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Stronger Economic Recovery with Advancing Reforms

Thirty months have passed since the economy bottomed out in the beginning of 2002. During this period the average annual growth rate reached around 3%, of which the private demand contribution is more than 2%, indicating a private demand-led economic growth. Since the fall of 2003, a high growth rate of more than 5% was realized due to an increase in capital investment as well as a pickup in consumption, highlighting the dynamic recovery of Japan's economy against the other G7 nations.

The current recovery is driven by three forces. The first one is an increase in exports to the United States, China and other countries. External demand played a leading role in the early stage of the recovery. The second one is the structural reform centered on finance, regulations, tax system and public expenditure that achieved success in eliminating the pressure from the Japanese economy and contributed to the growth in private demand. The third one is the positive force achieved through a significant progress in the balance sheet adjustment, which took ten years following the collapse of the bubble economy, and an advancement of corporate reforms that have helped enterprises recover almost to the levels of the period prior to the collapse.

This recovery is different from the past two ones that took place in the 1990s in the following ways. First, the contribution of government expenditure to the growth is negative, and the recovery is led by private demand. Also, share prices in industries related to non-performing loans, such as banks, real estate, construction, and wholesale and retail, continue their upward trends, reflecting the progress in non-performing loan disposal, excessive debt reductions and rise in profitability rates, etc. Furthermore, the unemployment rate is falling in the course of economic recovery, as the sense of over-employment is fading out, and movements for creating employment are coming to the fore in the corporate sector.

The positive effects of both cyclical and structural factors, which underpin the economic growth, is behind the strong growth rate.

Strength of Recovery Continues

On the unexpectedly strong growth rate, there is a cool-headed view that Japan's economic recovery is driven by external demand, and that it might soon suffer a setback due to changes of trends in the US and Chinese economies. However, the contribution of external demand to the economic growth was less than 30% in FY2003. Compared with previous recoveries, the current one is characterized by the large contribution of private demand to economic growth. It is not appropriate to call it "external demand driven."

Furthermore, private demand has a strong potential for recovery. This can be illustrated by the effects of the growing consumption of digital home appliances. These effects not only support the increase in consumption, but they also lead investment. Flat-screen TVs and other products with high value added tend to be manufactured at home, thus broadening the base of related domestic industries and spreading the positive effects over to other areas of demand. In other words, a virtuous cycle of consumption and investment is at work. Such a trend is reflected in the first increase in three years in domestic establishment of Japanese companies. This situation is in contrast with the economic recovery in 2000, which was centered on the IT sector, including personal computers and the increase in demand flowed out of Japan to other countries. In order to ensure sustainable recovery, it is necessary for an improvement in employment to lead to an increase in household finances, as this is expected to result in steady increase in consumption.

As for the structural reform, the related initiatives will continue to be steadily implemented in the future and will gradually bear fruit. Economic relief measures in the past, which depended on public investment, used to be implemented as temporary demand-driven maneuvers. Unlike them, the structural reform aims to thoroughly reinforce the foundations of the economic structure. Disposal of non-performing loans is advancing in order to reach the target outlined in the Financial Revitalization Program: to reduce major banks' non-performing loans ratio by half by the end of March 2005. Initiatives for regulatory reform, including the steady and successful efforts in the Special Zones for Structural Reform, invigorate the economy.

Broadening the Recovery is Needed

It is believed that the economic recovery will continue, but still there are a few points of caution.

First, there are discrepancies in the recovery trends of regional economies, and small and medium enterprises (SMEs) are still in a severe environment. Since the economic recovery does not rely on public spending, the economic recoveries of such regions as Hokkaido, Tohoku, and Shikoku are falling behind those of the favorable Tokai and Chugoku regions, etc. Also, the SMEs, which are faced with competition with low-priced imported products and with rising prices of crude oil, steel and other materials, are in a severe economic situation. An important task will be to spread the effects of the overall economic recovery to the areas that are still falling behind. Toward this end, it is necessary to promote economic revitalization measures tailored to the characteristics of each region.

Second, there is a risk that the deceleration of foreign economies will have a negative impact. At the current phase of development of Japan's economy, inventory levels are low and there is no big build-up of capital stock. However, it is necessary to consider the possibility that, if deceleration were to occur in the US and Chinese economies, an adjustment mechanism of capital stock and inventories will come into effect through slowing down of exports. Even though the economic recovery is driven by private demand, a change in the trend of external demand which supports manufacturing will have a ripple effect that cannot be ignored.

Third is the issue of overcoming deflation. Regarding asset deflation, there are signs that the situation is changing. Stock prices have been on the upturn since the spring of 2003, and land prices around central urban areas have bottomed out. However, moderate deflation still continues as indicated by the rate of increase in the consumer price index which is below zero. In order for the rate of increase in consumer price to steadily keep levels above zero, further improvement of the GDP gap and steady growth in the money supply will be necessary. The government projects a nominal growth rate of around 2% or more from FY2006 onwards. Further united efforts undertaken by the government and the Bank of Japan to overcome deflation will still be necessary.

Addressing Concerns over Rising Interest Rates

Another source of concern for the private demand-led economic recovery is the movement of interest rates. However, a large increase in interest rates might have some negative impacts on the economy through investment cost increases, expansion of losses associated with bond holdings, and heavier burden on public finance due to increase of interest payments.

The financial situation in the US is entering a phase of increase in interest rates, and long-term interest rates are projected to rise against the backdrop of dynamic economic recovery. The general view is that consumer price will continue to decline moderately during this year. Also, quantitative deregulation in Japan will continue until the economy surely emerges from deflation. Therefore, the possibility for interest rates to put pressure on the economic development in the near future is considered low.

On the other hand, according to the past experiences, when economic boom and monetary easing continue over the long term, they may trigger a bubble. The development of the asset bubble occurred in Japan in the late 1980s. The expansion of IT investments grew into a global bubble at the end of the 1990s, and the implementation of restrictive monetary policies resulted in the collapse of the bubble. Therefore, the role of monetary policy is expected in order to avoid both boom and bust, and make the recovery sustainable. It is important to strengthen the confidence of the market that deflation will be overcome, and to increase the transparency of monetary policy. After emerging from deflation, it is an important issue with respect to monetary policy to present directions as to the extent and the duration of the monetary easing conditions, which would lead to stabilizing market expectations through dialogue with the market. A variety of discussions are seen including one proposal to continue the monetary easing policy with the condition that it be "until the prices reach a certain rate of increase or level." At any event, a wide range of examination is needed.

Continued Implementation of Structural Reform in Public Finance to Cope with Aging and Declining Birthrates

One of the characteristics of the economic recovery that started in the beginning of 2002 is that it is not supported by public spending. This is a rare case for the period that followed the end of the high economic growth. However, the situation is that public investment in fact does not boost the economic growth, but tax reforms implemented in FY2003, such as the reduction of taxes related to research and development and capital investment, are propping up the recovery of the economy. Such fiscal policy has become a common practice for the major nations in Europe and America in recent years. In other words, direct demand-driven policies such as public investment are not considered economy-boosting measures, though revitalizing the economic society by tax reforms could be implemented.

Ensuring sustainable stability of expenditure and revenue is extremely important in order to address the issue of declining birthrates and aging society. Improvement in the combined primary balance deficit of the national and the local governments has been advancing during 2004. Reform of public finance can be launched in a wide range of areas: social security system, national and local governments, tax system and expenditure, but in order to break away from the current critical situation in public finance, it is necessary to implement steady reforms by FY2006 in line with the policy for realization of a primary balance surplus outlined in Reform and Perspectives. Such reforms include continued efforts for thorough reduction of expenditure coupled with judgment of necessary tax measures.

Globalization of Japan's Economy into Asia

Globalization is advancing in every aspect of Japan's economy, from goods and services, to finance and labor. The utilization of IT and its most representative example, the use of computers, is further accelerating this process.

In retrospect, the movement of international economy centered on Japan is characterized by an expansion from activities focused on the US to activities that encompass Asia. For instance, regarding trade of goods, transactions with Asian countries exceeded transactions with the US in 1988. As for the flow of services and finance however, the relations with the US remain of greatest importance. Against this backdrop, a new type of relations with the Asian countries in the field of manufacturing industries, called fragmentation of production, is being established. In addition, the impact of the collapse of the bubble economy in the 1990s has reduced the importance of Tokyo as a global financial center.

One of the benefits of globalization is that it is a widely and thinly-spread process that thoroughly permeates the economy. Therefore, it is very difficult to experience it instantaneously. On the other hand, one of the setbacks is that the effects of globalization occur swiftly and in a concentrated manner in one specific area, and could cause a sudden bankruptcy of companies and subsequent unemployment. By world standards, the Japanese are cautious about globalization. Unfortunately, it is impossible to clarify which of the setbacks attributed to globalization is indeed a genuine cause of problems. The expansion of the income gap, rather than being an issue inflicted by globalization, is an employment problem caused by insufficient response to the technological innovation.

The Necessity of Structural Reform that Give Rise to Globalization Benefits

In order to gain benefits through free trade, it is necessary to implement structural reform to eliminate the obstacles to generating benefits, and to achieve maximum results from the market economy by utilizing the functions of price mechanisms.

In the past, Japan's economy has ventured into the flow of globalization, and has achieved significant benefits. However, many latent benefits still remain to be gained. These include the existence of a gap between domestic and foreign prices, the low level of direct inward investment, and the possibilities for accepting more skilled foreign workers.

Looking at the initiatives for structural reform launched in the abovementioned fields, it can be judged that reforms in the 1990s were implemented with significant delay. Even the concerns over the hollowing-out of Japan's industry associated with the transfer of domestic companies to overseas locations are in fact caused by stagnation in employment creation stemming from the delay in structural reform. It is necessary to implement further structural reform in the fields of regulation, tax system, employment and others, and to draw out the potential benefits of globalization. Economic partnerships with the Asian countries, including free trade agreements (FTA), will achieve even greater results if they are implemented in line with initiatives for structural reform.

There are concerns that the increase in the tax-social security contribution wedge against the backdrop of the aging society and declining birthrates will sap the vitality of the economy. So far, labor costs have had little reduction effect on international competitiveness. However, from now on, an increase in the wedge is projected, and it is important to consider the relationship between benefits and contributions build sustainable public finance-social security system, as well as promote the structural reform to revitalize the economy.

Globalization can also be a tool for stimulating the development of the tourism industry. This cannot be achieved by simply attracting tourists to Japan. It is necessary to improve the appeal of local regions to make them attractive for foreign visitors. It is important to launch efforts, and not only in the economic field, but in the fields of society and culture as well, to transform local regions into places that even Japanese people would like to visit or live in. Local economies should strive to capitalize on their respective characteristics, and implement efforts for community-driven vitalization. Such initiatives are already being launched in some regions.

Isolation Can Not be an Option for Japan's Economy

By subsuming an ever-increasing number of countries in its flow, globalization multiplies the benefits for the participating nations. This is the basic principle of achieving benefits from transactions under the conditions of market economy. Therefore, Japan needs to further advance structural reform in order to obtain benefits. Isolation from the global trends is not an option for Japan's economy. The flow of subsumption is swiftly gaining in power in the world economy, and Japan must not be left behind. This requires expeditious decision-making in implementing policies.

Globalization universalizes economic activities that are carried out in countries and regions subsumed in the globalization flow, and transforms them into activities that share common global standards. Thus, production factors such as labor and capital and products, such as goods and services, become standardized, and can be interchangeably used throughout the world. This will result in more efficient economic activities and a stable increase in global income levels.

On the other hand, such trends are consistently backed up by pro-industrialization values and therefore incorporate elements that are incompatible with other trends which respect more intellectual-type of values and demand diversified evaluations. Against the backdrop of the aging society and declining birthrates in particular, education, nursing care, medical care and others are areas in which standardized services alone cannot sufficiently meet the requirements of the people. In the industrial field as well, knowledge is priced even higher and further development of sophisticated intellectual abilities will enhance the comparative advantage of Japan. From this perspective, Japan is now at a point where it must implement reforms that will draw out the benefits of globalization, and parallel to this foster talented human resources that can respond to the needs of the age.

From Outward Globalization to Inward Globalization

Globalization can be likened to a wave. Some people fear that it might erode and wash away national wealth. On the other hand, there are great hopes that the wave of globalization will bring riches. Which way globalization will affect the economy depends on the domestic economic structure of the recipient country. If outdated systems are preserved unchanged and fail to catch the wave, it will gradually erode the country's wealth. The ideal approach will be to advance structural reform in order to ride the crest of the wave, and thus proactively take advantage of the benefits of globalization.

In the past, Japan's economy used to obtain benefits through outward activities. However, it is expected to strengthen initiatives for obtaining benefits through inward activities by opening Japan to the globalization flow. Towards this end, Japan must build a new economic structure tailored to the new challenges and take the leadership position that befits its status as an advanced Asian country. The importance of the globalization perspective was identified back in the 1980s. However, almost no progress was made in initiatives to open Japan to globalization. Proactive efforts are required in order to solve this issue.

Nurturing the Buds of Reform Further

According to the Annual Survey of Corporate Behavior (2004) carried out by the Cabinet Office, more than 50% of the respondents think that Japanese companies as a whole need to strengthen their restructuring efforts. The majority of the companies intend to pursue further restructuring, which is a positive sign for future structural reform.

It is necessary to realize that today, when the buds of structural reform are coming to be seen and the economic recovery continues, is the turning point that will decide the future of Japan's economy. The baby boom generation will start to retire in 2007. It is important to advance further reforms and to reinforce the economic structure. Also, the process of overcoming deflation is still halfway through, and the government and the Bank of Japan must undertake joint policy efforts. Even after deflation is overcome, it will be necessary to continue efforts to facilitate the flow of capital, labor and other production factors into highly-productive areas, to establish an economic relationship of sustainable household finances, companies and public sector under the conditions of price stability, and to set the economy on the path of steady growth.

In this report, analyses are presented from two viewpoints: revitalization of regional economies, and taking advantage of the benefits of globalization. The key to realizing sustainable growth in Japan's economy will be to redouble efforts for structural reform and continue to implement successful initiatives one by one in the fields of both regional economies and globalization.

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