Section 3 From an Intensive Adjustment Period to a Concentrated Consolidation Period

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The negative effects of the collapse of the bubble economy in the early 1990s lasted more than ten years. The three excesses of over-employment, excessive capital stock, and excessive debt have been a major drag on economic activities. As was made clear in previous sections of this report, it is thought that adjustment of these excesses has now been largely completed. In order to advance these adjustments, multifaceted structural reform has been promoted. Of these adjustments, disposal of non-performing loans as part of financial system reforms was an issue directly caused by the collapse of the bubble economy and the most deep-rooted problem. Below is a summary of economic trends in the intensive adjustment period (FY2001-FY2004) followed by a clarification of the trends regarding disposal of non-performing loans, taking into account their relationship with the economic recovery. Then the current state of land prices and their characteristics since the collapse of the bubble economy are examined. After that, moves to avoid deflation, the biggest challenge for stable growth of the economy, are considered. Finally, challenges toward the concentrated consolidation period (FY2005-FY2006) are summarized.

1. Outline of Intensive Adjustment Period

Steady measures for the major challenges of economic management

The intensive adjustment period began by inheriting the difficult economic trends resulting from the collapse of the IT bubble (1999-2000). The unemployment rate was continuing to increase and the effective ratio of job offers to applicants declined to 0.51 by the end of 2001. Company bankruptcies were increasing, the non-performing loans of financial institutions were 26.8 trillion yen, and the non-performing loans ratio reached 8.4% (March 2002, the major banks). Prices were continuing to decline and there was concern that this would result in a deflationary spiral.

In response to this situation, the government adopted a policy of not relying on easy public spending but advancing structural reforms including financial system reforms, regulatory reforms, tax reforms, and expenditure reforms. Looking at the major policies, (1) the financial system reforms included formulation of the Program for Financial Revival (October 2002), acceleration of the disposal of non-performing loans, and advancing integrated responses by industry and finance. As a result, the financial system has stabilized, and the partially remaining full deposit guarantee (a system for guaranteeing up to a principal of 10 million yen and its interest for each depositor in a financial institution through deposit insurance in the event that the financial institution goes bankrupt) was removed in April 2005 as planned. (2) Over 1000 regulatory reform items have been implemented. In addition, by spring 2005 over 500 Special Zones for Structural Reform had been created, and market tests to compare private and public sector efficiency in the provision of services were introduced on a trial basis in FY2005. Furthermore, new businesses utilizing the special measures of the minimum capital system have been increasing since 2003. (3) Concerning tax reforms, advanced tax reductions for economic revitalization have been carried out since FY2003, and research and development and capital investment tax reductions, and reduction and simplification of financial and securities tax systems have been implemented. (4) Concerning expenditure reforms, the goal is to keep the ratio of general government expenditure to nominal GDP from exceeding its level in FY2002 (around 37.6%) until FY2006, and this ratio is expected to decline to 36.2% in FY2005. Furthermore under the principle of "leave to the localities what they can do," reform of subsidies, transfer of tax revenue resources, and reform of local allocation tax have been implemented to complete the reform package of three issues.

Economic achievements in the intensive adjustment period

The major economic challenges of the intensive adjustment period were to prevent the deflationary spiral and advance the disposal of non-performing loans, etc. as a preparatory period for the realization of mid-term growth led by private demand. These challenges were interconnected, and it was necessary to clarify the mid-term outlook and adopt comprehensive measures. Below is a summary of the achievements of these measures.

First, concerning steady recovery of the economy, the overall aim was achieved given that the economic recovery phase was sustained for more than three years. Furthermore, the deflationary spiral has been avoided. The Bank of Japan's quantitative easing policy, which it has been implementing since 2001, supported economic recovery through stabilization of the financial markets and long-term interest rates by supplying abundant liquidity to financial institutions.

Second, the disposal of non-performing loans is proceeding according to policy targets, and the government was able to normalize the non-performing loans issue of the major banks. The non-performing loans ratio of the major banks had reached the 8% level by March 2002, but in March 2005 it was 2.93%. A big achievement is that as a result of this reduction financial system, uneasiness was eliminated.

Third, concerning public finance structural reform, looking at the primary balance of the central and local governments, in FY2002 and FY2003 there was a deficit of 5.5% (ratio to nominal GDP) but subsequently it improved by around 1% and it is expected to decline to approximately 4.4% in FY2004.

On the other hand, there are also sectors whose improvement is lagging. Deflation is continuing, although at moderate levels. Furthermore, wide variations can be seen in the regional economies. Tokai and Chugoku are recovering faster but Hokkaido and Shikoku are lagging. These problems show that steadily avoiding deflation and urgent revitalization of the regions through regional voluntary measures remain as future challenges.

Stock prices (Nikkei average stock prices) were 12,999.70 yen at the end of March 2001 and reached their lowest value since the collapse of the bubble economy (7,607.88 yen) on April 28, 2003. However, since then they have begun to increase due to improvements in corporate performance and in addition due to the decline in financial uneasiness surrounding the major banks with the government deciding on an injection of public capital into Resona Bank in order to avoid a financial crisis in May 2003, etc. and as of June 2005, they had increased by more than 40% relative to their lowest value. Due to the fact that stock prices are rising in this way, concerns that the appraisal value of stocks held by financial institutions will decline and lead to a decline in capital adequacy ratios have abated.

2.Normalization of the Non-performing Loans Issue

As financial uneasiness increased in 1996, a special measure to guarantee the full value of deposits through a deposit insurance system was adopted. This system was funded by deposit insurance premiums collected from financial institutions by the Deposit Insurance Corporation of Japan and tax money. Subsequently, through the financial system stabilization policies(21) begun at the end of the 1990s, etc., efforts toward the elimination of financial system uneasiness, including such measures as elimination of the Japan premium (it became more difficult for Japanese banks to procure foreign currency on international financial markets and they were charged relatively high interest), removal of the full deposit guarantee centered on fixed-term deposits, etc. (April 2002), ending of the mechanisms funded by tax money, etc., made steady progress.

Against this background, in October 2002 the Program for Financial Revival was announced. The aim of the program was drastic disposal of non-performing loans with a view to recovering confidence in Japan's financial system and financial administration and building financial markets respected by the world. It was a big first step toward elimination of financial system uneasiness. In order not to cause needless uneasiness to depositors while strengthening policies such as the acceleration of the disposal of non-performing loans, etc., the removal of the full deposit guarantee for ordinary deposits, etc. was postponed until April 2005.

As a result, the non-performing loans ratio of the major banks in March 2005 was 2.93% and the halving of this ratio to the 4% level, targeted by the Program for Financial Revival, has been sufficiently achieved. (Figure 1-3-1). Therefore it can be concluded that the non-performing loans issue centered on the major banks has been normalized.

Figure 1-3-1 State of disposal of non-performing loans by the major banks

Furthermore, the removal of the full deposit guarantee was implemented as planned without any chaos (April 2005); (1) depositors are selecting financial institutions carefully and (2) financial institutions are making efforts to strengthen their management foundations with a sense of urgency, and the temporary and exceptional structure from 10 years ago has come to an end. Removal of the full deposit guarantee was achievable precisely because financial system uneasiness had declined and at the same time, it can be said that achieving the removal of the guarantee made it easier for mechanisms for future strengthening of the financial system to work.

(1) Advancement of the disposal of non-performing loans

The Program for Financial Revival aimed to halve the non-performing loans ratio of the major banks to the 4% level by March 2005. The program set out policies for the strengthening of financial administration centered on the following three measures: (1) tightening of assessment of assets, (2) enhancement of capital adequacy, and (3) strengthening of governance.

Concerning the tightening of assessment of assets, a special inspection (March 2002) was re-implemented (March 2003)(22) and gaps between the results of Financial Services Agency inspections and self-assessments by the major banks were disclosed on an aggregate basis and the banks were asked to narrow the gap.

    Concerning enhancement of capital adequacy, the program sets out a policy of verification that deferred tax assets are proper and reasonable. In order to ensure smooth progress in the reduction of the stocks held by financial institutions to below a certain level, stock purchases by the Bank of Japan were carried out (a total of approximately 2 trillion yen from November 2002 to September 2004).

Concerning strengthening of governance, the program presents rigorous measures including strengthening of the functions of external auditors, and clarifying the responsibility of the management of a bank which has not achieved its plan for sound management, etc.

Along with these measures, with respect to corporate revival the program emphasized the sale of non-performing loans utilizing the Resolution and Collection Corporation (RCC) and corporate reconstruction funds.

Trends of non-performing loans

Concerning the current state of non-performing loans (classified assets based on the Financial Reconstruction Law), from "The Status of Non-Performing Loans (NPLs)" (Financial Services Agency), the following facts can be understood. (The figures below are based on all Japanese banks.)

First, the total value of non-performing loans shows a marked decline (Figure 1-3-2). It has declined approximately 19 trillion yen compared to March 2002 and was approximately 24 trillion yen as of September 2004.

Figure 1-3-2 Trends of non-performing loans

Second, the amount that has newly become non-performing loans due to worsened business conditions, etc. (the amount newly counted under "special attention" loans and "doubtful" loans) is declining. The factors behind the decline in the emergence of new non-performing loans include improving business sector profits as the tightening of assessment becomes largely consolidated, steady economic recovery advances, and each company makes management efforts, and the fact that due to the easing of assets deflation (picking up of stock prices, decrease in the rate of decline of land prices), the quality of assets of borrowing companies is not getting worse.

Third, "doubtful loans and below" subject to off-balancing (including bankrupt or de facto bankrupt loans), have slightly increased because the increase resulting from the emergence of new loans and the downward transition of "special attention" loans was greater than the decline resulting from off-balancing. However, it has been decided that measures leading to off-balancing loans classified as "doubtful loans and below" within three years will be taken in line with the so-called "2 year-3 year rule" presented in the April 2001 Emergency Economic Package. For this reason, along with future advancement of disposal, these loans will be excluded from non-performing loans.

Fourth, "special attention loans," which are one category better than "doubtful loans or worse," are declining. This is due to the fact that although there was an increase caused by the emergence of new loans of this type, some of them became normal loans and conversely some of them downward transitioned to "doubtful loans and below," one category worse, due to the worsened business conditions, etc. of borrowers. On the other hand, because "special attention loans" are the route to downward transition from there, their decline is decreasing pressure for additional increases in "doubtful loans and below."

Financial intermediary functions are improving

With a view to recovering financial intermediary functions also, the disposal of non-performing loans was necessary. In other words, the disposal of non-performing loans had become a heavy burden, the risk tolerance of financial institutions had declined, their lending position had weakened, and this had led to sluggishness in the money supply as a result.

Therefore, it needs to be confirmed whether or not the normalization of the non-performing loans issue referred to above is working in such a way as to recover the intermediary functions of financial institutions. When financial institutions provide loans, it is reasonable to suppose that the amount of profit they can make from the loan (level of rate of lending yield) and the degree of risk they can take, in other words, the soundness of the financial institutions themselves (non-performing loans ratio, capital adequacy ratio) have an impact. So when the loans supply curve of financial institutions is estimated by carrying out a regression analysis setting these factors as the explanatory variables and the growth rate of the end-of-period loans balance as the explained variable, it can be seen that the curve is gradually shifting to the right. (Figure 1-3-3). This is shown by the fact that even though the loans' return on interest is the same, loans are in an increasing trend even more than before and the result is that loans capacity is steadily recovering. This result is also backed by the Bank of Japan's Short-term Economic Survey of Enterprises in Japan (TANKAN survey). In the TANKAN survey, a questionnaire survey of companies asking them whether it is easy to borrow from financial institutions or not is conducted and the "lending attitude DI" is calculated. This figure is the proportion of respondent companies that replied "accommodative" minus the proportion of respondent companies that replied "severe." According to this index, the proportion of companies replying "accommodative" has been continuously increasing since around 2004. This applies not only to major companies, but also to small- and medium-sized companies.

Figure 1-3-3 Estimate of the loan supply curve of financial institutions

Loans to corporations remain lower than for the previous year but against the background of the restrictive lending policy of the Housing Financing Corporation, etc., loans to individuals are growing. In this context, the April 2005 loans average balance for regional banks and member banks of the Second Association of Regional Banks combined was +0.2% compared to the same month the previous year, the first time in six years and one month that it was higher than the same month in the previous year.

(2) Measures for corporate and industrial reconstruction combined with the disposal of non-performing loans

Establishment of the Industrial Revitalization Corporation of Japan, etc.

While encouraging the acceleration of the disposal of non-performing loans in this way, in order not to needlessly dissipate the management resources of the industrial sector, in combination with the acceleration of the disposal of non-performing loans, the Government of Japan aimed to facilitate and accelerate corporate and industrial reconstruction. As a part of this process, the Industrial Revitalization Law was drastically amended and the Industrial Revitalization Corporation of Japan was established.

The Industrial Revitalization Corporation of Japan was launched in April 2003 (Hereafter abbreviated as "the corporation") set the end of March 2005 as the deadline for applications for debt purchases and by that deadline, had approved support to 41 companies.

The corporation (1) carries out a strict assessment of assets including the description of the business and legal and contractual aspects, etc. when an application is made by a business, main financing bank, etc. and based on that, not only carries out balance sheet adjustments, but also provides support for the formulation of a drastic business reconstruction plan that incorporates selection and concentration of business activities. Based on that business reconstruction plan, the feasibility of reconstruction is determined and the Industrial Revitalization Committee made up of experts decides whether or not to provide business support. (2) If the decision is made to provide support, the corporation seeks the cooperation of financial institutions other than the main financing bank for the reconstruction plan, makes adjustments to the financial support, and as necessary approves the purchase of debt, etc. (3) After making the debt purchase, the corporation provides support for the implementation of the business reconstruction plan and monitors progress, sells the purchased debt, etc. within three years, and aims to end the provision of support.

These measures by the corporation also made it possible for financial institutions to remove loans of debtors from the non-performing loans account and contributed to the disposal of non-performing loans, etc. by selling the debt to the corporation and removing it from the balance sheet or by carrying out debt write-offs, etc. based on highly feasible drastic business reconstruction plans.

(3) Evaluation of the Program for Financial Revival and other policies

The decline in the non-performing loans ratio is not only due to the better economy

Some are saying that the major factor behind the decline in the non-performing loans ratio is improving company profits resulting from the better economy rather than the achievements of policy measures.

So it is necessary to examine the off-balancing-removal of non-performing loans from the balance sheets of financial institutions-of companies by reason ("improved business conditions," "collection," etc.) Doing so, it can be seen that in aggregate between FY2002 and FY2004 no more than around 15% (relative to total off-balancing) of the decline in non-performing loans of the "doubtful" loans or worse type was due to economic recovery (Figure 1-3-1 above). Therefore, although it is certainly true that economic recovery supported the decline in the non-performing loans ratio, its direct contribution to the disposal of non-performing loans was relatively small, so it has to be concluded that policy off-balancing was extremely effective.

The acceleration of the disposal of non-performing loans did not depress the economy

Some were worried that "if the disposal of non-performing loans is accelerated, there is a danger that that will worsen the economy and end up causing non-performing loans to increase." They were concerned that the disposal of non-performing loans would lead to a contraction in the activities of financial institutions and so bring about a worsening of the real economy. However, it can be thought that this concern was not realized.

First, the decline in financial institution loans did not deepen as a result of the disposal of non-performing loans. The decline in loans by financial institutions had already begun in 1998, immediately after the increase in financial uneasiness and the decline in loans did not accelerate during or after the intensive adjustment period.

Second, this is largely backed by the view of companies (Figure 1-3-4). In the Bank of Japan's TANKAN survey, a questionnaire is conducted on the cash position of companies and the lending attitude of financial institutions as seen from the perspective of companies. Both of these worsened at the time of the 1997-1998 financial system crisis, then improved during the IT bubble, but once again slightly worsened during the economic decline which resulted from the collapse of that bubble (from the end of 2000 to the beginning of 2002). However, they have continuously improved along with the subsequent economic recovery, and the lending attitude DI of financial institutions as seen from the perspective of small and medium enterprises is continuously improving. For example, it became "more accommodative than severe" in 2004.

Figure 1-3-4 Situation of company finances

Therefore, implementation of the Program for Financial Revival (October 2002) did not worsen company finances; on the contrary, since then, they have been continuously improving.

The number of unemployed people did not increase as a result of the acceleration of the disposal of non-performing loans

It was said that "there is a danger that if the disposal of non-performing loans is accelerated, the number of unemployed people will increase." Various estimates were made of how many displaced workers and unemployed people would result from the disposal of non-performing loans required under the Program for Financial Revival. These estimated values varied widely, but an ex-post estimate conducted now shows that the number of unemployed people is on the whole fewer than these estimated values. (Table 1-3-5).

Table 1-3-5 Impact of disposal of major banks' non-performing loans on employment

It is thought that the number of unemployed was kept so low due to the impact of the facts that (1) the number of bankruptcies was kept down through the use of "safety net guarantees and loans" (guarantees were introduced in January 2001 and loans in December 2000); and (2) rehabilitation-type bankruptcies increased rather than liquidation-type bankruptcies. "Safety net guarantees and loans" is a system to facilitate funds procurement for small and medium enterprises that are facing the bankruptcies, etc. of companies they do business with and it led to the prevention of chain reaction bankruptcies, etc. On the other hand, with liquidation-type bankruptcies, 100% of the employees were displaced and many of them ended up unemployed, whereas with rehabilitation-type bankruptcies, it was possible to minimize the displacement of employees because the aim was to make the most of the value of the company and enable it to continue(23).

Challenges of financial institutions

Taking into account the above, it can be concluded that the disposal of non-performing loans through financial system reforms has steadily advanced and this has led to normalization of the non-performing loans issue without worsening economic trends.

In this way, the major banks have largely overcome the non-performing loans issue but the future challenges for financial institutions are to (1) improve the content of capital adequacy, (2) improve profitability, and (3) strengthen the management capacity of regional financial institutions. Certainly as a result of financial system reforms, the non-performing loans ratios of financial institutions have more than halved and their capital adequacy ratios have never gone below levels considered appropriate(24), with the major banks maintaining their ratios at around 9-14%. However, in order to ensure that the financial system is not shaken by the non-performing loans issue, etc. again in the future, the soundness and resilience of financial institutions must be increased. In order to achieve this, it is important to (1) set interest rates that can sufficiently cover bad debt losses anticipated from past data, and (2) put in place capital adequacy that can sufficiently absorb worsening of the economy or bad debts that are not fully predictable from the data. This applies not only to the major banks but also to regional financial institutions and small and medium-sized financial institutions.

First, looking at the content of capital adequacy, it is not necessarily the case that only profit earned by the power of financial institutions themselves and funds procured from the capital markets are accumulating. The relative weight of public funds and net deferred tax assets is high and in March 2005 they accounted for 26% and 15% of capital adequacy respectively (seven major financial groups, consolidated basis). It is important for financial institutions to gradually reduce these relative weights and maintain and expand capital adequacy through their own profits.

Second, the increase in the profit rate, which is relatively low compared to European and North American banks, is important. It has been pointed out that one characteristic of Japanese banks is their low profit margin for loans. When profit margins that can sufficiently cover anticipated bad debt losses (called risk premiums) are not set, if bad debts are large or occur frequently, there is a danger that the management of financial institutions themselves will worsen. Looking at the cost structures of Japanese banks, it cannot necessarily be said that their expenditure ratios, including labor costs, etc., are high compared to that of European and North American banks, with their loss ratios resulting from bad debts (credit cost ratios) fluctuating around 1%, close to the same level as North American banks. However, it cannot be said that the profit margin (profitability) is sufficient to cover these costs, so it is necessary to strengthen profitability (Appended Figure 1-3).

Third, concerning small and medium-sized and regional financial institutions, it was decided to formulate an action program concerning relationship banking (region-based financing)(25) possessing specifics different to the major banks in the Program for Financial Revival, and in March 2003 the Action Program Concerning Enhancement of Relationship Banking Functions was formulated. Furthermore, in the Program for Further Financial Reform (December 2004), with a view to (1) reconstruction and revitalization of the regions, (2) facilitation of financing for small and medium enterprises, and (3) strengthening of the management capacity of small and medium-sized and regional financial institutions, it was decided to further promote region-based financing and in response to this the Action Program Concerning Enhancement of Relationship Banking Functions was formulated (March 2005). The action program requires all financial institutions to formulate and disclose a Region-based Financing Promotion Plan by the end of August 2005. The plan is to be formulated under the management discretion of the financial institutions themselves, and is to show individuality taking into account the specifics of the regions, etc. and is to be specific and easy to understand. The characteristic feature of these plans is that they state that relationship banking functions are to be improved by implementing the measures based on these plans under the policies of promoting information disclosure, etc. and the discipline resulting from it (evaluation of users).

3. Trends of Land Prices

With the collapse of the bubble economy, land prices rapidly declined. Nationwide official land prices peaked in 1991 and have declined for 14 consecutive years since then. In this section the changes in land prices that are occurring are considered.

The rate of decline in official land prices is decreasing even in the regions

According to the land price publication (January 2005 survey), the national average land price continued to decline but the rate of decline has decreased for residential zones for two consecutive years and for commercial zones for three consecutive years. The rate of decline has decreased not only in the three metropolitan areas but also in local areas, with the rate of decline in local areas decreasing in residential zones for the first time in eight years and in commercial zones for the first time in seven years. (Figure 1-3-6).

Figure 1-3-6 Official land prices and ratio of land assets to nominal GDP

Official land prices peaked in 1991 and as a result of the collapse of the bubble economy they have been declining ever since. Now they are at almost half the level of the time of the peak (national average: an overall decline of 50.7%, decline in residential zones of 45.8%, decline in commercial zones of 69.4%). Land assets as a proportion of nominal GDP increased by 5.6 times during the bubble period but they had declined by 2.6 times at the end of 2003. This is the lowest level since 1981, the initial year of the current National Accounts Statistics (1993 SNA basis).

Declining areas are getting fewer and increasing or flat areas are increasing

Looking at land prices for commercial zones on average for municipalities, excluding five wards(26) in the center of Tokyo and Musashino City, etc. land prices have not yet begun to increase. However, looking at the share of areas that are "increasing," "flat," or "declining" among all areas that have been continuously surveyed, in 2005 the share of areas that are "increasing" or "flat" increased compared to the previous year (Figure 1-3-7).

Figure 1-3-7 Share of areas with increasing, flat or almost flat land prices in commercial zones

In the commercial zones of the Tokyo wards, since about 2003 areas that are "increasing," "flat," or "almost flat" have been increasing and in 2005 they exceeded 60% of the total. They also rapidly increased in the commercial zones in the government-designated cities of Osaka, Nagoya, Sapporo, and Fukuoka in 2005 and rose to approximately 30% of the total in Nagoya and Sapporo.

In this way on a national basis land prices continue to decline as before but they are showing an increasing trend of leveling off, or are beginning to show signs of leveling off, especially in the center of the three metropolitan areas, etc.

The picking up of land prices is centered on the major cities

Here, we will examine this point in detail. Comparing land price trends in the commercial zones of major cities (central zones) in 2003, the year the national average rate of decline of commercial zones began to decrease, and 2005, the most recent year, there are the following characteristics (Figure 1-3-8, Appended Figure 1-4).

Figure 1-3-8 Land Prices in Central zones (commercial zones)

(1) In the major cities - Tokyo (Chiyoda Ward, Chuo Ward, Minato Ward), Nagoya City (Nakamura Ward), Osaka City (Chuo Ward), Fukuoka City (Chuo Ward), Sapporo City (Chuo Ward), Yokohama City (Nishi Ward) - the number of "increasing" areas grew, the rate of decline is also decreasing, so land prices leveled off markedly. There is a trend for land prices to increase more in high-price areas and it is thought that this trend reflects the fact that these areas are highly convenient and profitable. In particular, in Tokyo and Nagoya some areas showed a price increase of more than 10% in 2005. Furthermore, even though there are still no areas in which prices have leveled off in the other government-designated cities, there are cities in which the rate of decline is steadily decreasing (Sendai City (Aoba Ward), Kobe City (Chuo Ward), etc.). A similar trend can also be seen for the rate of decline to be smaller in high-price areas which already have high land prices.

(2) There are even many regional cities in which the rate of decline is decreasing. Some areas in Kagoshima City, Okayama City, etc., have appeared in which land prices have stopped declining and have begun to remain flat or increase because of the measures to increase the convenience and profitability of these areas.

(3) On the other hand, in regional cities such as Akita City, Asahikawa City, Beppu City, etc., the trend is for the decline in land prices to be stronger in 2005 than in 2003. A trend can also be seen in which the rate of decline is higher in high-price areas.

Next, we will examine land price trends in regional cities more thoroughly. Comparing 2004 and 2005, of the 106 regional cities, other than the three metropolitan areas, with a population of 100,000 or more (as of the end of March 2004. Cities which have established urbanization promotion areas), there were 18 cities in which the rate of decline was expanding in both residential zones and commercial zones (17% of the total), 19 cities in which the rate of decline was expanding in residential zones only (18% of the total), and 1 city in which the rate of decline was expanding in commercial zones only (1% of the total). Areas in which the rate of decline is expanding are largely concentrated in Hokkaido/Tohoku and Shikoku/Kyushu. In order for the picking up of land prices to spread throughout the country, it is required for regional cities to take measures to increase the profitability and convenience of their land. (Appended Table 1-5).

Trends of the market for the securitization of real estate

As land prices in the major cities pick up, the market for the securitization of real estate and in particular for real estate investment trusts (REITs(27)) is strong. Aggregate total assets in the market for the securitization of real estate from FY1997 to FY2004 reached 20.2 trillion yen, and the number of investments reached 2,529. REITs accounted for approximately 2.5 trillion yen (approximately 12%) of this(28). REITs are investment corporations that use capital adequacy collected by selling securities to investors and borrowings from financial institutions as capital to purchase highly profitable real estate properties and return rental income or the profit from sale of the properties to investors. These securities are purchased by financial institutions, companies, individual investors, foreign nationals, etc. In the United States, REITs first appeared in 1960 and showed high growth in the 1990s. As of the end of 2004 there were 190 listed stocks and their aggregate market value had risen to approximately 32 trillion yen. In Japan REITs first appeared with a legal amendment in November 2000 (Law Concerning Investment Trusts and Investment Corporations). The characteristics of REITs are (1) their basic functions are similar to those of real estate companies but if requirements such as payment of dividends to investors in excess of 90% of distributable income are met, as a limit to income amount, deduction of dividends is allowed, and the taxable income of corporate tax is reduced, (2) before the amendment it was not possible to carry out major operations through assets other than negotiable securities but after the amendment, it was possible to establish investment trusts and corporations with real estate as their major focus of operations. REITs are listed on the stock exchange and can buy and sell generally.

Since REITs listed two stocks on the Tokyo Stock Exchange in September 2001 they have become popular, with 17 stocks listed as of May 2005 (16 on the Tokyo Stock Exchange, 1 on the Osaka Stock Exchange) and their aggregate asset value rising to 2 trillion yen. It is expected that the number of stocks listed will increase in future. There were 494 properties held by REITs at the end of March 2005. In 2001 nearly 90% of these investments were in offices but by the end of March 2005 dispersion of investment was advancing with 64.7% going to offices, 21.6% to commercial facilities and 11.5% to housing (Ministry of Land, Infrastructure and Transport survey, acquisition price basis, same below). Nearly half of the properties were located in five wards in central Tokyo (Chiyoda Ward, Chuo Ward, Minato Ward, Shinjuku Ward, Shibuya Ward), more than 60% were in one of Tokyo's 23 wards, and nearly 80% were concentrated in the Kanto region.

In this way the reason for the strength of REITs is that there are advantages for both property owners selling real estate to the REITs and the investors purchasing the securities issued by the REITs. For real estate owners, even if they attempt to effectively utilize the real estate they possess or sell off unused real estate, in light of the nature of real estate transactions in which it is difficult to divide or parcel out the asset, a flexible sale is difficult. In this context, because REITs are attracting attention as favorable investment targets, even in a low interest rate environment they are powerful as highly motivated buyers with abundant financial muscle. For investors, REITs are an attractive financial product because they can be expected to give a higher rate of return than bank deposits in a low interest rate environment or even ordinary stocks. The advantages to both parties match up so REITs are growing. This is one factor revitalizing the commercial real estate market primarily in Tokyo, etc.

The most common type of investor in REITs is financial institutions. Looking at the breakdown of buyers on a number-of-investments basis (2004), financial institutions accounted for 42% of investments, individual investors for 22%, and foreign nationals for 21%(29). Financial institutions have to deal with the stagnation of loans to corporations, and are investing in REITs as a favorable operations destination and loaning the funds necessary for REITs to acquire properties. At the same time, they are making an effort to sell investment trusts incorporating REITs (Fund of Funds(30)) to customers.

The Tokyo Stock Exchange REIT Index is continuously increasing but the rate of return on dividends is in a declining trend. This is due to marked price rises against a background of high popularity and the difficulty of acquiring highly profitable properties. In future it will be necessary to pay attention to whether or not (1) REITs investments overheat, real estate that is relatively expensive compared to profitability is purchased and profitability declines, (2) investments by REITs in real estate lead to rejuvenation and effective medium- and long-term use of that real estate, and (3) sales by REITS to ensure profits lead to a collapse of market values, etc.

Future land price trends

The picking up trend in land prices is strengthening, for example the rate of decline is decreasing even in the regions. For this reason, it is thought that the risk of having a negative impact on the balance sheet of companies and households and generating more non-performing loans is declining.

Here we summarize the views of companies and households concerning future land prices. According to the Land Investment Trends Survey (Ministry of Land, Infrastructure and Transport), companies with their headquarters in Tokyo or Osaka are expecting that land prices will pick up and companies in Tokyo in the September 2004 survey expected prices to increase. (Appended Figure 1-6). Households were asked their view of future land price trends in the Opinion Survey on the General Public's Mindset and Behavior (Bank of Japan). According to this survey, the proportion of households stating that "land prices are more likely to decline" has begun to gradually decrease in 2002 or 2003, and in the 2004 June survey, it became less than the proportion of households stating that "land prices are more likely to increase." Subsequently they stated that "land prices are more likely to increase" in four consecutive surveys up until the March 2005 survey.

The future direction of real estate prices in commercial zones in the center of major cities

Real estate securitization, etc. is revitalizing land transactions primarily in urban areas and leading to a picking up of real estate prices. Looking at the central commercial zones of major cities, rents have not yet stopped declining while the decline in the expected rate of return is striking and it is necessary to be careful to ensure this does not go too far. We estimated price levels for commercial-use real estate in the central commercial zones of major cities (total of land and buildings) assuming a simple model based on the profit return method and using data for rents and expected rate of return. In Tokyo and Osaka, etc. from about 2004, price levels have been moderately increasing (Appended Figure 1-7, Appended Note 1-6). It is thought that if the revitalization of land transactions leads to an improvement in rents in future, the picking up of real estate prices will gain more momentum.

4. Efforts to Overcome Deflation

Deflation is a continuous decline in prices and moderate deflation is continuing in the Japanese economy. Here we will consider the current state of efforts to overcome deflation and future challenges.

Current state of deflation

Efforts to overcome deflation are here evaluated through consumer prices, domestic corporate goods prices, and the GDP deflator.

The rate of decline of consumer prices has been decreasing since the second half of 2003 and signs of the easing of deflation have continued to appear. This is mainly due to the large impact of the increase in the proportion of medical expenses paid by patients themselves, the increase in the price of rice, and upward pressure on import and other prices resulting from price rises in the international commodity market from around the beginning of 2004. In the second half of the year the price of rice began to decline, there was also a decline in telephone communication costs and electric bills and there was a phase in which the rate of decline marginally increased compared to the previous year. Subsequently, however, the rate of decline has been decreasing once again with price increases for petroleum products such as gasoline, etc. (Figure 1-3-9)

Figure 1-3-9 Price Index

Domestic corporate goods prices showed a year-on-year increase for the first time in seven years in 2004(31). Behind this is the impact of prices for crude oil, steel, non-ferrous metals (nickel, copper, etc.), etc. beginning to increase in the international commodity market from around the beginning of 2004. This was because the strength of the world economy, including the economic growth of China, etc. led to a continuing squeeze on supply and demand of raw materials and in addition the impact of speculative funds, etc. among other factors sustained the bull market. Reflecting this, from spring 2004 domestic corporate goods prices started to show a year-on-year increase. The main factors contributing to price rises were petroleum and coal products, chemical and related products, iron and steel, and non-ferrous metals which are impacted on by the international commodity market.

The GDP deflator has declined for seven consecutive years since 1998. Since 2003 a reduction in the degree of decline in the household consumption and private non-residential investment deflators has been seen, and in 2004 the private residential investment deflator began to increase.

Comprehensively looking at these price trends, it is concluded that the Japanese economy remains in a state of moderate deflation.

(1) Three factors that hold the key to overcoming deflation

When looking at deflationary factors, it is effective to understand them in terms of demand aspects, supply aspects and financial aspects. Below is an evaluation of the current state of each of these factors. To state the conclusion first, the three factors combined are weakening compared to previously and progress in moves to overcome deflation can be seen.

Demand aspects

Looking at the situation with respect to demand aspects, progress toward overcoming deflation became sluggish in 2004 as the economy underwent a temporary slowdown. As was seen in Section 1, at the start of 2004 the GDP gap (percentage of real GDP relative to potential GDP) shrank to about -0.7% because of high growth. Subsequently the gap expanded once again reflecting the temporary slowdown. In the period from January to March 2005, the gap improved to the level of a year ago, reflecting high growth but it remains below zero.

Supply aspects

Deflationary pressure from supply aspects is in a decreasing trend. Let's classify changes in consumer prices into the "import competition factor (electrical goods)," the "import competition factor (excluding electrical goods)," the "deregulation factor," the "technological innovation factor," etc.(32) (Figure 1-3-10).

Figure 1-3-10 Impact on supply side prices

The import competition factor (electrical goods) continues to be a factor contributing to a decline in prices. The import competition factor (excluding electrical goods) was putting downward pressure on prices due to cheap imports from China, etc. but since 2003, the downward pressure has been easing (Appended Figure 1-8). From around the end of 2004 clothing, etc. were major factors resulting in an increasing trend, albeit within a narrow range. The deregulation factor is expanding downward pressure on prices through reduced electricity and telephone charges, etc.

During this period the technological innovation factor has been functioning as a factor pushing down prices, as the improvement of performance of personal computers, etc. relative to price has led to a decline in the effective price.

Financial aspects

In order to overcome deflation, it is necessary to closely monitor financial indicators such as money supply, etc. Recently growth in the monetary base has been declining and the money supply has been stagnating. This will be described later in this report but the major factor responsible for this is that the demand for borrowing of companies has not fully recovered, so the credit creation of banks has not been revitalized.

On the other hand, a few signs of change are appearing due to progress in the disposal of non-performing loans and continuing economic recovery (Figure 1-3-11). (1) Through normalization of the non-performing loans issue centered on the major banks, financial system uneasiness has been largely eliminated. Reflecting this, the lending attitude of financial institutions as seen from the perspective of companies is improving. (2) The willingness to borrow of companies as seen from the perspective of financial institutions is also recovering.

Figure 1-3-11 Signs of revitalization of credit creation functions

It is expected that if these indicators continue to improve, the credit creation functions of banks will be revitalized and this will lead to growth in the money supply.

The future direction of prices

However, reflecting the fact that the economy is in a temporary slowdown, etc., the time that the market anticipates that consumer prices will begin to show a year-on-year increase has been put back. For example, according to the projection of a private economist (ESP Monthly Survey of Japanese Economic Forecasts), in the July 2004 survey when long-term interest rates increased, consumer prices were expected to begin increasing between July and September 2005, but in the June 2005 survey they were expected to increase between January and March 2006 (Figure 1-3-12).

Figure 1-3-12 A private economist's projections of consumer prices

In addition, looking at the prices outlook of companies in the various questionnaire surveys, etc. (Appended Figure 1-9), the majority of respondents in both the Change in input prices DI (Diffusion Index) (TANKAN survey) and the Purchase price of input materials and products BSI (Business Survey Index) (Business Outlook Survey) began in the first quarter of 2004 to expect prices to increase, reflecting the increase in prices in the international market for raw materials. On the other hand, although the majority of respondents in the Change in output prices DI (TANKAN survey) and the Sales price of products and service BSI (Business Outlook Survey) expected prices to decline, that majority decreased but the improvement came to a slight halt in the second half of 2004. Looking at the overall picture, it can be discerned that progress toward the elimination of deflation has slowed down slightly.

One method of understanding the medium- and long-term price outlook is to calculate the disparity in the rate of return of inflation-linked government bonds and ordinary nominal fixed interest rate government bonds (both ten-year bonds). The idea behind this is that the disparity between the rate of return of inflation-linked bonds that are government bonds for which the value of the hypothetical principal increases or decreases along with prices, and that of fixed-interest bonds with the same maturation period is basically equivalent to the market's expected inflation rate in that period. The disparity in the rate of return as a 10-year average has generally been around 0.8% since autumn 2004, but in June it declined to around 0.6%.

Not much time has passed since the issuing of Japan's inflation-linked government bonds commenced in March 2004 and not many such bonds have been issued to date, so it is necessary to keep in mind the fact that their rate of return will be significantly influenced by factors other the expected inflation rate, such as flexibility and market needs, etc(33).

In this way, as deflation continues, albeit moderately, the evaluation of financial policy management, including quantitative easing policies, can have an impact on the view of the future direction of prices. So in order to get expectations of the future direction of prices to rise and contribute to overcoming deflation, it is important for the Bank of Japan to carry out practical financial policy management, while taking into account market trends and expectations.

Taking into account the above, in order to secure the emergence from deflation within the concentrated consolidation period, it is necessary that the government, together with the Bank of Japan, strengthen and expand policy efforts.

(2) Why is it that the increase in the price of raw materials has not spread to prices overall?

Since spring 2004, domestic corporate goods prices have continuously increased due to the increase in the price of raw materials such as crude oil, steel, etc. Based on experience to date, it was anticipated that this increase in the cost of raw materials would soon be passed on to the consumer stage. However, this time such passing on is not occurring and deflation is being sustained. This issue needs to be considered.

The increase in the price of raw materials is not spreading to the prices of domestic corporate final goods

Looking at domestic corporate goods prices by demand stage, prices are increasing at the raw materials and intermediate materials stage, but a moderate decline is continuing at the final goods stage (Figure 1-3-13). Furthermore, looking at domestic corporate goods prices by industry, in raw-materials industries with a high proportion of raw materials, prices increased but in processing industries with a high proportion of final goods, prices either did not increase very much or actually declined.

Figure 1-3-13 Domestic demand products under the corporate goods category

The corporate goods prices index mostly consists of manufacturing industries except for some industries (electric power, gas, water, etc.). Manufacturing industries have a relatively high proportion of goods in their input structure compared to non-manufacturing industries, so they are strongly affected by changes in the prices of input goods (Appended Figure 1-10). In addition, comparing raw-materials industries and processing industries, there is a relatively high proportion of raw materials in the input structure of raw-materials industries, so the increase in product prices resulting from an increase in raw material costs is large, whereas there is a relatively low proportion of raw materials in processing industries, so the increase in product prices there is low.

This was also confirmed with a regression analysis. When an analysis was done setting the rate of increase in corporate goods prices in each industry as the explained variable, and the rate of increase of input prices in each industry, changes in product supply and demand (= operation rate or Supply/Demand DI), and the rate of increase in unit labor costs (rate of increase in wages minus the rate of increase in labor productivity) as the explanatory variables, the following facts were learned. (Appended Table 1-11).

(1) In raw-materials industries input costs and supply and demand are having a significant effect on increases in corporate goods prices and corporate goods prices are increasing reflecting increases in the price of raw materials.

(2) In processing industries supply and demand and unit labor costs are having a significant effect on increases in corporate goods prices and the tightening of supply and demand resulting from the economic recovery is pushing up corporate goods prices, while the decline in unit labor costs is pushing down corporate goods prices. The decline in unit labor costs is a manifestation of wages restraint to bring down the labor share and productivity improvements. On the other hand, input costs are not having a significant effect on increases in corporate goods prices.

Approximately one-third of domestic corporate goods prices are accounted for by raw materials industries and approximately two-thirds by processing industries, so processing industries have the largest proportion. Because this time the increase in prices in the processing industries has been low, unlike in the 1970s the increase in domestic corporate goods prices has been more moderate.

Factors explaining why an increase in consumer prices has not been seen

Changes in domestic corporate goods prices are a price trend which is relatively close to the "upstream" of the economy compared to consumer prices, which are relatively close to the "downstream," and the breakdown (relative weight) of goods-related items and services-related items is approximately half each. Although the year-on-year change in services-related prices has been declining since the end of 2004 due to reduced prices for public utilities, to date it has largely been fluctuating close to zero, whereas the year-on-year change in goods-related prices has been negative(34). It is thought that because goods-related prices more easily reflect price trends in the processing industries than the raw-materials industries, it is relatively easy for them to be affected by supply and demand factors and unit labor costs as seen above.

It was possible to confirm this with a regression analysis as well. The rate of increase in goods prices was set as the explained variable and the rate of increase in unit labor costs, expected rate of price change, Supply/Demand D.I., and rate of increase in domestic corporate goods prices were set as the explanatory variables (Figure 1-3-14). The results showed that all the explanatory variables had a significant impact except domestic corporate goods prices. The fact that the Supply/Demand DI is "excess supply" is having the effect of pushing down prices and the decline in the rate of increase in unit labor costs is also pushing down prices. The fact that Supply/Demand DI is in a state of "excess supply" has been having the effect of pushing down prices consistently since 1998, when consumer prices began to decline and in 2004 too, this factor explained between half and one-third of the downward pressure but that downward pressure is moderately declining as a result of the economic recovery. Unit labor costs explain approximately 20% of the downward pressure and to date the downward pressure is continuing. The expected rate of price change made a big contribution to the downward pressure in 2001-2002 but since 2003 it has been fluctuating close to zero.

Figure 1-3-14 Consumer price index and estimation result of the function of goods prices

Goods prices, which account for half of the weight of consumer prices, are declining due to the fact that supply and demand continues to be in a state of "excess supply" and because unit labor costs are declining as a result of productivity improvements, etc. These are the main factors explaining why an increase in consumer prices has not been seen.

5. Challenges in the Concentrated Consolidation Period

In the intensive adjustment period that ended in FY2004, it became clear that the negative legacy after the collapse of the bubble economy had been largely overcome. The following two points can be presented as the economic achievements of that period. (1) Macroeconomic indicators are improving reflecting the fact that allocation of the basic resources of the economy - people, goods and capital - has become more flexible. The unemployment rate is steadily declining; furthermore, the efficiency of resource allocation is increasing and the pick up in the productivity of the overall economy (total factor productivity that cannot be attributed to capital or labor) is being sustained (Appended Note1-1 above). (2) The excess issues have been largely resolved, so the surplus of resources in the market has decreased. For that reason, price volatility is having a bigger effect on resource allocation and an environment is being developed, albeit gradually, in which price signals can work more easily.

However, it can be said that these achievements have not yet reached the point where they produce large benefits for the overall economy. The expected growth rate of the market remains low and the time that the market projects that the Consumer Price Index will begin to show a year-on-year increase has been put back. It is thought that one of factors behind this is that the spread of achievements crossing over sectors is lagging. The challenges in the concentrated consolidation period (FY2005-FY2006) need to be considered based on awareness of this issue.

The aim of structural reform

The major aim of structural reform in the market economy is to restore flexible price movements and get market functions to work sufficiently by reforming factors such as regulations and systems that obstruct market functions. Through such reforms, it can be expected to directly increase the options available to the people and improve their living standards. In addition, it is possible to strengthen the supply side as the economic resources of people, goods and capital are allocated to sectors with higher productivity and profitability.

The over-employment, excessive capital stock and excessive debt the Japanese economy has been struggling with since the 1990s have been acting as factors that obstruct the functions of market mechanisms. As a result of over-employment, labor market supply and demand eased over a long period of time. As a result of excessive capital stock, capital investment in technological innovation which leads to productivity increases was dampened. As a result of excessive debt, pressure was put on company profits while on the other hand, companies gave priority to debt repayment, so job creation was put back and capital investment stagnated. Until adjustments of these three excesses took place, it was difficult for prices to play a positive role in resources allocation leading to the strengthening of supply capacity.

Let's examine the extent to which people, goods and capital began to be allocated in a more fluid manner in each industry in the intensive adjustment period. The Lilien Indicator is an indicator showing the flexibility of the allocation of resources among industries. It focuses on the growth rate of the factors of production (employment, investment, funds, etc.) and calculates the extent of the difference between the growth rates in each industry compared to the growth rate of the overall economy. In general, a higher value of the indicator shows that resources are being allocated in each industry in a more fluid and dynamic (flexible) manner. From estimates it can be seen that in the intensive adjustment period the movement of employment, investment and funds was revitalized and flexibility increased. (Figure 1-3-15) This result suggests that the factors of production were gradually allocated to highly profitable growth sectors, efforts to build a foundation for sustainable growth made progress and the possibility that the supply side is continuing to get stronger. It is expected that as a result, an increase in the productivity of the overall economy and an expansion in the potential supply capacity (production frontier) will be realized.

Figure 1-3-15 Strengthening of the supply side - Lilien Measure

A couple of facts which illustrate these changes are that since the collapse of the IT bubble the rapid reduction in wage costs was a major step toward the restructuring of employment which subsequently led to an improvement in the condition of companies; progress in measures to reconstruct and reorganize companies with excessive debts through industrial revitalization has had the effect of improving the efficiency of loans given by financial institutions, etc.

Elimination of excesses through advancement of quantitative adjustments

As a result of the advancement of quantitative adjustments, the excess issues have been large resolved but in some sectors a few challenges remain.

(1) Efforts to eliminate over-employment are also manifested in the Okun Coefficient (which shows the increase in the economic growth rate for a one percentage point decline in the unemployment rate). According to estimated results since 1980 (Appended Note 1-7), in recent years the coefficient has been getting smaller compared to the second half of the 1990s. The factor which had the biggest impact on this result was that in the second half of the 1990s, companies engaged in labor hoarding (= over-employment) and so changes in unemployment were small relative to changes in production. Through the process of subsequent employment restructuring, recently the number of unemployed people has been steadily declining and the coefficient has been getting smaller. Based on these facts it is thought that the efficiency of the labor market has been gradually increasing. However, issues remain such as the large amount of structural unemployment resulting from mismatches, and issues related to the employment of youth, such as the large number of freeters and NEETs (young people Not in Education, Employment or Training after graduation).

(2) Concerning capital stock, the sense of excessive capital stock of companies was largely eliminated by 2005. However, there is a lack of investment strength. Future investment requires the creation of an environment that includes clear avoidance of deflation, a steady increase in the expected growth rate of entrepreneurs, etc.

(3) Concerning debt, excessive debt has been largely eliminated with the interest-bearing debt/cash flow ratio declining to pre-bubble levels, etc. However, bank loans continue to decline and it is expected that continuing quantitative easing policies will contribute to an increase in bank loans.

Realization of price signal effects is important

In this way, the Japanese economy has taken a step toward more efficient resource allocation but it has not yet reached the point where price signal functions work sufficiently. The important point is that it is difficult for the price declines seen to date during the process of adjusting the excesses to directly lead to positive resource allocation of labor and capital, in other words, movement to sectors with highly productive and profitable sectors. Furthermore, concerning financial aspects, there is the issue that in a deflationary period real interest rates remain at a high level because the interest rate does not become negative and there is a limit to price adjustments. Therefore, from this perspective too it is important to avoid deflation. Furthermore, the challenge is to ensure that through the ongoing process of eliminating excesses, prices begin to adjust more flexibly and factors of production reliably move to highly productive and profitable sectors based on price signals.

Toward strengthening of supply capacity

Considering the major change occurring on the supply side beginning in the second half of the 1990s, in other words, the decline in the labor force population (all people aged 15 years old or older who are willing to work), strengthening of supply capacity is all the more important. Growth in the labor force population slowed down substantially in 1998 and in 1999 the labor force population began to decline. It continued to decline for the six consecutive years from then until 2004. Factors behind this include the decline in the population aged 15 years old or older and the decline in the labor participation rate (in particular a decline amongst the elderly). In an environment in which employment, a factor of production, becomes a scarce resource, it is necessary for goods and capital to be flexibly allocated in order to match employment so that as a result people, goods and capital are more efficiently combined.

Here is an overview of the important points for the strengthening of supply capacity. First is to strengthen and enhance the elements of supply themselves. Second is to ensure that price signals can sufficiently play their role. Third is to spread to other sectors the developments in sectors that are advancing the efficient allocation of resources.

Let's look at the first point, the elements of supply. The decline of the labor supply reduces supply capacity. Therefore, it is required to carry out further reforms of the labor market, enabling people who are willing to work, primarily the elderly and women, to do so. Furthermore, increasing the quality of workers through education and changing jobs of workers to a job better suited to them, etc. also lead to strengthening of supply capacity. And the more efficient resource allocation is also effective, so recently total factor productivity has been in an increasing trend. It is necessary to continue to strengthen measures to increase productivity by advancing the accumulation of capital that takes full advantage of the achievements of technological innovation and ensuring that innovation results in new products, etc.

Concerning the second point, an environment in which price signals can work is gradually being put in place and this is a chance to produce achievements from structural reform. This is because price volatility has an important role to play in structural reform designed to eliminate the factors that obstruct the functioning of market mechanisms and use the power of the market to improve the efficiency of the allocation and combination of people, goods and capital. It is necessary to continue to reform systems through structural reform, eliminate market distortions and strengthen the flexibility of prices. At the same time, an important part of an environment enabling price signals to work sufficiently is ensuring a steady economic recovery so that the expected growth rate increases and there is a shared and steady outlook that deflation is being avoided.

Concerning the third point, the spread of reform to other sectors is important. Taking the example of the employment sector, in which quantitative adjustments are most advanced, the key to ensuring that the advancement of adjustments has positive ripple effects for the overall economy is wage movements. The anchor of wage trends is the rate of increase of labor productivity, and the point is whether or not there is an increase in real wages commensurate with the rate of increase of labor productivity. As analyzed in Section 1, during the process of adjusting over-employment, the growth in real wages was less than the rate of increase in labor productivity and as a result the labor share declined. If improving employment conditions lead to an increase in real wages commensurate with the rate of increase in labor productivity, advancement of structural reform in the labor market will surely lead to an increase in overall demand from the bottom up. Furthermore, ensuring steady investment profits through research and development and front-loaded investment in market sectors with future potential (the environment, medical and nursing care services, etc.) increases the marginal efficiency of investment and leads not only to growth in those market sectors, but also bolsters positive trends in the allocation of capital. In this way, it is necessary to make a chain reaction of reform from sectors that have already achieved results to other sectors and to strengthen the transmission routes.

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