Economic growth in Japan in 2004 was the highest recorded since 1996. However, a closer look shows that most of that performance was thanks to exceptionally rapid growth in the first quarter of the year. Since then, quarter-on quarter GDP fell in the second, third and fourth quarters.
Still, there is ground for some optimism. The latest phase of expansion in Japan, while matching those of the 1990s with output growth at an annual rate of slightly more than 2% since 2002, was different in three respects. First, the public sector made a negative contribution, primarily as a result of deep cuts in public investment. Second, declining public demand was offset by private domestic demand, which has expanded at an annual pace of 2.5% since 2002. Third, in contrast to the experience in the 1990s, external demand has played a positive role, accounting for a third of the recent growth.
In fact, double-digit rises in exports since mid-2003 helped drive the recovery. China (including Hong Kong) is a key market, accounting for a third of the rise in Japanese exports during the course of the expansion, supported by strong demand from other Asian countries. The positive effect of rising exports on profits has been magnified by corporate restructuring that has reduced costs, particularly through cuts in employment and wages, and improved balance sheets.
Indeed, the liabilities of the non-financial corporate sector have fallen from a peak of 200% of GDP to around 170% at present, which is nearly the level of the bubble period. These factors have helped to boost profits by more than a quarter in 2002-2003, with further gains in 2004. Improved profitability and rising capacity utilisation have driven business investment at an annual rate of 6%. Capital spending has also been encouraged by profitable investment opportunities based on advances in information technology.
While employment continued to decline during the early part of the recovery, the positive developments in the corporate sector spilled over to the labour market during the first half of 2004. The unemployment rate has now fallen from a post-war high of 5.5% at the beginning of 2003 to under 5%, although declines in the working-age population and in the participation rate also contributed.
The improved labour market conditions slowed the fall in employee compensation and boosted consumer confidence by reducing concern about job security, contributing to a further decline in the already low household saving rate. These factors have sustained private consumption, which has also benefited from the easy stance of monetary policy, in particular, the prolonged period of zero interest rates. Private consumption has risen at an annual rate of 1.2% since 2002, accounting for about a third of the rise in aggregate demand.
Despite strong economic growth, deflation has persisted since the first half of 2003. Indeed, deflation has become quite entrenched, with a decline in the core consumer price index in 2004 for the sixth consecutive year.
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Prospects for growth
So why should the economy rebound in 2005? Reasons include the favourable monetary conditions, continued world trade growth, rising profits and improved balance sheets in the corporate sector, which will support fixed capital spending, as suggested by machinery orders. In fact, the slowdown since the first quarter of 2004 reflects higher oil prices and slower growth in overseas markets. But the most recent surveys at home confirm the broad improvement in business sentiment among firms of all sizes, and services as well as manufacturing.
The reduction in production capacity and the rising age of the capital stock should also help encourage firms to invest in new equipment and to introduce new technology. In addition, external demand should help sustain business investment. Growth in Japan’s export markets is projected to continue at double-digit rates in 2005 and 2006, despite some moderation in China.
Although business investment has fallen from 20% of GDP in 1990 to around 15% at present in nominal terms, its share of GDP remains one of the highest in the OECD area. This contributed to the upward trend in the capital-output ratio from 158% to 212% over the decade to 2000. Nevertheless, a number of factors suggest that business investment may continue to grow over the next few years.
For a start, the rise in the capital-output ratio was largely due to shrinking output. Firms had postponed new investments, allowing the average age of the capital stock to increase from less than 10 years in 1990 to 12 years at present and reducing production capacity by 10% from its peak. The ageing of the capital stock during a period of rapid technological advance provided profitable investment opportunities that firms, having reduced costs and improved their balance sheets, were in a position to pursue.
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There is scope for continued growth of business investment to help sustain the recovery in 2005 and 2006. There are concerns, as in other OECD countries, that outsourcing to lower-cost economies will reduce domestic investment. However, foreign direct investment outflows from Japan have fallen from an annual average of 5.6 trillion yen during the 1990s (1% of GDP) to 4 trillion since 2000. China accounted for a relatively small proportion, although its share rose to 8% in 2003. The net impact of increased integration with China on investment in Japan is probably positive. Indeed, the rebound in investment has been led by large manufacturers in response to a rapid increase in exports, with China playing the leading role.
Japan’s ability to get back on track and make the recovery sustainable will depend importantly on consumer spending. Income gains may be necessary, though, particularly in light of the recent declines in the household saving rate, which is now estimated to be less than half of its 1999 level and is below the OECD average. However, adjusted for deflation, wages have been increasing at a 3.2% annual rate since their trough in the autumn of 2003. Given the correlation between profit margins and real wages, further increases in corporate profitability should support wage growth. In sum, a rise in private consumption, accompanied by a smaller but still positive contribution from external demand, should sustain growth at around 1.5% in 2005 and 2006. So, where are the potential threats to growth? On the external side, a hard landing in China and a further increase in oil prices are perhaps the most prominent. While China has played a key role in Japan’s expansion, the direct impact is limited by the fact that exports to China amount to less than 3% of Japan’s GDP. Moreover, the moderation of shipments to China has been offset by higher sales to other countries, particularly in Asia, though their import growth may ultimately depend on China.
In sum, a sharper-than-expected slowdown in China would certainly affect, but not end, the current expansion.
As for oil prices, structural changes in Japan have made it much less sensitive to price shocks, both compared to past experience and to other major economies. A key domestic risk to the expansion is that the upward trend in wages (on a seasonally-adjusted basis) will falter.
Another risk is the possibility of a significant rise in interest rates, which could create problems in financing the government deficit and affect performance in the corporate sector. Despite the overall reduction in debt, Japan may be more vulnerable to higher interest rates in the short run than its major trading partners. Firms with debt-equity ratios that are more than one standard deviation higher than the mean account for 36% of stock market capitalisation and 31% of employment in Japan compared to 19% nd 16%, respectively, in the US.
Despite these risks, economic growth hould become firm for long enough to lift Japan out of deflation. Financial markets expect prices to begin rising in 2005, while a survey by the Bank of Japan indicates that 40% of consumers believe that inflation will be positive by mid- 2005, while only 6% expect prices to still be falling.
OECD (2005), Economic Survey of Japan, Paris.
©OECD Observer No 246/247, December 2004-January 2005