Japan: Selected Issues

Abstract

Japan: Selected Issues

Economic Policy Uncertainty1

The Japanese economy is facing formidable challenges (high public debt, weak growth, and lingering risks of deflation). Without credible policy frameworks these challenges are contributing to higher policy uncertainty, holding back sentiment. This paper constructs a novel measure of economic policy uncertainty (EPU index) using the frequency of articles that appear in major domestic newspapers containing keywords related to “economy”, “uncertainty” and “policy.” The EPU index suggests that policy uncertainty has increased substantially over the past year, consistent with other measures of economic uncertainty. Furthermore, econometric results show an economically large and statistically significant effect of policy uncertainty on output, employment and investment. Strengthening policy frameworks and institutions, adopting concrete and credible policy actions can help reduce policy uncertainty and support domestic demand.

A. Background

Japan faces important policy challenges and choices. If not properly managed, high policy uncertainty can emerge. For instance, putting Japan’s high public debt on a sustainable path will involve critical policy decisions about the composition and timing of fiscal adjustment. With monetary policy stuck in a liquidity trap for most of the previous two decades, and in the context of BoJ’s unprecedented monetary easing program, the future course of monetary policy and its implications for the economy are also likely to affect the degree of policy uncertainty. Finally, structural policies spanning labor markets, deregulation, and trade integration are all critical to raise Japan’s declining growth potential, and based on surveys of Japanese firms pose an important source of uncertainty as well.2 There is therefore a growing concern that policy uncertainty is contributing to weak domestic demand, by delaying firm investment and hiring and creating incentives for outsourcing if there are fixed costs or if investments are partially irreversible. If agents are risk averse, higher uncertainty can also lead to precautionary savings, depressing demand. Economic activity could also be affected if financial conditions tighten in response to policy uncertainty.

This paper uses a novel approach to measure economic policy uncertainty in Japan by using the frequency of articles published on economic policy uncertainty in major domestic newspapers and studies its impact on output, employment, and investment. This paper relates to a growing literature studying how policy uncertainty affects the real economy (Bloom et. al. (2007), Bloom (2009), Baker et. al. (2016), Fernandez-Villaverde et. al. (2015), Gulen and Ion (2016)) and there are several studies which have found important effects of policy and broader uncertainty on economic activity in Japan (Morikawa (2010), Ono and Sullivan (2013), Matsuura (2013), Ito (2016) and Kitao (2016)).

B. Measuring Economic Policy Uncertainty

Following Baker et. al. (2016), we use search algorithms to count the number of newspaper articles that include certain keywords such as ‘uncertain’ or ‘uncertainty,’ ‘economic’ or ‘economy,’ and one or more policy relevant terms such as ‘tax,’ ‘regulation,’ ‘spending,’ ‘deficit,’ ‘budget,’ or ‘central bank’ published in four major domestic newspapers: Yomiuri, Asahi, Mainichi and Nikkei.3 Article counts at the monthly frequency are scaled by the total number of articles published after applying appropriate seasonal adjustments and are then normalized. The list of keywords used to perform the search is reported in Table 1.

Table 1.

Economic Policy Uncertainty Keywords

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The economic policy uncertainty index (EPU index, Figure 1) peaks around political events and elections as well as during economic recessions and big events (e.g. the collapse of Lehman Brothers). The EPU index is showing a trend increase after the global financial crisis and then a gradual decline coinciding with the launch of Abenomics. Since 2015, policy uncertainty has increased, amid concerns over spillovers from China, the introduction of the negative interest rate policy (NIRP), Brexit risks, and the decision to delay the consumption tax hike. The EPU index is correlated with other measures of uncertainty including implied or actual stock market volatility and measures based on the dispersion of household expectations of growth prospects. The EPU index is also related to measures of political uncertainty, for example the index constructed in Ito (2016) which uses data on approval ratings by political parties in opinion polls that are conducted monthly by the Japanese news media (Table 2).

Figure 1.
Figure 1.

Economic Policy Uncertainty Index

(1987-2015=100)

Citation: IMF Staff Country Reports 2016, 268; 10.5089/9781475522525.002.A009

Sources: Authors’ calculations.
Table 2.

Correlation of Japan EPU Index with Other Measures of Economic Uncertainty

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Based on the dispersion of responses on the growth potential of the economy from the BoJ's survey of households.

This is the original Japan EPU index constructed using a different set of keywords and a smaller set of newspapers

C. Economic Impact of Policy Uncertainty

We consider the impact of economic policy uncertainty using (i) a VAR model to study its dynamic impact on output, employment, consumption and investment; and (ii) a standard investment equation.

VAR Analysis: We estimate a VAR using quarterly data for 1988Q1–2015Q4 with the following variables: EPU index, log of Nikkei index, nominal interest rate (2 year JGB yields), log of employment, log of GDP and its components (i.e. consumption and investment). We control for the level of economic activity in Japan’s trading partners in all specifications and allow for a linear trend. We use the standard Cholesky decomposition to identify shocks. We explore the robustness of our results to the inclusion of other variables such as the VIX index and equity price volatility to explore additional effects of economic policy uncertainty after controlling for general economic uncertainty.4 Our baseline results (Figure 2) suggest an economically and statistically significant negative impact of policy uncertainty on output, employment and investment.5 A one-standard deviation shock to policy uncertainty reduces output by about 0.33 percent, employment by 0.15 percent and investment by 1 percent over one year. Controlling for other measures of economic uncertainty, the effects are reduced by about one-half for output and employment, and by 15-35 percent for investment.

Figure 2.
Figure 2.

VAR Results: Impulse Responses to EPU Shock

Citation: IMF Staff Country Reports 2016, 268; 10.5089/9781475522525.002.A009

Investment equation: We supplement the VAR analysis by estimating a standard investment equation, augmented with our economic policy uncertainty index:

ItKt1=β0+β1Q+β2X++β3EPU+εt

Where ItKt1 is the ratio of investment to last period’s capital stock, Q is the ratio of the market value of equities to the net worth of nonfinancial corporates, X denotes other control variables such as the real effective exchange rate (REER), real interest rate (average long-term bank lending rate minus investment deflator) and economic outlook (proxied by the leading index). The sample period includes the post-bubble period from 1994Q1–2015Q4. Table 3 shows the estimates under different specifications, using the coefficients for different variables multiplied by their standard deviation to better assess their relative economic significance. All the variables have the expected signs and both Tobin’s Q and the EPU index have relatively large and statistically significant effects on investment. As expected, when other measures of economic uncertainty or other control variables are included (specifications 3-6), the coefficient estimate for the EPU index declines but remains significant.

Table 3.

Aggregate Investment Equation Estimates

Independent variable: real investment to capital stock ratio (in percent)

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*, **, *** indicate statistically significant coefficients with 10%, 5%, and 1% confidence levels, respectively.

D. Conclusions and Policy Implications

Policy uncertainty seems to have increased recently and preliminary estimates suggest that it could have a large dampening effect on demand, especially investment. Strengthening policy frameworks and institutions and adopting concrete and credible policy actions can help reduce policy uncertainty and support domestic demand.

References

  • Baker, S. R., N. Bloom, and S. J. Davis, 2016. “Measuring Economic Policy Uncertainty,forthcoming in the Quarterly Journal of Economics.

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  • Bloom, N., S. Bond, and J. van Reenen, 2007. “Uncertainty and Investment Dynamics,Review of Economic Studies, 74, 391415.

  • Bloom, N., 2009. “The Impact of Uncertainty Shocks,Econometrica, 77 No. 3 (May), 62385.

  • Fernandez-Villaverde, J., P. Guerron-Quintana, K. Kuester, and J. Rubio-Ramirez, 2015. “Fiscal volatility shocks and economic activity,American Economic Review, 105, No. 11 (November).

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  • Gulen, H. and M. Ion, 2016. “Policy uncertainty and corporate investment,Review of Financial Studies, 29, No. 3 (March), 52364.

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  • Ito, A., 2016. “Government Policy Uncertainty and Economic Activities”, RIETI Discussion Paper Series, 16-J-016.

  • Kitao, S., 2016. “Policy Uncertainty and the Cost of Delaying Reform: A case of aging Japan”, RIETI Discussion Paper Series, 16-E-013.

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  • Matsuura, T., 2013. “Why Did Manufacturing Firms Increase the Number of Non-Regular Workers in the 2000s? Does International Trade Matter?RIETI Discussion Paper, 13-E-036.

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  • Morikawa, M., 2010. “Volatility, Nonstandard Employment, and Productivity: An Empirical Analysis Using Firm-Level Data,RIETI Discussion Paper, 10-E-025.

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  • Morikawa, M., 2013. “What Type of Policy Uncertainty Matters for Business?RIETI Discussion Paper Series 13-E-076.

  • Morikawa, M., 2016. "How Uncertain Are Economic Policies? Evidence from a survey on Japanese firms." RIETI Policy Discussion Paper Series 16-P-008.

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  • Ono, Y. and D. Sullivan, 2013. “Manufacturing Plants' Use of Temporary Workers: An Analysis Using Census Microdata,Industrial Relations, Vol. 52, No. 2, pp. 41943.

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1

This note features preliminary results of a joint project between the Economic Policy Uncertainty project (Steven J. Davis), IMF (Elif Arbatli, Naoko Miake, Ikuo Saito, all APD) and REITI Policy Uncertainty Project (Arata Ito). The final results of the project will be featured in a forthcoming IMF Working Paper.

2

See Morikawa (2013, 2016).

3

Our index tries to improve upon the existing Japan EPU index in Baker et al. (2016) by increasing its coverage from two to four newspapers, adjusting the keywords for economic policy uncertainty through detailed audits and constructing three sub-indices that capture uncertainty related to fiscal, monetary and structural policies.

4

Other measures of economic uncertainty would include uncertainty related to policies. The fact that the EPU index continues to have a negative effect on economic activity when other measures of economic uncertainty are included suggests that the EPU index captures additional sources of policy uncertainty.

5

We did not find a significant effect of EPU index on consumption. This could reflect a slower response of consumption to policy uncertainty. The composition of consumption could matter: Ito (2016) finds a significant response of consumption of durable goods to shocks to policy uncertainty. It could also be the case that consumption responds more strongly to sub-components of policy uncertainty, for instance fiscal policy uncertainty.

Japan: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept