Annual Report on

The Japanese Economy and Public Finance


- Japanese Economy Heading for New Growth Era

with Conditions for Growth Restored -

Cabinet Office

Government of Japan

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Chapter 1

Japanese Economy Heading for New Growth Era and its Challenges

    The current economic recovery, which began in early 2002, is now in its fifth year. The condition of the Japanese economy shows that the foundation for economic recovery is now firmly in place, with the corporate sector, the household sector and the overseas sector having recovered in a balanced manner. With this background, the structural problem, namely the corporate sector's excesses in employment, equipment and debts, that had been putting downward pressure on the economy, has been eliminated, and the economy is overcoming the deflation that had been continuing since the late 1990s. On the policy front, fiscal deficits have been decreasing thanks to the expenditures reform, centered on fiscal structural reform, in addition to the economic recovery. As for monetary policy, the Bank of Japan, in March 2006, lifted the quantitative easing policy that had been in place since March 2001.
    Based on these developments, Chapter 1 makes a comprehensive analysis of the current situation of the Japanese economy and recent trends in fiscal and monetary policies from various perspectives. In Section 1, the background of the continuing economic recovery will be analyzed from a medium- and long-term perspective, after outlining the current economic situations. In Section 2, monetary policy will be discussed based on detailed analyses of the deflationary situation, which has been improving. In Section 3, impacts of a rise in interest rates on the economy will be studied, after outlining the trends in monetary/assets markets. In Section 4, the trend in government's fiscal balance, which is still severe but is improving, will be analyzed. In Section 5, arguments discussed in Section 1 through 4 will be organized and important points for forecasting future economic trends will be presented.

Section 1 Background for the Continued Economic Recovery and Future Challenges

1. Recent economic trend

(1) Private demand-led economic recovery continuing

(Economic recovery, through two adjustment phases, continuing)
    The Japanese economy has been continuing its recovery since the beginning of 2002 and is now in its fifth year. The recovery has been continuing since mid-2005 when the economy got out of its adjustment phase that had been mainly triggered by the adjustment of the information-related sector and a slowdown in exports and began at the end of 2004, with the corporate sector, the household sector and the overseas sector having recovered in a balanced manner.
    However, it is not that the economy has continued its recovery without a hitch. The recovery slowed down twice in the process. We can divide the recovery phase into several periods.
    The first period is from 2002, when the recovery began, to 2003. The economy turned upward after hitting bottom at the beginning of 2002 because exports began to post a rapid increase buoyed by the recovery of the US and Chinese economies, and because inventory adjustment, which had been continuing since the collapse of the IT bubble in late 2000, came to an end. However, during this period, corporations strengthened their restructuring efforts and were desperately reducing the three excesses in employment, equipment and debts. As a result, the growth of consumption and business investments was limited, and the pace of economic recovery was moderate. Moreover, in and after the latter half of 2002, exports slowed down due to intensified situations in Iraq and the subsequent Iraq war, and the economy marked time.
    The second period was from the latter half of 2003 to mid-2005. With the Iraq war coming close to an end, exports recovered around mid-2003. In addition, corporate earnings posted high growth thanks in part to their restructuring efforts, and their business investments picked up gradually. Although the recovery of the household sector was slower than the corporate sector's, consumption firmed up as the unemployment rate turned downward at the beginning of 2003, and the compensation of employment stopped decreasing by the end of 2004. In the latter half of 2004, however, there was a global glut of information-related goods, caused partly by higher estimates for demand ahead of the Athens Olympics. The pace of economic recovery in Japan became moderate due to inventory adjustment in the information-related sector and slower exports. As a result, the Japanese economy marked time again.
    The third period is from the mid-2005 to the present time. The impact of the inventory adjustment in the information-related sector that began in the latter half of 2004 was relatively mild thanks to a pickup in global demand for information-related goods, and production and shipments began to increase by the middle of 2005. In addition, in the latter half of 2005, exports, mainly to Asia and the US, recovered and production began to increase both in the information-related and non-information-related sectors. Corporate earnings, though affected by higher crude oil prices, have kept improving, and business investments have increased in a broad range of industries. Private consumption has kept to a moderate increase amid continued improvement in employment conditions. As just described, the Japanese economy, after getting out of its adjustment phase in mid-2005, has kept recovering, led by private demand, such as business investments and private consumption, with the corporate sector, the household sector and the overseas sector recovering in a balanced manner.

(Economic recovery continuing in a balanced manner accompanied by structural changes)
    The characteristics of the current economic recovery in terms of business cycle will be analyzed in detail later. Let us briefly mention its three major characteristics here.
    First, the current economic recovery has been continuing for more than four years, by far longer than the postwar average of 33 months. In the process of the economic recovery, the Japanese economy overcame several destabilizing factors, including changes in world situations like the Iraq war, global adjustment in the information-related sector, and higher oil prices. This suggests that the Japanese economic structure has become stable after going through changes, such as corporate restructuring and the disposal of non-performing loans.
    Second, the current recovery has spread to a wide range of fields without distinction among industrial sectors or between the household sector and the corporate sector. In this sense, it is a balanced recovery. This is in contrast to the recovery in the 1990s, when the recovery was made only in specific industrial sectors and was heavily dependent on demand from the public sector. That economic recovery has taken root in a wide range of businesses is one of the reasons behind the continuing economic recovery.
    Third, the current economic recovery is not simply a cyclical improvement, but rather a recovery accompanied by important structural changes in several sectors. Since the corporate sector has almost eliminated the excesses in employment, equipment and debts, corporations' break-even point has sharply declined and their business efficiency has improved drastically. With this background, macro-economic productivity, which had been on the decline during the 1990s, has begun to show improvement. In addition to the supply-side improvement, on the demand side, private consumption has been continuing its steady growth thanks to the recovery of business investments and the improvement of employment conditions. As a result, the supply-demand situations in the goods/services market and in the labor market have improved, and the deflationary situation that has been continuing since the late 1990s has begun to improve. Although the state of regional economies is still uneven, they are on the way to recovery as a whole.

(Recent trend of GDP that shows economic recovery)
    Real GDP growth rate has increased slightly, posting an increase of 3.2% in fiscal 2005 after a gain of 1.7% in fiscal 2004 (Figure 1-1-1). A study of quarterly real GDP growth rate (changes in annualized rate from the preceding quarter) in and after 2005 shows that real GDP posted high-growth rates in the January-March and April-June quarters of 2005, growing 5.1% and 5.5%, respectively. This was partly due to the fact that private consumption posted high growth in reaction to the sluggish growth at the end of 2004 caused by weather factors, such as a warm winter and typhoons, and on the strength of an improved income environment. It also reflected the high growth of business investments on the strength of improvement in corporate earnings. In the July-September quarter of 2005, the growth rate of real GDP dropped to 1.0%, partly in reaction to the high growth posted in the preceding quarters. However, amid the continued increase in business investments, real GDP grew 4.5% in the October-December quarter of the same year, buoyed by high private consumption, mainly on seasonal goods prompted by a severe winter and by higher contribution of external demand resulting from increased exports, mainly to the US and Asia. In the January-March quarter of 2006, the growth rate of real GDP slackened slightly, to 3.1%, partly in reaction to the high growth in the preceding quarter and partly due to lower contribution of net exports caused by increased imports. However, the recovery has been continuing, led by domestic demand, such as private consumption and business investments.
Figure 1-1-1 GDP Growth Rate and its Contribution

(2) Corporate sector maintaining its strong performance

(Both exports and production continuing their recovery since mid-2005)
    The economic adjustment phase that began in late 2004 was mainly due to the inventory adjustment of information-related goods and the slowdown in exports. However, by mid-2005, the production of information-related goods got out of its inventory adjustment phase against the background of global improvement in demand for information-related goods, and exports, mainly to Asia, also picked up. Thereafter, amid the continued increase in exports, production of not only information-related goods but also non-information-related goods, such as general machinery and transport equipment, has been increasing (Figure 1-1-2). Meanwhile, some general-purpose materials, such as steel, are under inventory adjustment due to worsened supply-demand situations caused by supply pressure from China. However, on the whole, there is no major increase in inventory.
Figure 1-1-2 Production Trends
    A study of production trends by sector shows that production has been increasing in the information-related sector in line with the improvement in global demand for information-related goods. As for production of semiconductors, whose supply and demand fluctuates greatly, the global shipments of semiconductors by the US, Japan, other Asian countries, and European countries combined decreased sharply from the latter half of 2004 to mid-2005 but began to pick up later, and have still been increasing moderately in 2006 (Figure 1-1-3 (1)). Semiconductor production in Japan moves in line with the global silicon cycle. As for the book-to-bill ratio (BB ratio) of semiconductor products machinery, an indicator of semiconductor production about six months ahead, Japanese-made semiconductor products machinery has generally stayed above the benchmark 1 since mid-2005. US-made machinery has also stayed above a BB ratio of 1 since the beginning of 2006, suggesting that semiconductor production will remain firm for some time to come (Figure 1-1-3 (2)).
Figure 1-1-3 Changes in Japan's Semiconductor-Related Production Index, World Semiconductor Shipments (Market-by-Market Contribution) and BB Ratio
    In the non-information-related sector, production tends to differ slightly depending on whether it is processed goods or material goods. Production of general machinery and transport equipment slowed down in mid-2005, partly in reaction to the high growth posted at the beginning of 2005(1), but again picked up in the fourth quarter of the same year. These movements reflect ever-increasing exports and the steady growth of domestic demand. A study of trends in export volume shows that exports began to recover in mid-2005 and then picked up momentum gradually from late 2005 to early 2006 (Figure 1-1-4). A study of export trends by goods and region shows that exports of electrical machinery, mainly to Asia, improved sharply from mid-2005, while exports of general machinery and transport equipment, mainly to the US, picked up momentum from the fourth quarter of 2005.
Figure 1-1-4 Export Trends by Region and Goods
    On the other hand, in and after 2005, such industries as steel and paper/pulp were somewhat in the process of inventory adjustment, under which production growth was restrained amid increasing inventories. This reflects adverse market conditions for general-purpose products caused by an increase in imports. A study of an inventory graph shows that while the processing industry is in a recovery phase, the material-related industry is in an adjustment phase with production decreasing amid increasing inventories. (Figure 1-1-5). However, in the field of high-class steel products, such as those for use in automobiles, demand is strong and steel output has been increasing, albeit moderately, since the beginning of 2006.
Figure 1-1-5 Inventory Trends by Processing and Material Industry
    As just described, though there are slight differences from one industry to another, inventory has been kept restrained and there are not major increases in inventories in the mining and manufacturing industry as a whole. A factor analysis of inventory trends by estimating the functions that explain investment in inventories in terms of shipments, product supply-demand judgment, and the inventory level in the preceding business term shows that there were build-ups in "unwanted inventories" from late 2004 to early 2005 but that the inventories decreased by mid-2005 thanks to tightening of supply-demand (Appended Figure 1-1). Since the latter half of 2005, the situation has been a mixture of bullish build-ups of inventories prompted by increased shipments and unwanted increases in inventories due to worsened supply-demand situations.

(Production capacity expanding on the strength of higher operating ratio)
    The index of production capacity, which had been on the decline, began to increase in mid-2005 (Figure 1-1-6). As corporations have eliminated their idle facilities, their production capacity is now about 10% lower than in 2000. Meanwhile, they kept increasing production. As a result, the operating ratio rate in such industries as general machinery and transport equipment has risen to a considerably high level. The operating ratio has also increased in the industries that had been boosting their production capacity, such as electrical machinery. These facts seem to indicate that corporations are shifting to increased production capacity.
Figure 1-1-6 Changes in Production Capacity Index by Type of Industry
    By type of industry, the electronic parts and devices industry started to expand production capacity in 2004, reflecting increasing demand for digital consumer electronics. In addition, general machinery and transport equipment manufacturers also began to boost their production capacity in 2005. Expanding production capacity makes it possible to increase production in a quick and efficient manner. At the same time, however, if demand grows slower than production capacity, it would result in increasing inventories. Therefore, the increase in production capacity, though it has been moderate so far, requires us to keep tabs on demand and inventory trends more closely than before.

(Steady corporate earnings with both sales and profit continuing to increase)
    Amid the continuing economic recovery, corporate earnings have also been improving. According to the Financial Statements Statistics of Corporations by Industry, both the ordinary profit and ordinary profit to sales ratio of all industries increased for four consecutive years from fiscal 2002 to fiscal 2005 and are now above the levels during the years of the asset-inflated economy (Figure 1-1-7 (1)). By type of industry, Mortar vehicles and Electrical machinery increased profits, reflecting strong performance in exports and the yen's depreciation, and nonmanufacturing industries, mainly Real estate and Retailing also increased profits, reflecting an increase in domestic demand (figure 1-1-7 (2)). At the same time, amid soaring oil and other material prices, there is a polarization of the profit pattern, with Iron & Steel and some other industries that have passed on the higher costs to their product prices posting increased profits, while Transportation and some other industries that have been unable to do so have been seeing their profits decline.
Figure 1-1-7 Changes in Corporate Earnings
    Behind the increasing corporate earnings, though higher oil prices are putting downward pressure on earnings, is slow growth in fixed costs thanks to a decrease in the three excesses in employment, capital stock and debts, in addition to consistent sales growth on the strength of increases in both domestic and external demand.
    A breakdown of year-to-year changes in ordinary profit into sales factors, labor cost factors, and variable cost factors, etc., by using the Financial Statements Statistics of Corporations by Industry, shows the following characteristics (Figure 1-1-8). First, higher sales contribute to steady increases in profits for both manufacturing and non-manufacturing. The year-to-year growth of sales has continuously secured positive growth of earnings for manufacturing since late 2002 and for non-manufacturing since the beginning of 2003. Second, although the labor cost has been increasing slightly since 2005, the growth in labor cost as a whole has remained restrained, and its impact on corporate earnings has been limited. Third, the impact on corporate earnings of variable costs, or sales costs minus labor costs, has been decreasing since mid-2004. This is particularly conspicuous in the manufacturing industry, suggesting that the impact of the soaring prices of oil and other materials have begun to be felt. Calculation of the impacts of changes in output price and input price on manufacturers' earnings shows that a rise in input price prompted by higher oil prices has been pushing manufacturers' earnings down since 2004. Output prices have also been rising gradually since the latter half of 2004 and some of the costs have been passed on to product prices. However, the earnings-reducing effect of higher input prices is much stronger, indicating that soaring prices of materials for petroleum products, etc. have been putting pressure on corporate earnings. However, since the earnings-boosting effect of sales volume increases is stronger than the earnings-reducing effect of higher input prices, corporate earnings have kept increasing.
Figure 1-1-8 Breakdown of Contributions of Year-to-Year Changes in Ordinary profit
    Amid continuing decreases in the three excesses, in employment, capital stock and debts, corporations' ratio of the break-even point to sales (the level of sales whereby corporations are neither making a profit nor incurring a loss) has been declining since 2002 for both manufacturing and non-manufacturing. According to Short-term Economic Survey of Enterprises in Japan conducted by the Bank of Japan (TANKAN survey, June 2006), the diffusion index of "excessive employment" minus "insufficient employment" was minus 5 points, suggesting corporations' sense of employment shortage has increased. The TANKAN survey also shows that corporations no longer have a sense of excessive production capacity (Figure 1-1-9). As for debts, the ratio of interest-bearing debts to cash flow, which peaked at 12.4-folds at the end of 1993, dropped to 6.4-folds at the end of fiscal 2005, almost at the same level seen before the bubble period.
Figure 1-1-9 Situations of the Three Excesses
    The elimination of the three excesses and the resulting decrease in fixed costs has pushed corporations' ratio of the break-even point lower. An analysis of what factor or factors contributed to the lowering of the ratio of the break-even point to sales after 2002 shows that the decline of the ratio in 2002-2003 was largely due to decreases in labor costs and paying interest expenses. The analysis also shows that increases in sales and restraints on fixed costs greatly contributed to the decline of the ratio in and after 2004 (Appended Figure 1-2). The manufacturing's ratio of the break-even point to sales declined more sharply than the non-manufacturing's ratio, reflecting that manufacturing's sales growth has been larger than non-manufacturing's, and that manufacturing have continued to curb labor costs.
    Regarding the outlook for fiscal 2006, the TANKAN survey (June) shows that "all enterprises in all industries" expect their ordinary profit to increase 1.5%. By type of industry, Electrical machinery in the manufacturing industry, and Retailing and Information communication in the nonmanufacturing industry forecast higher profit increases.

(Strong growth of business investment continuing)
    According to the National Accounts, business investment has continued to post strong growth, rising 7.0% in fiscal 2003, 5.6% in fiscal 2004, and 7.5% in fiscal 2005, all in real terms. As for fiscal 2006, the TANKAN survey (June 2006) business investment by all enterprises in the manufacturing industry increases 11.0% and 3.8% by all enterprises in the nonmanufacturing industry increases, both having a fairly high growth forecast for a survey conducted in June.
    As for business investment trends by type of industry, the TANKAN survey shows that the manufacturing industry continued to post a double-digit increase in fiscal 2005, while the nonmanufacturing industry steadily increased business investment. A breakdown of business investment in the manufacturing industry shows that Electrical machinery, which posted a high growth rate in fiscal 2004, took a breather in fiscal 2005, but that Industrial machinery and Motor vehicles increased business investment on the strength of an increase in business investment demand and a recovery of exports (Figure 1-1-10). Moreover, the Basic materials that had been cautious about business investment, such as Chemical and Iron & Steel, began to increase their business investment. Among non-manufacturing Real estate, Information communication, Wholesaling & Retailing and Electric & Gas utilities steadily increased their business investment in fiscal 2005.
Figure 1-1-10 Growth Rate of Business Investment by Type of Industry

(Corporations have become increasingly positive about business investment, but efficiency of the investment has been maintained.)
    Although corporations are basically cautious about business investment, they appear to have become slightly positive about business investment recently, reflecting more than four years of continuous economic recovery. Specifically, though corporations are implementing business investment within the limit of their cash flow, the ratio of business investment to cash flow has been increasing recently in both the manufacturing and nonmanufacturing industries (Appended Figure 1-3). As the amount of business investment was less than depreciation costs and write-off amounts, corporation's tangible fixed assets were on a declining trend. However, according to the Financial Statements Statistics of Corporations by Industry, the amount of tangible fixed assets of the manufacturing industry began to increase in 2005 (See Appended Figure 1-3). However, nonmanufacturing industry's outstanding balance of tangible assets has been decreasing.
    Behind this lies the fact that corporations' operating ratio has been increasing thanks to the continuing economic recovery. A study of the relationship between manufacturers' operating ratio and their business investment shows that a rise in operating ratio and an increase in business investment have come to take place at the same time (Figure 1-1-11). In the Transportation machinery and Industrial machinery, a rise in operating ratio and an increase in business investment have been continuously observed for several years now. On the other hand, in the Electrical machinery, a decline in operating ratio and a slowdown in business investment were observed from the latter half of 2004 to the first half of 2005. Then, both operating ratio and business investment turned upward from around mid-2005.
Figure 1-1-11 Operating ratio and Business Investment
    Although business investment has increased slightly, the pace of increase in capital stock is extremely moderate compared with those observed during the past recovery phase, and the efficiency of business investment shows no decline. Calculation of the efficiency of business investment, which is added value divided by tangible fixed assets, by using the Financial Statements Statistics of Corporations by Industry, shows that both the manufacturing and nonmanufacturing industries have been improving the efficiency of business investment on the strength of increasing added value (Appended Figure 1-4).

(Increase in business investment reflects a rise in corporations' expected growth rate)
    Although business investment has been increasing, the possibility of capital investment becoming excessive would be remote if the economy continues to grow at the rate of its potential growth rate. It can be explained by monitoring the trends of each corporation's expected growth rate as follows.
    Whether or not business investment will continue to increase in the future depends on the level of each corporation's expected growth rate. In order to realize a stable expected growth rate, it must be consistent with the potential growth rate of the macro economy.
    If the capital coefficient and extraction ratio are constant in an equilibrium situation, it is possible to calculate a combination of business investment growth and business investment-to-capital stock ratio that is consistent with the level of corporation's expected growth rate. Conversely, it is possible to guess, from the actual growth rate of business investment and the business investment-to-capital stock ratio, what level of expected growth rate the corporation is assuming. Figure 1-1-12 (1) shows that the capital coefficient had been on an upward trend during the 1990s but it turned slightly downward in recent years (Figure 1-1-12 (1)). The capital coefficient declines when TFP makes an upward refraction. A factor analysis shows that capital productivity has improved as the negative contribution of a rise in real GDP growth, or the denominator, which was brought about by increasing productivity, is at work. As for the extraction ratio, it rose slightly above 4.5% in the late 1990s and has been moving horizontally thereafter.
Figure 1-1-12 Business Investment and Expected Growth Rate
    Calculation of corporation's expected growth rate based on these trends of capital coefficient and extraction ratio shows that corporations assumed an expected growth rate of above 1.5% for fiscal 2005 (Figure 1-1-12 (2)). The Annual Survey of Corporate Behavior also shows that corporations' expected growth rate has been on a rising trend. In the FY2006 survey, the expected growth rate over the next three years and the next five years came to 1.9% in real terms. The corporations' expected growth rate is slightly higher than the potential growth rate estimated from the production function, which stood at around 1.5% as of 2005. However, given the fact that the potential growth rate has been rising in recent years, it can be said that the expected growth rate is consistent with the potential growth rate.

Column 2

Income surplus exceeds trade surplus

    According to the International Balance of Payments Statistics for 2005, Japan's surplus in income balance, including income from investments, accounted for 2.3% of the nominal GDP, exceeding the surplus in trade balance that accounted for 2.1% for the first time. Therefore, if we follow the stage theory of balance-of-payments development (Note), Japan may head for a "matured creditor nation" with a surplus in income balance and a deficit in the trade and services account.
    If the time series changes of Japan's balance of payments are seen from the perspective of the "International balance of payments development stage theory," Japan shifted to an "immature creditor nation" in the 1980s with its income balance, in addition to its trade and services balance, posting a surplus, and then from the late 1980s to the latter half of the 1990s, Japan steadily followed the path to a "matured creditor nation," with the surplus in the trade and services balance continuing its downward trend during that period. In reality, however, the surplus in the trade and services balance has stopped decreasing since 2000 due to an increase in exports. In 2005, the surplus in the trade and services balance declined, but this was not due to a decrease in exports but largely due to an increase in imports prompted by higher crude oil prices.
    Since Japan's external assets are expected to continue to increase backed by its current-account surplus, the surplus in the income balance is expected to increase in the long term. However, Japan's exports will remain on a rising trend partly backed by the high economic growth of Asian countries, Japan's major trading partners. Therefore, the possibility of Japan immediately shifting to a "mature creditor nation" is remote. However, with crude oil prices still standing at a high level, we need to keep close watch on the trend of trade balance.
(Note) "International balance of payments development stage theory" explains changes in balance-of-payments structure with the external flow of funds, by focusing attention on the fact that a country's savings and investment balance will change in accordance with the economic development stage of the country. It was first put forward by Crowther in 1957.

Column 2 Table: Changes in Japan's Balance of Payments (relative to nominal GDP)

(3) Improving household/labor sector

(Amid tightening labor supply and demand, the labor market is improving moderately, with the unemployment rate declining.)
    With the economic recovery continuing, the labor market has further improved, though there are still severe situations remaining, such as employment of young people and regional disparity. The number of employees is increasing and the unemployment rate is declining.
    Reflecting increasing demand for labor from the corporate sector, the situation in the labor market has further tightened. As of the first quarter of 2006, the effective job offer ratio stood at 1.03, the highest level since 1992. A breakdown of the effective job offer ratio into full-time employment and part-time employment shows that the job offer ratio for full-time employment stands at about 0.6, continuing its rising trend since 2003. On the other hand, the job offer ratio for part-time employment stands above 2, but its growth has slackened (Figure 1-1-13). A breakdown of new job offers by industry shows that offers for full-time employment have increased from the manufacturing and construction industries, in addition to the tertiary industries, such as medical services and welfare, restaurants, and wholesale/retail. Meanwhile, offers for part-time employment are largely accounted for by service and other tertiary industries mentioned above. Regarding corporations' sense of employment surplus or shortage, the Survey on Labor Economy Trends shows that the shortage of part-time workers remains unchanged and that the percentage of corporations feeling a shortage of full-time workers has been higher than the percentage of corporations feeling a surplus of full-time workers since the latter half of 2003. Moreover, new hiring by corporations that had held on recruitment has increased in recent years. The quality of employment has also improved, with demand not only for part-time workers but also for full-time workers increasing.
Figure 1-1-13 Trends in Job Offers, etc.
    Amid the tightening trend of labor supply and demand, the number of employees has been increasing moderately. According to the Labour Force Survey, the number of employees in all industries has been on a moderate increasing trend since 2003, and the trend picked up steam in fiscal 2005, with the number of employees increasing by 650,000 from the previous year. By industry, the increase in employment remains high among such tertiary industries as medical service/welfare, wholesale/retail and information/communications. The number of employees in the manufacturing industry, which had been on a declining trend, began to increase (Figure 1-1-14). In order to study the background behind the increase in the number of employees in the manufacturing industry, we calculated to what extent a one-unit increase in exports, including its spillover effects, would increase employment in each industry by using input-output tables, and checked its correlation with the actual growth of employment. As a result, we have found that the increase in employment is high among export-oriented industries with high employment-creation effects. Therefore, we believe that, as far as employment in the manufacturing industry is concerned, the steady increase in exports has much to do with the employment increase.
Figure 1-1-14 Changes in the Number of Employed Workers by Industry, Changes in Employment in Input-output Table
    The unemployment rate has been on a downward trend after hitting a peak of 5.5% at the beginning of 2003. In fiscal 2005, the unemployment rate stood at 4.3%, declining further from the 4.6% in the preceding year. Seen from the perspective of transition among the state of being employed/unemployed, the decrease in the unemployment rate at the beginning of 2003 reflects that the probability of transition from being employed or not being in the labor force to becoming unemployed has deceased partly, due to a lull in corporate restructuring (Figure 1-1-15). In and after 2004, the probability of becoming employed rose, reflecting the increase in the number of employees, and the decline in the unemployment rate has become clear.
Figure 1-1-15 Changes in Unemployment Rate and Flow of Workforce among Different States of Being Employed/Unemployed

Column 3

Structural Unemployment

    Generally speaking, the unemployment rate is affected not only by changes in demand caused by business cycles but also by the efficiency of the labor market that introduces job seekers to employers. Therefore, unemployment is sometimes classified into frictional unemployment, structural unemployment and cyclical unemployment. Frictional unemployment is caused simply by a time lag from seeking employment to entering the workforce. Structural unemployment is caused by employment mismatches in the quality of workers and the regions. Cyclical unemployment is actual unemployment minus frictional and structural unemployment. However, since it is difficult to strictly distinguish between frictional unemployment and structural unemployment, they are both called structural unemployment.
    One way to obtain the structural unemployment rate is by calculating the unemployment rate on the assumption that labor supply and demand is in equilibrium when the vacancy rate and the unemployment rate are the same (the unemployment rate thus obtained is called the equilibrium rate of unemployment). There are several ways to obtain the equilibrium rate of unemployment by using a UV curve that describes the relationship between the unemployment rate and the vacancy rate. One way is by calculating the equilibrium rate of unemployment applying the slope of a UV curve of a specific period when labor supply and demand was in equilibrium. Another is done by calculating the rate including the structural shift factors of a UV curve in the estimation. The equilibrium rate of unemployment obtained by these methods was somewhere between 3% and 4% as of 2005.
    Another method for obtaining the structural unemployment rate is by obtaining the non-accelerating inflation rate of unemployment (NAIRU). This is based on the empirical fact that a decline in the unemployment rate caused by tighter labor supply and demand would accelerate the inflation rate through higher wages in the short term. Theoretically speaking, NAIRU and the equilibrium rate of unemployment are identical, if we suppose that the labor market is divided into several markets and that wage growth rates are determined by excessive demand or excessive supply in each market. NAIRU can be obtained by estimating a wage function. As the Japanese economy has been in a deflationary phase since the late 1990s, it is difficult to obtain stable estimation results. Still, estimation results show that NAIRU is somewhere between 3.5% and slightly above 4%.
    In any case, the estimation results of the structural unemployment rate should be approached allowing a certain amount of leeway.

Column 3 Table: Definition of Structural Unemployment Rate and Recent Estimated Figures

    As for the movement of wages, although contractual cash earnings (excluding special cash earnings) posted positive growth in 2005, it was an extremely moderate growth (Figure 1-1-16). However, since the number of employees has been increasing moderately, the compensation of employment (wages multiplied by the number of employees) has been posting stable growth.
Figure 1-1-16 Growth of Contractual Cash Earnings and Compensation of Employment

(Private consumption is increasing moderately)
    As income and consumer confidence has been steady thanks to the improvement in employment conditions, private consumption has been increasing moderately. According to national income statistics, the consumption of households (real) has been increasing moderately as a trend, rising 1.6% in fiscal 2004 and 2.4% in fiscal 2005. In the fourth quarter of 2005, the consumption of households posted an annualized growth rate of 2.6% over a year earlier on the strength of brisk sales of seasonal goods, such as winter clothing and heating appliances, reflecting lower-than-usual temperatures. In the first quarter of 2006, consumption expenditure slowed down slightly, posting an increase of 2.0%, partly in reaction to the brisk spending in the preceding quarter. On the average, consumption has been increasing moderately at slightly above 2% in real terms.
    Although growth in private consumption is affected by weather factors in the short term, its underlying trend is determined by income and consumption propensity. Since consumption propensity is the other side of savings rate, it is safe to say that the long-term trend of savings rate is affected by the ratio of elderly households dipping into their savings from the perspective of life cycle and the outstanding balance of financial assets, etc. Therefore, assuming that the long-term trend of consumption is affected by such variables as the ratio of elderly households and the outstanding balance of financial assets, in addition to income, we estimated the long-term equilibrium relationships of these variables and studied how far current consumption has deviated from the long-term equilibrium. We have found that actual consumption was slightly above the long-term equilibrium in 2004 but that the consumption was almost at the same level as the long-term equilibrium from 2005 to the beginning of 2006 (Figure 1-1-17). Behind the difference in movement between the long-term trend of consumption and the actual consumption is consumer confidence. A study of the consumer confidence index for the same period shows that consumer confidence improved sharply in around 2004, due partly to the simultaneous improvement of the employment environment and income growth. However, the index also shows that, in the period thereafter, consumer confidence has been moving steadily at a high level on the whole, except for a slight rise in late 2005, indicating that it is consistent with the deviation of actual consumption from the long-term equilibrium (Appended Figure 1-5).
Figure 1-1-17 Consumption Viewed from Long-term Equilibrium Relationship, Actual Consumption/Trends
    Therefore, it can be said that private consumption is moving within the growth range determined by income and other basic factors, accompanied by short-term fluctuations. In 2005, the compensation of employment rose about 2% in real terms and the outstanding balance of financial assets increased by slightly more than 4%, in part helped by higher stock prices. Therefore, the growth in consumption trend stayed at slightly above 2% as of 2005 (See Figure 1-1-17).

(Consumption trends by goods)
    A breakdown of the recovery of consumption in the current economic recovery period by goods and services in nominal terms shows several characteristics.
    According to the synthetic consumption index(2), both supply-side statistics and demand-side statistics show that the recovery trend of service consumption became clear in 2004, and the recovery of consumption of goods also became clear in 2005 (Figure 1-1-18). As for individual items, the supply-side statistics show that consumption of clothing and personal items, which posted a decline in 2004, increased slightly in 2005. The increase can be partly attributed to the government move to promote no-necktie cool work clothes in the summer of 2005 and brisk sales of winter clothing prompted by a drop in temperature late in the year. Consumption of petroleum products increased sharply. This was mainly due to price hikes and an increase in demand for heating oil prompted by the severe winter. On the other hand, consumption of household electric machines decreased slightly in 2005 after increasing sharply in 2004. This was in part in reaction to the sharp increase in sales of air conditioners and TVs in 2004, which was prompted by a heat waves and the Athens Olympic Games, and in part due to a sharp decline in the prices of digital consumer electronics which reduced consumption in nominal value. Service consumption increased in 2005 in a wide range of businesses, including restaurants, entertainment services, personal services (for instance, fitness club and cultural activities), and hotels/other lodgings. As for items common to both supply-side and demand-side statistics, medical/health care has been steadily contributing to the growth of consumption, partly reflecting the advancement of the aging population. In addition, financial transactions increased sharply in 2005, reflecting that increased stock transactions prompted higher stock prices.
Figure 1-1-18 Trends of Nominal Consumption by Goods and Services
    The above movements can be summarized as follows. First, the increase in consumption of clothing and various services, given their high income elasticity, indicates that the income environment of consumers has been improving. Second, the growth in consumption of petroleum products, caused by rising petroleum prices, is adding a burden on household budgets because the price elasticity of gasoline and kerosene is low and because they are essential products. Third, the advancement of the aging population has pushed up service consumption, and the ratio of service consumption will continue to increase in the long term.

(Savings rate declining, reflecting the aging population and increasing consumption.)
    According to National Accounts, the household savings rate kept declining for seven consecutive years after hitting 11.5% in fiscal 1997, and fell to 2.7% in fiscal 2004(3). A breakdown of the decline into income factors and consumption factors shows that both income and consumption have been contributing to the decline of the savings rate (Appended Figure 1-6), with disposable income continuing to decline after hitting a peak in fiscal 1997, reflecting the downward trend of compensation of employment and operating surpluses (including the business income of self-employed individuals), while final consumption expenditure has been increasing moderately on the average. In particular, the growth in household income, though improving on the strength of a pickup in employment situations, has remained almost flat since fiscal 2002, when the current economic recovery began, while consumption expenditure has been recovering. This has been making a major contribution to the decline in the household savings rate. Incidentally, it is necessary to keep in mind that the household savings rate in the National Accounts is different from the savings rate in Family Income and Expenditure Survey, etc. Since the National Accounts hypothesize that owned houses are rented out, the owners and the imputed rent from home ownership is taken into consideration, and the savings rate tends to be lower.
    The decline in savings rate in recent years reflects two aspects: one is that consumption expenditure has been increasing in line with the economic recovery, and the other is that elderly households are increasing in the long term. This can be verified by conducting the following analyses.
    According to the life cycle hypothesis, generally speaking, people increase savings when they are young and dip into the savings when they get old. Therefore, aging of the population is believed to lower the savings rate. In order to explain the trend of the household savings rate with population factors we conducted analyses from two approaches: one by using the correlation of macro variables from the data of the National Accounts, and the other by using age-group data of household budget surveys and changes in population composition.
    First, with regard to the National Accounts-using approach, as variables explaining the long-term trend of the household savings rate, we used the dependent population ratio, which is a variable showing aging effect, the financial asset balance, interest rate levels, and the balance of saving and investment of the general government(4), in line with the analysis conducted in the Annual Report on the Japanese Economy and Public Finance 2005. The results of the estimation confirmed that a co-integrative relationship is formed among these variables, and that the actual household savings rate does not deviate from the theoretical value of this model in the long term (Figure 1-1-19). The estimation shows that the rise in the dependent population ratio due to the progress of aging has been consistently contributing to the decline in the household savings rate, and that the accumulation of financial asset balance has also been contributing to the decline of the savings rate. If the long-term equilibrium relationship continues to be formed, the progress of aging is expected to further lower the savings rate.
Figure 1-1-19 Long-term Equilibrium Relationship of Savings Rate
    Next, by using Family Income and Expenditure Survey data by age group, we examined the likely impact of changes in the population composition on savings rate in the case where there is no change in the trend of savings behavior of each household divided into age group and year of birth(5). Specifically, we divided each household attribute into age group and year of birth by using the results of the Family Income and Expenditure survey of workers' households and analyzed the trend of each household's savings rate by dividing the data into the age effect (the impact according to life cycles), the generation (the impact that appears due to differences in year of birth), and the period effect (the impacts seen in all households in that period, including economic fluctuations) (Figure 1-1-20). The age effect shows that, as the life cycle hypothesis assumes, the savings rate of people in their 30s to 50s is high and that the savings rate of elderly people aged 60 years or older is low, while the generation effect shows that, among the generations born after World War II, the younger the generation is, the higher the generation's propensity is to save. The period effect shows that the savings rate was rising slightly higher in the 1990s, but that it now stands almost at the same level as in around 1980. An estimation of the impact of future changes in population composition, on the assumption that there is no change in the household attribute divided into age group and year of birth, shows that the household savings rate will decline from about 25% in 2005 to 23% in 2010, due to aging of the population. However, it should be kept in mind that the estimate covered workers' households, and that if households with heads not working and therefore whose savings rate is low were included, the savings rate would decline considerably (See Appended Figure 1-6).
Figure 1-1-20 Cohort Analysis and Impact of Aging Population on Savings Rate

(Housing construction, mainly houses for rent and condominiums, remains firm)
    Amid the continued economic recovery, housing starts remains firm, reflecting improvement in the income environment and persistently low levels of interest rates (Figure 1-1-21). Housing starts in fiscal 2005 stood at about 1.25 million units, posting an increase for the third consecutive year. Construction of owned houses and detached houses for sale decreased slightly, but construction of houses for rent and condominiums for sale posted a sharp increase. By region, construction, mainly of houses for rent and condominiums, increased conspicuously in the three metropolitan areas of southern Kanto (Tokyo metropolitan area), Tokai, and Kinki. Housing starts in other regions, mainly in urban areas, are also on an increasing trend.
Figure 1-1-21 Trends of Housing Starts
    Behind the strong growth in the construction of houses for rent and condominiums, mainly in three metropolitan areas and local cities, is that, in terms of demand, people's willingness to acquire housing and to invest in rental houses has increased against the background of low interest rates and the improvement in the income environment. Also behind it are the increasing inflow of population into urban areas and the fact that the Dankai Jr. generation (second-generation baby boomers) has entered the age of first-time housing acquisition. Looking at the inflow/outflow of population in various areas, it is seen that the inflow of population into major regional cities, in addition to the Tokyo metropolitan area and Nagoya metropolitan area, has been increasing as a medium-term trend (Figure 1-1-22 (1)). Behind the population inflow into urban areas are the facts that premises in convenient urban areas have increased their attractiveness as a result of the continuous decline in land prices following the collapse of the bubble economy, and that the land that had been disposed of by corporations has come to be used as sites for the construction of houses for rent and condominiums. The increase in the construction of houses for rent partly reflects the fact that old houses for rent have entered a replacement cycle. With respect to this point, the construction of houses for rent posted a sharp increase twice in the past: in the 1970s and 1980s. In view of the fact that the houses for rent constructed in those days and still existing have decreased considerably in the past five years, it is thought that some of them are now being replaced (Figure 1-1-22 (2)).
Figure 1-1-22 (1) Population Mobility in Cities
Figure 1-1-22 (2) Replacement Cycle of Houses for Rent
    With respect to the construction of condominiums, there had been concern about adverse effects of the problem of falsified earthquake-resistance strength that surfaced in late 2005 on housing demand, such as making persons planning to acquire housing cautious and delaying the authorization of building construction. However, as far as statistics up to the beginning of 2006 are concerned, no adverse effects of the problem were observed, with both sales and construction of condominiums doing well. Sales of condominiums, which had been on a weak note on a year-to-year basis since November 2005, posted a sharp increase in March 2006, and the contract rate has remained at a high level (Appended Figure 1-7).

2. Characteristics of Current Economic Recovery Phase Seen from Aspects of Business Cycle

    The current economic recovery, which started at the beginning of 2002, has continued for more than four years. In this section, the characteristics of the current economic recovery that has continued will be analyzed.

(1) Backgrounds of past business cycles and characteristics of current one

(Current economic expansion lasting long after short-lived expansion in the 1990s)
    The duration of post-war economic expansion periods, excluding the current business cycle, lasted an average of 33 months. However, the duration of economic expansion tended to shorten during the 1990s, after hitting a peak during the period of the bubble economy in the latter half of the 1980s. Specifically, the duration of the economic expansion period had shortened from 51 months between 1986 and 1991 to 43 months between 1993 and 1997 and 22 months between 1999 and 2000 (Appended Table 1-8). The ratio of the duration of economic expansion in each 10-year period comes to 82% in the 1960s, 65% in the 1970s, 58% in the 1980s, and 57% in the 1990s, indicating smaller ratios in the 1980s and 1990s (Figure 1-1-23). Although it is difficult to make a strict comparison due to the difference in the duration of comparison period, if the economic expansion is supposed to have continued from the beginning of 2002 to the beginning of 2006, the ratio of the duration of economic expansion in the period from 2000 to the beginning of 2006 comes to over 80%.
Figure 1-1-23 Ratio of Economic Expansion Period
    It has been pointed out that the duration of business cycle has tended to be getting longer in many countries in the world. According to IMF (2002), the average duration of the economic expansion period in and after the 1970s in 21 advanced countries is about 5 years, and the average duration of the recession period is about 1 year(6). The average duration of economic expansion in Japan during the same period is 2.7 years and the average duration of the recession period is 1.8 years. In Japan, the duration of the business cycle is short and the ratio of the duration of economic expansion to one business cycle is small. The average duration of business cycle in the 21 advanced countries became longer from about 4 years in the 1970s to about 6 years in the 1980s and 1990s. This is mainly attributed to the fact that the duration of economic expansion has become longer. OECD (2002) point out that behind the trend toward longer economic expansion periods are the facts that the management method for macro economy, including monetary policy, has become sophisticated and that the proportion of the service industry, which is less susceptible to business fluctuation than the manufacturing industry, has increased(7). In the mean time, with respect to countries where the business cycle has become shorter, it is generally considered to be because they are less capable of coping with negative shocks due to the rigidity of their labor market and product market. It points out that the shortening of the business cycle in Japan in the 1990s may have something to do with such structural problems (See forecited IMF (2002)).

(Economic fluctuation expanded in the 1990s but narrowing in the 2000s.)
    The magnitude of fluctuation in economic growth rate has stabilized as a general trend in advanced countries, with the margin of fluctuation during economic expansion periods becoming smaller and the margin of decline during recession periods becoming more shallow every 10 years since the 1970s. On the other hand, the margin of fluctuation in Japan expanded in the 1990s, with the margin of decline during recession periods expanding. However, the fluctuation has narrowed in Japan since the beginning in 2000s.
    As a method to observe the magnitude of economic fluctuation, the size of GDP gap variance in major countries and regions was sequentially calculated. It shows that the fluctuation in Japan, the US and the Euro area narrowed in the 1980s after expanding sharply in the 1960s and 1970s due partly to the first oil crisis (Table 1-1-24). The fluctuation further narrowed in the US and the Euro area from the 1990s to the 2000s, but in Japan the variance expanded again in the 1990s due partly to the collapse of the bubble economy. An analysis of the contribution of domestic demand and external demand to the expansion of the GDP gap variance in Japan in the 1990s shows that external demand contributed to lowering the variance and that domestic demand was the main contributor to the expansion of the variance. In the 2000s, however, Japan's economic fluctuation has become smaller.
Table 1-1-24 GDP Gap Variance in Japan, US, and Euro area
    A calculation of the growth rate of real GDP per quarter during economic expansion periods and recession periods shows that the growth rate turned downward sharply from the 7th business cycle starting in 1971 to the 8th cycle starting in 1975. It rose slightly during the bubble years and then has been moving almost horizontally since the 1990s (Figure 1-1-25). If the average growth rate of real GDP during the period from the beginning of 2002 to the end of fiscal 2005 is tentatively calculated, it comes to 2.5% (the average of year-to-year quarterly growth rates), almost the same growth rate as in the expansion periods in the 1990s.
Figure 1-1-25 Real GDP Growth Rate during Economic Expansion and Recession Periods
    On the other hand, the growth rate during recession periods has been on a downward trend. In the past, the Japanese economy posted positive growth even during recession periods (growth recession). However, it posted negative growth in the 12th cycle starting in 1993 and 13th cycle starting in 1999.

(Correlation with world economic cycle increased in and after 2000)
    A calculation of the correlation coefficients of real GDP of Japan, the US, Group 7, 12 Euro area countries and East Asian countries shows that correlation between Japan and each of the countries/regions decreased in the 1990s compared to the 1980s (Table 1-1-26). This indicates that the Japanese business cycles in the 1990s may have been greatly influenced by domestic factors, such as the collapse of the bubble economy and the subsequent problem of non-performing loans. Moreover, given the fact that correlation between Japan and East Asian countries increased in the latter half of the 1990s, it can be said that the factors peculiar to the Asian region, such as the Asian currency crisis, may have had a major impact.
Table 1-1-26 Correlations between Business Cycle of Japan and the World
    Incidentally, Japan's correlation with the US, G7, Euro area countries and East Asia again increased sharply in and after 2000. This indicates that the correlation between the business cycle in Japan and the business cycle in the world has recovered. In addition to the converging trend of business cycles in the world, there is a global movement toward interrelationship in financial services. For instance, the real long-term interest rates in major countries have tended to converge. There is also a similar movement in stock prices in major countries recently (for detail, see Section 2).

(Contribution of consumption increasing in the current economic recovery)
    A calculation of contribution of demand components to GDP growth during economic expansion periods shows that consumption and investment have consistently made a big contribution (Figure 1-1-27). In terms of contribution rate, the role of consumption, which used to contribute to more than 50% of real GDP growth in the past, had tended to continue to decrease its role, with its contribution rate dropping to about 30% in the 12th business cycle starting in 1993 and to about 20% in the 13th cycle starting in 1999. On the other hand, investment, whose contribution rate used to stand at about 20% in the past, has increased its relative role, with its contribution rising to about 40% in the 1990s. However, in the economic expansion phase in and after 2002, the contribution rate of consumption rose sharply to about 40%, backed by factors such as improvement of employment situations, and consumption has become the largest contribution component, exceeding that of business investments (about 30%).
Figure 1-1-27 Contribution Rates of Demand Components in Economic Expansion Period
    Combined public demand for public investment and government consumption, whose contribution rate rose in the first half of the 1990s, made negative contribution in the 13th cycle starting in 1999 and the current recovery phase. As for external demand, it sometimes made positive contribution and other times negative contribution during economic expansion periods. However, its contribution rate in the current economic expansion period stands at about 25%, a relatively large contribution compared with its past expansion period.
    As described above, the current economic recovery is being led by private demand, with consumption, investment and external demand recovering in a balanced manner as a result of a rise in consumption's contribution.

(2) Characteristics of the economic recovery under deflation

    One of the characteristics of the current economic recovery is that it is lasting long despite moderate deflation of prices. The following takes a look back on the trend of the current economic recovery from the aspect of deflation.

(Negative impacts of deflation offset by improvement of corporate structure)
    It's natural that the kind of deflationary spiral in the 1930s causes adverse effects on the economy. In the presence of various downward rigidities in nominal terms, even the kind of moderate deflation that was seen in and after the latter half of 1990s would cause adverse effects on the economy. Specifically, deflation has negative aspects in that 1) the real debt outstanding increases, 2) real interest rates would stay at a high level under the nonnegative constraint that the interest rate does not fall below zero percent, and 3) if there is a negative shock, it would cause large fluctuations in production, employment, as quantity adjustment is likely to occur due to lack of price changes caused by the rigidity of nominal wages.
    With respect to these points, the following is confirmed by examining the extent of impact of deflation on the Japanese economy.

i) Real debt outstanding
    In the period from 1998 to 2005, the real debt outstanding, if it was calculated by taking the rate of change in consumer price index into account, would have come about 2% higher than its nominal term due to deflation during the period. And if calculated by taking the domestic demand deflator into account, the real debt outstanding would have come 7% higher than its nominal term. However, since corporations reduced their debts faster than the increases in the real debt outstanding, the debt outstanding in real terms was about 6.1% lower than the figure based on the consumer price index, and about 1.3% lower than the figure based on the domestic demand deflator (Figure 1-1-28 (1)).
Figure 1-1-28 Real Debt Outstanding, Real Interest Rate, Phillips Curve

ii) Real interest rate
    Interest rates also rose sharply in 2001 due to the progress of deflation. Then, they did not rise to an extremely high level compared with the past as a result, as deflation did not progress at an accelerating pace, and as nominal long-term interest rates declined thanks to the effects of the Bank of Japan's quantitative easing policy and tight management of fiscal policies (Figure 1-1-28 (2)).

iii) Rigidity of nominal wages
    With respect to the rigidity of nominal wages, a Phillips curve (nominal wage in vertical scale and unemployment in horizontal scale) shows that the slope of the curve flattened in the latter half of the 1990s, indicating that wages did not decline for the rise in unemployment rate. However, the nominal wage per hour was lowered in and after 2001, easing the rigidity slightly, and along with it, the unemployment rate began to decline after hitting a peak at the beginning of 2003 (Figure 1-1-28 (3)). In order to statistically confirm this point, a Phillips curve showing the correlation between unemployment rate and wage per hour was estimated and the stability of the coefficients examined. The examination shows there was a structural change in around 2000. Chapter 2 analyzes in detail the background of the elimination of the rigidity of nominal wages and the declines in unemployment rate and labor distribution rate. It indicates that, due to the presence of corporations' excessive debts, employers may have given priority to the continued existence of their corporations rather than to ensuring wages.

(Reasons behind the avoidance of deflationary spiral: Impact of external factors, such as world economy and policy managements)
    As described above, the negative impact of deflation, which had initially raised concern, did not materialize, as a result, and the economy has been continuing its recovery since 2002 without falling into a deflationary spiral. Behind this lies the fact that external factors, such as the world economy and policy managements, offset the negative impact of deflation and propped up the economy.
    First, in the initial stage of the current economic recovery, external demand prompted the reversal of the economy under deflation. In particular, a sharp increase in exports to China supported domestic production. The contribution of exports to China to the growth in the export volume index during the current economic recovery phase is about 3 percentage points on average, sharply higher than in the past (Figure 1-1-29). Thanks in part to the high economic growth in China and other Asian countries, Japan is blessed with a relatively good export environment compared with other OECD countries. With respect to this point, the growth rate of export markets (the weighted average of import growth in importing countries) shows that the average growth rate of Japan's export markets rose from 7.9% for 1990-2001 to 8.2% for 2002-2005, while the average growth rate of the US's export markets declined from 6.8% to 6.2% during the same period. The growth rate of the export markets of other OECD countries have slowed down on the whole (Appended able 1-9).
Figure 1-1-29 Contribution of Chinese Economy
    Second, credit uncertainty did not materialize thanks to financial revitalization efforts, and corporate bankruptcies and unemployment resulting from the disposal of non-performing loans were held as smaller than had been initially expected. This has helped avoid the situations of extreme shrinkage of finance, such as credit crunch, and lower corporations' debt ratio. As a result, credit spreads among corporations have narrowed and inter-business credit has been expanding since 2004 (Figure 1-1-30).
Figure 1-1-30 Lending Attitude of Financial Institutions, Yields on Corporate Bonds, Inter-business Credit
    When the government, in 2001, announced a policy calling on major banks to directly dispose loans to borrowers in danger of bankruptcy or worse within three years in principle, some people worried that it would drastically increase unemployment. In reality, however, the number of the unemployed did not increase as much as was anticipated. This was because the amount of corporate bankruptcy was much smaller than expected, thanks to the improvement of the framework for corporate rehabilitation, and because, even in the case of bankruptcy cases, reconstruction-oriented disposal, rather than liquidation-oriented disposal, of non-performing loans increased(8). As a result, the decline in the unemployment rate that began at the beginning of 2003 helped ease households' concerns about employment prospects, and this, in turn, made a big contribution to the recovery of consumption. With respect to this point, correlation obtained by a regression analysis between the consumer confidence index and the volume of news on employment anxiety and job offers is statistically significance. When the volume of news on employment anxiety began to decrease after hitting a peak in around 2002 amid improving labor supply and demand, the consumer confidence index also began to improve (Figure 1-1-31).
Figure 1-1-31 Consumer Confidence Index and News on Employment Anxiety
    Third, reflecting the Bank of Japan's quantitative easing policy and the government's fiscal consolidation efforts, not only nominal short-term interest rates but also long-term rates have been held down, and currency exchange rates have remained relatively stable compared with their movements in the 1990s. As an indicator to indicate overall financial situations, including exchange rate trends, in the open economy, there is the Monetary Condition Index (MCI). It is a weighted average of real short-term interest rates and real effective exchange rates. The MCI was consistently moving toward easing until the beginning of 2006, after hitting a peak in around 2000 (Figure 1-1-32). This reflects the fact that real effective exchange rates moved toward the yen's depreciation, while real interest rates moved almost horizontally. Incidentally, the depreciation of real effective exchange rates reflects the impacts of not only the depreciation of nominal effective exchange rates but also declines in prices (because a decline in prices lowers the prices of yen-denominated products relative to dollar-denominated products). As already discussed, the rise of real long-term interest rates has been held down. Since a rise in interest rates was held down, it helped restrain an increase in interest burden on the corporate sector that had been saddled with excessive debts as of the beginning of the 2000s, and provided them with debt-servicing capability, resulting in contributing to the elimination of the excessive debts, as will be discussed in detail in Chapter 2. The fact that currency exchange rates remained stable also contributed to the corporate sector's systematic expansion of their overseas operations.
Figure 1-1-32 Changes in Monetary Condition Index

(Reasons behind lasting economic recovery despite deflation: Behavior of the corporate and household sectors)
    The following characteristic movements of the corporate and household sectors can be pointed out as the reasons behind the lasting economic recovery despite deflation.
    First, amid the continuing economic recovery, the corporate sector is extremely cautious in its business management. In the corporate sector, a rise in wages is limited despite improvement in earnings. The corporate sector is also cautious about increasing borrowings. Chapter 2 will analyze this point in detail. In the meantime, it can be said that corporations have been striving for efficient management against the background of changes in corporate governance. Consequently, corporations' the break-even point ratio has remained at a lower level than in the past and their resistance to external shocks has increased (See Appended Figure 1-2).
    Second, in the current recovery phase, recovery is not limited to specific industries but is seen in a wide range of businesses. This is in stark contrast to the situation observed in 1999-2000, when recovery was limited only to IT-related industries. Behind the recovery in a wide range of businesses is the fact that private consumption, investments, and external demand are growing in a balanced manner. In order to examine the variation in recovery among business categories, coefficients of variance of corporate earnings were calculated. The result of the calculation shows that the variance has decreased, as many industries recovered simultaneously during the current recovery phase (Figure 1-1-33). The fact that recovery has spread to various types of businesses means that the Japanese economy has increased its resistance to external shocks. Specifically, although higher crude oil prices are putting downward pressure on corporate earnings, its impact on the industrial sector as a whole has been limited, with only some industries affected seriously.
Figure 1-1-33 Coefficients of Variance of Corporate Earnings in Economic Recovery Phases in and after the 1990s
    Third, the momentum of economic recovery is not limited to the corporate sector but has spread to the household sector, with private consumption and business investments recovering in a balanced manner. As already described, a characteristic of the current economic recovery phase is that the contribution of private consumption to the growth rate of GDP has been increasing. Behind the increased role of private consumption is the fact that the improvement of the employment situation has increased consumer confidence amid the moderate increase in income.

(3) Factors that should be kept in mind in business cycles

    Since the deviation of actual results of economic activities from their forecasts is accumulated in any economic recovery phase, it is inevitable that such distortions are accumulated in the economy and eventually lead to the next business cycle. According to past experiences, such autonomous movement of the economy is largely due to capital stock adjustment and inventory cycle. In this section, the points that should be kept in mind with regard to investments and inventory trends from the perspective of business cycles are examined.

(Trends of digital consumer electronics-related investment requiring attention other than IT-related investment)
    A breakdown of corporate investments into IT-related investment and non-IT-related investment based on the JIP database(9) shows that, in business cycles up to the 1990s, while non-IT-related investment posted relatively large fluctuations, IT-related investment tended to increase regardless of business cycle (Figure 1-1-34 (1)). However, the fluctuations of IT-related investment were larger than those of non-IT-related investment during the expansion period from 1999 to 2000 and the recession period in 2001, and IT-related investment resulted in expanding the fluctuations of the investment cycle during the periods. It is impossible to make a comparison for 2003 and beyond on the same base due to lack of data. However, judging from the trends of capital goods shipments and software investment, it seems that IT-related investment has been relatively stable during the current economic recovery period (Figure 1-1-34 (2), (3)). However, since the shipments of semiconductor manufacturing equipment and flat panel display manufacturing equipment, which are not classified into IT-related investment, are higher than in the past, it is necessary to keep in mind that their future trends may be swayed by market and demand trends of digital consumer electronics and so on.
Figure 1-1-34 Business Investment and IT-related Investment

(Fluctuations of investments by private-sector corporations moving toward stability)
    In order to examine the stability of investments, the variance of investments by private-sector corporations was calculated for every five years. The calculation shows that the variance rose sharply in the late 1980s to early 1990s, including the bubble years and the collapse of the bubble, and in the late 1990s when there was a financial crisis. It also shows that the variance declined in and after 2000, indicating that the fluctuation of investments has been stabilizing (Appended Figure 1-10). A breakdown of the variance of investments by private-sector corporations into the variance for individual industries and the covariance common to all industries shows that in the late 1980s and late 1990s, when the variance rose sharply, the fluctuation of investments increased because the covariance rose in those periods. It indicates that there were common shocks in the economy in those periods. On the other hand, the decline in variance of investments by private-sector corporations in and after 2000 mainly reflects the fact that the covariance declined.
    Judging from data now available, investments are highly likely to remain firm for some time to come. However, it is necessary to keep a close watch on the possibility of capital stock becoming excessive prompted by the deviation of actual growth from corporations' expected growth rate due to unexpected shocks.

(Risk of inventory adjustment on the whole is limited, but trends of IT-related industries require attention)
    With regard to the inventory cycle, since recovery has been seen in a wide range of industries in the current economic recovery phase, as already described, the risk of inventory adjustment by specific industries leading to overall inventory adjustment may be small. Inventory adjustment speed in the short term has increased thanks in part to the advancement of corporations' inventory control skills in recent years. The elasticity of production to fluctuations in shipment has been moving at a level of around 1 recently, suggesting that corporations have been adjusting their production in response to the movement of shipment (Appended Figure 1-11). As a result, with the elasticity of inventory to fluctuations in shipment approaching zero, fluctuations in shipment tend not to directly lead to fluctuations in inventory, as the fluctuations in shipment have come to be absorbed by production adjustment.
    However, minor inventory adjustments are implemented in the individual industries, such as IT-related inventory adjustment in late 2004 and adjustment by steel and other materials industries in mid-2005. Therefore, the movements of individual industries deserve continued attention. Seen in that light, IT-related industries have the largest impact on the recent fluctuations of inventory as a whole. It is necessary to pay attention to the fact that a diagram of IT-related inventory cycle in recent years shows inventory growth is gradually increasing, although shipment growth is still faster than inventory growth (Figure 1-1-35)
Figure 1-1-35 IT-related Inventory Cycle

3. Points to Keep in Mind Regarding Future Economic Trends

    Among the factors that should be kept in mind, when considering future economic trends, are the impact of the sharp rise in crude oil prices and world economic trends. It is also necessary to pay attention to the impact of a future rise in interest rates.

(1) Crude oil price trends and their impacts

(Crude oil prices remaining high)
    Crude oil prices rose in August and September 2005 from concern that the supply of crude oil and petroleum products would become tight following the big hurricane that devastated petroleum-related facilities in the areas along the Gulf of Mexico (Figure 1-1-36). Crude oil prices then fell and were stable for a while as the concern about the soaring oil prices eased slightly on the rising speculation that a protracted rise in crude oil prices would limit demand growth and on the smooth progress in the build-up of crude oil stock. In the beginning of 2006, crude oil prices fluctuated slightly due to the cold wave on the US east coast. Since March, oil prices have stayed at a high level due to concerns about oil supplies caused by geopolitical risks, such as Iran's nuclear problems and the destruction of an oil center in Nigeria.
Figure 1-1-36 Changes in Oil Prices, Real Price of Crude Oil
    As for the level of crude oil prices, the WTI stood at an average of $63/bbl in the January-March quarter of 2006, up 193% from the $22/bbl at the beginning of 2002, when the current rise in oil prices began. Dubai also followed the same trend, standing at an average of $60/bbl in January-March of 2006, up 189% from the level at the beginning of 2002. On the other hand, the real price of crude oil adjusted to the general price level is not at a high level compared with actual crude oil prices, but recently it has risen considerably. Assuming that the level of real crude oil prices as of April 2006 is 100, the comparable price level during the first oil crisis (1974) comes to 95, almost the same level as at present. However, the price level during the second oil crisis (1981) comes to over 150, suggesting that present real crude oil prices are still at a low level compared with those days (Figure 1-1-36 (3)). However, it is necessary to keep in mind that real oil prices have also risen sharply to a level about three times as high as they were at the beginning of 2002.
    Behind the current sharp rise in crude oil prices is the fact that the production capacity of oil-producing countries and the refinery capacity of oil-consuming countries are limited due to insufficient investment in the past, and inability to meet the increasing demand for oil worldwide prompted by the expanding economies of China, India and other emerging counties, as well as the United States. Therefore the sharp rise in crude oil prices in recent years is highly likely to continue for some time to come, rather than a temporary phenomenon. According to the medium-term outlook announced by the International Energy Agency (IEA) in December 2005, an optimistic economic growth forecast projects that, despite higher crude oil prices, global oil demand will continue to grow at an annual rate of more than 2% over the next five years (from 2006 to 2010). The report says this is because China and other emerging countries have come to enter a phase of rapid industrialization requiring massive consumption of energy(10). As for oil production, although OPEC has announced it would increase daily output by 1.5~2 million barrels, oil supply is expected to remain tight for some time to come, as the output increase requires 2~3 years.

(Sharp rise in oil prices and world economic trends)
    A study of the impacts of sharp rises in oil prices on Japan, the US and Germany in the past oil crisis and at this time shows that the impact of higher oil prices on the world economy at this time has so far been limited.
    A study of the movements of the consumer price index (general) and core CPI (excluding foods and energy) shows that prices posted double-digit inflation rates in the three countries during the first oil crisis, and that there were some increases in prices during the second oil crisis, but that there has so far been no sharp increase in prices in the current phase of rising oil prices (Figure 1-1-37 (1)).
Figure 1-1-37 CPI, Short-term Interest Rates, and Revenue Transfers-to-Nominal GDP Ratio in Japan, Germany and US
    During the past oil crises, the three countries implemented tight monetary policies to prevent inflation from accelerating, and as a result, interest rates rose sharply. However, since inflation is moderate this time, the three countries' monetary policies are less tight, and as a result, the rise in short-term interest rates is the smallest (Figure 1-1-37 (2)).
    A study of the ratio of revenue transfers resulting from a rise in oil prices to GDP shows that the ratios in the United States, which is an oil-producing country, were not relatively high, even during the past oil crises. The ratios in Japan and Germany were large, at about 3% during the first oil crisis. In the current phase of rising oil prices, the ratios in the two countries stood at about 0.5% in 2005, indicating that the impact of the sharp rise in oil prices on revenue transfer is limited (Figure 1-1-37 (3)).
    The recycling of oil money resulting from the sharp rise in oil prices this time is characterized as follows(11).
    The ratio of oil-producing countries' net increase in oil export value to world GDP is about 1.2% in the current phase of the sharp rise in oil prices, or about the same level as the 0.8% in the second oil crisis and the 1.1% in the first oil crisis (Figure 1-1-38 (1)). Incidentally, the world oil balance in the current phase shows that oil-exporting countries posted a surplus of 437 billion dollars, while the US suffered a deficit of 124 billion dollars, other advanced countries a deficit of 198 billion dollars (including 40 billion dollars for Japan), China a deficit of 5.3 billion dollars, and other developing countries a deficit of 5.3 billion dollars.
Figure 1-1-38 Recycling of Oil Money
    The funds oil-producing countries gain as a result of a rise in oil prices are believed to lead to an increase in their overseas investment in financial assets, but their share in the world capital flows in the current phase stands at about 37%, down from 39% in the second oil crisis and 58% in the first oil crisis. The presence of oil money in the world financial market is no longer large, and it is hard to say that oil money greatly influences price formation on the world financial and asset markets.
    In the past two oil crises, oil money was indirectly used for lending to developing countries through bank deposits mainly in advanced countries, and this was blamed to have caused debt crises in the 1980s. Although it is not clear where oil money has been invested in the current phase, it is believed that the money has been invested directly in diversified financial products, and that only less than one-third of the money was invested in bank deposits and US Treasury bonds.
    Since oil-producing countries have become cautious about investing their increased income, increases in their imports are smaller than in the past and this could have slightly downward impacts on the world economy (Figure1-1-38 (2)).

(Impacts on domestic industry and household budget)
    The impact of a steep rise in oil prices on the Japanese economy is not limited to the income transfers to oil-producing countries. It would also exert pressure 1) on corporate profits until the oil price increase is passed on to the prices of their products and 2) on private consumption due to a decline in real income.
    As for its impact on corporate activities, generally speaking, if rising input costs can be passed on to output prices, its impact on profits would be held down, but if it is difficult to pass on the input costs to output prices, it would exert pressure on profits. A factor analysis of ordinary profit increases in the processing and raw materials industries by breaking down the factors into sales increase, cutbacks on labor and other fixed costs, and deterioration of terms of trade caused by higher crude oil prices shows that in both industries the deterioration of terms of trade caused by higher input prices pushes profits down, while sales increase works to offset the profit decline (Figure 1-1-39). However, in raw materials industries, the impact of a rise in oil prices is to a certain extent offset by the progress in passing on the oil price increase to output prices, while, in processing industries, the impact of deterioration of terms of trade on profits is great, as passing on to end-product prices is restrained due partly to an intensifying competitive environment.
Figure 1-1-39 Factor Analysis of Year-to-Year Changes in Ordinary profit
    Among nonmanufacturing industries, those with a high input ratio of crude oil or oil products, such as fuel oil, felt a strong impact of the rise in oil prices. Assuming that a rise in oil prices is completely passed on, we calculated output prices by using an input-output table and compared them with actual price inflation rates in the past four years. The comparison shows that the actual price inflation rates are far below their theoretical value in all nonmanufacturing industries, except marine transportation (Figure 1-1-40). This suggests that electric power and some other industries are cutting basic charges amongst deregulation, and that in trucking and other land transportation industries and fisheries, their output prices are declining due to intensifying competitive environments and competition with foreign goods. In these industries, a rise in crude oil prices is eventually exerting pressure on their profits.
Figure 1-1-40 Theoretical Value and Actual Price Inflation in Nonmanufacturing
    The sharp increase in crude oil prices also exerted pressure on household budgets to some extent, with the consumer prices of energy consumption-related items rising 1.6% in 2004 and 3.6% in 2005 (Figure 1-1-41). Time series data of the Family Income and Expenditure Survey show that the weight of purchase of energy consumption-related items has been increasing recently. By region, the weight of purchase of energy consumption-related items in cold areas, such as Hokkaido and Tohoku, is about 70% higher than in Tokyo.
Figure 1-1-41 Changes in Share of Energy Consumption, Region-by-Region Weight

(2) World Economic Trends

(Present state of the world economy and its outlook)
    The world economy has been recovering steadily. In 2005, although affected by further rises in crude oil prices and hurricanes that hit the US, the world economy as a whole continued its steady growth, thanks in part to the strong growth of China and other emerging countries, with the GDP growth rate of the world economy coming to slightly below 5% in that year. As of early 2006, the world economy is continuing its steady recovery, with the US and EU economies, which had slowed down slightly in the latter half of 2005, regaining their recovery momentum.
    According to forecasts by international organizations, the world economy is expected to post a growth slightly below 5% in 2006, or almost the same steady growth as in 2005 (Table 1-1-42). The US is expected to post a growth rate slightly higher than its potential growth rate (about 3%) on the strength of increases in investment and consumption. The growth rate of the Euro area economy is expected to rise to about 2% in 2006 from the lower half of the 1% level in 2005, helped by the world economic recovery. China is expected to continue to post a high growth rate at the 9% level.
Table 1-1-42 World Economic Outlook by IMF and OECD

(Risk factors for world economy)
    As just described, the world economy has been continuing its steady recovery. At the same time, however, major countries' long-term interest rates, which had been stable, have recently begun to rise sharply, while the problems that have been pointed out as risk factors for several years, such as higher crude oil prices, global external imbalances, and steep rises in housing prices, still remain unsolved.
    An observation of international financial trends shows that long-term interest rates in many countries in the world have stayed at relatively low levels amid the continued stable movements of prices. Among the factors behind this is the fact that international funds have been recycling smoothly from rapidly growing emerging countries and oil-producing countries to the US, with external imbalance. A study of global current-account balances in 2003 through 2005 shows that the United States is the largest deficit country, with its deficit accounting for about 70% of the global current-account deficits (Figure 1-1-43). On the other hand, among the countries with current-account surplus, Japan remains the largest country contributing to the financing of such deficits, followed by China with about 14%, up from 7% in 2003, and oil-producing Saudi Arabia and Russia with about slightly below 8%, up from about 4-5%. In this manner, Japan, emerging countries and Russia are financing the current-account deficit of the United States. If the US economy continues its steady growth, the country's external imbalance is likely to expand. Therefore, we need to pay attention to whether or not the international capital movement continues to be carried on smoothly. In particular, when long-term interest rates are rising in Japan, the United States and European countries amid tighter monetary policies in advanced countries, we need to pay attention to what impact the policies will have on the international capital movement. In addition, amid concerns about the possible adverse impact of higher crude oil prices on core inflation, we have to pay attention to whether or not monetary policy responses by the United States and other countries will be implemented smoothly to avoid a sharp rise in long-term interest rates and a slowdown of the economic growth.
Figure 1-1-43 World Current-Account Imbalances

(3) A rise in interest rates and its impacts

(Risk of a rise in interest rates caused by fluctuations of market participants' expectations)
    Economic impacts of a rise in interest rates are analyzed in detail in Section 3. However, we have to keep in mind that a rise in interest rates caused by fluctuations of market participants' expectations is a risk factor. The impacts of a rise in interest rates discussed in Section 3 are the result of reflection of economic fundamentals in a normal economic recovery period and they should be absorbed in market activities. However, with the Bank of Japan lifting its quantitative easing policy, there is a risk of unexpected rises in interest rates in the short term as market participants' expectations fluctuate in the process of the adjustment of short-term interest rate levels. Such a rise in interest rates might have a measurable impact on corporate earnings through exchange rate fluctuations.

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