Recent Economic Developments

This paper reviews economic developments in Japan during the 1990s. The paper focuses on the weak recovery that began in 1994, against the background of the long and deep recession from mid-1991 to late 1993. Output and labor market developments are described. The paper examines the sharp deterioration in the fiscal position, including the effects of fiscal policy actions, and discusses the progressive easing of monetary policy since 1991. External sector developments are also analyzed, followed by an overview of trade and structural policies.


This paper reviews economic developments in Japan during the 1990s. The paper focuses on the weak recovery that began in 1994, against the background of the long and deep recession from mid-1991 to late 1993. Output and labor market developments are described. The paper examines the sharp deterioration in the fiscal position, including the effects of fiscal policy actions, and discusses the progressive easing of monetary policy since 1991. External sector developments are also analyzed, followed by an overview of trade and structural policies.

I. Introduction

This review of recent economic developments focuses on the weak recovery that began in 1994, against the background of the long and deep recession from mid-1991 to late 1993. Output and labor market developments are described in Chapter II. (Recent developments in inflation are analyzed in Chapter IV of the supplement to this paper.) Chapter III examines the sharp deterioration in the fiscal position, including the effects of fiscal policy actions. Chapter IV discusses the progressive easing of monetary policy since 1991. External sector developments are analyzed in Chapter V, followed by an overview of trade and structural policies in Chapter VI. Finally, Chapter VII reviews developments in the banking sector.

The annexes to the chapters study specific issues raised in the main text. Nonfinancial private sector balance sheet positions are examined in Annex I. Regarding fiscal issues, Annex II discusses the use of flow of funds data in fiscal monitoring, while Annex III analyzes the authorities’ medium-term objectives for the “bond-financing ratio” and how it relates to the general government balance. Annex IV explores the impact of the decline in equity prices on the balance sheets of the banking sector.

II. Output and Labor Market Developments

1. Aggregate demand and output

The 1991-93 economic recession, which ended in October 1993, was the second longest (at 30 months) and the deepest (with peak to trough growth averaging only 0.4 percent per annum) since the downturn associated with the first oil shock (Table 1 and Chart 1). 1/ The subsequent recovery has been much weaker than average, with output in the last five quarters increasing at an average annual rate of 3/4 percent, compared to an average annual increase of 5 1/2 percent in three previous recoveries (Chart 2). As a result, the gap between actual and potential output is estimated to exceed 5 percent of potential. 1/

Table 1.

Japan: Growth Rates of Real GDP and Demand Components, 1989-95 1/

(Percentage change from previous year or quarter)

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Sources: Economic Planning Agency, Annual Report on national Accounts; and data provided by the Japanese authorities.

At 1985 prices.

Contribution to real GDP growth.

Government consumption and investment.



(Percentage change from previous year)

Source: EPA, National Income Accounts.


Index (trough of cycle=100)

Source: Nikkei Telecom.1/ Troughs defined as: 1993Q4 for current downturn; 1987Q2 for 1986-87 downturn; 1983Q2 for 1982-83 downturn; 1975Q1 for 1974-75 downturn.

Economic growth through 1994 was weak and uneven. Following a first quarter increase of 0.8 percent, led by private consumption growth of 1.3 percent and a positive contribution from net exports, both components worsened in the second quarter, drawing down overall growth to 0.2 percent. Growth again picked up in the third quarter, as abnormally hot weather induced higher consumption expenditures, and business fixed investment recorded its first increase in 11 quarters. However, almost all components of domestic and foreign demand fell in the fourth quarter, with overall output falling by 1 percent (quarterly rate). For the year as a whole, real GDP rose by only 0.5 percent.

The weak pace of economic activity continued in the first part of 1995. First quarter growth was only 0.1 percent, with increased private investment offset by falling public investment, while private consumption was basically flat. More recent indicators, including reductions in industrial production, weak retail sales, and declining net export volumes suggest that activity in the second quarter will also be subdued.

The fragile and erratic nature of the recovery has been the result of a number of factors. First, the process of working off excess capital stocks accumulated during the previous boom period has depressed private investment, typically an engine for economic recovery. Second, as land and equity prices have fallen significantly following the bursting of the asset price bubble of the late 1980s, households, enterprises and banks have attempted to restore their balance sheets by limiting expenditures. National net wealth has fallen by 12.5 percent over 1990-93, and by an estimated further 3 percent in 1994 (see Annex I). Third, the persistent rise of the yen, equivalent to over 40 percent since early 1990 in real effective terms, has placed downward pressure on wages, prices and profits, further restraining consumption and investment.

Real private consumption grew by 2.2 percent in 1994. The growth in employee compensation remained subdued at 2.3 percent (as in 1993), as the spring wage round (“shunto”) resulted in an historically low increase of 3.1 percent, and hours worked fell by 0.5 percent. However, disposable incomes were boosted by tax cuts totaling ¥6 trillion, which were provided at end-June and end-December. Household debt ratios worsened slightly as net wealth remained constant, while an increase in net fixed assets (mainly housing) was financed through borrowing. This worsening, as well as the uncertainty resulting from unprecedented rates of unemployment, may have motivated the rise in the household saving rate in 1994. Nevertheless, consumption was boosted by weather-related expenditures in the summer, and increased expenditures on consumer durables were induced by rapid growth in residential investment. Consumption in the fourth quarter subsequently fell by 0.6 percent, in part reflecting an unwinding of the temporary effects in the previous quarter.

Consumption was basically flat in the first quarter of 1995, recording an increase of only 0.1 percent. Part of this weakness is thought to have been the result of the Kobe earthquake, disrupting business directly in the affected area, and inducing a more solemn attitude throughout the country. The 1995 spring “shunto” declined further to only 2.7 percent, while hours worked have remained flat, implying only a slight increase in the growth rate of labor compensation this year. Moreover, fears arising from continued increases in the unemployment rate and possible implications of the recent strength of the yen for employment prospects may further raise the household saving rate.

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Private business investment declined by 8.9 percent in 1994, its third straight year of contraction. Following 11 consecutive quarters of negative growth beginning in early 1991, business fixed investment has recorded three quarters of positive, albeit weak, growth. The recent upturn reflects a number of factors. While levels of capacity utilization in manufacturing remain below their 1974-94 average of 92.3, the index has been increasing since late 1993, and is now 8 percent above its trough (Chart 3). Industrial production has displayed a similar pattern. Corporate profits have increased since late 1993, albeit somewhat erratically, in part due to the reduction in depreciation charges relating to the surge in investment undertaken in the late-1980s. The Bank of Japan’s May Tankan survey included an upward revision to investment intentions, registering expectations of positive growth for the first time since 1991.



Source: Nikkei Telecom.1/ Percentage of respondents reporting improving business conditions versus deteriorating.

While existing capital/output ratios remain above trend, a continuation of present investment levels implies a working off of excess capital in coming years. However, nonfinancial enterprise balance sheets have worsened significantly in recent years, with net wealth having declined by 23.6 percent over 1989-93, and by an estimated further decline of 10 percent in 1994. Moreover, the yen’s recent sharp appreciation (increasing by 17 percent against the U.S. dollar between January and May) is expected to worsen export opportunities and accelerate the shift abroad of productive canacity by domestic producers. 1/ These factors imply that the growth of business fixed investment will most likely remain subdued in the near term.

Following the re-emergence of growth in residential investment in 1993, it accelerated to almost 10 percent in 1994. The number of new units started last year, at some 1.57 million, exceeded the 1.46 million started in the United States, despite twice the population in the latter country. This growth was fueled in part by low interest rates. In addition, both the loan ceiling and special premium on financing from the Housing Loan Corporation (HLC) were raised on three occasions over 1992-93, as was the maximum residential floorspace eligible for finance. As a result, the amount of outstanding credit with this institution increased by 14.8 percent in 1994, compared to a 2.4 percent increase with banks. At the end of 1994, the HLC held over 40 percent of outstanding housing credit, compared to 35 percent in 1992.

The number of starts remained above an annual pace of 1.5 million in the first two months of this year, while dipping only slightly below this rate in March and April. Although the rate of growth in residential investment is anticipated to fall significantly this year, the outlook remains strong for this sector for a number of reasons. First, the reduction in interest rates this spring should further lower borrowing costs. Second, in spite of the high rate of housing investment in 1994, it does not appear that there is an excess supply of housing stock. It is estimated that the ratio of residential housing stock to trend GDP, while increasing slightly in 1994, remains below its peak 1980 level, after having risen dramatically in the 1970s.

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On a national accounts basis, stockbuilding contributed positively to growth in 1994, following two years of negative contributions. This pattern continued through the first quarter of 1995, albeit at a lesser rate. Industrial inventories, in contrast, fell in the first three quarters of 1994, and for the year as a whole. The inventory-shipment ratio also fell, for the first time in three years. In the first quarter of 1995, production increased by a further 1.3 percent, while shipments rose by only 0.1 percent, resulting in a small rise in inventories.

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Real government spending on current goods and services grew by 2.8 percent in 1994, up from 1.7 percent in 1993. Public investment grew by 5 percent in 1994, compared to double-digit growth in 1992-93, the result of additional stimulative measures undertaken by the government (see Chapter III). Given that the growth in public investment has been greater than the growth in real GDP since 1991, the public investment to GDP ratio, equivalent to 9 percent in 1994, significantly exceeds its 1985-91 average of 6.7 percent. While it appears that this surge may have peaked, with negative growth in public investment in late 1994 and early 1995, and further reductions in current indicators of public works contracts and construction, the recently approved supplementary budget contains measures to further accelerate public goods spending (including earthquake-related reconstruction expenditures).

2. Saving-investment balances

The Japanese economy has experienced a remarkable shifting of domestic public and private net saving positions over the last five years (Table 2). Between 1989 and 1994, the private sector’s net saving balance has improved by 7.3 percentage points of GDP, while the public sector balance has worsened by 6.4 percentage points. Within the former sector, the vast bulk of the improvement has been from private enterprises, while in the latter, the deterioration has been largely accounted for by a 5.0 percentage point worsening in the government’s position.

Table 2.

Japan: Saving and Investment Balances, 1989-94

(In percent of GDP)

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Sources: Economic Planning Agency, Annual Report on National Accounts; and staff estimates.

Current account balance.

Staff estimate.

Residential investment.

The improved private sector net saving position is largely the result of a sharp fall in enterprise investment, which, as discussed earlier, resulted from an excess of capital accumulation during the bubble period and declining levels of capacity utilization, as well as falling equity prices and profitability, and tightened enterprise liquidity. 1/ Household net saving rose somewhat over this period, as expenditure growth was reduced in part to improve balance sheet positions, and the residential investment ratio declined, although the latter rose in the last two years. The worsening public sector position reflects both endogenous effects of changes in the business cycle, as well as policies adopted to provide countercyclical support to the economy. The reduction in the government saving ratio since 1991 reflects cyclically weak revenue performance, as well as, in 1994, tax cuts provided to households. The sharp increase in the government investment ratio since 1991 reflects successive stimulus packages.

3. Labor market activity

The labor market continued to face sizable pressures in 1994. The unemployment rate averaged 2.9 percent for the year, an historic high, with continued increases in early 1995 (Chart 4). Even so, the increase in the unemployment rate was restrained by reductions in labor force participation rates, especially for men (Chart 5). Following a cumulative 12 percent decline in scheduled hours worked over 1988-93, due both to the recession, and to government policy, scheduled hours worked have remained constant between the third quarter of 1993 and the first quarter of 1995. The level of total employment has also remained flat, while the ratio of job offers to seekers has returned to its pre-bubble average.



Sources: Ministry of Labor, Monthly Labor Statistics; Management and Coordination Agency, Labor Force Survey; and staff estimates.1/ Seasonally adjusted data. Shaded areas refer to periods of recession as defined by the Japanese authorities.


Source: Nikkei Telecom.1/ Seasonally adjusted data. Shaded areas refer to periods of recession as defined by the authorities.

There are indications that labor market adjustments are not yet complete. Rather than hiring additional labor, firms are increasing overtime hours, which have risen by 7 percent since the end of 1993, although their level remains well below the historical average. Survey results in the May Bank of Japan Tankan indicate that the difference between enterprises which judged their employment levels as “excessive” rather than as “insufficient” was 24 percentage points (and was 31 percentage points for manufacturing enterprises). Moreover, these differences have hardly changed since the end of the recession. 1/ Private sector estimates of excess employment range from 2 to 3 million (equivalent to 3 - 4 1/2 percent of the labor force).

The growth of nominal monthly wages (including bonuses) slowed sharply as the recession persisted through 1993, but has since rebounded slightly. Monthly wage increases were persistently less than the amounts negotiated each spring (“shunto”), however, because of declining total hours worked and reduced bonus payments. Real wage growth has returned to levels seen in the late 1980s, after declining slightly in 1993. The 1995 “shunto” of 2.7 percent is an historic low, although flat or even declining consumer prices combined with increased overtime hours should result in real wage growth of about 3 percent. 2/ While wages in manufacturing grew at a somewhat faster pace, so too did output and productivity. As a result, unit labor costs declined in 1994, and the pace of decline accelerated in the first quarter of 1995.

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III. Fiscal policy

This chapter discusses recent fiscal policy initiatives. Section 1 briefly reviews fiscal developments and budgetary performance since 1992. Section 2 highlights the policy initiatives announced last year--including the tax reform and pension reform plans, and the new 10-year public investment plan--and examines the medium-term implication of these initiatives. 2/ 3/

1. Fiscal developments since 1992

a. Four fiscal stimulus packages introduced in FY 1992-93

Following a long period of consolidation beginning in the late 1970s that virtually eliminated the general government deficit (excluding social security) by FY 1990 (April-March), the fiscal position of the general government began to deteriorate with the onset of the economic slowdown in FY 1991 (Chart 6). As the recession deepened, the focus of fiscal policy shifted from consolidation to providing countercyclical support to domestic demand. To this end, four major fiscal stimulus packages were adopted between August 1992 and February 1994.


(In percent of GDP)

Sources: Ministry of Finance; Economic Planning Agency; and staff estimates and projections.1/ The fiscal year Is from April to March.2/ Based on implementation of the 1994 pension reform and tax reform plans, and the ¥630 trillion public investment plan for 1995-2004.

In total, the four packages amounted to over ¥45 trillion, equivalent to 9 1/2 percent of GDP (Table 3). The core of the packages were substantial increases in public investment (Chart 7). Direct spending on public investment was boosted by about ¥20 trillion (4 percent of GDP) over the baseline, and, as a result, real public investment rose by over 40 percent from 1991 to 1994. Other key components of the packages included: increased lending authority for the Housing Loan Corporation and other government-affiliated financial institutions; accelerated purchases of land for future public works sites; subsidies and tax incentives to promote housing acquisition and business equipment purchases; and measures to stabilize employment. In addition to these expenditure measures, the fourth package (announced in February 1994) included a major cut in income taxes. The tax cut amounted to ¥5.9 trillion (1 1/4 percent of GDP)--virtually all of the cut (¥5.5 trillion) was due to a 20 percent across-the-board reduction in national and local personal income taxes that was adopted as a temporary measure for FY 1994. 1/

Table 3.

Japan: Summary of Economic Stimulus Packages, 1992-94

(In trillions of yen, unless otherwise indicated)

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Sources: Data provided by the Japanese authorities; and staff estimates.

Includes disaster relief, unidentified land component of public investment, and FILP lending to public corporations for public works.

Including ¥0.5 trillion of land purchases to be conducted over a five-year period.


(Billions of Yen)

Sources: Ministry of Finance; Economic Planning Agency; and staff estimates and protections.

b. FY 1994 budgetary operations

Notwithstanding the substantial effects of these packages, the economy remained weak, thus fiscal policy in FY 1994 continued to provide support to demand. This support was both from the revenue and expenditure sides, but was particularly pronounced on the revenue side, as the tax cuts announced in February 1994 package were implemented by reductions in withholding tax in June and December 1994. 2/ On the expenditure side, although no further major fiscal stimulus packages were introduced in FY 1994, public investment grew considerably over the rapidly expanded level in FY 1993 on account of the carryover spending of previous packages, and two supplementary budgets. 1/

Revenue developments reflected the weak economy as well as the impact of tax cuts. At the general government level, total revenues are estimated to have declined by 3/4 percent of GDP compared with FY 1993 levels, falling from 33 1/2 to 32 3/4 percent of GDP. While social security revenues are estimated to have grown by 6 1/4 percent, due partly to the pension reform plan, taxes and fines are estimated to have declined by about 5 1/2 percent compared with FY 1993 levels. As a share of GDP, taxes and fines are estimated to have declined from 19 3/4 percent in FY 1993 to 18 1/2 percent, the lowest level since FY 1980. 2/ Automatic stabilizers were allowed to operate, as the revenue shortfall was not offset by expenditure cutbacks.

While the initial budgetary plans (for both the general account and the FILP) for FY 1994 held the line on expenditure growth, two supplementary budgets were adopted in early 1995. The first included agricultural support in the wake of the Uruguay Round agreement, including ¥600 billion of public works on agricultural projects. The second included a total of ¥1 trillion additional expenditures (including ¥700 billion of public works) for urgent reconstruction and relief measures from the earthquake that hit the Kobe region on January 14.

Taking into account the carryover from previous packages, the initial general account and FILP budgets, and the two supplementary budgets, expenditures at the general government level are estimated to have risen by slightly over 4 percent, compared with 7 1/2 and 5 3/4 percent in FY 1992 and FY 1993, respectively. The growth rate in capital spending (public investment and land acquisition) moderated to 4 3/4 percent after double-digit growth in FY 1992-93, while growth in current spending remained at around 4 percent. Reflecting slow growth in nominal GDP, expenditures rose substantially in relation to GDP, reaching almost 36 percent in FY 1994 compared with 34 1/2 percent in FY 1993.

These revenue and expenditure developments have increased the general government deficit (excluding social security) sharply to 6 1/2 percent of GDP from 4 1/2 percent of GDP in FY 1993 (Table 4). The structural balance of the general government (excluding social security) deteriorated by about 1 1/2 percent of GDP to 5 percent of GDP (Chart 6). 1/ The balance on social security was broadly unchanged from the previous year at 3 1/2 percent of GDP (Charts 8 and 9).

Table 4.

Japan: General Government Balances, FY 1987-95

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Sources: Economic Planning Agency, Annual Report on National Accounts, 1995; and staff estimates and projections.

The fiscal year begins on April 1.

In percent of potential GDP.


(Percent of GDP)

Sources: Economic Planning Agency, Annual Report on Notional Accounts; and staff estimates.1/ Figures for FY 1994 and FY 1995 ore staff estimates.

(Percent of GDP)

Sources: Economic Planning Agency, Annual Report on National Accounts; and staff estimates.1/ Figures for FY 1994 and FY 1995 are staff estimates.

c. FY 1995 budgetary operations

In setting fiscal policy for FY 1995, the authorities initially sought to balance the need to pursue sound fiscal management, primarily through expenditure control, against the cyclical requirement of promoting and sustaining economic recovery. 2/ To this end, the expenditure side of the initial budget for FY 1995 was slightly contractionary compared with the revised budget for FY 1994, while the revenue side was cyclically neutral, continuing essentially the same size of tax cuts as FY 1994. A supplementary budget was introduced and approved by the Diet in May 1995, however, to appropriate a total of ¥2.7 trillion additional expenditures for earthquake reconstruction and measures to counter the impact of the yen appreciation. With this supplementary budget, the budget implies a neutral stance--at a continuing high level of support--of fiscal policy in FY 1995.

At the general account level, the FY 1995 supplementary budget offsets the decline in the deficit that would otherwise have occurred (Table 5). The initial deficit was projected at 2 1/2 percent of GDP, implying an unchanged initial-over-initial stance from FY 1994. As the outturn for the deficit was wider in FY 1994 than initially expected on account of revenue shortfalls and supplementary expenditures, the FY 1995 initial deficit was smaller than the FY 1994 revised deficit. The FY 1995 supplementary budget, however, raises the deficit to 3 1/4 percent of GDP, unchanged from FY 1994 revised deficit.

Table 5.

Japan: Central Government General Account Budget, FY 1990-95 1/

(In billions of yen)

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Source: Data provided by the Japanese authorities.

This presentation differs from that of the authorities; certain revenue and expenditure items in the official presentation are reclassified as financing Items.

Includes administrative costs.

Comprises cash expenditures related to commitments entered into in previous years as well as noncash expenditures, including equity contributions to international organizations. The figures for FY 1993-95 Include central government debt cancellation of local governments’ outstanding liabilities under the no-interest lending program.

Bonds issued for noncash expenditures. The figures for FY 1993-95 include transfers to finance central government debt cancellation.

Figures for FY 1994 end FY 1995 ere based on staff projections of GDP.

Includes public works spending under the no-interest lending program.

Revenue estimates for FY 1995 reflect the impact of the tax reform package that replaced the FY 1994 temporary income tax cut with a combination of temporary and permanent cuts, and the impact of tax breaks due to the earthquake (Table 6). Tax and stamp duty revenues are budgeted to rise by 5 1/2 percent (or 1/4 percent of GDP), compared with the FY 1994 revised figure. Among major tax items, corporate tax revenue is projected to be very buoyant with growth of 12 1/4 percent, reflecting an expected rapid pick up in corporate profits from the subdued level in FY 1994, while individual income taxes and taxes on goods and services are budgeted to rise by 4 3/4 and 4 percent, respectively. This performance is predicated on the official economic outlook--envisaging real GDP growth of 2 3/4 percent in FY 1995--which appears overly optimistic in light of recent developments.

Table 6.

Japan: Tax Receipts of the Central Government General Account, FY 1990-FY 1995

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Source: Data provided by the Japanese authorities.

Percentage changes calculated relative to most recent data of previous year.

With the supplementary budget in May, total general account expenditures are now budgeted to rise by 4 1/4 percent (or 1/4 percent of GDP) over FY 1994. Public works expenditures grow moderately by 1 1/2 percent, implying an unchanged ratio to GDP, which represents a continued return toward the underlying trend level following the rapid expansion in FY 1992-93. 1/

The FILP budget for FY 1995 also provides for a return toward the underlying trend level (Table 7). The revised FILP budget declines by 6 1/2 percent (excluding portfolio investment) to ¥40.8 trillion, compared with the revised FILP of ¥43.7 trillion in FY 1994. Still, at 8 1/2 percent of GDP, it remains substantially above its level before the recession. 2/ In formulating the FY 1995 FILP, the selective allocation of funds was emphasized, with the goal of contributing to stable economic growth and increasing standards of living. Priority sectors are housing, small businesses, and local governments and municipal enterprises.

Table 7.

Japan: Fiscal Investment and Loan Program (FILP), FY 1990-95

(In billions of yen)

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Source: Ministry of Finance, zaisei Kinyu Tokei Geppo (Financial and Monetary Statistics Monthly).

Difference between “sources of funds” and “uses of funds” reflects short-term off-program investments of the Trust Fund Bureau.

Reflects the funding of the “lend-back” system under which the postal savings system, public pension funds, and the postal life insurance fund receive funds for portfolio management on their own account.

Excluding portfolio investment.

Compared with preliminary outturn of the previous year.

Compared with revised plan of the previous year.

As a percentage of projected GDP.

Local government expenditures are officially estimated to increase by 4.3 percent in FY 1995 under the Local Finance Plan. Increasing financial needs, owing in part to slow growth in transfers from the central government as well as the permanent reduction in the local income tax, will be met by increased local government borrowing through bonds and FILP intermediation.

At the general government level, the staff estimates that the deficit (excluding social security) will worsen to 7 percent of GDP in FY 1995, compared with 6 1/2 percent of GDP in FY 1994. Total revenues are estimated to grow by only 1 1/4 percent over FY 1994 (unchanged at 32 3/4 percent of GDP), assuming lower real growth (3/4 percent) in FY 1995 than the official economic outlook (2 3/4 percent growth). Reflecting expenditure plans under the general account and FILP budgets and the Local Finance Plan, total expenditures are estimated to grow by 3 percent in FY 1995, rising to 36 1/2 percent of GDP from 36 percent of GDP in FY 1994. The structural deficit of the general government (excluding social security) is expected to remain unchanged at 5 percent of GDP. The social security surplus is expected to narrow slightly to 3 1/4 percent of GDP, resulting in an overall general government deficit of 3 3/4 percent of GDP.

2. Medium-term implication of recent policy initiatives

a. Three initiatives

In FY 1994, three major policy initiatives with important medium-term implications were adopted: tax reform; a new 10-year public investment plan; and pension reform.

The tax reform package was adopted in September 1994. The package consists of: a permanent cut in personal income taxes of ¥3.5 trillion (0.7 percent of GDP) starting in FY 1995; a temporary income tax cut of ¥2.0 trillion (0.4 percent of GDP) for FY 1995 and FY 1996; and a rise in the consumption tax rate from 3 to 5 percent in FY 1997 (raising revenues of 0.8 percent of GDP). Taking into account the small permanent portion of the FY 1994 tax cut (¥0.4 trillion, or 0.1 percent of GDP), the overall package is revenue neutral from FY 1997 onward. 1/ The staggered implementation of the reform measures--i.e., the time lag between reductions and increases in taxes--is a device to meet the short-term need to support the hesitant recovery. To provide flexibility to respond to cyclical developments, some measures are subject to review depending on economic conditions: the extension of the temporary tax cut into FY 1996 will be reviewed in formulating the budget for FY 1996, while a final decision on the size of the consumption tax increase will be made in late 1996. 2/

A new 10-year public investment plan was announced in October 1994. The plan calls for ¥630 trillion in spending from FY 1995 to FY 2004, replacing the previous plan that envisaged ¥430 trillion for FY 1991 to FY 2000. 3/ The annual allocation of the spending will be decided in each year’s budget, including the shares undertaken by the central and local governments, and public enterprises. Assuming a smooth allocation of actual spending to each year, the new plan implies additional public investment equivalent to 3/4 percent of GDP per year over the previously projected medium-term path (Chart 7). With this plan, Japan’s public investment (excluding land purchases) would continue to exceed 8 percent of GDP in the medium term, compared with the average level for other G-7 countries of about 3 percent. 4/ The plan emphasizes projects related to living standards, social welfare and culture--including increasing the availability of sewage treatment, park space, education facilities and public housing. Nearly 65 percent of the total is allocated for such projects. No sources of funding were specified in conjunction with the plan.

A pension reform plan was approved by the Diet in November 1994. Major reform items include: increases in contribution rates in stages from 14 1/2 percent in 1994 to 29 1/2 percent in 2025; 1/ 2/ a phased increase in the pension eligibility age from 60 to 65 during FY 2001-2020; and a change in the indexation method of benefits from gross to net income--after payments of taxes and social security contributions. As a result of the full implementation of the reform plan, the public pension fund would be in balance in FY 2025 and thereafter, with the current size of nominal reserves--about ¥100 trillion--maintained. 3/ For the period through 2000, the reform is projected to improve the social security balance by about 1 percent of GDP per year relative to a “nonreform” baseline. 4/

b. Medium-term fiscal position

As a result of weak activity and counter-cyclical fiscal actions, including four packages and tax cuts, the general government deficit (excluding social security) is estimated to have deteriorated from 1/4 percent of GDP in FY 1991 to 7 percent of GDP in FY 1995 (Chart 6). The deterioration indicates that a large part of the consolidation effort of the 1980s has been reversed. 1/ The swing in the structural balance during FY 1991-1995 suggests that slightly over one half of the deterioration reflects the impact of discretionary actions, while the rest is due to cyclical factors that tend to reverse themselves as output returns to potential.

As discussed in earlier sections, the general government deficit (excluding social security) in FY 1995 of 7 percent includes the impacts of the cycle (2 percent of GDP) and some temporary factors: one-off spending measures associated with the carry-over from the past fiscal packages and earthquake reconstruction (3/4 percent of GDP); and the temporary component of the income tax cut (1/2 percent of GDP). Excluding these factors, the underlying structural deficit in FY 1995 is estimated to be 3 3/4 percent of GDP.

Starting with this fiscal position in FY 1995, and taking into account the medium-term effects of the policy initiatives described above, the staff projects an improvement in the fiscal position through FY 1997. As the economic recovery eventually picks up, the impact of the cycle is projected to narrow to 1 3/4 percent of GDP in FY 1997. Moreover, the temporary factors will be unwound, and the consumption tax increase (3/4 percent of GDP) will take effect in April 1997. The improvement in balance due to these developments will be partially offset by higher spending (particularly on capital expenditure, social welfare expenditure, and interest payments). 2/ Consequently, the general government deficit (excluding social security) is projected to narrow to 5 1/2 percent of GDP in FY 1997, with the structural deficit (excluding social security) of 3 3/4 percent of GDP.

After 1997, despite the elimination of the impact of the cyclical weakness on revenues, the general government deficit is projected to widen. This is because: population aging raises social welfare expenditure; public investment spending rises in line with the 10-year public investment plan; and debt-servicing payments grow. By FY 2000, the deficit (excluding social security) rises to 5 3/4 percent of GDP. Combined with the decline in the social security surplus due to population aging, the overall general government balance is projected to worsen by 1 1/4 percent of GDP during FY 1997-2000 to reach almost 4 percent of GDP (Table 8).

Table 8.

Japan: Medium-Term Fiscal Position

(In percent of GDP)

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Source: Data provided by the authorities; and staff estimates.

In percent of potential GDP.

Includes medical expenditure and central government contribution to pension funds.

c. Medium-term fiscal strategy

The fiscal consolidation has been guided by the announced medium-term objectives expressed in terms of the “bond-financing” ratio of the general account budget, defined as the ratio of bond financing to the total size of the general account budget. Specifically, the bond-financing ratio is the ratio of new bond issues to the sum of revenues and new bond issues--or, the proportion of overall general account expenditure (including debt amortization) that is financed through new bond issues. 1/

The current target involves reducing this ratio to 5 percent or lower by FY 2000. 2/ As debt amortization is expected to remain at about 5 percent of the general account budget, attainment of this goal would imply that new bond issuance would be approximately equal to debt amortization; hence, the general account (excluding financing items) would be in balance, and the nominal stock of debt would stop rising. This, in turn, would imply that debt-to-GDP ratio would decline over time as nominal GDP grows. 3/

Regarding strategies to achieve this target, few quantified programs apart from pension reform have been presented. The authorities’ strategies seem to be similar to those that played important roles in the fiscal consolidation process of the 1980s: restraint of expenditure through tight ceilings on budget requests by government agencies, coupled with tax revenue growth. In late 1980s, tax revenue growth was extraordinarily buoyant, owing in part to higher direct tax receipts due to the economic boom as well as to the effect of the sharp increase in asset prices on taxes related to property and securities transactions. Tax revenue buoyancy, however, has declined sharply in recent years, and a similar surge in buoyancy is unlikely to occur again. 4/ Thus, the large discrepancy between the target and the projected path based on the currently announced policies, as shown in Annex III, underscore the needs for further policy initiatives toward fiscal consolidation.

IV. Monetary Developments

1. Monetary policy and interest rates

The Bank of Japan (BOJ) began to ease monetary policy in mid-1991 in response to weakening economic activity. The official discount rate (ODR) was lowered gradually by a total of 4 1/4 percentage points to a record low rate of 1 3/4 percent in September 1993 (Chart 10). Short-term rates fell sharply from 8 percent in early 1991 to slightly below 2 percent at end-1993. Over the same period, the 10-year government bond rate declined steadily, from 6 1/2 percent to 3 percent.



Source: Bank of Japan, Economic Statistics Monthly; and staff calculations.1/ End-period.

The BOJ’s accommodative stance was maintained through the first half of 1994, with the result that the overnight call money rate fell by 1/4 percentage point to slightly over 2 percent by May 1994. Short-term market rates rose slightly in the first quarter, however, reflecting signs of economic recovery. By the fall of 1994, amid expanding signs of a pickup in activity, the BOJ allowed market conditions to tighten modestly, as the interest rate on overnight call money rose by 1/4 percentage point, leading to similar increases in other short-term market interest rates. Long-term rates rose steadily through the first half of 1994, to reach an average of 4 3/4 percentage points (an increase of 1 3/4 percentage points), reflecting improving economic prospects, reinforced by increases in overseas bond yields. These developments implied a steepening in the yield curve, as the differential between the 10-year government bond rate and 3-month CD rate widened to reach 2 1/2 percentage points, the largest spread since 1986. Nominal interest rates remained broadly stable in late 1994 and early 1995.

Developments in financial markets since mid-February 1995--following a period a period of broad stability in both the effective value of the yen since mid-1993 and in equity prices in 1994--prompted a change in the course of policy. Between mid-February and end-March, the effective value of the yen rose by 8 percent, while equity prices, as measured by the Nikkei 225, dropped by 10 percent to around 16,000. In response to the emergence of the downside risks to the recovery posed by the sharp appreciation of the yen and the drop in equity prices, the BOJ announced an easing of policy on March 31, via a reduction of the overnight call rate by 1/2 percentage point, bringing it for the first time to the level of the ODR. The initial market reaction to the method and the extent of the easing was unfavorable, propelling the yen even higher and causing equity prices to drop. Reflecting the decline in the call rate, short-term interest rates fell by roughly 1/2 percentage point, while long-term bond yields declined by over 1 percentage point. On April 14, citing the possible negative impact of the yen’s rise and the weak state of the stock market on the economy, the BOJ announced a cut in the ODR of 3/4 percentage points. This step brought the ODR to 1 percent, a new historical low. The overnight call rate fell to 1/4 percentage point above the ODR, reestablishing the long-standing differential with the ODR, while both short- and long-term interest rates fell by about 1/4 percentage point on the news. Short- and long-term rates continued to decline through early June to reach around 1 percent and 2 3/4 percent respectively, reflecting expectation of further monetary easing.

In all, since the onset of the downturn in mid-1991, short-term market rates have dropped by 7 percentage points, while bond yields have fallen by 3 3/4 percentage points. In terms of the effect on aggregate demand, however, part of the impact on monetary conditions has been offset by three factors: declining inflation, widening bank intermediation spreads, and the appreciation of the real exchange rate. CPI inflation (excluding fresh food and energy) has declined from over 3 percent in early 1991 to -1/4 percent recently, while domestic wholesale price inflation--the relevant price index from the point of view of production decisions--has fallen from 1 1/2 percent to -3/4 percent over the same period (Chart 11). Thus, real interest rates have declined by considerably less than the decline in nominal interest rates would suggest.



Source: Bank of Japan, Economic Statistics Monthly; and staff estimates.1/ Excluding fresh food, energy, and the effect of the rise in consumption taxes in 1989.

A second factor offsetting the effective easing of monetary conditions has been that bank lending rates have not declined by as much as market interest rates. As shown in the second panel of Chart 11, bank intermediation spreads widened gradually from 1990 to reach 2 percent in early 1994, before declining to 1 1/2 percent recently; nonetheless, they remain substantially above historical levels. Reflecting these factors, the real cost of bank lending, and in particular, adjusted for wholesale price inflation has fallen only moderately since 1991. Last year’s consultation report examined the extent to which the widening of intermediation spreads could be attributed to normal lags in the adjustment of lending rates to market rates versus other factors. 1/ It was argued that banks had made “unusually” large profits in 1990 and 1991, possibly in efforts to raise their operating profits to offset losses on bad loans to compensate for the higher credit risk during the recession, and to meet Bank for International Settlements (BIS) capital-adequacy ratios. Empirical work shows that the effect of these factors has declined progressively. By early 1995, average lending rates could be explained almost entirely by “normal” cyclical factors (Chart 11, second panel). Another indicator of monetary conditions is the Tankan index of banks’ willingness to lend (Chart 12, second panel). The index suggests that businesses perceive that banks’ have become increasingly willing to lend since the onset of the recession.




Source: Nikkei Telecom; and staff estimates.1/ An increase indicates a tightening of monetary conditions.

Also, the stimulative effect of lower interest rates on domestic demand has been tempered by the contractionary impact of yen appreciation on external demand since mid-1992. The estimated impact on aggregate demand of these offsetting factors is captured in the staff’s monetary conditions index (MCI), which weights a 10 percent decline in the real effective exchange rate and a 1 percentage point drop in the real short-term interest rate roughly equally. Chart 12 shows that monetary conditions eased substantially between mid-1991 and mid-1992, reflecting the drop in real interest rates and a broadly stable real exchange rate. The MCI then rose sharply through mid-1993--due to a 25 percent appreciation of the real exchange rate--before declining through early 1994--in line with a reduction in short-term real interest rates. Since early 1994, however, monetary conditions have tightened further--reflecting rising short-term real interest rates in 1994 and the sharp appreciation of the yen by around 15 percent since early 1995. Thus, despite the substantial decline in nominal interest rates since the onset of the downturn in mid-1991, monetary conditions currently stand at their mid-1991 level.

2. Monetary and credit aggregates

There have been notable differences in the behavior of the monetary and credit aggregates since mid-1992. While M3 growth has remained broadly stable, the growth of Ml, M2+CDs and broadly defined liquidity has picked up steadily (see tabulation below and Chart 13). In contrast, bank lending and domestic credit have continued to stagnate since 1993, reflecting weak loan demand. This section discusses the reasons for the divergent behavior of the monetary aggregates, and also for the gap between the growth of money versus the credit aggregates.



Source: Bonk of Japan, Economic Statistics Monthly; and staff calculations.1/ End-period.2/ Monthly average.
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After bottoming out at about 3 percent in late 1992, the growth of M3 has remained in the range of 3 1/2 - 4 1/2 percent. 3/ In contrast, M2+CDs - - the aggregate most closely watched by the BOJ - -has risen by over 4 percentage points to reach 3 1/2 percent in early 1995. This divergence cannot be explained by a shift from the accounts of credit cooperatives, labor cooperatives or agricultural cooperatives to bank deposits, and only about 1/2 percentage point is accounted for by the much publicized shift from postal savings accounts to demand deposits. The remaining 2 1/2 percentage points divergence is attributable to a shift out of trust fund accounts into bank deposits, reflecting declining equity prices in the latter half of 1993 and since mid-1994. Ml growth has risen sharply since late 1992 to a range of 4 1/2 - 6 percent in 1994, reflecting falling interest rates.

On the asset side, both bank lending and domestic credit continued to stagnate through 1994, rising somewhat in early 1995. Banks have, in part, matched increases in deposit liabilities with decreases in short-term foreign liabilities. The remainder of the counterpart to the growth of M2+CDs in 1993 can be explained by increased holdings of government bonds by deposit money banks. In 1994, non-bank financial institutions also started to acquire bonds, while reducing their net lending to banks in the interbank markets. The counterpart to growth in M2 + CDs has thus been a decrease in banks net borrowing from nonbank institutions.

V. External Developments

1. Current account

Having declined steadily in the second half of the 1980s, Japan’s current account surplus rose sharply in 1991-92 both in U.S. dollar terms and as a proportion of GDP (Table 9 and Chart 14). In 1993, the surplus increased further in U.S. dollar terms, reaching a record high of $131 billion, though it declined moderately as a proportion of GDP. In 1994, the surplus declined moderately in terms of U.S. dollars. As a proportion of GDP, however, it declined more substantially, falling from 3.1 to 2.8 percent--well below the peak of 4 1/4 percent in 1986.

Table 9.

Japan: Currant Account Summary, 1986-95

(In billion, of U.S. dollars)

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Sources: Bank of Japan, Balance of Payments Monthly; and staff estimates.

Sum of the seasonally adjusted trade balance and the seasonally unadjusted invisibles balance.

Seasonally adjusted.

Seasonally unadjusted.

Official seasonally adjusted currant account.