Japan
Economic and Policy Developments

This paper reviews economic and policy developments in Japan during the 1990s. It suggests that, while growth is likely to be adversely affected in the near term owing to the fiscal consolidation measures adopted as part of the FY1997 budget, the prospects are favorable for continued economic recovery, supported by improved labor market developments and external demand. A declining working-age population, however, will constrain underlying growth over the longer term. The paper also suggests that a deeper and more accelerated fiscal adjustment would help ensure a declining debt ratio over the medium term.

Abstract

This paper reviews economic and policy developments in Japan during the 1990s. It suggests that, while growth is likely to be adversely affected in the near term owing to the fiscal consolidation measures adopted as part of the FY1997 budget, the prospects are favorable for continued economic recovery, supported by improved labor market developments and external demand. A declining working-age population, however, will constrain underlying growth over the longer term. The paper also suggests that a deeper and more accelerated fiscal adjustment would help ensure a declining debt ratio over the medium term.

I. Introduction

1. The economic slowdown that followed the bursting of the asset-price bubble in 1990 was unusually deep and prolonged and, even with the pickup of growth in 1996, output still remains well below potential. Nonetheless, developments during the past year have provided encouraging evidence that a solid foundation has been laid for sustained economic recovery. In particular, growth has accelerated sharply, reflecting the supportive stance of macroeconomic policies, considerable progress in addressing private sector balance sheet and capital stock imbalances, and the yen’s depreciation since mid-1995. The improved economic environment has provided the opportunity for important structural and fiscal policy initiatives that will help the economy adapt to the substantial demographic shifts that are expected to occur in Japan.

2. The recent progress on these fronts is described in the subsequent chapters. Chapter I discusses recent economic and monetary policy developments. It suggests that, while growth is likely to be adversely affected in the near term due to the fiscal consolidation measures adopted as part of the FY 1997 budget, the prospects are favorable for continued economic recovery, supported by improved labor market developments and external demand. A declining working-age population, however, will constrain underlying growth over the longer term. Concern regarding the fiscal implications of population aging has helped prompt a shift from fiscal stimulus toward a contractionary fiscal stance in FY 1997 and the adoption of a medium-term deficit reduction strategy. These developments are described in Chapter III, which also suggests that a deeper and more accelerated fiscal adjustment than is currently contemplated would help ensure a declining debt ratio over the medium term and could improve the credibility of the commitment to fiscal consolidation, thereby minimizing the adverse impact on aggregate demand.

3. The subsequent chapters focus mainly on structural issues. Balance sheet difficulties of the banking sector have weighed heavily on the economy in recent years. Chapter IV reviews the progress that has been made by the banks in reserving against losses, and describes the regulatory and supervisory initiatives in this area. It concludes that, while considerable progress has been made on average, a number of institutions face a large overhang of nonperforming assets, raising questions as to their viability as interest rates rise to more sustainable levels and financial markets are deregulated. Chapter V examines the recent progress toward structural reform and deregulation. It described a number of significant measures that have been adopted in recent years, but highlights estimates that suggest that there are substantial additional economic gains that could be reaped from further progress in this area. For example, Chapter VI details the government’s recent proposals to deregulate financial markets, which, when implemented, are expected to significantly improve the efficiency of the Japanese financial system.

4. On the external front, Chapter VII describes recent trade policy developments, noting that trade tensions between Japan and its trading partners appear to have lessened during the past year, possibly reflecting the increased use of the dispute settlement mechanisms of the World Trade Organization. Chapter VIII concludes with a discussion of Japan’s official development assistance (ODA) and notes that, while Japan remained the largest provider of ODA in 1996, fiscal constraints are likely to place significant constraints on ODA in coming years.

II. Economic Developments and Long-Run Prospects

A. Output and Price Developments

Output developments

5. The recovery strengthened markedly in 1996 following several years of anaemic growth (Table II.1 and Chart II.1).1 GDP growth rose to 3½ percent in 1996, compared with 1½ percent in 1995, supported by: (i) the stimulative effects of low interest rates and expansionary fiscal policies; (ii) a rise in confidence following the Kobe earthquake and terrorist attacks in 1995; and (iii) progress in completing capital stock and balance sheet adjustments, which had restrained growth in previous years. Growth in the latter half of the year was also bolstered by the lagged response of external demand to the yen’s depreciation since mid-1995.

Table II.1.

Japan: Growth of Real GDP and Demand Components, 1992-97 1/

(Percent change from the previous period)

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Sources: Nikkei Telecom; and WEFA.

At 1990 prices.

Final private domestic demand is the sum of private consumption, residential investment, and business fixed investment. Final domestic demand is final private domestic demand plus government consumption and investment.

Contribution to real GDP growth.

Government consumption and investment.

CHART II.1
CHART II.1

JAPAN COMPARISON OF FOUR CYCLES 1/

Index (trough of cycle=100)

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

Source: Nikkei Telecom.1/ Troughs defined as: 199304 for current cycle; 198702 for 1986–87 cycle; 198302 for 1982–83 cycle; 197501 for 1974–75 cycle.

6. Despite the pickup in activity, growth was uneven in 1996, partly due to special factors. In particular, the 2 percent surge in GDP in the first quarter, and the subsequent stagnation in activity during the second and third quarters, partly reflected the fact that the seasonally adjusted data did not fully take into account the effect of the leap year.2 Concern regarding E-coli contamination also slowed household consumption of foodstuffs. Growth rebounded by 1 percent in the fourth quarter, owing to the dissipation of these factors, as well as households’ efforts to avoid the April 1, 1997 increase in the consumption tax.

7. Growth promises to be similarly unsteady in 1997. GDP rose sharply in the first quarter, increasing by 1½ percent, mainly due to a further surge in consumption ahead of the consumption tax hike. Available data suggest that a substantial portion of this increase will be unwound in the second quarter. While this is expected to be offset in part by a pickup in external demand, overall activity would be expected to slow temporarily, until the effects of the consumption tax have waned.

8. Private consumption growth accelerated to 2¾ percent in 1996 (year-over-year basis), despite the dampening effect of concern regarding E-coli contamination of food products in the third quarter. Consumption surged by a further 4½ percent in the first quarter of 1997, reflecting demand for consumer durables (particularly automobiles) ahead of the April 1 increase in the consumption tax. Besides the temporary effect of the tax hike, more fundamental factors have contributed to the increase in consumption. Employment growth accelerated in 1996 and early 1997 (labor market developments are discussed in more detail below), which contributed to employees’ disposable income growth in excess of 2 percent (year-over-year basis) in real terms during the first four months of 1997. Also, some observers have suggested that household demand for durables was bolstered by the fact that many of the goods (particularly automobiles) purchased during the bubble period of the late 1980s have reached the end of their replacement cycle. Finally, low interest rates also are thought to have contributed to improved consumer demand. As a result, the staff estimates that, on a national accounts basis, the household saving rate has fallen substantially compared with 1995 (Table II.2).

Table II.2.

Japan: Saving and Investment Balances, 1991-96

(In percent of GDP)

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Source: Nikkei Telecom, WEFA, and staff estimates.

Staff estimate.

Residential investment.

Current account balance.

9. Looking ahead, a reversal of at least a part of the earlier increase in consumption would be expected in the second quarter, as confirmed by recent monthly data for retail sales and passenger car registrations. While concerns have been raised regarding the longer-term impact of the consumption and income tax hikes on disposable income and consumption, labor market developments appear broadly favorable for consumption growth in the year ahead.3 The spring 1997 shunto wage round provided for an increase in base wages of 2¾ percent (the same rate of increase as in 1996), and preliminary surveys suggest that summer bonuses could increase by 3¼ percent from last year. At the same time, employment prospects appear likely to improve further based on the June tankan survey of near-term employment expectations, as well as the results of a recent survey that indicated that corporate hiring will increase by 13 percent in FY 1998.

10. Residential investment strengthened considerably in 1996, rising by 13¾ percent (year-over-year basis), but fell by 4 percent in the first quarter. The pickup from the historically weak investment rate recorded in 1995 reflected the effects of low interest rates, which raised housing affordability indices to historical highs, and a slowdown of price declines in the real estate sector. The rise in residential investment also resulted from efforts to avoid the consumption tax, since the tax was not levied on houses for which purchase contracts were signed before October 1996, regardless of the completion date. Monthly data on housing starts point to a further decline in the second quarter and, since the housing stock as a share of potential GDP still appears modestly above its longer-run trend, residential investment demand may continue to be sluggish in the period ahead, despite low interest rates and increased demand for more modern housing.

11. Business investment rose by 6½ percent in 1996 (compared with an increase of 4 percent in 1995), and grew by a further ¾ percent in the first quarter of 1997. By contrast, inventory adjustments exerted a small negative contribution of 0.1 percentage point to growth in 1996. The pickup in fixed investment reflected a considerable improvement in business conditions: real interest rates are low, corporate profitability has risen sharply since 1994, and equity prices have been relatively stable during the past several years following the sharp correction that began in mid-1990 (Chart II.2). These factors have contributed to a steady improvement in business confidence, particularly within the manufacturing sector, which benefited from the depreciation of the yen from the historically high levels recorded in early 1995. In addition, the capital-to-output ratio has largely adjusted from the unusually high levels achieved in the late 1980s, at the end of the bubble period (Chart II.2). Deregulation in the telecommunications sector also helped support investment in 1996; restrictions on the personal ownership of cellular phones were removed, which spurred considerable infrastructure investment among providers of cellular telephone services.

CHART II.2
CHART II.2

JAPAN INDICATORS OF BUSINESS INVESTMENT, 1980–97

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

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

12. Prospects for continued strength in business investment appear favorable. Although capital and construction goods shipments have dipped in recent months, the level remains high and machinery orders appear to remain relatively strong. Vacancy rates are relatively low, suggesting scope for improvement in the construction sector. In addition, technological changes, in the face of the upward trend in capacity utilization ratio and the low capital-to-output ratio, should also support investment in equipment. However, a sustained improvement in business investment will depend importantly on the activities of smaller and nonmanufacturing enterprises, whose financial health has generally lagged behind those of other firms.

13. The growth of government consumption moderated to 2¼ percent in 1996 (year-over-year basis) from 3½ percent in 1995, and fell to less than ¼ percent in the first quarter of 1997. By contrast, public investment outlays jumped by 10 percent in 1996, versus ¼ percent growth in 1995, but fell by 12¾ percent in the first quarter of 1997. The volatility of public investment reflects the impact of the September 1995 stimulus package and outlays related to reconstruction efforts following the Kobe earthquake. While public investment fell from 9¾ percent of GDP in mid-1996 to 7½ percent of GDP in the first quarter of 1997, it remains about 1 percent of GDP above the average recorded during the late 1980s. The sharp first-quarter decline in public investment was larger than most analysts had anticipated, possibly reflecting difficulties in seasonally adjusting the data in the face of the large stimulus packages in previous years, as well as the relatively late approval of the supplementary budget for FY 1996. Nonetheless, recent government fiscal commitments suggest that public investment is likely to be constrained in the period ahead.

14. While net external demand subtracted nearly 1 percentage point from GDP growth in 1996, the annual figure masks a significant turnaround in the external position. The foreign balance fell in the first half of the year, continuing the downward trend begun in 1993, but the balance rose in the latter half of 1996 and early 1997 (Table II.1). The turnaround resulted from a sharp deceleration in the growth of imports since late 1995 and rapid export growth from the second quarter of 1996, reflecting the lagged effects of the yen’s depreciation since mid-1995. While net external demand slowed somewhat in the first quarter of 1997, more recent monthly data suggest that this was due to an import surge ahead of the consumption tax hike, as well as a desire by firms to shift sales into the following fiscal year. Thus, even assuming that structural factors (including an increased preference for imports and effects of shifts in Japanese production abroad) continue to weigh on the foreign balance, net external demand appears likely to provide a significant boost to activity in 1997.

Price developments

15. Deflationary forces moderated in 1996. The CPI inflation rate remained near zero, while the GDP and consumption deflators from the national accounts rose by ¼ percent, after declining in 1995 (see tabulation below). However, this partly reflected the yen’s depreciation since mid-1995—the domestic component of the WPI index continued to fall in 1996. Price indices jumped sharply in April, by roughly 1½ percent, reflecting the effect of the 2 percentage points increase in the consumption tax. This was roughly consistent with the experience in 1989, following the introduction of the 3 percent consumption tax, when the CPI inflation rate rose by roughly 2 percentage points.4

B. Labor Market Developments

16. The current recovery has been marked by unusually slow employment growth, which has been ascribed to uncertainties about the recovery and the need for industrial restructuring in the face of the sharp appreciation of the yen that occurred during 1993 to mid-1995. As a result, firms have been reluctant to take on full-time employees, especially given the Japanese lifetime employment system and the difficulties that were faced in adjusting the size of labor forces during the recent downturn.5 As a result, firms have tended to respond to improved demand conditions in 1995–97 by adjusting overtime hours, part-time employment, and bonus payments rather than taking on full-time employees and raising base wages.

Price Inflation

(Percent change of period average from previous year)

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Core inflation excludes fresh food, fuel, water, and light.

17. As a result, employment remains well below the levels recorded in previous cyclical upturns, despite employment growth of 1.6 percent in the first quarter of 1997 from the previous year (Chart II.3). The unemployment rate also remains unusually high for this point in the cycle, and reached 3½ percent in May, the historical high set in June 1996, albeit mainly owing to a rise in the participation rate. The chart also illustrates the fact that regular employment—which excludes part-time, temporary, or daily employment—has been especially weak (particularly in the manufacturing sector) and remains just below the cyclical peak reached in the fourth quarter of 1993.

CHART II.3
CHART II.3

JAPAN COMPARISON OF FOUR CYCLES 1/

Index (trough of cycle=100)

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

Source: Nikkei Telecom.1/ Troughs defined as: 1993Q4 for current downturn; 1987Q2 for 1986–87 downturn; 1983Q2 for 1982–83 downturn; 197501 for 1974–75 downturn.2/ Regular employment excludes part time, daily, or temporary employment.

18. Weak employment growth has been centered in the manufacturing sector, related in part to the pressures caused by the yen’s sharp appreciation to mid-1995 (Chart II.4 and Figure II.1). More recently, however, employment growth in this sector has rebounded, reflecting the effect of the yen’s depreciation since mid-1995 on competitiveness. By contrast, service sector employment, and employment in the wholesale and retail sectors, which have been relatively insulated from exchange rate developments, remained comparatively steady in recent years. Employment declines in recent years have also been concentrated within larger enterprises—defined as enterprises with 500 or more employees—plausibly owing to the fact that these firms appeared to lag behind the rest of the economy in restructuring their work forces in 1991 and 1992.

CHART II.4
CHART II.4

JAPAN EMPLOYMENT INDICATORS

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

Source: Nikkei Telecom and WEFA.1/ 500 or more employees.2/ Scheduled hours and wages refer to activities of regular employees during regular hours.3/ Year-over-year growth of 12-month moving overage.
FIGURE II.1.
FIGURE II.1.

CONTRIBUTIONS TO NON-AGRICULTURAL EMPLOYMENT GROWTH, 1994-97

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

19. Uncertainties about the durability of the recovery and the high cost of full-time employees, given the lifetime employment system in Japan, have encouraged firms to respond to the recent pickup in demand by increasing average hours worked and taking on part-time employees. Overtime hours have increased sharply since late 1994, particularly in the manufacturing sector, which has more than offset the effect of recent legislation to reduce the length of the work week (Chart II.4).6 Reflecting the effects of industrial restructuring, labor productivity growth in the manufacturing sector has grown at an average annual rate of 4¼ percent during 1994–96, and rose by 9 percent in the first quarter of 1997.7 After a two-year period of stagnation in 1992–93, economy-wide labor productivity growth accelerated to reach 3 percent in 1996, and rose by ½ percent in the first quarter of 1997.

20. Wage growth also appears to have been affected by efforts to avoid permanent increases in labor costs. For example, the four-quarter growth of average monthly cash earnings has risen sharply, reaching 3¼ percent in the first quarter of 1997. However, the growth of scheduled (i.e., base wage) cash earnings has declined steadily since 1990, and was only 1¼ percent in the first quarter of 1997. Thus, the pickup in wage growth has mainly reflected overtime pay and semiannual bonuses, rather than contractual increases in base pay.

C. Financial Market Developments and Bank of Japan Independence

Recent developments

21. The Bank of Japan (BOJ) began to ease monetary conditions in mid-1991 as activity weakened, and by end 1994 the official discount rate (ODR) had been lowered in seven steps from 6 percent to 2 percent (Chart II.5). In the face of continued evidence of a sluggish recovery, as well as the sharp appreciation of the yen, the BOJ lowered the ODR by a further 1 percentage point in April 1995. In July 1995, following the cut in U.S. short-term interest rates and coordinated intervention to resist the appreciation of the yen, the BOJ announced a further easing of monetary conditions consistent with a decline in the overnight call rate of about ½ percentage point to just below the ODR. Signs of continued sluggishness in economic activity prompted a further ½ percentage point cut in the ODR and the overnight rate in September 1995, where they have remained since.

CHART II.5
CHART II.5

JAPAN SELECTED INTEREST RATES, 1988–97

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

Source: Nikkei Telecom and WEFA.1/ End–period.

22. While short-term interest rates have been held steady since September 1995, long-term bond yields have been volatile, mainly reflecting changes in market perceptions regarding the strength of the recovery and the prospects for short-term interest rate hikes. Yields rose during the first half of 1996 owing to the strong GDP growth in the first quarter and expectations of a possible tightening by the BOJ. At the same time the Nikkei 225 stock price index rose sharply from the recent low set in June 1995 to reach a five-year high in June 1996. However, incoming data suggested that growth had slowed considerably in the second and third quarters, and bond yields began to fall in mid-1996. With growing fears that fiscal consolidation could impede the recovery, and that financial sector deregulation would erode bank profitability, bond yields fell further in late 1996 and early 1997, setting new historical lows. At the same time, the Nikkei also weakened, and by May had fallen by nearly 25 percent from its 1996 high. In May, however, confidence in the economy’s ability to weather fiscal consolidation apparently strengthened, long-term yields rose sharply, and the Nikkei recovered roughly half its earlier losses.

23. Overall monetary conditions—as measured by the staff’s monetary conditions index (MCI)—tightened considerably from late 1992 to mid-1995, despite the decline in short-term interest rates (Chart II.6).8 The increase in the MCI was principally due to the sharp appreciation of the yen during this period, but also reflected the fact that falling inflation muted the decline in real interest rates. The rise in the staff’s financial conditions index—which also takes into account the effect of fiscal policy and stock market developments—was somewhat less pronounced, reflecting the impact of the stimulative fiscal policies that were introduced during this period. Since mid-1995, however, monetary and financial conditions have eased considerably, again principally due to the depreciation of the yen, but also reflecting the continuation of fiscal stimulus in 1996. During 1997, conditions are expected to tighten somewhat, owing to the fiscal consolidation that was adopted as part of the FY 1997 budget, but to remain relatively stimulative.9

CHART II.6
CHART II.6

JAPAN INDICATORS OF MONETARY AND FINANCIAL CONDITIONS, 1980–97 1/

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

Sources: Nikkei Telecom; and staff estimates1/ An increase indicates a tightening in monetary and financial conditions. The MCI is a weighted average of changes in the real interest rate and the real exchange rate. The FCI also includes the change in the fiscal stance and the stock price index; this index is presented on an annual basis because quarterly fiscal data are not available.

Monetary aggregates

24. During 1990–92, the growth of the broader measures of money and liquidity slowed sharply, reflecting the slowdown in overall activity (Chart II.7). However, with the pickup in activity and the decline in interest rates, growth of M2+CDs, the aggregate most closely watched by the BOJ, rose steadily from minus ½ percent (12-month rate) in 1992 to 3¼ percent in 1995, and has remained in the 3 percent range since that time. By contrast, M1 growth accelerated much more sharply during the recovery, rising to over 16 percent in mid-1996, mainly reflecting a substitution into transactions deposits owing to the low interest rate environment. Ml growth slowed in the latter half of 1996 and into 1997, but still remained high at 9 percent in May 1997.

CHART II.7
CHART II.7

JAPAN MONEY, CREDIT AND POSTAL SAVINGS, 1985–97

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

Sources: Nikkei Telecom, WEFA, and staff calculations.1/ End–period.2/ Period overage.

25. Deposits with the Postal Saving system (PSS) have increased sharply as a share of M2+CDs since 1991, reaching 22 percent in early 1997 (Chart II.7). The increase likely reflects the importance that depositors attached to the government guarantee of PSS deposits, given the failures in the rest of the banking sector. PSS deposits also have the advantage of carrying an interest rate that is guaranteed for 10 years, while also allowing penalty-free withdrawals after six months, which was an especially attractive feature during a declining interest rate environment.10

26. The growth of domestic credit and bank lending has been extremely weak during the recovery (Chart II.7). Bank lending growth averaged only ½ percent during 1993–96 and was zero during the 12 months to May 1997. While credit to the household sector has been robust, reflecting strength in the housing sector, loans to the business sector have been weak. This partly reflects the improved profit performance of larger corporations and low interest rates, which has allowed these larger firms to finance investments using internally generated funds or new bond issues. However, another factor explaining slow loan growth has been the weak financial performance of small- and medium-sized firms, which tend to rely more heavily on bank loans.

Amendments to the Bank of Japan Law and BOJ independence

27. In June 1996, legislation was passed in the Diet to amend the Bank of Japan Law of 1942 (the amended law will come into effect on April 1, 1998), which aimed at improving the transparency and independence of the Bank of Japan, and set the BOJ’s mandate as the achievement of a “sound national economy through the maintenance of price stability.” Measures to increase independence include the elimination of the Ministry of Finance’s (MOF) ability to issue broad policy directives to the BOJ, and a reduction in the MOF’s supervisory responsibility over the central bank and its budget. The amendment also explicitly states that government officials would only participate as nonvoting members of the Policy Board during discussions of monetary policy issues (government officials currently participate in Policy Board discussions as nonvoting members), and the MOF would no longer have the authority to remove the Governor. Table II.3 summarizes the principal measures contained in the amendment.

Table II.3.

Amendments to the Bank of Japan Law

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Sources: Merrill Lynch, Japan Economic and Fixed Income Monthly, May 15, 1997; and news reports.

28. The legislation reduces significantly the explicit control of the MOF over the BOJ, and represents an important step toward increasing the independence and transparency of monetary policy in Japan. Nonetheless, the BOJ will be required to “maintain close communication with the government to ensure there is sufficient mutual understanding to secure consistency between the government’s economic policy and its monetary policy.” The new Law also explicitly allows the government to request a postponement of the Policy Board’s monetary policy decision until its next meeting. While the Policy Board would have the right to reject such a request, the frequency of such requests, the Board’s willingness to reject them, and whether such requests would be made public is unclear. Moreover, since the scope and timeliness of the published Board minutes have yet to be decided by the new Policy Board, the degree to which policy transparency will be enhanced also remains to be seen.

29. In addition, while the MOF will no longer have broad authority over the BOJ’s budget, it will retain oversight responsibility over most administrative expenses. While the legislation explicitly requires that budgetary disagreements between the MOF and the BOJ be made public by the MOF, there are concerns that the absence of complete budgetary autonomy could impinge on the independence of monetary policy.

30. Cross-country studies of the impact on inflation of central bank independence have tended to consider the BOJ as an outlier. As illustrated in the figure below, taken from the October 1996 World Economic Outlook, Japanese inflation has tended to be lower than in many other industrial countries whose central banks would be considered to be relatively independent.11 Walsh (1996) has suggested that the Japanese experience is less atypical than it first appears when consideration is given to the fact that the overall macroeconomic environment in Japan—including its low unemployment rate—tended to favor low inflation.12 He also suggests that the historical dominance of a single party in Japan, as well as the dominance of the BOJ by the MOF insulated monetary policy from pressures to inflate the economy.13 If these conclusions are correct, they would tend to suggest that Japan’s enviable inflation record in the past does not necessarily imply a lessened need for greater BOJ independence in the years ahead.

FIGURE II.2.
FIGURE II.2.

CENTRAL BANK INDEPENDENCE AND INFLATION

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

D. Balance of Payments and Exchange Rate Developments

Exchange rate developments

31. After a period of relative stability, the yen appreciated sharply in the period from end-1992 to mid-1995, rising by over 40 percent in nominal effective terms (Chart II.8). The yen’s movement during this period was most pronounced against the U.S. dollar, while the yen was roughly stable against the Deutsche mark. The strength of the yen has been ascribed to a number of factors including the cyclical asymmetry between the United States and Japan, which contributed to the sharp decline in Japanese/U.S. interest differentials, and shifts in portfolio preferences of Japanese investors in favor of Japanese assets. Also contributing to the yen’s appreciation was a growing perception among market participants that the United States was not averse to a lower dollar, given the large U.S. current account deficit vis-à-vis Japan.14

CHART II.8
CHART II.8

JAPAN EXCHANGE RATES AND INTEREST RATE DIFFERENTIALS, 1985–97

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

Sources: IMF, Information Notice System: and Nikkei’ Telecom.1/ Based on IMF MERM rate.2/ Japan: ten–year government bond rate; United States: ten–year government bond rate.3/ Japan: three–month CD rate; United States: three–month CD rate.4/ Japan: ten–year government bond rate; Germany: ten–year government bond rate.5/ Japan: three–month CD rate; Germany: three–month interbank rate.

32. The yen’s appreciation (and the dollar’s weakness) was halted in mid-1995 following concerted intervention by the industrial countries, as well as statements by G-7 officials calling for an orderly reversal of earlier exchange rate movements. The yen subsequently depreciated by about 20 percent between June and January 1996 in nominal effective terms, spurred by the reduction in the Japanese overnight rate in July, a cut in the official discount rate in September, as well as the August 1995 announcement of measures to liberalize capital outflows from Japan, which was followed by concerted intervention in support of the U.S. dollar.

33. The yen was roughly stable in effective terms during January-August 1996. However, during the latter half of 1996 and early 1997, the yen again depreciated markedly, and by April 1997 the yen had lost a further 10 percent of its value and stood at roughly the same level as at the beginning of 1993 in nominal effective terms. The yen’s weakness partly reflected cyclical disparities between the United States and Japan, which contributed to a marked widening of interest rate differentials in favor of U.S. dollar-denominated assets. More recently, the yen has rebounded strongly, gaining 5¼ percent between April and May 1997, partly owing to a delayed reaction to statements by G-7 Ministers in March that the process of reversing the previous depreciation of the dollar had been completed, and statements by U.S. officials expressing concern regarding the rise in the Japanese current account surplus.

Current account developments

34. The current account surplus reached a recent peak of ¥.4.7 trillion in 1993, but fell sharply thereafter to ¥7.2 trillion (1.4 percent of GDP) in 1996 (Table II.4 and Chart II.9). This decline was the result of a narrowing of the trade surplus, from ¥15.5 trillion in 1993 to ¥9.1 trillion in 1996, and a rise in the deficit on the services account from ¥4.8 trillion to ¥6.8 trillion during the same period. The drop in the trade surplus was partly offset in 1996 by a sharp increase in net investment receipts, which reflected increases in U.S. interest rates and a rise in Japan’s net foreign asset position, which reached ¥103 trillion (21 percent of GDP) at the end of 1996.

Table II.4.

Japan: Current Account Summary, 1992-97

(In billions of yen)

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Sources: Nikkei Telecom; WEFA; and staff estimates.

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

Seasonally adjusted.

Seasonally unadjusted.

CHART II.9
CHART II.9

JAPAN EXTERNAL BALANCE AND ITS DETERMINANTS, 1990–97

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

Sources: Nikkei Telecom, WEFA, and staff estimates.1/ Real net exports of goods and services on a national accounts basis.

35. The decline in the trade surplus partly reflected the effects of the yen’s rapid appreciation between 1992 and mid-1995, which slowed export growth relative to import growth, as well as J-curve effects following the yen’s correction after mid-1995 (Table II.5). Exports grew only modestly in 1992–96, as export unit values declined and volumes grew moderately.15 Export volumes were also adversely affected by a slowing of demand in partner countries. The decline in import unit values during this period more closely mirrored the yen’s appreciation, and import volumes rose considerably more rapidly than domestic demand.

Table II.5.

Japan: Merchandise Trade Prices and Volumes, 1988-97 1/

(Percentage change from previous period, yen basis)

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Sources: Staff estimates derived from Nikkei Telecom, WEFA, and WEO.

Annual price and volume figures are constructed as period averages of underlying monthly data.

Data for trading partners weighted using Japan’s export shares.

Japan’s export price based on customs-clearance unit value, world export price based on weights using Japan’s export shares.

Japan’s import price based on customs-clearance unit value.

FIGURE II.3.
FIGURE II.3.

TRADE DEVELOPMENTS, 1990-97

(Four-quarter percent changes)

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

36. The tabulation below illustrates the macroeconomic and other factors that have contributed to the decline in the current account surplus to 1996, utilizing simulations of the staff’s current account model.16 The exchange rate’s appreciation reduced the surplus in 1995 and 1996 by about 1 percent of GDP (the appreciation’s earlier impact had been to raise the surplus, owing to J-curve effects). The other macroeconomic factor that helped to lower the surplus was the (modest) pickup in domestic demand; domestic growth caused the surplus to fall by the equivalent of 1 percent of GDP in 1996. By contrast, however, growth abroad had a larger positive effect on the surplus, reflecting the relatively sluggish pace of activity in Japan.

Current Account Simulations

(In percent of actual GDP)

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The figures represent the difference between the actual surplus and the balance that would have occurred if the respective variable had been held constant at its 1992:Q4 level; the exception was foreign demand (i.e., world imports), which was assumed to grow at roughly half its actual rate. The effect of structural factors was calculated by assuming that the residuals of the behavioral equations were zero in 1993–96.

37. However, the sum of these effects is relatively small, particularly in 1996, suggesting that other, possibly structural, factors may have been at work to lower the surplus. Indeed, simulations of the model, assuming that the residuals were equal to zero over the 1993–96 period, but that the macroeconomic variables equaled their actual values, resulted in a predicted level of the surplus that was 1.1 percent of GDP higher than the actual level of the surplus in 1996. The impact of these structural factors on trade volumes is illustrated in Figure II.4, which compares the actual levels of trade volumes to the levels that would be predicted on the basis of the staff’s trade model. As can be seen, export volumes were substantially lower than would have been predicted on the basis of historical trends in 1995 and 1996. Conversely, manufactured import volumes were significantly higher than would have otherwise been expected.

FIGURE II.4.
FIGURE II.4.

MERCHANDISE TRADE VOLUMES

Index 1990=100, four-quarter moving avenges)

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

38. Factors that have been cited to explain these trends include: (i) the increased importance of capital goods in Japan’s exports and the slowdown in investment among Japan’s major trading partners; (ii) the weakness of the global market for integrated circuits that began in late 1995, which adversely affected exports; (iii) the impact of the need to keep pace with technological innovations and a surge in imports related to information technology; and (iv) the slowdown of automobile exports to the United States. In the latter case, overseas production of Japanese automobiles has risen significantly in recent years, suggesting a possible substitution from Japanese production. Indeed, auto exports from Japan to the United States and the European Union have been on a declining trend in recent years, which has moderated Japan’s surplus with these regions (Table II.6).17

Table II.6.

Japan: Regional Trade Flows, 1991-97

(In billions of yen, customs-clearance basis)

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Source: Nikkei Telecom and WEFA.

39. There is also evidence that the shift in Japanese productive capacity overseas has led to so-called “reverse imports,” or the import of products made by Japanese companies that had previously been manufactured domestically.18 In particular, the rapid increase in the share of Japanese production located overseas has increased, from around 6 percent in FY 1991 to around 9 percent in FY 1995, has been associated with a large increase in sales by Japanese manufacturing firms’ overseas affiliates to Japan. This phenomenon can be seen in the rapid increase in imports from Southeast Asia as well as other developing countries.

40. More recent data suggest that the decline in the current account surplus halted in mid-1996. Indeed, the balance rose somewhat to ¥8 trillion (annual basis) in the first quarter of 1997, despite the fact that imports surged ahead of the introduction of the consumption tax. Looking ahead, it seems likely that the surplus will rise in 1997, despite the cyclical recovery in Japan, owing to the lagged effect of the yen’s appreciation since mid-1995 and the rise in Japan’s net foreign asset position (and thus net investment receipts).

Recent capital account developments

41. Private capital outflows have declined steadily in recent years, to a large extent mirroring the drop in the current account surplus (Table II.7). The deficit on the financial account (which includes direct investment, portfolio investment, and other investment) fell from ¥12.8 trillion in 1992 to ¥3.0 trillion in 1996, mainly owing to a decline in the other investment category. Capital outflows related to the buildup of official assets also have been significant, owing to efforts to stem the yen’s appreciation, and total reserves (excluding gold) rose from US$72 billion at the end of 1991 to US$217 billion at the end of 1996.

Table II.7.

Japan: Capital and Financial Account Summary, 1992–97

(In billions of yen, not seasonally adjusted)

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Source: Nikkei Telecom and WEFA.

E. Long-Run Growth and Measures of Potential Output

42. The sharp decline in GDP growth in Japan after 1990 has raised concern that the economy has suffered a structural decline in productivity, rather than simply a cyclical slowdown. While this perception may have spurred progress on the deregulatory front, it has also contributed to a pessimistic outlook regarding Japan’s future prospects, which may be unwarranted. This issue is examined below, using a simple model of potential output.

43. An often used approach to measuring potential output assumes that output can be approximated as a Cobb-Douglas function of capital, labor, and total factor productivity (TFP), which in logarithmic form can be expressed as:19

y=αl+(1α)k+t(1)

where y is the log of GDP, l is the log of the labor input, k is the capital stock, and t is the log of total factor productivity (TFP). The variable α represents labor’s share of income. The measure of potential output is then defined by replacing the labor input and TFP by their trend values.

44. The labor input is defined as total persons employed, while trend employment is constructed first by applying a Hodrick-Prescott (HP) filter to the total labor force. A trend unemployment rate is constructed by applying the same HP filter to the unemployment rate (the trend unemployment rate is assumed to be 2.5 percent from end-1987). The trend level of employment is then calculated by applying the trend level of the unemployment rate to the labor force. The capital stock is constructed by cumulating national accounts data on business fixed investment and residential investment, assuming annual depreciation rates of 10 percent and 5 percent, respectively.20 As regards factor shares, the labor share is assumed to be 65 percent, the share of private fixed capital is set at 26 percent, and the share of residential capital is set at 9 percent, roughly consistent with historical averages.

45. Under these assumptions, an estimate of total factor productivity can be derived from equation (1) above, which is illustrated in Chart II.10. As can be seen actual TFP appears to follow a segmented log-linear trend, with a break in 1973:Q4. In particular, productivity growth is estimated to have been 3 percent up to this date and to have fallen to just under 1 percent thereafter.21

CHART II.10
CHART II.10

JAPAN TOTAL FACTOR PRODUCTIVITY, EMPLOYMENT, AND POTENTIAL GDP

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

Source: Staff estimates.

46. The choice of the breakpoint was somewhat arbitrary, but corresponded to the results reported by Soejima (1996), who identifies breaks in trend growth of Japanese GDP around this date.22 The existence of a break in productivity growth in the early 1970s is also a result that has been found for a number of other industrial countries, including the United States. A number of explanations have been proposed for the drop in productivity growth, including the effect of the first oil price shock, a change in the composition of the labor force, a decline in research and development spending or a drop in its productivity, or a shift in the composition of output toward services. In addition, Wolff (1996) presents evidence to suggest that the productivity slowdown also was related to an increase in the average vintage of the capital stock, as well as the effect of slower output growth on innovation.

47. These estimates do confirm a marked slowing of TFP growth during the 1990s. However, the decline is interpreted as cyclical, following the above trend growth in the late 1980s. Indeed, TFP growth has exceeded its estimated trend rate since early 1995, as it returns to a cyclically neutral level.

48. One drawback to the calculations described above is that they are based on the assumption that the relevant measure of the labor input is total employment, rather than total hours worked. This issue is especially relevant in the case of Japan, since average hours worked have exhibited a marked downward trend during the 1960s and early 1970s, and again during the late 1980s and early 1990s (Figure II.5). The decline initially reflected the move toward a five-day work week and, more recently, legislation requiring a 40-hour work week.

FIGURE II.5.
FIGURE II.5.

EMPLOYMENT HOURS AND ALTERNATE ESTIMATES OF TOTAL FACTOR PRODUCTIVITY

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

49. However, estimates based on an estimate of total hours worked did not materially change the conclusion that there was a structural break in productivity growth in the early 1970s.23 As in the earlier case, the hypothesis that TFP followed a segmented trend with a break in 1973Q4 could not be rejected. Moreover, and somewhat surprisingly, the hours- based estimates suggested almost the same decline in productivity growth—from 3½ percent to 1¼ percent. Finally, the trend value of the hours series was also included as a regressor in the equation, but was not significant, suggesting that the TFP series was not contaminated by the structural shift in hours.

50. These results should be interpreted with some degree of caution given the relatively strong assumptions used to derive the estimates. Nonetheless, they provide encouraging confirmation that the growth slowdown in recent years has not reflected a structural decline in productivity growth, but has mainly been a cyclical phenomenon. This, in turn, suggests the scope for the above trend in the period ahead, as the economy returns to potential and the output gap closes.

51. Nonetheless, growth prospects are tempered by demographic trends, which have already resulted in a decline in the working-age population since 1995. In the absence of a significant increase in the participation rate of the elderly, a falling workforce is expected to slow the rate of potential output growth over the medium term from 2¼ percent in 1996 to about 2 percent by 2002. Moreover, the hours-based estimates of TFP are closer to their trend level than the employment-based measure, since employment hours have been trending downward in recent years. This suggests the possibility that the degree of economic slack might be smaller than would be suggested by an employment-based measure of potential output.

III. Fiscal Developments

52. FY 1997 represents a pivotal year for Japanese fiscal policy, as the overall stance has shifted from one of expansion to consolidation. From FY 1992–96, fiscal policy was used to support the economy, and, as a result, the general government balance deteriorated from a surplus of 3½ percent of GDP in FY 1991 to a deficit of 4¼ percent of GDP by FY 1996, owing to cuts in taxes and increases in spending. This year, however, the deficit is projected to fall to about 2½ percent of GDP, reflecting a rise in the consumption tax, the ending of temporary income tax cuts, a drop in government investment spending, and reforms to the system for paying for medical treatment. Plans for further fiscal consolidation have also been announced, including medium-term deficit targets and proposals for additional cuts in spending in FY 1998.

A. Past Fiscal Trends

53. The Japanese fiscal deficit has exhibited large swings, deteriorating through the 1970s, improving through the 1980s, and then deteriorating again through the first half of the 1990s (Chart III.1). While some of these movements reflect cyclical factors, including the effects of the bubble economy during the late 1980s and the subsequent downturn, most of the changes in the deficit have been structural, reflecting active use of countercyclical fiscal policies.

CHART III.1
CHART III.1

JAPAN GENERAL GOVERNMENT BALANCE, FY 1973–97 1/

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

Sources: Ministry of Finance; Economic Planning Agency; and staff estimates and projections.1/ The fiscal year is from April to March.

54. In particular, the structural general government balance deteriorated by over 5 percent of GDP between FY 1991 and FY 1996—around two-thirds of the overall fall during this period—reflecting efforts to stimulate the economy. Most of this stimulus, particularly on the spending side, was included in a series of supplementary budgets, culminating in a ¥14 trillion package announced in September 1995 (Table III.1; the impact of past packages on public investment is shown in Chart III.2). 24 As a result of these spending initiatives, government outlays as a share of GDP rose sharply from 31 percent in FY 1991 to 36¼ percent in FY 1996 (the effects of population aging also contributed through an increased social security expenditure ratio). By contrast, tax cuts, which were only partially offset by increases in social security contribution rates, contributed to a drop in the revenue ratio from 34½ percent to 32 percent over the same period (Table III.2 and Chart III.3).25

CHART III.2
CHART III.2

JAPAN PUBLIC INVESTMENT PROFILE, 1990–97 1/

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

Source: Ministry of Finance; Economic Planning Agency; staff estimates and projections1/ The baseline shows the path from increasing investment by the 5x per annum. it implies investment spending 560 trillion yen between FY 1995 and FY2004, the period of the government’s medium-term investment plan
CHART III.3
CHART III.3

JAPAN GENERAL GOVERNMENT EXPENDITURES AND RECEIPTS FY 1984–FY 1997 1/

(Percent of GDP)

Citation: IMF Staff Country Reports 1997, 091; 10.5089/9781451820539.002.A001

Sources: Economic Planning Agency, Annual Report on National Accounts; and staff estimates.1/ Figures for FY 1996 and FY 1997 are staff estimates.
Table III.1.

Japan: Summary of Economic Stimulus Packages, 1992–95

(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.

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

Includes ¥0.5 trillion of land purchases by a government-affiliated urban development organization.

Table III.2.

Japan: General Government Balances, FY 1989–97 1/

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Sources: Economic Planning Agency, Annual Report on National Accounts, 1996; and staff estimates and projections.

The fiscal year begins on April 1.

In percent of potential GDP.