than that seen in the previous economic recovery phases. Nominal business investment also continued to increase for the fourth consecutive quarter since the July-September quarter of 2002, though the pace of increase remained relatively moderate. Such increase in real business investment was brought about by the decline in business investment deflators due to the drop in price and improvement in quality of capital goods.

According to the Financial Statements Statistics of Corporations by Industry (quarterly), overall nominal business investment declined by 8.4% in FY 2002 over the previous year. By industry, the margin of decline was large in the manufacturing industries, down 16.1% over the previous year. On the other hand, the margin of decline is relatively small in the non-manufacturing industries, down 4.6% over the previous year. The breakdown of manufacturing and non-manufacturing industries shows that the declining trend came to an end in many industries (see Appended Figure 1-4).

Figure 1-1-19 Pattern of Recovery in Business Investment

blackcircle End of stock adjustment in the manufacturing industries

The main factor behind the upturn in business investment in the manufacturing industries in FY 2002 may be the end of stock adjustment.

In the second half of 2001, enterprises started to adjust their capital stock in order to adjust the level of capital stock to a future demand level. To this end, enterprises reduced business investment to prevent increases in capital stock and also decreased production capacity by disposing of existing equipment.

As a result, the growth of capital stock gradually decelerated and the adjustment made progress to a favorable level. Along with this progress in adjustment, 1) operating ratio stopped its decline and turned up during the October-December quarter of 2001. The rise in operating ratio increased incentives for investment to enhance production capacity. 2) As business investment has been restrained up to now, according to the estimation, the average age of equipment recently increased from about 10 years in the 1990-1994 period to 12 years, which indicates that equipment is increasingly aging. Such equipment aging means a future increase in demand for replacement investment.

On the other hand, factors encouraging business investment gradually became apparent. 3) First, business sentiment started to show signs of recovery. According to the BOJ's Tankan diffusion index (DI), business sentiment has been improving moderately in both large companies and SMEs in the manufacturing industries since it bottomed out in the January-March quarter of 2002. This means that companies' outlooks about the economy are gradually becoming brighter. In addition, as outlined above, 4) corporate profits have also started to show improvement. The trend of corporate profits is fundamentally important in connection with allocation of funds for business investment, and therefore improvement in business earrings will lead to increases in business investment. However, as companies are putting priority on debt repayment when using cash flow, such improvements in corporate profits are not affecting business investment as significantly as before (See Chapter 2, Section 1 for financial restrictions on business investment).

Considering all these factors and looking at the capital stock cycle diagram, we can see that business investment in the manufacturing industries has gone through stock adjustment and started to increase(10) (see Figure 1-1-20).

Figure 1-1-20 Capital Stock Cycle

blackcircle Factors behind the increase in business investment in the non-manufacturing industries

Though the mechanism of capital stock adjustment may also function in the non-manufacturing industries, it is not as clear as in the manufacturing industries, as shown in the capital stock cycle diagram. In the non-manufacturing industries, the situations in individual industries seem to influence business investment to a greater extent. For example, the following factors affected business investment in FY 2002: 1) in the real estate industry, business investment increased mainly for large-scale urban-development projects in the Tokyo metropolitan area; 2) in the retail industry, business investment increased due to the opening of new supermarkets or homeware stores; 3) in the electricity industry, business investment has been restrained in the course of attempts to achieve business efficiency since the second half of 1990s; and 4) in the communication industry, business investment decreased with respect to fixed-telephone services.

blackcircle Business investment will continue to increase in FY 2003

The increase in business investment is expected to continue in FY 2003. According to the BOJ's Tankan Survey for September, overall business investment (scale/industry) increased by 2.2% over the previous year. Such an increase is comparable to the increases seen in September in FY 1996 and FY 2000, the previous phases of recovery in business investment. Among others, large manufacturing companies are expected to achieve high growth in business investment, and non-manufacturing companies and SMEs are also increasing their business investment relatively in a steady manner. (11) However, in light of the trends in the following indicators, it is difficult to expect a drastic increase in business investment for the time being.

Shipment of capital goods, an important supply-side indicator of investment demand, remained almost flat (see Figure 1-1-21). While shipment of capital goods includes capital goods for exportation, it does not include imported capital goods, which also contribute to increasing business investment. The gross supply of capital goods in Japan, which was obtained by taking these conditions into consideration, showed almost the same trend as that of shipment of capital goods. (12)

Next, we will review the trends of machinery orders and construction budgets as leading indicators. Machinery orders showed signs of recovery whereas construction budgets, a leading indicator for construction investment, remained almost flat. The latter trend may be largely due to that fact that the current round of investment in large-scale redevelopment projects in the Tokyo metropolitan area has been completed.

Figure 1-1-21 Trends in Business Investment-Related Indicators

blackcircle Requirements for sustaining the increase in business investment

In order to sustain the increase in business investment, it is important that a steady increase in future demand is foreseeable while corporate profits continue to improve and financial restrictions are eased. Only under such circumstances will enterprises make business investment to increase capital stock growth.

However, the mid-term growth rate that companies currently expect is extremely low. According the "Questionnaire Concerning Corporate Activities for FY 2003" by the Cabinet Office, the average expected growth rate for the next three years as of January 2003 was as low as 0.7%. Such a low rate would quickly terminate the phase of business investment increase that has finally got underway. Whether the expected growth rate among enterprises will rise will be a crucial point in the future

3. Changes in the Severe Employment Situation

Though positive signs started to be seen in the business sector, as outlined above, they were moderate and based on the premise of personnel cost reduction through corporate restructuring, which means that the situation was still severe with respect to employment and wage. Under these circumstances, however, the impact of positive signs in the business sector is extending to and having a favorable influence on this severe employment and wage situation. We will analyze the trends in employment and wage below.

(1) Upward trend in the number of employees

The employment situation was severe as the unemployment rate remained at a high level. However, the number of employees has been increasing since the end of 2002, following the increase in job openings. We should pay attention to how such positive trends will intensify in the current situation of restructuring pressure and an employment mismatch.

blackcircle Unemployment rate remained flat

The unemployment rate rose from the 4.5%-5.0% range to about 5.5% in 2001, but then declined and remained within the 5.3%-5.5% range since the October-December quarter of 2001 (see Figure 1-1-22). This flat trend of the unemployment rate, although it remained at a high level, was brought about by 1) the number of unemployed (seasonally-adjusted) staying at around the 3.6 million-person level; and 2) the number of job holders staying at around the 63 million-person level. We will now review the trends in these factors in detail.

Figure 1-1-22 Unemployment Rate

blackcircle Reasons for the number of persons totally unemployed remaining flat

The number of persons totally unemployed remained almost flat largely because of the flat trend in the number of involuntary job leavers due to corporate bankruptcy and restructuring. The number of involuntary job leavers increased significantly in 2001 (see Figure 1-1-23) because of increasing corporate bankruptcy and restructuring pressure. Such increase in restructuring pressure is also seen in the trend of unit labour cost (see Figure 1-1-24). The personnel cost per production unit continued to rise all through 2001 due to the decline in production, which indicates that personnel cost, one of the fixed costs, was a heavy burden on companies. The BOJ's employment assessment DI also shows that the number of companies that felt an employment excess increased. Therefore, companies strengthened restructuring measures and reduced the number of employees as well as held down wages for the purpose of reducing personnel cost. Furthermore, the number of corporate bankruptcies also increased during this period; according to the Survey on Labour Economy Trends, more business establishments implemented employment adjustment (see Figure 1-1-25).

Figure 1-1-23 Trend in the Number of Persons Totally Unemployed, by reason of job seeking

Figure 1-1-24 Trends in Unit Labour Cost (ULC)

Figure 1-1-25 Trends in the Share of Business Establishment That Implemented Employment Adjustment

However, since the beginning of 2002, the number of corporate bankruptcies took a downward turn. With a combination of the effects of restructuring efforts and the increase in production, the unit labour cost also took a downward turn. Furthermore, the number of companies that felt an excess of employment showed a falling off and the share of business establishments implementing employment adjustment decreased accordingly. As a result, the number of involuntary job leavers was flat. (13)

Meanwhile, the number of voluntary job leavers also fluctuated sideways. Most of them were young people who took a job in a severe employment market but found that it was not what they wanted and finally left it. In particular, when more jobs are provided and the balance of labour supply and demand improves, as described below, the number of such voluntary job leavers will increase. (14)

blackcircle Reasons for the number of job holders remaining flat

The number of job holders remained almost flat, though some fluctuations were seen in the breakdown.

First, while the number of employees gradually improved from the previous downward trend, the number of self-employed persons and family workers showed a declining trend due to the aging population (see Figure 1-1-26). The number of employees did not show any sign of increase for a while after the economy hit bottom. This may be due to the tendency to reduce personnel cost. Corresponding to the trends of corporate bankruptcy and restructuring, however, as the trends of corporate bankruptcy and restructuring took a break, the number of employees took a favorable turn and started to increase thereafter.

Second, the breakdown of the number of employees indicates that the number of full-time workers stopped its decline and started to increase whereas the margin of increase in the number of temporary/daily workers started to reduce. The number of temporary/daily workers, including part-time workers, increased due to personnel cost reduction. However, as personnel cost and restructuring pressure decreased, as mentioned above, the tendency to use part-time workers seems to have taken a break.

Figure 1-1-26 Breakdown of Job-holders by Status

blackcircle Trend of those not in labour force

One of the background factors of the flat trends in the numbers of persons totally unemployed and job holders was the movement toward "exit from job market," which means that job holders leave jobs and stop seeking a new job or persons totally employed stop seeking a job.

Along with the long-term decline in the labour force participation rate(15) for males, the number of those not in the labour force increased (see Figure 1-1-27). This resulted from a gradual increase in the number of elderly persons, for which the labour force participation rate was low, due to the aging population (see Appended Figure 1-5).

Those not in the labour force were considered to be also affected by the economic trend. In particular, it was said that females would move out of those not in the labour force and join the labour market when the economy was on an upward trend, while they would move out of the labour market and become not in the labour force when the economy was on a downward trend. Recently, however, the labour force participation rate for females has also been decreasing. As in the case of males, this seems to be due to the weakening of factors that would encourage them to join the labour force because it took a long time to see an increase in the number of employees along with the progress in the aging population.

Figure 1-1-27 Trends in the Labour Force Participation Rate for Males and Females

blackcircle Structural unemployment rate continued to rise

Thus, the increase in the number of employed fell far behind the bottoming out of the economy, and the number started to rise only in an extremely moderate manner. This seems to be reflecting the lack of demand for labour. However, the trends in the new job offers showed that demand for labour actually existed. The number of new job offers took an upward turn in the January-March quarter of 2002 and continued to rise sharply all through 2002. In the April-June quarter of 2003, it reached a level 10% up over the same quarter of the previous year (see Figure 1-1-28).

Figure 1-1-28 Trends in the Number of New Job Offer

The unemployment rate staying at a high level despite the increase in new job offer suggests that a number of vacancies remain unfilled, which implies the existence of a mismatch between job offer and job seekers with respect to conditions of employment such as skills/qualifications and age. From this viewpoint, we will examine the degree to which the share in the current unemployment rate corresponds to the structural unemployment rate arising from such "employment mismatch" and the degree to which the share corresponds to the cyclical unemployment rate arising from short demand for labour. Figure 1-1-22 above shows that, in the current unemployment rate within the 5.0%-5.5% range, about 4% corresponds to the structural unemployment rate and the remaining 1% and more corresponds to the cyclical unemployment rate.

Such a high level of structural unemployment indicates that the unemployment rate will not decline drastically even if the economy improves. This situation will not only cause pain to those unemployed but also cause serious damage to the society as it means that human resources are not being effectively utilized. How we should solve this "employment mismatch" is an important issue. (We will consider this issue in detail in Chapter 2, Section 4).

(2) Wages also stopped their decline

Wages also improved from the previous downward trend to a flat trend, largely because overtime allowance (nonscheduled earnings) increased and bonus (special earnings) stopped its decline. However, due to the review of wage system, the downward pressure on basic wage (scheduled earnings) seems to be strong.

blackcircle Wages stopped their decline

When looking the trend of wages, the total amount of cash earnings continued to decline since it fell below the level of the previous year in the April-June quarter of 2001 (see Figure 1-1-29). In the July-September quarter of 2002, in particular, the margin of decline expanded to a fall of 3.5% over the same quarter of the previous year. Subsequently, however, the margin of decline diminished moderately and the year-on-year change became positive in the April-June quarter of 2003.

The end of the decline in wages was brought about by changes in basic wage, overtime allowance and bonuses. We will now examine these factors.

Figure 1-1-29 Breakdown of Wages

blackcircle Bonuses stopped their decline following the increase in overtime allowance

Overtime allowances correspond closely to the economic trend. The amount of overtime allowances had been declining over the same period of the previous year until the April-June quarter of 2002 but turned up in the July-September quarter of 2003. This trend corresponded to the trend of production.

One of the characteristics of the Japanese wage system is that the amount of bonus fluctuates significantly in response to the rise or fall of corporate profits. When looking at the trend of bonuses,(16) the amount of bonuses paid in the summer of 2002 declined by 9.7% over the previous year, with the margin of decline exceeding that of the winter of 2001. However, as corporate profits improved, the margin of decline diminished for the bonus paid in winter 2002, and the amount of bonus paid in summer 2003 was almost the same as that paid in the previous year.

blackcircle Basic wage also improved from the previous downward trend to a flat trend

In contrast to overtime allowance and bonus mentioned above, basic wages had hardly declined in the past. However, they started to decline in the July-September quarter of 2001. In the April-June quarter of 2002, the margin of decline became the largest, down by 1.6% over the same quarter of the previous year. The margin of decline gradually diminished and became almost zero in the April-June quarter of 2003.

The trend of basic wages seems to be affected by 1) fluctuation in the amount of basic wages paid to regular workers and 2) fluctuation in the ratio of part-time workers (see Appended Figure 1-6). When looking at the fluctuation in the amount of basic wages paid to regular workers, the rate of wage increase achieved in the Spring labourer offensive (Shunto) declined from around 2.0% in 2000 and 2001 to the 1.0%-1.5% range in 2002 and 2003. It is considered that the average wage cannot be maintained at the same level as the previous year without a wage increase of about 2.0% including regular wage increases. Such decline in the rate of wage increase may be one of the causes of the decrease in basic wages paid to regular workers in FY 2002 over the previous fiscal year. We should be cautious of such trend because it is likely to continue in FY 2003.

On the other hand, as shown above, the ratio of part-time workers continued to rise until the middle of 2002 and the upward trend took a break at that level. Therefore, the end of decline in the ratio of part-time workers may be one of the causes that the margin of decline in basic wages diminished and became almost zero. (17)

blackcircle Future trend of wages

The recent end of decline in wages was brought about by increase in production, improvements in corporate profits and break of the trend of corporate restructuring.

When quantitative analysis is conducted on decisive factors for wages by using corporate profits and (cyclical) unemployment rate as explanatory variables, it is revealed that the trend of wages is affected by these factors (see Appended Note 1-2 for details). Furthermore, the basic wage system is being fundamentally reviewed (see Chapter 2, Section 4 for details), which will restrain wage growth. In order to maintain an increase in wages, it is necessary that companies complete restructuring measures quickly, production continues to increase and corporate profits also continue to improve.

4. Households Showing Firmness

Compared with positive signs in the business sector, movements in the household sector were stagnant. Without an increase in private consumption, a self-sustaining economic recovery cannot be achieved. However, on the other hand, it is true that private consumption is showing firmness in the current severe income environment. We will analyze the trends in private consumption below.

blackcircle Private consumption increased moderately

Households had been placed in a severe income environment where compensation of employee decreased due to the decline in employment and wages. Accordingly, disposable income, which is calculated by taking interests payable/receivable as well as taxes and social insurance premiums payable into consideration, also decreased. Real disposable income, which is calculated by taking price fluctuations into consideration, continued to decrease over the previous year since 2000 (see Figure 1-1-30).

Figure 1-1-30 Contribution Analysis on Disposable Income of Households

Under these circumstances, real private final consumption expenditure on an SNA basis has been increasing moderately since FY 1998. In particular, the rate of increase has been around 1.5% since FY 2001.

As a result, the savings rate declined. On an SNA basis, the savings rate declined from 9.3% in FY 2000 to 6.6% in FY 2001, falling below the rate of Germany and France and coming close to the rate of the U.S. (see Figure 1-1-31) Presumably, the savings rate will also decline for FY 2002. Japan's savings rate, once high, is now changing significantly (see Column 1-1). (18)

Figure 1-1-31 International Comparison of Household Savings Rates

Column 1-1 Difference in the savings rate between the "System of National Accounts (SNA)" and the "Household Survey" There are two types of household savings rates, one is the microscopic rate based on the System of National Accounts (SNA) and the other is a rate for workers' households (households of salaried workers). The former was 9.8% in 2000 and 6.9% in 2001, while the latter was 27.9% in 2000 and 2001 and 26.9% in 2002. The SNA-based savings rate has been declining whereas the Household Survey-based rate has been almost flat, and the levels of these two rates have diverged from each other nearly by 20%. The main factors for the divergence between the two rates with respect to the level and the trend may be the following two. The first is the handling of no-occupation households. The SNA-based savings rate includes no-occupation households as it is a macroscopic rate while the Household Survey-based savings rate does not include them as it is the rate for households of salaried workers. The Household Survey provides the savings rate of no-occupation households separately, which has been declining and reached -29.6% in 2002. The SNA-based savings rate including no-occupation households should necessarily be lower than the Household Survey-based saving rate excluding them. The other factor is the handling of imputed service of owner-occupied dwellings. In the calculation of the SNA-based saving rate, households that have their own houses are deemed to be receiving rent and paying rent, on the assumption that they rent their own houses to themselves. Accordingly, both their disposable income and spending increase and therefore the SNA-based saving rate declines as a result. Taking these factors into consideration, a weighted average is calculated between the Household Survey-based savings rate and the savings rate for no-occupation households, and then it is adjusted in light of the influence of imputed service of owner-occupied dwellings (see Figure Column 1-1). The level of the adjusted Household Survey-based saving rate is lowered and has shown a significant drop in recent years, indicating a trend that is extremely similar to that of the SNA-based savings rate. Though divergence still exists between the two, it is revealed that these two factors mentioned above have contributed significantly to the divergence the two savings rates. The adjusted Household Survey-based savings rate for 2002 was lower than that for 2001. Consequently, the SNA-based savings rate is expected to also decline in 2002. Figure Trend of Household Savings Rate

blackcircle Reasons for the declining savings rate

Why is the savings rate declining in Japan?

The basic stance for the analysis on consumption is the "Life Cycle/Permanent Income Hypothesis" that households decide their consumption level based on income that they can expect for a long period to come (permanent income), rather than based on short-term fluctuations in income. According to this hypothesis, when households consider the current decline in income as a temporary fluctuation, they will maintain their consumption to a certain level without adjusting it to such decline in income. If we expand on this theory, we could reach the conclusion that the rising consummation level implies that households consider the current decline in income as a temporary fluctuation and expect an increase in income in the long term.

However, with many indicators of consumer sentiment remaining low, we cannot find any conclusive evidence that households expect an increase in income over the long term. According to the Household Survey, workers' households reduced spending along with the decline in disposable income, which rather suggests a decline in permanent income. (19) All these facts imply that it is difficult to explain the overall movement only from the perspective of permanent income. In order to examine the overall current consumption trend, it is necessary to take other factors into consideration.

What are the other factors that brought about the decline in the savings rate?

The first factor for the declining savings rate was the aging population. According to the Life Cycle/Permanent Income Hypothesis, aged people would dip into their savings for living expenses, which means that the savings rate would be negative. Besides, the population aging is currently increasing at a high speed. Therefore, the macroscopic savings rate should decline along with aging of the population.

In the Household Survey, the savings rate for households headed by aged jobless persons has actually been negative and the negative margin has been expanding (see Figure 1-1-32). Besides, the ratio of households of aged jobless persons to all households has also been rising. Thus, the aging of the population seems to be one of the factors for the declining savings rate.

Figure 1-1-32 Savings Rate for Households Headed by Aged (60 and over) Jobless The second factor may be the real balance effect along with deflation. Households increase their outstanding financial assets through savings every year, but deflation seems to raise their purchasing power and encourage them to spend part of their savings.

Outstanding nominal financial assets continued to increase for a long time but reached a peak and started to decline in FY 1999 (see Figure 1-1-33). More specifically, the margin of increase in cash and deposits, which account for the majority of outstanding financial assets, has been decreasing, and equities have also been decreasing because of the declining purchase costs and revaluation loss due to the drop in stock prices. However, outstanding real financial assets, which had gone through adjustment to price fluctuations, remained almost flat. This indicates that households are refraining from increasing cash and deposits and putting them into spending to the extent that the outstanding real financial assets would not decrease.

Figure 1-1-33 Outstanding Household Financial Assets By age group, the amount of outstanding financial assets was largest for aged people, both on gross and net bases (see Figure 1-1-34). Spending by households headed by aged jobless persons mentioned above seems to be increasing as a result of these effects.

Figure 1-1-34 Current Outstanding Amounts of Savings and Debts per Household, by age group of the head of household

blackcircle Requirements for sustaining increase in private consumption

As outlined above, along with the recent decline in the savings rate, private consumption has been increasing at a modest pace. What requirements should be satisfied to sustain the increase in private consumption?

The factors promoting the aging of population will continue to affect private consumption. However, aged persons' income will decrease as the age at which they could receive pensions is raised and the real balance effect will ease along with the progress in overcoming the deflation. Accordingly, the factors promoting the aging may be restrained. Therefore, what is more important is to make households' outlooks for the future brighter and increase permanent income, which is expected by households for the future, thereby encouraging private consumption.

We have examined movements in the business and household sectors after the economy hit bottom. There are positive signs in the business sector, such as improvements in corporate profits and business investment. On the other hand, with respect to exports as well as production, which is closely related to exports, growth has been slowing down recently. However, exports and production are expected to recover as the growth rate of the U.S. economy increases, and when they do recover, positive signs in the business sector will be encouraged. Furthermore, the impact of positive signs in the business sector is gradually extending to the employment and wage situations. However, such movements have yet to develop as to bring about positive signs in the household sector. Indeed, the Japanese economy is still under a strong adjustment discipline due to problems such as NPLs and excessive debts. We should pay attention to the direction in which these positive signs, which are seen mainly in the business sector, will lead the economy under these circumstances. Based on this awareness, we will address the economic prospects in Section 4. Before that, we will analyze the current status of deflation, which is one of two sides of a coin with the economy, and its causes.

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