A quarterly magazine of the IMF

June 2006, Volume 43, Number 2

Japan's BACK!
Daniel Citrin and Alexander Wolfson

After its lost decade, Japan's economy is set on a recovery path

Japan is on the move again, and it seems for real this time. Over the past year or so, much has been written about the revival of the Japanese economy and its emergence from the ashes of the lost decade that began in the early 1990s. But for those who missed it, here is the news: the Japanese economy is heading for its longest expansion in the postwar period—one that has already lasted more than four years. In 2005, Japan grew by almost 3 percent and, over the course of the year, was the fastest-growing of the Group of Seven economies (on a fourth-quarter on fourth-quarter basis). And, although the recovery initially was driven mainly by exports, the latest phase has been led by buoyant domestic private spending, for both consumption and investment (see Chart 1).

What happened? To answer this question, consider what the Japanese economy was like 10 years ago. During Japan's deepest and longest postwar recession, private spending and economic activity were beset by structural problems in the banking and corporate sectors. In the aftermath of the bursting of the land and equity price bubbles in the early 1990s, persistently high nonperforming loans and a declining value of banks' equity portfolios constrained bank credit and sapped household and business confidence. And the corporate sector was burdened by the three excesses from the bubble period: debt, capacity, and labor. These imbalances combined to hold down both investment demand and household income (and thereby consumer spending). The depth of the problems and the gradual approach to dealing with them, along with certain unforeseen external shocks, led to the vicious circle of falling demand and falling prices that persisted for so long.

Ten years on

The Japanese economy of today stands in sharp contrast with that of 10 years ago, especially in the banking and corporate sectors.

Healthier banks. By end-September 2005, the ratio of nonperforming loans at major banks had fallen to below 2½ percent from a peak of 8½ percent in early 2002; the situation at regional banks improved as well, although more modestly. With banks having less need to make provisions against impaired assets and bad loans, their profitability also recovered, although it still remains low by international standards. On the whole, Japan's banks are now less vulnerable to shocks and better able to support economic activity. Whereas corporate restructuring and the economic recovery helped reduce the overhang of bad debts, heightened government efforts in supervision and other areas played a vital role in restoring the banking system to health.

Stronger companies. Firms have largely succeeded in tackling the excesses of the 1990s by trimming costs, reducing unused capacity, and using increased profits to reduce their indebtedness. The focus has been on the following issues:

• Improved profits. With persistent efforts to cut labor and other costs, the exit of inefficient producers and suppliers, and stronger demand, firms of all sizes have enjoyed a surge in profitability. Indeed, the ratio of current profits to sales stands at the peak levels of the late 1980s for both the manufacturing and nonmanufacturing sectors (see Chart 2).

• Improved balance sheets. Strenuous efforts to reduce debt burdens have paid off, particularly for medium and large firms. The nominal value of corporate debt has been slashed by ¥125 trillion since 1996, and debt-sales ratios are back down to historical pre-bubble averages in manufacturing, with steep declines in the rest of the economy as well (see Chart 3). As a result, firms' cash flows have been freed to upgrade physical and human capital and to reward both employees and shareholders with higher bonuses and dividend payouts.

• Elimination of capacity overhang. Along with repaying debt, corporate restructuring efforts since the mid-1990s have involved slashing new investments to deal with excess capacity. As a result, the fixed capital overhang was eliminated; by 2005, capacity utilization had returned to its 1980–89 average range (see Chart 4).

• Completion of adjustment in labor costs. Company efforts to shed surplus labor also appear to have borne fruit. After initially relying on more conventional strategies, such as cutting back on new hires and overtime work, firms have shifted to a more aggressive approach—laying off workers and beginning to replace full-time workers with part-time ones or workers on fixed-term contracts. But with sales declining in nominal terms in a deflationary environment, unit labor costs continued to rise through 1999. The labor cost burden declined thereafter, however, and by 2005 had returned to early 1990s levels. Although some further adjustment may be forthcoming, just as the success in reducing excess capacity has been supporting investment since 2003, the improved labor cost position has supported employment and wage growth since early 2005. Job-offer ratios are at an all-time high, and full-time jobs are now growing faster than part-time jobs.

These positive developments have become increasingly evident and are being recognized by both the Japanese public and international investors. Stock prices have more than doubled from their 2003 low, land prices have bottomed out and begun to rise, and consumer confidence is buoyant. And, although price deflation has proved stubbornly persistent, consumer price inflation finally turned slightly positive in late 2005. In a move symbolic of the strength of the recovery and the end of a long and painful period, the Bank of Japan in early March exited from its extraordinary policy of "quantitative easing," which featured a massive provision of liquidity to banks in the midst of Japan's financial system crisis and deflation problem.

The near-term economic outlook is indeed very favorable, with the IMF now forecasting real GDP growth of close to 3 percent in 2006 and above 2 percent in 2007. But does the brighter outlook reflect the fruits of reform or just the predictable rebound, after enough time, from a cyclical trough? Although it is difficult to give a definitive answer, it is striking that Japan's turnaround followed stepped-up regulatory pressure on banks to clean up their balance sheets. The improvement in financial sector health, in turn, helped support corporate sector revitalization (and vice versa). At the same time, a decline in the importance of cross-shareholdings between banks and insurance companies on the one hand and keiretsu companies on the other has promoted a more efficient resource allocation because managers are now better able to make decisions on the basis of price and quality. In general, Japan's improved economic performance has coincided with a gradual shift away from the insular business and government practices of the past. Still, lingering structural rigidities hold back growth. The process of removing labor and product market distortions, cutting overbearing regulation, and strengthening the antitrust framework is only now under way.

The next 10 years

What remains to be done? The agenda is long and includes steps to improve labor utilization, enhance competition in product markets, liberalize the agricultural sector, and encourage foreign direct investment. At the same time, the high public debt (a legacy of the post-bubble years) needs to be brought down. Although it is generally agreed that such reforms are needed—the most recent elections in September 2005 were seen as a public endorsement of further reform—implementing them may be tough, given staunch opposition from entrenched interests and the beneficiaries of the status quo.

With near-term economic prospects looking good, Japan's main challenge is to ensure strong self-sustaining growth in the face of mounting demographic pressures. Japan is aging rapidly, with a birth rate well below the population's replacement rate. The working-age population has been contracting since 2000, and the elderly dependency ratio (the share in the working-age population of people at least 65 years old) is the highest among industrial countries. Although it is true that a shrinking population requires a lower overall growth rate to maintain current living standards, strong per capita income growth is needed to meet the rising pension and health care costs associated with a graying society.

With a declining labor force, per capita growth will depend on higher productivity achieved by using resources more efficiently and by taking advantage of technological advances. A recent government-sponsored report, "Japan's 21st Century Vision," sets out the importance of raising productivity and reaping the benefits of globalization to avoid deteriorating living standards, for example by encouraging foreign direct investment, liberalizing agricultural trade, and easing labor supply constraints by relaxing both labor regulations and immigration policy.

Can the government and the private sector work together to transform the economy and create this "new Japan"? Early signs are encouraging. Japan's economy seems poised to enter a new phase, the hallmark of which will be a move to more normal financial conditions, a smaller government, and a more efficient private sector.

Normalized financial conditions. With deflation coming to an end, households and firms will need to deal with a return of real interest rates to more normal levels. Even as financial conditions normalize, monetary policy is expected to remain accommodative. In the first stage, the removal of surplus liquidity from the banking system will be implemented gradually over several months, during which the key interest rate will stay at zero. Beyond this period, interest rate rises are likely to be gradual, given the expected path of prices.

A smaller government. After years of large deficits, fiscal consolidation is under way to arrest the rise in public debt and create room for the spending needs associated with an aging population. With net debt of the public sector approaching 100 percent of GDP, the precarious fiscal position could act as a drag on recovery prospects. Progress is being made toward the official goal of achieving a primary surplus (excluding social security) by early in the 2010s, with the primary deficit falling to some 3 percent of GDP in FY2005 from 5½ percent in FY2003 (see Chart 5).

So far, the emphasis has been geared toward expenditure restraint, notably through cuts in wasteful infrastructure spending. But revenue measures will need to play an increasing role in coming years, including a likely increase in the consumption tax (which in Japan is at the lowest rate among all industrial countries with a similar tax). In addition, a mixture of benefit cuts and premium increases will be needed to address the sharp projected rise in social security and medical care expenditures (on current trends, and despite recent pension reforms, spending on social security will rise to 20 percent of GDP in FY2025 from 16 percent of GDP in FY2005, with medical care expenditures doubling).

The government is also expected to continue to reduce its role in the economy by scaling back the activities of its financial institutions. Loans at such institutions other than Japan Post have already dropped by 20 percent since 2000, and deposits at Japan Post—which largely fund suboptimal public investments—are also down 20 percent. The privatization of Japan Post, the world's largest deposit taker, will remove a source of unequal competition for the private banking system. Privatization will take a long time, but the benefits from a more efficient use of Japanese savings could be sizable.

A stronger banking sector. There has been significant consolidation among Japanese city banks, which now comprise three large banking groups that have earned sizable profits in recent years. Better profitability will allow banks to repay public capital injections and shore up their capital bases. In the near term, rising interest rates should bolster profits by raising net interest margins, but the key to sustaining financial sector strength and avoiding future problems will be to continue moving toward better loan pricing (based on forward-looking risk assessments of loans) and away from excessive collateral-based lending. This will be particularly important as the improvement in corporate health supports revived demand for bank lending. (Indeed, in February 2006, credit growth finally turned positive after eight years of uninterrupted decline.)

A more efficient corporate sector. To a large extent, Japan's economic prospects depend on whether companies are able to productively use their restored balance sheets and not repeat past errors (that is, by keeping debt ratios at healthy levels, responding to price signals, and focusing on profits). The corporate sector's focus is shifting from paying down debt toward expanding operations. Large Japanese manufacturers are well placed to face the challenges of globalization and have rationalized operations and intensified global integration, notably by establishing production facilities in China and Southeast Asia. The latest survey of overseas operations of Japanese manufacturers suggests that the ratio of overseas production to total output may reach 34 percent over the medium term from 28 percent in FY2004. In addition, firms have increased spending on research and development and have begun raising investment to replace an aging capital stock (see Chart 6). The adjustment in labor costs will help sustain firms' demand for full-time workers, which bodes well for income and consumption growth.

The quality of corporate governance will play a key role in ensuring that Japanese companies make the most of their strong current position. Already, there are signs that the environment for corporate governance is improving as the tight links with the banks (exemplified by large cross-shareholdings) continue to weaken and accountability to shareholders increases. Despite some recent high-profile scandals, the competition for corporate control seems to be intensifying: merger activity is at an all-time high, and cash-rich firms are under increased pressure to raise dividend payouts. New rules to ease corporate acquisitions and clarify takeover defenses could accelerate this process, although much will depend on implementation (the proposal to allow foreign firms to use their shares to acquire Japanese firms has already been delayed).

Turning point for Japan

Japan truly seems at a crossroads. With the improvements described above, and facing a generally supportive external environment, it should achieve much higher growth over the coming decade. Indeed, several academic observers and market analysts now believe that Japan's trend productivity growth has accelerated and that overall GDP growth could reach 2–2½ percent on a sustained basis even with a declining population. Achieving growth at such a pace would demonstrate the benefits of past reforms and could help create a virtuous circle to support the next set of structural reforms needed to safeguard the strong expansion.

Self-sustained growth in Japan would have significant global benefits. Growth in Japan, the world's second-largest economy, would have knock-on effects throughout Asia and the global economy and contribute to a more balanced pattern of global growth. This would also help to reduce global current account imbalances. The road has been long, but Japan is now well placed to contribute to a stable and vibrant world economy.