The recession in Japan during 2001 has once again renewed the focus on the policies needed to bring about a sustained economic recovery. Prime Minister Koizumi has advocated an action plan focused on addressing the weaknesses in the banking sector, bringing about fiscal reform and consolidation, and accelerating structural reforms to raise productivity growth. There have also been calls for further monetary easing to arrest ongoing deflation.
Because Japan is an important trading partner and supplier of capital to the Asian region, the implementation of such policies will have implications not only for the Japanese economy, but also for other countries in the region. This chapter examines the nature of the economic and financial relations between Japan and its regional neighbors, and then explores the possible impact of policies and developments—structural reforms that boost productivity, fiscal consolidation, monetary easing, and a loss of confidence in financial markets if reforms are not implemented—on the Japanese and regional economies.
Japan’s Economic and Financial Links with the Asia-Pacific Region
Trade flows between Japan and other countries in the Asia region have undergone significant change since the mid-1980s. Japan has become increasingly reliant on Asia as a market for its exports and as a source of imports. The growth of Japanese exports to the Asia-9 countries has averaged 8½ percent a year (in U.S. dollar terms) since the mid-1980s, compared with aggregate export growth of 5¼ percent a year, and the share of exports to these nine economies increased from an average of 27½ percent during 1986–91 to 38½ percent during 1996–2001 (Table 12.1).1 Asia is now the largest destination for Japanese exports, with Taiwan Province of China, Korea, Hong Kong Special Administration Region (SAR), and China being the most important destinations, while the United States and Europe have both declined in importance.
Trade Links Between Japan and Asia
Trade Links Between Japan and Asia
Japanese Exports to Asia | Japanese Imports from Asia | Asian Exports to Japan | Asian Imports from Japan | |||||
---|---|---|---|---|---|---|---|---|
1986–91 | 1996–2001 | 1986–91 | 1996–2001 | 1986–91 | 1996–2001 | 1986–91 | 1996–2001 | |
(Percent of total exports or imports) | ||||||||
Asia-9 | 27.5 | 38.4 | 27.7 | 37.0 | 14.8 | 11.7 | 24.0 | 18.9 |
Newly industrialized countries | 18.4 | 22.7 | 11.9 | 11.2 | 11.4 | 8.3 | 24.5 | 17.7 |
Taiwan Province of China | 5.1 | 6.6 | 4.2 | 4.1 | 13.0 | 10.1 | 31.4 | 26.2 |
Korea | 5.8 | 5.9 | 5.4 | 4.8 | 18.4 | 10.8 | 29.6 | 19.4 |
Hong Kong SAR | 4.3 | 5.9 | 1.0 | 0.6 | 5.5 | 5.7 | 17.9 | 12.5 |
Singapore | 3.2 | 4.3 | 1.4 | 1.8 | 8.7 | 7.4 | 20.8 | 16.7 |
ASEAN-4 | 5.7 | 9.8 | 10.7 | 12.2 | 25.1 | 15.9 | 24.9 | 21.4 |
Thailand | 2.1 | 3.1 | 1.6 | 2.9 | 16.2 | 15.0 | 28.2 | 24.8 |
Indonesia | 1.4 | 1.7 | 5.4 | 4.2 | 41.9 | 22.3 | 25.8 | 17.1 |
Malaysia | 1.5 | 3.0 | 2.7 | 3.5 | 17.8 | 12.5 | 23.3 | 21.1 |
Philippines | 0.7 | 2.0 | 1.0 | 1.6 | 19.2 | 15.5 | 18.0 | 20.3 |
China | 3.3 | 5.9 | 5.2 | 13.7 | 15.7 | 17.0 | 20.0 | 19.0 |
Memorandum: | ||||||||
United States | 33.9 | 29.3 | 22.4 | 21.3 | 25.3 | 20.3 | 15.7 | 14.1 |
Europe | 20.8 | 17.2 | 17.4 | 15.7 | 14.2 | 15.3 | 11.7 | 10.6 |
Trade Links Between Japan and Asia
Japanese Exports to Asia | Japanese Imports from Asia | Asian Exports to Japan | Asian Imports from Japan | |||||
---|---|---|---|---|---|---|---|---|
1986–91 | 1996–2001 | 1986–91 | 1996–2001 | 1986–91 | 1996–2001 | 1986–91 | 1996–2001 | |
(Percent of total exports or imports) | ||||||||
Asia-9 | 27.5 | 38.4 | 27.7 | 37.0 | 14.8 | 11.7 | 24.0 | 18.9 |
Newly industrialized countries | 18.4 | 22.7 | 11.9 | 11.2 | 11.4 | 8.3 | 24.5 | 17.7 |
Taiwan Province of China | 5.1 | 6.6 | 4.2 | 4.1 | 13.0 | 10.1 | 31.4 | 26.2 |
Korea | 5.8 | 5.9 | 5.4 | 4.8 | 18.4 | 10.8 | 29.6 | 19.4 |
Hong Kong SAR | 4.3 | 5.9 | 1.0 | 0.6 | 5.5 | 5.7 | 17.9 | 12.5 |
Singapore | 3.2 | 4.3 | 1.4 | 1.8 | 8.7 | 7.4 | 20.8 | 16.7 |
ASEAN-4 | 5.7 | 9.8 | 10.7 | 12.2 | 25.1 | 15.9 | 24.9 | 21.4 |
Thailand | 2.1 | 3.1 | 1.6 | 2.9 | 16.2 | 15.0 | 28.2 | 24.8 |
Indonesia | 1.4 | 1.7 | 5.4 | 4.2 | 41.9 | 22.3 | 25.8 | 17.1 |
Malaysia | 1.5 | 3.0 | 2.7 | 3.5 | 17.8 | 12.5 | 23.3 | 21.1 |
Philippines | 0.7 | 2.0 | 1.0 | 1.6 | 19.2 | 15.5 | 18.0 | 20.3 |
China | 3.3 | 5.9 | 5.2 | 13.7 | 15.7 | 17.0 | 20.0 | 19.0 |
Memorandum: | ||||||||
United States | 33.9 | 29.3 | 22.4 | 21.3 | 25.3 | 20.3 | 15.7 | 14.1 |
Europe | 20.8 | 17.2 | 17.4 | 15.7 | 14.2 | 15.3 | 11.7 | 10.6 |
Japan’s imports from Asia have also grown considerably, with 37 percent sourced from the region during 1996–2001, compared with 27¾ percent during 1986–91. Imports from China, in particular, have shown remarkable growth, rising by an average of nearly 15 percent a year since the mid-1980s—more than twice the rate of growth of aggregate imports—and their share has risen from 5¼ percent to 13¾ percent of the total. Korea, Taiwan Province of China, and Indonesia are other important sources of imports. The shares of imports from the United States and Europe have both declined modestly.
There have also been substantial changes in the composition of trade between Japan and Asia. Japan’s imports of machinery and transport equipment from the Asia-9 have increased from less than 5 percent of total imports in 1985 to nearly 35 percent, while other manufactured goods increased from less than 20 percent to 35 percent.2 Imports of fuel and other crude materials, on the other hand, have fallen substantially. While imports from most countries are heavily weighted toward machinery and transport equipment, those from China and Indonesia are mainly in the form of low-end consumer goods and raw materials, respectively. On the other hand, the composition of Japanese exports to Asia has remained largely unchanged, with machinery and transport equipment accounting for a little under 60 percent of the total, and other manufactured goods making up most of the remainder.
While Japan remains a very significant trading partner, Asia has actually become relatively less reliant on Japan (although, given the significant increase in the importance of trade in the Asian countries in recent years, the absolute reliance has still increased).3 The share of Asian exports going to Japan has declined. During 1986–91, 14¾ percent of exports from the Asia-9 went to Japan, but this share fell to 11¾ percent during 1996–2001. The United States (22 percent) and Europe (15 percent) are both more important export destinations than Japan. Korea, Indonesia, Malaysia, and the Philippines have all greatly reduced their reliance on Japan, although for the ASEAN-4 and China, Japan remains an important destination.4 The importance of Japan as a supplier of goods has also declined, although it remains the single most important supplier to the region. During 1986–91, about one-fourth of the Asia-9’s imports came from Japan, but this declined to 19 percent during 1996–2001.
In terms of financial flows, Japanese foreign direct investment (FDI) accelerated following the liberalization of capital controls in the early 1980s, and surged during the second half of the decade. This sharp rise reflected both the strong economic growth in Japan and in foreign markets, and the appreciation of the yen, which encouraged companies to relocate production overseas to maintain cost competitiveness (Bayoumi and Lipworth, 1998). Initially, the United States attracted most of this capital, with much of the investment being concentrated in the real estate, service, and finance and insurance sectors. However, the capital going to the Asia-9 countries also picked up—with Hong Kong SAR, Singapore, Thailand, and Indonesia seeing the largest share—and was more concentrated in the industrial sector. Japanese investment accounted for a significant proportion of total FDI flows to the Asia-9 countries (for which data are available) during the second half of the 1980s.
Japanese FDI flows moderated significantly in the 1990s—particularly in the first half of the decade—as the sharp decline in asset prices in Japan and the subsequent slowdown in growth and balance sheet difficulties in the business sector took a toll. These weaker FDI flows, however, were largely the result of lower investment in the United States and Europe, and investment in Asia actually increased (although it did weaken sharply in 1999 and 2000 in the aftermath of the Asian crisis, before picking up again in 2001). Investment in this period was concentrated in Singapore, Thailand, and Indonesia, while from the mid-1990s investment into China also accelerated (Table 12.2).5 However, despite the greater concentration of Japanese FDI in the Asia region, the relative importance of Japanese investment to these countries declined during 1996–2001 (to about 16 percent of the total).
Financial Links Between Japan and Asia
Financial Links Between Japan and Asia
Japanese FDI to Asia | Share of Japanese FDI in Host Country |
Portfolio Investment Flows Between Japan and Asia |
Lending by Japanese Banks to Asia | |||||||
---|---|---|---|---|---|---|---|---|---|---|
(Percent of foreign bank lending) |
||||||||||
(U.S. dollars, millions) | (Percent) | (U.S. dollars, millions) | (U.S. dollars, millions) | |||||||
1988–91 | 1996–2001 | 1986–91 | 1996–2001 | 1988–91 | 1996–2001 | 1991–95 | 1997–2000 | 1991–95 | 1997–2000 | |
Asia-9 | 4,304 | 6,591 | … | … | –471 | –3,831 | 284,616 | 157,201 | 57.3 | 32.8 |
Newly industrialized countries | 2,285 | 2,212 | … | … | 131 | –8,960 | 225,293 | 98,642 | 57.9 | 31.0 |
Taiwan Province of China | 280 | 287 | 32.4 | 15.6 | … | 463 | 4,055 | 2,854 | 25.6 | 15.1 |
Korea | 267 | 517 | 38.0 | 8.5 | … | –904 | 14,799 | 15,110 | 41.4 | 28.4 |
Hong Kong SAR | 1,047 | 646 | … | … | … | –6,552 | 121,755 | 46,676 | 64.4 | 35.8 |
Singapore | 691 | 762 | 20.7 | 22.6 | … | –1,968 | 84,684 | 34,003 | 56.9 | 29.7 |
ASEAN-4 | 1,561 | 2,887 | –314 | 4,654 | 45,136 | 44,353 | 56.4 | 38.5 | ||
Thailand | 565 | 1,186 | 41.2 | 28.1 | … | 2,002 | 20,535 | 19,638 | 62.8 | 52.9 |
Indonesia | 504 | 878 | 17.2 | 12.4 | … | 938 | 17,869 | 15,285 | 60.3 | 35.8 |
Malaysia | 378 | 368 | … | 12.6 | … | 1,526 | 5,432 | 6,706 | 52.1 | 35.2 |
Philippines | 113 | 454 | … | 21.8 | … | 188 | 1,301 | 2,725 | 17.8 | 17.4 |
China | 459 | 1,492 | … | 8.3 | –287 | 475 | 14,186 | 14,205 | 50.3 | 31.1 |
Memorandum: | ||||||||||
World | 39,273 | 27,699 | … | … | 14,684 | 26,627 | … | … | … | … |
United States | 20,251 | 8,742 | … | … | 16,711 | 4,564 | … | … | … | … |
Europe | 8,635 | 7,456 | … | … | –9,799 | –37,096 | … | … | … | … |
Financial Links Between Japan and Asia
Japanese FDI to Asia | Share of Japanese FDI in Host Country |
Portfolio Investment Flows Between Japan and Asia |
Lending by Japanese Banks to Asia | |||||||
---|---|---|---|---|---|---|---|---|---|---|
(Percent of foreign bank lending) |
||||||||||
(U.S. dollars, millions) | (Percent) | (U.S. dollars, millions) | (U.S. dollars, millions) | |||||||
1988–91 | 1996–2001 | 1986–91 | 1996–2001 | 1988–91 | 1996–2001 | 1991–95 | 1997–2000 | 1991–95 | 1997–2000 | |
Asia-9 | 4,304 | 6,591 | … | … | –471 | –3,831 | 284,616 | 157,201 | 57.3 | 32.8 |
Newly industrialized countries | 2,285 | 2,212 | … | … | 131 | –8,960 | 225,293 | 98,642 | 57.9 | 31.0 |
Taiwan Province of China | 280 | 287 | 32.4 | 15.6 | … | 463 | 4,055 | 2,854 | 25.6 | 15.1 |
Korea | 267 | 517 | 38.0 | 8.5 | … | –904 | 14,799 | 15,110 | 41.4 | 28.4 |
Hong Kong SAR | 1,047 | 646 | … | … | … | –6,552 | 121,755 | 46,676 | 64.4 | 35.8 |
Singapore | 691 | 762 | 20.7 | 22.6 | … | –1,968 | 84,684 | 34,003 | 56.9 | 29.7 |
ASEAN-4 | 1,561 | 2,887 | –314 | 4,654 | 45,136 | 44,353 | 56.4 | 38.5 | ||
Thailand | 565 | 1,186 | 41.2 | 28.1 | … | 2,002 | 20,535 | 19,638 | 62.8 | 52.9 |
Indonesia | 504 | 878 | 17.2 | 12.4 | … | 938 | 17,869 | 15,285 | 60.3 | 35.8 |
Malaysia | 378 | 368 | … | 12.6 | … | 1,526 | 5,432 | 6,706 | 52.1 | 35.2 |
Philippines | 113 | 454 | … | 21.8 | … | 188 | 1,301 | 2,725 | 17.8 | 17.4 |
China | 459 | 1,492 | … | 8.3 | –287 | 475 | 14,186 | 14,205 | 50.3 | 31.1 |
Memorandum: | ||||||||||
World | 39,273 | 27,699 | … | … | 14,684 | 26,627 | … | … | … | … |
United States | 20,251 | 8,742 | … | … | 16,711 | 4,564 | … | … | … | … |
Europe | 8,635 | 7,456 | … | … | –9,799 | –37,096 | … | … | … | … |
Japanese FDI to Asia has been focused in the industrial sector—particularly the electrical machinery sector in the second half of the 1990s—and has implied a movement of productive capacity out of Japan to the recipient countries. Consequently, these investments are likely to have had important implications for the pattern of trade between the countries. Indeed, Bayoumi and Lipworth (1998) find evidence that both FDI flows and stocks have a significant impact on imports from the recipient country to Japan, but that only FDI flows have an impact on exports from Japan to the recipient country. They argue this is consistent with the view that while FDI permanently raises imports from the recipient country to Japan, it only temporarily raises Japanese exports largely through the short-term need to equip new factories. Kawai (1998), however, argues that FDI has a permanent impact on both imports and exports, although the impact on imports is larger.
Portfolio flows between Japan and the region have been more two-way than has FDI, because of investments in Japan from the regional financial centers of Hong Kong SAR and Singapore. Indeed, stock data show that Japan was in a net portfolio liability position with the rest of Asia at end-2001. With respect to other countries, investments have generally been small, with the exceptions of Malaysia and Thailand.
Japanese banks were large lenders to Asian countries during the second half of the 1980s and early 1990s.6 According to BIS data, the outstanding stock of lending by Japanese banks to the Asia-9 countries rose from $140 billion in 1985 to a peak of $333 billion in 1994. The largest recipients were the regional financial centers of Hong Kong SAR and Singapore, although all destinations except Taiwan Province of China, Malaysia, and the Philippines experienced significant growth in lending. During 1991–95, Japanese banks are estimated to have supplied over 60 percent of the total outstanding international bank lending to Hong Kong SAR, Thailand, and Indonesia. It is likely that at least part of this increase was associated with financing Japanese subsidiaries operating in these countries. With the onset of their financial difficulties and the emergence of a significant Japan premium, however, Japanese banks have withdrawn from Asian markets since 1995, a process accelerated by the Asian financial crisis. While this has been part of the trend toward a lower exposure to bank finance by the Asian countries since the financial crisis, Japanese banks have withdrawn at a faster pace than banks of other nationalities, and the share of Japanese bank lending to the region has declined to about 30 percent, although they are still estimated to be the largest (identified) lender to eight of the nine countries.7
Impact of Reforms on the Japanese and Asian Economies
While the importance of trade and financial links with Japan has declined for Asian countries, they remain important, and consequently economic developments in Japan continue to have important implications for other countries in the region. Thailand, the Philippines, and Indonesia are at the high end in terms of reliance on Japan, while Singapore and Hong Kong SAR are at the low end. Given these linkages, an analysis of the implications of developments and policies in Japan on the Asia-Pacific region needs to be undertaken with a model that adequately captures the interrelationships. The G-cubed (Asia-Pacific) model—based on the theoretical structure of the G-cubed model outlined in McKibbin and Wilcoxen (1998)—is well suited for such analysis, having both a detailed country coverage of the region and rich links between the countries through goods and asset markets.8 In this section, simulations of the G-cubed (Asia-Pacific) model are used to assess the implications of policies and risks in Japan for the domestic and regional economies.9
Structural Reforms That Boost Productivity Growth in Japan
The implementation of a broad range of structural reforms—such as those discussed in Chapter 5—would be expected to boost productivity growth in Japan. To assess the potential impact of such policies, a simulation is considered in which the expected growth rate of labor augmenting technical change is increased (relative to baseline) by 3 percent a year for 3 years, and 1 percent a year for another 8 years, before returning to trend after 11 years (this is modeled to broadly reverse the decline in productivity that took place during the 1990s).
Following the positive shock to productivity, real GDP in Japan immediately increases relative to the baseline, although the impact on growth is initially limited by two factors (Figure 12.1). First, because there will be more Japanese goods available globally in the long run, the relative price of these goods falls—that is, the long-run real exchange rate (the relative price of Japanese goods) depreciates. Forward-looking financial markets understand this outcome, and the exchange rate actually depreciates in the short run, raising inflation and inducing a tightening of monetary policy. Second, because of the expected rise in future labor productivity, there is a substitution in the production process away from capital and other inputs toward labor, which, in the short run, causes investment to fall. This fall is reinforced by the price effect from the exchange rate depreciation, which makes imported capital goods more expensive. However, as the initial fall in investment peters out in the second year after the shock, the impact of the increase in productivity is fully felt and real GDP begins to rise sharply, increasing 15 percent above the baseline after 10 years.
The increase in productivity in Japan has a negligible impact on the regional economies in the short term (Figure 12.2). The depreciation of the yen reduces their competitiveness, offsetting the increase in production in Japan, which raises the demand for intermediate inputs, and the higher real income, which increases the demand for final goods. However, over time, the increase in activity in Japan dominates the impact of the higher real exchange rate, and real GDP in the regional economies rises above the baseline, although there is some reallocation of capital toward Japan that acts to reduce the positive spillovers. The largest growth impact is felt in the Philippines, Taiwan Province of China, and Malaysia.
Asia: Effects of an Increase in Japanese Productivity Growth
Source: IMF staff estimates.Fiscal Consolidation
Prime Minister Koizumi has stressed the importance of fiscal consolidation, limiting the net issuance of Japanese government bonds (JGBs) to ¥30 trillion in FY2001, and suggesting a medium-term objective of achieving primary budgetary balance by the early 2010s. To assess the possible implications of such a policy, the impact of a phased, fully credible, fiscal consolidation is considered, where government expenditure is reduced by 1.7 percent of GDP in the first year, 3.4 percent of GDP in the second year, and 5 percent of GDP from the third year onward (relative to baseline).10
The reduction in government spending reduces aggregate demand through conventional Keynesian channels. However, in the model, the effects of the policy on anticipated future fiscal deficits is also important. In response to the announcement of a fully credible fiscal consolidation plan, real interest rates fall as financial markets react to the lower expected future deficits, and the yen depreciates by about 15 percent as capital flows overseas in response to the decline in interest rates (Figure 12.3). As households anticipate lower future tax obligations, consumption rises, while the exchange rate depreciation boosts net exports. These factors more than offset the declines in government expenditure and private investment—the latter owing to the lower expected growth during years 2–4, which pushes down equity prices—and real GDP rises in the first year. Because inflation rises in response to the depreciation and the pickup in growth, short-term interest rates rise (if interest rates did not rise, the initial output response would be even more positive). However, real GDP falls below baseline in the second and third years as the positive impact from the financing gains is more than offset by the decline in government spending, and it is only from the fifth year that GDP once again moves above the baseline as the positive impact of the decline in real interest rates and the real exchange rate on consumption, investment, and net exports is fully felt.
Because the fiscal consolidation is fully credible, the short-term output cost is less than in the case where the authorities’ commitment is not believed. In this case the initial positive impact felt though real interest rates, the exchange rate, and the decline in household saving is not forthcoming to mitigate the contractionary impulse from the decline in government spending (see Callen and McKibbin, 2001, for more details).
The relative trade reliance on Japan and the size of the external debt stock determines the transmission of the decline in government expenditure in Japan to other countries in the region. In the short term, there is only a small impact on other Asian countries (Figure 12.4). While some countries see a small negative impact in the short run as the initial increase in demand in Japan is offset by the loss of competitiveness from the depreciation of the yen, countries with high debt levels (such as Indonesia) actually see an increase in real GDP. In the second year, all the Asian economies are gaining more from lower capital costs than they are losing from a temporary slowdown in Japan and the weaker yen, and the benefits over the medium term are estimated to be considerable.
Quantitative Monetary Easing
In an attempt to combat ongoing deflation, the Bank of Japan moved to a quantitative monetary framework in March 2001, and increased its purchases of long-term government bonds. While this has moved policy into uncharted waters, and consequently is difficult to quantify, the G-cubed model provides an insight into the possible transmission mechanism both in Japan and across the region. In this simulation, the Bank of Japan is assumed to purchase government bonds sufficient to bring about a permanent 1 percent increase in the money supply relative to the baseline.
The monetary injection raises inflation expectations and consequently lowers short-term real interest rates (nominal interest rates, of course, are constrained by the zero bound) and depreciates the exchange rate (Figure 12.5). The decline in real interest rates and rise in equity prices temporarily stimulates private consumption and investment and the yen depreciation temporarily boosts net exports. The result is a temporary rise in real GDP through standard Keynesian channels—a demand stimulus accompanied by a fall in real wages and real interest rates temporarily increasing aggregate supply. Over time, however, price adjustment removes the real effects of the monetary shock and the economy settles down to the original baseline with higher prices but not higher inflation, because the shock is a rise in the level of money balances (a shock to the rate of growth of money results in a larger stimulus to demand, but also a permanent change in the underlying inflation rate in Japan). Long-term interest rates change little because the inflationary impulse is temporary, while the change in the real exchange rate that stimulates net exports is largely eroded by the second year.
The effects on the rest of Asia are small (Figure 12.6). The temporary boost to aggregate demand leads to an increase in the demand for Asian goods in Japan, but this is offset by the rise in the price of these goods when converted into yen within the Japanese economy. Indeed, in the first year, the exchange rate effect dominates, and exports from each Asian economy to Japan—and into third markets in which they compete with Japanese goods—fall. In the second year, the demand stimulus in Japan has not declined as quickly as the real exchange rate, and therefore Asian exports are higher than in the baseline for several more years. Despite the export response being negative for growth in Asian economies in the first year, real GDP is broadly unchanged as equity prices rise in anticipation of the growth in periods 2 through 5, which raises private wealth and consumption sufficiently to offset the export decline.
Of course, the numerical results from the simulations are subject to considerable uncertainty in the current economic environment (for example, the behavior of velocity, which is assumed to remain constant in the simulation, is very difficult to predict under such a quantitative easing scenario), while the model is obviously unable to address the questions of whether an increase in the Bank of Japan’s quantitative target could actually be achieved through stepped-up purchases of government bonds and whether, in the presence of a weak banking system, a higher quantitative target would affect the real economy. However, the simulation suggests that the primary transmission channels of such a bond purchase would be through inflation expectations, the exchange rate, and equity prices. Further, it suggests that if part of an overall monetary easing that was successful in boosting the Japanese economy, a depreciation of the yen would have a minimal impact on other regional economies.
A Loss of Confidence in the Yen
If investors perceive that the reforms needed to restore healthy growth in Japan over the medium term are not being implemented, thus increasing the risk of a further round of financial difficulties in the banking sector and raising questions about the sustainability of public debt, there could be a significant outflow of capital. This possibility is modeled by assuming that the risk premium on all Japanese assets increases by 3 percentage points relative to baseline (this is done in the interest parity condition between yen- and U.S. dollar-denominated government bonds).11
The increase in the risk premium on Japanese assets results in a substitution out of yen assets and into foreign assets. Consequently, long-term real interest rates rise, equity prices decline, and the yen depreciates by about 45 percent as capital flows out of Japan (Figure 12.7). The decline in equity prices results in a decline in Tobin’s q, which causes investment to fall, while consumption is also adversely affected by the decline in private wealth. While the yen depreciation boosts competitiveness and net exports, this is not sufficient to offset the decline in consumption and investment, and activity declines significantly.
The impact on other countries in the region is broadly neutral in the first year, but positive thereafter (Figure 12.8). Again, a number of things are happening. Countries benefit from the lower capital costs caused by the additional inflow of capital (the mirror of the outflows from Japan), which stimulates investment and helps economies with high foreign debt levels. However, exports are negatively affected, although countries that sell goods to the domestic Japanese market are more affected than those that sell inputs for exports because the slowdown in Japan is asymmetric within the economy: exporting firms gain from the weaker yen whereas firms focused on the domestic economy suffer. In addition, countries that compete with Japan in third markets will lose competitiveness because of the yen depreciation. Adding these effects together, all Asian countries gain in terms of GDP.
Conclusions and Policy Implications
This chapter has highlighted a number of important issues in understanding the transmission of shocks between Japan and the Asia-Pacific region. Because trade and financial linkages are significant, developments are transmitted across countries through both goods and asset markets, and the adequate modeling of these links is important if a complete assessment is to be made. While the actual magnitude of the impact of the policies and shocks considered will likely differ from the precise numerical predictions of the model, the insights provided about the transmission mechanism are important. For example, the results suggest that trade linkages often work in the opposite direction to financial linkages, and that there is often a trade-off between the positive effects from a shock through one channel and the negative effects through the other. Indeed, financial flows act as automatic stabilizers in many of the simulations considered. It also appears to matter whether the trade linkages are for final consumption goods or for intermediate goods to be used in production. The relative importance of each channel determines the overall impact of the policies.
The simulation results have a number of implications for the ongoing policy debate in Japan, and for policymakers in other Asian countries as they assess the potential impact of any policy changes in Japan on their own economies.
Trends in Japanese productivity growth have important implications for both the domestic economy and the region. Structural reforms that boost productivity growth over the medium term will provide a boost to growth domestically and in the region (Table 12.3).
As Japan moves toward fiscal consolidation over the medium term, the results give some grounds for optimism that the economic impact can be limited. While there will undoubtedly be a negative short-term impact on activity, this could be fairly limited if the announcement were credible—perhaps legislated in a fiscal responsibility act that specified a long-term public debt target and the tax, expenditure, and social security policies to back up that target—and would be quite quickly replaced by the positive impact from the decline in real interest rates and rise in equity prices. The negative short-run impact could also be offset by a more expansionary monetary policy. The existence of financial as well as trade linkages means that the effects of the fiscal consolidation in Japan are broadly neutral for the region in the short-run, but beneficial over the medium term.
The results suggest that a quantitative easing of monetary policy through the Bank of Japan’s outright purchase of government bonds would stimulate the economy in the short run, and from a position of insufficient demand would help close the output gap. However, in the current situation the impact of such a monetary stimulus is highly uncertain, and the results should be taken more as indicating the transmission channels through which a policy relaxation could work, rather than the actual size of the impact it would have.
In terms of the exchange rate, an important point that emerges from the results is that the implications of a weakening of the yen depend on the reasons for the depreciation. For example, a depreciation due to a loss of confidence in Japan has a large negative effect on Japan, but could actually be positive for the region because of the increase in capital inflows they would receive. If the depreciation is due to monetary easing, however, this has a positive impact on the Japanese economy, but is broadly neutral for the region because the positive effect on growth in Japan offsets the loss of competitiveness from the yen’s depreciation.
Impact on Real GDP: Summary of Selected Simulation Results
(Percent deviation of GDP from baseline)
Reduction in government expenditure of 1.7 percent of GDP in the first year, 3.4 percent in the second year, and 5 percent from the third year onward.
Bank of Japan purchase of government bonds sufficient to bring about a permanent 1 percent increase in the money supply.
Increase in growth rate of labor augmenting technical change of 3 percent a year for 3 years, 1 percent a year for another 8 years, and then returning to trend.
A 3 percentage point increase in the risk premia on all Japanese assets.
Impact on Real GDP: Summary of Selected Simulation Results
(Percent deviation of GDP from baseline)
Phased Fiscal Consolidation1 |
Monetary Easing2 |
Increase in Productivity Growth3 |
Loss of Confidence in the Yen4 |
|||||||
---|---|---|---|---|---|---|---|---|---|---|
Impact after: | ||||||||||
1 year | 3 years | 5 years | 1 year | 5 years | 1 year | 5 years | 1 year | 5 years | ||
Japan | 0.2 | –1.0 | 0.4 | 0.4 | 0.0 | 1.2 | 6.3 | –0.1 | –8.8 | |
Taiwan Province | ||||||||||
of China | 0.1 | 0.6 | 1.1 | 0.0 | 0.0 | 0.1 | 1.6 | 0.2 | 2.7 | |
Korea | 0.1 | 0.5 | 1.1 | 0.0 | 0.0 | 0.1 | 1.3 | 0.2 | 3.0 | |
Hong Kong SAR | 0.1 | 0.7 | 1.4 | 0.0 | 0.0 | 0.1 | 1.8 | 0.2 | 3.7 | |
Singapore | 0.1 | 0.5 | 1.2 | 0.0 | 0.0 | 0.1 | 1.4 | 0.2 | 3.1 | |
Thailand | 0.0 | 0.5 | 1.0 | 0.0 | 0.0 | 0.1 | 1.5 | 0.1 | 2.7 | |
Indonesia | 0.1 | 0.3 | 0.6 | 0.0 | 0.1 | 0.1 | 0.7 | 0.2 | 1.5 | |
Malaysia | –0.1 | 0.6 | 1.3 | 0.0 | 0.0 | –0.1 | 2.0 | –0.3 | 3.0 | |
Philippines | 0.1 | 0.7 | 1.2 | 0.0 | 0.0 | 0.1 | 1.9 | 0.1 | 2.5 | |
China | 0.0 | 0.2 | 0.4 | 0.0 | 0.0 | 0.0 | 0.4 | –0.1 | 1.0 |
Reduction in government expenditure of 1.7 percent of GDP in the first year, 3.4 percent in the second year, and 5 percent from the third year onward.
Bank of Japan purchase of government bonds sufficient to bring about a permanent 1 percent increase in the money supply.
Increase in growth rate of labor augmenting technical change of 3 percent a year for 3 years, 1 percent a year for another 8 years, and then returning to trend.
A 3 percentage point increase in the risk premia on all Japanese assets.
Impact on Real GDP: Summary of Selected Simulation Results
(Percent deviation of GDP from baseline)
Phased Fiscal Consolidation1 |
Monetary Easing2 |
Increase in Productivity Growth3 |
Loss of Confidence in the Yen4 |
|||||||
---|---|---|---|---|---|---|---|---|---|---|
Impact after: | ||||||||||
1 year | 3 years | 5 years | 1 year | 5 years | 1 year | 5 years | 1 year | 5 years | ||
Japan | 0.2 | –1.0 | 0.4 | 0.4 | 0.0 | 1.2 | 6.3 | –0.1 | –8.8 | |
Taiwan Province | ||||||||||
of China | 0.1 | 0.6 | 1.1 | 0.0 | 0.0 | 0.1 | 1.6 | 0.2 | 2.7 | |
Korea | 0.1 | 0.5 | 1.1 | 0.0 | 0.0 | 0.1 | 1.3 | 0.2 | 3.0 | |
Hong Kong SAR | 0.1 | 0.7 | 1.4 | 0.0 | 0.0 | 0.1 | 1.8 | 0.2 | 3.7 | |
Singapore | 0.1 | 0.5 | 1.2 | 0.0 | 0.0 | 0.1 | 1.4 | 0.2 | 3.1 | |
Thailand | 0.0 | 0.5 | 1.0 | 0.0 | 0.0 | 0.1 | 1.5 | 0.1 | 2.7 | |
Indonesia | 0.1 | 0.3 | 0.6 | 0.0 | 0.1 | 0.1 | 0.7 | 0.2 | 1.5 | |
Malaysia | –0.1 | 0.6 | 1.3 | 0.0 | 0.0 | –0.1 | 2.0 | –0.3 | 3.0 | |
Philippines | 0.1 | 0.7 | 1.2 | 0.0 | 0.0 | 0.1 | 1.9 | 0.1 | 2.5 | |
China | 0.0 | 0.2 | 0.4 | 0.0 | 0.0 | 0.0 | 0.4 | –0.1 | 1.0 |
Reduction in government expenditure of 1.7 percent of GDP in the first year, 3.4 percent in the second year, and 5 percent from the third year onward.
Bank of Japan purchase of government bonds sufficient to bring about a permanent 1 percent increase in the money supply.
Increase in growth rate of labor augmenting technical change of 3 percent a year for 3 years, 1 percent a year for another 8 years, and then returning to trend.
A 3 percentage point increase in the risk premia on all Japanese assets.
References
Bayoumi, Tamim, and Gabrielle Lipworth, 1998, “Japanese Foreign Direct Investment and Regional Trade,” in Structural Change in Japan: Macroeconomic Impact and Policy Challenges, ed. by Bijan Aghevli, Tamim Bayoumi, and Guy Meredith (Washington: International Monetary Fund), pp. 63–94.
Callen, Tim, and Warwick J. McKibbin, 2001, “Policies and Prospects in Japan and the Implications for the Asia-Pacific Region,” IMF Working Paper 01/131 (Washington: International Monetary Fund).
Kawai, Masahiro, 1998, “Role of FDI for Structural Change in Japan’s Trade Patterns,” comment on Bayoumi and Lipworth in Structural Change in Japan: Macroeconomic Impact and Policy Challenges, ed. by Bijan Aghevli, Tamim Bayoumi, and Guy Meredith (Washington: International Monetary Fund), pp. 97–102.
Kohsaka, Akira, 1996, “Interdependence through Capital Flows in Pacific Asia and the Role of Japan,” in Financial Deregulation and Integration in East Asia, ed. by Takatoshi Ito and Anne O. Krueger (Chicago: University of Chicago Press), pp. 107–42.
McKibbin, Warwick, 2001, “Documentation of the G-Cubed Asia-Pacific Model—version 46n,” McKibbin Software Group Pty Ltd, Canberra, Australia. Available on the Internet: http://www.msgplcom.au/msgpl/apgcubed46n/index.htm.
McKibbin, Warwick, and D. Vines, 2000, “Modeling Reality: The Need for Both Intertemporal Optimization and Stickiness in Models for Policy-Making,” Oxford Review of Economic Policy, Vol. 16 (Winter), pp. 106–137.
McKibbin, Warwick, and Peter Wilcoxen, 1998, “The Theoretical and Empirical Structure of the G-Cubed Model,” Economic Modeling, Vol. 16 (January), pp. 123–48.
Nakamura, Yaichi, and Izumi Matsuzaki, 1997, “Economic Interdependence: Japan, Asia, and the World,” Journal of Asian Economics, Vol. 8 (Summer), pp. 199–223.
The Asia-9 are China, Hong Kong SAR, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan Province of China, and Thailand.
Nakamura and Matsuzaki (1997) find that Asian companies have been very successful at penetrating the Japanese market for electrical machinery and other manufactured goods, partly at the expense of U.S. and European companies.
These developments have taken place in the context of a near doubling in the share of world trade accounted for by Asian countries since the mid-1980s, and a decline in Japan’s share of world trade.
The country breakdown of Chinese trade data needs to be treated with caution, particularly for industrial countries, as trade with these countries is classified as trade with Hong Kong SAR if it passes through Hong Kong ports.
At end–2001, 17 percent of the outstanding stock of Japanese FDI (at market prices) was in the Asia-9, compared with 47 percent in the United States and 23 percent in Europe. Within Asia, Japanese FDI is largely concentrated in Singapore, China, and Thailand.
This discussion is based on BIS data. As noted by Kohsaka (1996), there are significant two-way financial flows between Japan, Hong Kong SAR, and Singapore in their roles as international and regional financial centers. The data for Singapore and Hong Kong SAR therefore likely overestimate the impact on domestic resource use in these countries.
This conclusion needs to be qualified, however, for China, Singapore, and Korea, where there is a large unidentified component (larger than the exposure of Japanese banks) in the country breakdown of outstanding lending. For China, and possibly Singapore, these are related to Hong Kong SAR banks, which, while included in the aggregate data, are not separately identified, for confidentiality reasons.
A number of studies—summarized in McKibbin and Vines (2000)—have shown that the G-cubed model has been useful in assessing a range of issues across a number of countries since the mid-1980s. Full details of the model, including a listing of equations and parameters, can be found on the Internet: http://www.msgpl.com.au/msgpl/apgcubed46n/index.htm.
In all the simulations, the Bank of Japan and other central banks are assumed to follow a fixed money stock rule.
While any consolidation would not happen this quickly, for the purposes of the simulations it is useful to have it occurring in a relatively short period of time so that the competing effects of the policy become more clearly visible.
The model includes risk premia on certain assets calibrated to be equal to whatever is required to make the model-generated asset returns equal to the observed returns in the base year (1999). These risk premia are held constant during the simulations unless they are exogenously changed (as in the current simulation).