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Japan’s adjustment to the increased cost of energy: A review of Japan’s successful adjustment policies in the face of the two major oil price increases since 1973

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1981
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Walter R. Mahler

The Japanese economy has managed to weather the second major oil price increase surprisingly well, compared with the experience of other large industrial economies and with its own experience after the first major price increase in 1973. The magnitude of these two sharp increases relative to the size of the Japanese economy was about the same. While the average dollar price of Japanese crude oil imports increased by about 140 per cent between 1978 and 1980, compared with 250 per cent between 1973 and 1975, petroleum imports as a percentage of gross national product (GNP) had increased from 1.7 in 1973 to 2.9 in 1978. But the impact of the second price rise was far more gradual than the first and the adverse consequences were much less severe. The most dramatic differences were in the areas of consumer prices, industrial production, employment, and labor productivity—all of which have shown remarkable resilience since 1978 (see Table 1).

The reasons for Japan’s greater success after the second oil price increase seem to have been a combination of cyclical factors, quick and appropriate policy actions, and a willingness among industry and labor to share the economic burden of these increases. When the first price rise occurred in 1973, Japan was experiencing rapid growth, a high rate of capacity utilization, a rapid growth of money, and an extraordinary acceleration in inflation, in part because of a domestic speculative boom. In 1978, by contrast, Japan had a moderate rate of growth, unutilized capacity, and relatively stable prices. Meanwhile the authorities had, by 1978, made substantial progress in shifting the economy toward less energy-intensive and more technology-intensive industries in order to maintain Japan’s competitiveness. The moderate nominal wage increases accepted by industry and labor helped to maintain employment and investment levels in spite of the second major oil price rise. Tight monetary policy successfully contained domestic inflation. In addition, a larger depreciation of the yen after the second price rise contributed to a sharper increase in exports and bolstered overall growth.

Japan’s economic performance during 1978-80 is even more remarkable when contrasted with the high levels of unemployment and inflation in other industrial countries, particularly during 1980. In each year during 1978-80, Japan’s real growth rate exceeded that of every other major industrial country. With the exception of the Federal Republic of Germany, Japan also had the lowest consumer price increases among the major industrial countries in each of these years, and the unemployment rate remained significantly below that of the other major industrial countries. While oil imports continued to account for a higher percentage of Japan’s energy consumption that it did in any of the other major industrial countries, Japan was able to make a more substantial reduction in its ratio of energy consumption to real GNP between 1973 and 1980; thus, this ratio continued to be lower in Japan than in any other major industrial country.

Domestic adjustment

At the time of the first oil price increase, Japan’s economy was growing rapidly and was in an “overheated”situation characterized by high utilization of productive capacity in manufacturing, low unemployment, a rapid rate of monetary expansion, and high inflation. During 1971-73, there had been excessive growth in the money supply—in part, associated with a large current account surplus—and, by early 1973, domestic prices were rising rapidly as a result of both domestic demand and speculative pressures and world commodity price increases. Because domestic economic conditions were less buoyant at the time of the second increase in oil prices, it was easier to absorb the shock of sharply higher import prices and to contain the impact on domestic prices.

Another important difference was that the rapid growth of the economy during the late 1960s and early 1970s had been based largely on the growth of energy-intensive industries and was especially vulnerable to the first unexpected rise in oil prices. As a result of the substantial adjustment of the structure of Japanese industry and the introduction of significant energy-saving measures in the period between the two major price increases, there was less dislocation after the second increase in oil prices. Structural adjustment in Japan’s industry was also prompted by increasingly keen competition in export markets from its newly-industrialized neighbors—Taiwan (Province), Korea, Hong Kong, and Singapore.

The Government was an active agent promoting the changes needed. It concentrated its assistance on the emerging energy-efficient, technologically sophisticated industries rather than on the ailing labor- and energy-intensive ones, such as textiles, shipbuilding, and aluminum smelting. This led to a substantial shift of resources from declining and stagnant industries to growing ones and resulted in the resumption of rapid gains in productivity in the latter part of the 1970s. The approach of Japanese corporate management- -which is more interested in the long-term prospects for growth than in quarterly profits—facilitated the shift to new energy-efficient industries. The lifetime employment and seniority system in Japan encouraged firms to invest in the retraining of workers to aid the process of structural adjustment and thus lessened workers’ fears of the introduction of labor-saving machines. As an example, Japan has emerged as by far the major user of computerized robots. Moreover, the development of energy-saving technology was stimulated by passing on fully to end-users the increase in imported energy costs.

Since the first oil price increase, Japan has made greater progress in reducing its ratio of energy consumption to GNP than has any other major industrial country. The ratio of the volume of oil imports to real GNP declined by 35 per cent between 1973 and 1980. There has been a substantial shift during this period toward alternative energy sources, including nuclear power, coal, and liquified natural gas.

External adjustment

The current account deficit was larger and lasted longer after the second oil price increase than it had after the first, mainly because the domestic sector remained stronger after the second price increase (see chart).

In the first period, the increase in oil prices was largely concentrated in a single year: 1974. However, the volume of non-fuel imports contracted because of the sharp slowdown in Japan’s economic activity, while Japan’s export volume expanded. As a result, the improvement in the non-fuel trade balance offset over two thirds of the US$17 billion increase in fuel imports (see Table 2). In 1975, the world recession halted the growth of export volume, but with declines in the volume of both fuel and nonfuel imports and little change in import prices, the current account returned to the position of moderate deficit that had existed in 1973.

The impact of the second oil price increase was felt more gradually, with more of the rise in the cost of fuel imports coming in 1980 than in 1979. At the beginning of 1979, Japan’s trade competitiveness had just begun to improve after the sharp decline associated with the appreciation of the yen in 1977 and 1978. Moreover, in contrast to 1974, domestic demand was still expanding rapidly with a growth rate among the highest in the industrial world. As a result of the strong domestic demand and the delayed impact of exchange rate changes on foreign trade, export volume in 1979 was lower than in 1978, while import volume continued its rapid increase. Partly in response to the massive turnaround in the trade account, the exchange rate depreciated sharply, greatly enhancing the competitiveness of Japanese goods in foreign markets. As the growth of domestic demand slowed in 1980 and foreign competitiveness improved, export volume increased sharply while both fuel and nonfuel import volumes declined. As a result, despite a further sharp rise in the value of fuel imports in 1980, there was a slight increase in the trade surplus.

Table 1.Japan’s performance during the two oil price increases, 1973-75 and 1978-80
1973197419751978197919801
Per cent change from previous year
Total domestic demand10.9−2.50.16.16.70.6
Of which:
Private consumption9.50.84.24.76.21.3
Private fixed investment8.0−7.2−4.56.68.22.0
Government consumption
and fixed investment7.0−6.65.710.53.5−1.3
Foreign balance2−1.51.51.7−0.9−1.03.6
Gross national product (GNP)10.0−0.51.45.15.64.2
Industrial production14.9−4.011.06.28.37.1
Real wages9.6−6.35.31.31.2−1.0
Labor productivity-15.51.2−3.17.97.96.1
Unit labor costs3.529.824.0−2.6−2.90.9
Oil prices331.4227.89.92.137.574.2
Import prices421.066.27.6−17.428.643.0
Consumer prices11.724.511.83.83.68.0
Broad money516.811.514.513.19.17.2
In per cent
Additional oil import bill
as a percentage of GNP
in base year63.80.11.42.2
Unemployment1.31.41.92.22.12.0
Manufacturing capacity
utilization93.585.773.080.086.787.3
Sources: Bank of Japan. Economic Statistics Monthly. Government of Japan Economic Planning Agency. Annual Report on National Accounts.

Indicates base year.

Staff estimates.

Percentage contribution to GNP.

Average increase in the year in dollar terms.

Contract prices in yen.

End-year basis; includes certificates of deposit since May 1979.

For 1974 and 1975. the base year is 1973: for 1979 and 1980. the base year is 1978.

Sources: Bank of Japan. Economic Statistics Monthly. Government of Japan Economic Planning Agency. Annual Report on National Accounts.

Indicates base year.

Staff estimates.

Percentage contribution to GNP.

Average increase in the year in dollar terms.

Contract prices in yen.

End-year basis; includes certificates of deposit since May 1979.

For 1974 and 1975. the base year is 1973: for 1979 and 1980. the base year is 1978.

The total deterioration in the trade balance over the two year period, 1978-80, was $28 billion. The estimated effect of price changes on the current account balance was $44 billion, of which $16 billion was offset by changes in trade volumes. In contrast, in the 1973-75 period, changes in trade volumes had completely offset the impact of price changes. This difference resulted primarily from the fact that nonfuel import volume expanded somewhat during 1979-80, compared to a sharp reduction during 1974-75.

Japan: major balance of payments items, 1973-80

(In billions of U.S. dollars)

Source: Bank of Japan. Balance of Payments Monthly

The degree of adjustment of the current and capital account in 1974 was strong enough to produce a small overall surplus, and there was little change in 1975. In contrast, after the second oil price increase there was an overall deficit of $13 billion in 1979 but a sharp swing to an overall surplus of $5 billion in 1980.

Although the growth of the economy remained more stable after the second oil price increase, the yen/dollar exchange rate fluctuated somewhat more than it had after the first. This was mainly the result of a sharper swing in the current account—from a substantial surplus in 1978 to a substantial deficit in 1979 and the first part of 1980 and then almost back to balance by the latter part of 1980—and to the emergence of wider interest rate differentials than had occurred after the first oil price increase.

Given the fact that Japan depended on imported fuels for about 90 per cent of its energy supply—a much higher percentage than the other major industrial countries—the sharp increase in oil prices resulted in expectations of a substantial worsening of the balance of payments and a weakening of the yen during 1979 and the first part of 1980. These expectations were reversed after April 1980 as a result of a reduction in the current account deficit, a decline in interest rates in the United States, a growing desire of international investors to diversify their assets, and accumulating indications that Japan had successfully adapted its economic policies to the new environment. Thus, the yen strengthened during the rest of 1980 as Japan’s relative success in maintaining economic growth and dampening inflationary expectations more than offset the effects of the substantial interest rate differentials vis-á-vis the United States that reemerged in the latter part of the year.

Adjustment policies

The different stances of policy in 1973 and 1978 reflected the different cyclical positions of the economy at those times. During the six months preceding the October 1973 oil price increase, monetary policy had been tightened and interest rates doubled in an effort to slow down the overheated economy. Interest rates were increased further during 1974 and the growth rate of the money supply substantially reduced. At the same time, government spending was curtailed and taxes were raised. Nevertheless, with the oil price increase aggravating an already high inflation rate, business anticipated an even more rapid acceleration of prices and there was a considerable increase in inventories, resulting, in part, from speculative hoarding associated with a worldwide boom in demand for basic commodities as well as for oil.

With a sharp reduction in domestic demand, industrial production declined by 15 per cent in 1974-75. This weaker domestic demand was partly, but not completely, offset by increased exports. During this period, the foreign balance contributed 3.3 per cent to the growth of real GNP, but the decline in domestic demand led to real GNP increasing by only 1 per cent. A reduction in manufacturing output, accompanied by a much smaller decline in employment, produced an overall decline in labor productivity—which fell by 2 per cent in contrast to a long-term annual growth rate of about 8 per cent. This decline, combined with nominal wage increases of about 17 per cent in both 1974 and 1975, resulted in a substantial increase in unit labor costs and a decline in profits. These lower profits, combined with business uncertainties about the long-term implications of the new energy situation for Japan, led to a reduction in private fixed investment.

There was little inflation during 1978, and domestically generated price increases were successfully contained during 1979 and 1980. Consumer prices increased by only 12 per cent during 1979-80, compared with a 38 per cent increase during 1974-75. The low inflation and the moderate level of economic activity at the end of 1978 made it easier for Japan’s economy to absorb the impact of the second oil price increase. But key to the successful containment of domestic inflation were the moderate nominal wage increases—of about 7 per cent—accepted by labor in 1979 and 1980. This willingness of industry and labor to share the adverse impact on real incomes, as the oil price rise led Japan’s terms of trade to deteriorate, contributed significantly to the maintenance of both employment and investment levels in 1979-80.

Timely and firm monetary policy facilitated the adjustment. Cognizant of the failure of economic policy to contain price increases in the early phase of the first oil price increase, the Government quickly reversed the stance of monetary policy in response to the announced oil price increases in late 1978. Interest rates were raised five times between early 1979 and March 1980, and the growth rate of the broad money aggregate (money and time and savings deposits) was reduced from an annual rate of 13 per cent at the end of 1978 to almost 7 per cent at the end of 1980. The strict monetary policy—reflected in relatively high real interest rates—and the credibility it was afforded by its consistency in moving against the acceleration of wholesale prices contributed to the avoidance of the speculative inventory accumulation that had followed the first oil price rise. Although substantial deficit financing continued during 1979-80, real government spending is estimated to have increased by only 2 per cent over these two years, compared with a 10 per cent increase in real GNP.

With the Government placing primary emphasis on containing the impact of the second sharp increase in the cost of oil on domestic prices, domestic demand weakened sharply in the second half of 1979 and remained weak during 1980. However, a continued increase in foreign demand sustained economic growth. The considerable depreciation of the yen contributed to a sharp increase in exports, while the growth of imports was restrained by the depreciation, by weak domestic demand, and by energy conservation measures. As a result, foreign demand made a negative contribution to real GNP growth in 1979 but accounted for more than 85 per cent of the increase in 1980. During the 1979-80 period as a whole, the foreign balance contributed 2.6 percentage points to the growth of real GNP, which increased by 9.8 per cent during the two year period.

Better performance

As a result of strength first in domestic and then in foreign demand, the growth rates of industrial production and of real GNP in 1979 and 1980 were sustained at moderate levels, in contrast to the sharp reductions that occurred during the two years following the first oil price increase. Starting from a relatively low level in 1978, manufacturing output increased and unemployment declined slightly. This contributed to maintaining a 7 per cent annual growth rate of labor productivity during 1979-80. There was little change in real wages during this period and unit labor costs declined slightly, contributing to an increase in corporate profit ratios, which in turn stimulated substantial new fixed investment.

The much better performance of the Japanese economy after the second major increase in the cost of oil was partly because it occurred during a period of moderate economic expansion, in contrast to the overheated situation in 1973. It was also partly a result of external factors—in particular, a sharper depreciation of the yen after the second price increase facilitated a slightly larger contribution to economic growth from the foreign balance than had occurred after the first price increase. In addition, the policy response in 1978 was quicker and the resilience of the economy had been strengthened by substantial industrial restructuring since 1973. Also important was the willingness of industry and labor to share the costs of the adverse terms of trade resulting from the higher oil prices, which allowed an adequate level of profits to fund the continued investment required by industry to adapt to the new energy price environment. In addition, labor’s emphasis on maintaining employment rather than maximizing wage increases facilitated the avoidance of the stagflation that affected all the major industrial economies after the first oil price increase. A restrictive monetary policy successfully limited the increase in domestic prices.F&D

Table 2.Japan: adjustment of external trade to the 1973-74 and 1979-80 oil price increases1(Changes in billions of U.S. dollars)
FuelNonfuelNonfuelTotal
Exportsimports2,3imports3trade balancetrade balance
1973-7418.6−16.6−7.211.4−5.2
1974-750.2−0.75.05.34.5
Total 1973-7518.8−17.3−2.216.7−0.7
Price(10.2)(−18.8)(−12.1)(−1.8)(−20.7)
Volume(8.6)(1.5)(9.9)(18.5)(20.0)
1978-795.5−14.0−17.94−12.4−26.4
1979-8026.8−24.7−4.122.7−1.6
Total 1978-8032.3−38.7−22.010.3−28.0
Price(19.5)(−38.1)(−20.4)(−0.9)(−44.1)
Volume(12.8)(−0.6)(−1.6)(11.2)(16.1)
Sources: Japanese Ministry of Finance. The Summary Report. Trade of Japan and Fund staff estimates.

Trade adjusted on custom clearance basis. Imports in this table are on a c.i.f. basis, while in the chart, imports are on a f.o.b. basis. Price and volume indexes are available only on a customs clearance basis.

Crude petroleum and product imports are about 90 per cent of total fuel imports.

For imports, negative numbers indicate increases and positive numbers indicate declines.

ln 1978 and 1979 some emergency imports appeared in the balance of payments but not in customs clearance data. For purposes of this table. $1.5 billion has therefore been added to customs imports in 1978 and $2 billion in 1979

Sources: Japanese Ministry of Finance. The Summary Report. Trade of Japan and Fund staff estimates.

Trade adjusted on custom clearance basis. Imports in this table are on a c.i.f. basis, while in the chart, imports are on a f.o.b. basis. Price and volume indexes are available only on a customs clearance basis.

Crude petroleum and product imports are about 90 per cent of total fuel imports.

For imports, negative numbers indicate increases and positive numbers indicate declines.

ln 1978 and 1979 some emergency imports appeared in the balance of payments but not in customs clearance data. For purposes of this table. $1.5 billion has therefore been added to customs imports in 1978 and $2 billion in 1979

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