Takatoshi Ito: Japan’s recovery: another false dawn?
Japan has to contend with deflation, a strong yen and long-overdue privatization of the post office in order to secure its recovery, says Takatoshi Ito
The past 10 years are now commonly considered Japan’s “lost decade”. Repeated recessions have plagued the country, and the economy has suffered deflation since 1998. But, by 2004 the economy seemed finally to be emerging from a long period of stagnation. National income grew by more than 6% annualized in the fourth quarter of 2003 and the first quarter of 2004 (see chart). The recovery from the contraction of 2001 to 2002 has been remarkable. Exports and investment in plant and machinery have been two engines of this growth. Exports to China, in particular, have been growing at 20% to 40% per annum over the past few years. The combination of strong Chinese demand for goods that Japan produces and the construction of low-cost production facilities in China to export to Japan by Japanese companies is improving economic prospects in the two countries. Similar reinforcing effects are working throughout east Asia.
So, is Japan finally getting out of recession and deflation? And is the current recovery sustainable?
The glass is half-full
Optimists would say that it is. Corporate profits are at an all-time high, after restructuring and shedding of non-core businesses. Manufacturing exports are rising. Several waves of banking crises are finally over, as weak banks either merged or were nationalized. Non-performing loans of the major banks were halved over the past two years, even though the inspection regime became tougher than ever. Consumers are now poised to spend more as wages and bonuses are increasing after many years of decline, and the unemployment rate is dropping. The problem of deflation is almost being conquered, as prices are no longer falling precipitously.
There are growing signs that Japan is finally emerging from the long tunnel of depressing events and macroeconomic underperformance. The Japanese economy grew by 2.5% in real terms in 2003 and was expected to grow by 4% in 2004. This compares with 4.3% in America and 2.2% in the eurozone for 2004. Japanese growth is expected to slow down to 2.3% in 2005, but this is still higher than Europe’s projected growth rate of 2.2%.
By late last year stock prices had risen by 50% from the trough in April 2003. This gave financial institutions that hold equities some breathing space. The increase in stock prices, fuelled by foreign investment in 2003, has contributed to an increase in consumption and investment. The unemployment rate is also moving in the right direction. After peaking at 5.5% in January 2003, it fell gradually to 4.7% in September 2004.
The glass is half-empty
Pessimists would say, “not so fast”. Japan’s biggest companies are investing more abroad than in Japan. Consumers are not spending because of concerns about increases in social security pension contributions now and in the future. Despite various attempts at reform – little more than sticking-plasters – the pension system is basically falling apart. Many young people are refusing to pay contributions (apparently breaking the law). The government, with a 150% debt-to-national income ratio, will have to start raising taxes soon, further dampening consumer demand. The economy grew only moderately in the middle of last year, and the prospects are not good. Banks might not be failing, but they are not expanding their business. Their capital reserves are still thin.
The current recovery is the third time that Japan has grown by more than 2.5% in the past 14 years. The first recovery was in 1995 to 1996, with a sudden end in 1997, mainly due to the tax rise in April 1997, followed by the Asian currency crisis and the Japanese banking crisis. The second recovery attempt was in 2000, with a sudden end in 2001 due to a collapse of the dotcom stock market bubble and the Bank of Japan’s mistaken decision in August 2000 to tighten monetary policy during deflation. The current recovery is largely supported by exports and export-related investment. If one of the two engines of growth in the world – namely America and China – fails, Japan may fall into another recession.
Who’s right – the optimists or the pessimists? The answer depends on how fast the remaining problems – deflation, the yen and structural reform – can be solved.
Deflation
Japan has been suffering from deflation, that is, falling prices, since 1998. Due to the deflation and low growth, nominal national income shrank by 4.5%, or ¥23 trillion ($225 billion), between 1997 and 2003. Japan has been waning, losing its status as an engine of growth or as a market for its Asian neighbours.
The rate of deflation, measured by consumer price index (CPI), has recently narrowed to close to zero, compared with an annual contraction of 1% in 2001 and 2002. However, the gross domestic product (GDP) deflator – a more general price indicator of all goods and services – is still showing deflation of about 2.5%. Deflation in Japan is not dead.
Deflation has been bad for the Japanese economy: not an acute problem like the Great Depression of the 1930s, but like a slow suffocation. Cumulatively, the loss from deflation is mounting. Past investment has become nonperforming as nominal profits shrink – thanks to a fall in the prices that goods can fetch – but nominal liabilities, like bank borrowings, do not.
Investment is discouraged because people become convinced that deflation will continue in the future. The central bank should aim at a low but positive rate of inflation.
Bank of Japan measures
In order to help recovery and to fight deflation, the Bank of Japan has maintained a zero-interest-rate policy and expanded the monetary base at a pace of around 20% a year for the past few years. However, there is still deflation. It is largely unknown territory for a central bank how monetary policy can be effective at a zero interest rate. In March 2001, the Bank of Japan expanded the monetary base by increasing excess reserves, that is, funds that commercial banks keep at the central bank as deposits. In addition, Toshihiko Fukui, who succeeded Masaru Hayami as governor in March 2003, gave a positive signal to the market when he made it clear that he would continue the zero-interest-rate policy until he ensured that deflation was conquered for good. Fukui has much better relations with the government, so that should also help in the fight against deflation.
Some researchers think that the current situation is what the great British economist John Maynard Keynes called a “liquidity trap” some 70 years ago. When the economy is caught in a liquidity trap, the government should use fiscal policy (taxes and public spending) to stimulate the economy. However, the Japanese government has been running fiscal deficits of 6% a year over the past several years, and has accumulated a gross debt of 150% of national income. Moreover, pension liabilities are also a hidden fiscal burden. Given all of this, additional deficit financing of bridges and tunnels might not be good for Japan in the long run. Moreover, the public is not demanding a fiscal stimulus. It is clear that fiscal consolidation – higher taxes or lower public spending, or both – has to start soon.
A strong yen
Japan’s shrinkage in 2002 put the country in crisis mode. At the beginning of 2003, the prospects for the economy were really bleak. By May 2003, the Nikkei stock index fell below 8000, one-fifth of the peak achieved at the end of 1989. But despite these weak conditions, the yen was appreciating.
The monetary authorities, namely the Ministry of Finance and the Bank of Japan, intervened in the foreign exchange market heavily from January 2003 to March 2004. The authorities sold ¥35 trillion, 7% of Japanese national income, between January 2003 and March 2004. Interventions were very frequent and were believed to have prevented the yen from appreciating beyond the critical ¥100/$ mark. Interventions stopped in mid-March 2004, and, at time of writing, no intervention had been conducted since then.
Threat posed by a dollar collapse
There remains the risk of a sharp yen appreciation or, more accurately, dollar depreciation vis-à-vis major currencies including the yen. The US current account deficit – at around 5% of national income – has to shrink. This could pose a serious problem, given that exports are still the most powerful engine for Japanese recovery and that America and China, whose currency is tied to the dollar, are the favourite destinations of Japanese exports. A dollar collapse could bring the Japanese recovery to a halt.
Given the pressures of America’s current account deficit, the best outcome would be that Asian currencies, including the Chinese yuan and the Malaysian ringgit, would float together against the dollar. That would be a realistic and the least chaotic solution for the collective welfare of Asian countries.
Structural reform
Structural reforms have been a hallmark of the Junichiro Koizumi government since it came into power in 2001. The aim is for the economy to be stimulated by foreign investment and new businesses. The reforms included various forms of deregulation, liberalizing entry to certain types of business, for example entry by for-profit corporations into agriculture, schools, hospitals and special nursing homes in experimental regions; and changes in the benefit system to create incentives to work. The reorganization of the Government Housing Loan Corporation, giving private-sector commercial banks more opportunities and market share in housing loans, was one prominent example of successful reform. However, the reorganization of the Highway Corporation into a company that builds highways and another that operates them does not seem to stop the extension of roads to sparsely-populated areas.
The most successful reform has been bank and corporate restructuring. Most major banks are now reporting healthier balance sheets than before. Although several weak banks, including UFJ (which is in the process of merging with Mitsubishi-Tokyo Financial Group), are still reporting large non-performing loans and undercapitalization, there is no financial panic. The nationalization of Resona Bank and Ashikaga Bank in 2003 shows that the Financial Services Agency can handle weak banks swiftly without raising concerns about systemic risk.
Corporate restructuring is also accelerating, thanks to the Industrial Revitalization Corporation Japan (IRCJ), a new public agency for coordinating corporate restructuring with creditor banks. The problem was that many major banks continued to extend credit to heavily-indebted customers because of personal connections. The IRCJ has taken over the cases of Kanebo (a textiles and cosmetics company), Daikyo (a real estate company) and Daiei (one of Japan’s largest retail chains) from private banks, and is working out a tough, fair restructuring plan as a neutral arbitrator.
Koizumi’s next target is the privatization of the huge postal system – a combination of postal delivery services, the savings bank and the life insurance agency. The postal financial institutions take in some 30% of household deposits.
Whether the three components will be divided before being privatized is the hotly debated issue. And privatization might not mean simply selling off various parts of businesses. For one, a privatized postal savings bank would dwarf any commercial bank, possibly creating a monopoly problem. Moreover, given that the savings bank and the life insurance company have been crowding out private-sector financial institutions and taking in funds for possibly-wasteful government projects, it might be better to shrink them. Whether Koizumi succeeds in this ambition may determine the health of the Japanese financial markets for years to come.
Takatoshi Ito
Takatoshi Ito is professor at the Faculty of Economics and Research Center for Advanced Science and Technology at the University of Tokyo. He is the author of a number of books and articles on international finance and the Japanese economy, among which are Financial Policy and Central Banking in Japan (2000) and No More Bashing: Building a New Japan–United States Economic Relationship (2001).