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Recent Economic and Financial Developments in Japan
Summary of a speech given by Toshikatsu Fukuma, Member of the Policy Board, at a meeting with business leaders in Ibaraki on November 24, 2006
December 27, 2006
Bank of Japan
Contents
Today, I will talk about recent and future developments in economic activity and the financial environment in Japan. The Bank of Japan made public its outlook for economic activity and prices through fiscal 2007 in the Outlook for Economic Activity and Prices, or the Outlook Report, released in October. Since then, some of our Policy Board members have had opportunities to explain our views. Therefore, today I would like to focus on issues that I think warrant attention.
I.Economic and Financial Developments
A.Developments Overseas
I would like to begin with economic developments overseas.
In the United States, deceleration in the pace of economic expansion is becoming clearer, but the economy is heading for a soft landing. The cooling of the housing market is continuing, but private consumption has remained fairly firm, supported by increases in employment and wages, the drop in gasoline prices, and also by wealth effects from the rise in stock prices. In the corporate sector, firms in a wide range of industries reported high earnings, including those in heavy manufacturing industries, which have performed strongly worldwide, and high-tech industries. Against this background, business fixed investment has also been firm.
Turning to other parts of the world, economies generally continue to expand. In the euro area, the momentum for economic recovery is becoming more evident, and emerging economies such as Brazil, Russia, India, and China -- the BRICs -- are growing at a fast pace. According to the economic outlook of the International Monetary Fund (IMF) released in September, the global economy is expected to grow by 5.1 percent in 2006. If we look at the forecast more closely and break down the growth forecast by country group, "other emerging markets and developing countries," including the BRICs, are expected to contribute 3.5 percentage points, exceeding the contribution of 1.6 percentage points by the 29 "advanced economies," which include the G-7 countries. As we can see, the emerging economies have increased their overall presence in the global economy, and helped by their high growth, the global economy is expected to continue expanding.
Meanwhile, stock prices in the world's major stock markets have been rising. For example, the Dow Jones Industrial Average has recently marked a record high owing to strong U.S. corporate profits and stock purchases related to mergers and acquisitions. Furthermore, stock prices in Mexico and Asian economies such as India and Indonesia have registered record highs, reflecting factors such as high economic growth and strong corporate profits in these economies. The rising trend in stock prices worldwide is also evident from the fact that the MSCI global equity index, which weights the stock indices of approximately 50 countries, recently registered a new high, exceeding the previous all-time high registered in 2000. High stock prices can have positive effects not only on firms but also on households by improving consumer sentiment through wealth effects, and therefore I will pay attention to future developments in stock prices.
B.Developments in Japan
Turning to Japan, the economy continues to experience a sustained period of moderate expansion with domestic and external demand increasing, generally in line with the projection of the October 2006 Outlook Report. However, since some indicators for domestic demand are somewhat sluggish, I think we should continue to watch economic activity closely. In what follows, I will look at economic developments in detail.
1.The corporate sector
a.Earnings from global operations
Both manufacturers and nonmanufacturers expect their profits for fiscal 2006, ending in March 2007, to increase for the fifth consecutive year. However, there are reports indicating that they expect a decline in earnings in the second half of the fiscal year. This seems to be basically because firms maintain a conservative approach in estimating profits and do not revise their earnings forecasts for the whole year even when their earnings for the first half of the fiscal year are better than expected. Nevertheless, we should carefully examine developments in corporate profits.
While the recent strength in corporate profits has been supported by the weak yen and the fall in crude oil prices, from a longer-term perspective, it owes to the strong performance of exports and the expansion of overseas operations.
Let me first look at exports. Exports have been strong against the background of the expansion of overseas economies and the enhanced international competitiveness of Japanese firms thanks to the depreciation of the yen. Given that craftsmanship is valued in Japan, the manufacturing sector accounts for more than 20 percent of GDP, which is higher than the equivalent share in the United States. Japan's manufacturing sector includes many highly competitive firms in heavy industry, and exports of their products are increasing. To Europe and the United States, exports of the following items are increasing: materials, machinery equipment, and construction machinery necessary for maintaining and repairing obsolete infrastructure; and industrial machinery for business fixed investment. Exports of materials, machinery equipment, and industrial machinery for building and expanding infrastructure are also increasing to emerging economies, which continue high growth as a result of industrialization. Furthermore, as the prices of energy and raw materials rise due to growing global demand, demand is strengthening worldwide for products that boast high fuel efficiency and environment-friendly technologies such as Japanese automobiles. Reflecting these developments, destinations for Japan's exports have diversified and the share of exports to the United States has decreased: in the period of January-September 2006, the U.S. accounted for 23 percent of Japan's exports on a value basis compared with around 30 percent in 2000. Against the background of these factors, Japan's exports seem to have become less susceptible to a deceleration in the pace of U.S. economic expansion than in the past.
Now, turning to Japanese firms' expansion of business abroad, their overseas sales as a proportion of total sales have recently been on an upward trend. The number of firms whose sales and profits overseas account for 60 to 70 percent or even more of their total sales and profits has also been increasing. Many Japanese firms generate profits from the global expansion of their operations through an approach where they rely on local workforces and production facilities but introduce Japanese management methods by shifting some of their managerial resources overseas. In expanding their business abroad, Japanese firms have enhanced the effectiveness of operations overseas by employing information technology (IT), which, among other things, has eased constraints traditionally associated with global operations, such as distance and time differences, thus leading to improved productivity.
For Japan's economy to remain on a sustainable growth path, it would be desirable for Japan to conclude more Economic Partnership Agreements (EPAs), Free Trade Agreements (FTAs), and international tax agreements to enable firms to further expand exports and overseas operations. In addition, innovation should be promoted through deregulation in the service sector in areas such as medical care, welfare, the environment, and education, where demand is expected to expand in the medium to long term, as well as in the agricultural sector.
b.Business fixed investment
Business fixed investment on the whole continues to be firm. Its driving force continues to be the manufacturing sector. Reasons for this include the dissipation of the perception among manufacturers of having excess production capacity; they proceeded with scrapping plants and other facilities in response to the introduction of accounting methods that recognize the impairment of fixed assets and in order to concentrate resources in key strategic areas. Since much of their remaining capital equipment is now obsolete, manufacturers are replacing, repairing, or upgrading it and, in some cases, are investing in new equipment to expand production capacity. In addition, manufactures' fixed investment is underpinned by their efforts to reinforce production capacity to meet strong global demand and by the shortening of investment cycles as a result of the increased share of IT-related capital goods in investment.
Against this background, business fixed investment has been increasing across a broader range of regions in Japan. There are reports indicating that strong demand for land in industrial complexes has caused a shortage of such land in some regions and development to expand industrial complexes is underway. Firmness in fixed investment has also been observed in small and medium-sized firms and firms in the nonmanufacturing sector. An example for the firmness in the latter is the redevelopment of outworn buildings in the Tokyo metropolitan area.
From a medium- to long-term perspective, to ensure continued economic growth in an era of population decline, it is important to increase productivity through business fixed investment. Therefore, potential demand such as for labor-saving, energy-saving, and green investment is expected to be strong. However, it is unlikely that business fixed investment will overheat, because stronger discipline imposed by capital markets is ensuring that firms make investment decisions only after having carefully examined whether an investment will help to increase corporate value. This is evident from the fact that business fixed investment remains subdued relative to the level of firms' cash flow. The index of production capacity also remains close to the bottom of its recent range, reflecting firms' cautious stance with regard to increasing production capacity.
2.The household sector
The strength in the corporate sector is gradually feeding through into the household sector, but so far the influence has not been as strong as expected. Let us take a closer look at developments in the employment and income situation. The number of employees has been increasing steadily and overtime payments and bonuses have been rising with the tightening of labor market conditions. On the other hand, regular payments have been sluggish, with the year-on-year rate of change that is close to zero, because employers continue to restrain labor costs due to intensified global competition. Consequently, the share of labor in income distribution has been near recent lows.
With regard to the effects of stockholdings on households, dividend payments have increased sharply in the past few years. However, while investors enjoyed a positive wealth effect from the surge in stock prices of emerging companies such as those traded on the Mothers section of the Tokyo Stock Exchange around the end of last year, the subsequent fall in stock prices in these markets may now be having a negative wealth effect on the household sector.
Indicators for private consumption have been somewhat sluggish, partly due to unfavorable weather conditions in the summer this year. However, given the recent tightening of labor market conditions, an increasing number of firms have decided to raise regular payments, initially for part-time and temporary workers only, but some have even decided to raise base wages of full-time employees. In addition, the recent decline in the prices of kerosene and gasoline will be a positive factor for private consumption.
Future developments in private consumption will depend on a range of factors including those I have just explained and I will therefore examine them with great care.
3.Price developments
Next, I will briefly touch on prices.
With regard to global price developments, upward pressures on unit labor costs and consequently consumer prices have been subdued in many economies, including Japan, due to intensified international competition among firms as a result of the entry of emerging economies, such as the BRICs, into the global market. In the United States, however, the disinflationary effects stemming from this phenomenon may have been weakening as evidenced by the fact that the rate of increase in unit labor costs has edged up, mainly due to the tightening of labor market conditions.
Turning to Japan, the environment surrounding prices has been gradually changing with the moderate economic expansion that has continued over a sustained period. The utilization of resources such as production capacity and labor has been rising, and firms are increasingly feeling a shortage of these resources. As for the output gap, excess supply has been dissipated and the positive output gap that we are seeing now is likely to continue. Against this background, wages have been rising moderately and, as a result, the downward pressure on prices from declining unit labor costs seems to be gradually weakening.
Looking at price indices, the domestic corporate goods price index (CGPI) has been increasing fairly strongly as a result of continuing high prices of internationally traded commodities such as nonferrous metals. The pace of increase in the CGPI, however, has been slowing somewhat recently due to the decline in crude oil prices. The year-on-year change in the consumer price index (CPI; excluding fresh food, on a nationwide basis) has been on a moderate positive trend.
4. Financial developments
The diffusion index (DI) for the financial position of firms in the Tankan(Short-Term Economic Survey of Enterprises in Japan) suggests that the financial environment is accommodative. The background to this is the following. First, even though firms' demand for funds to finance operations, business fixed investment, and mergers and acquisitions has gradually been rising, they continue to have high levels of cash flow due to strong corporate profits. Second, business-to-business credit has been recovering against the background of further improvements in the financial condition of firms. And third, financial institutions have become more willing to extend loans as constraints on capital have eased with the progress made in the disposal of nonperforming loans (NPLs) and the consequent rise in their credit ratings.
As for interest rates, credit spreads have barely widened as a result of fierce competition among financial institutions to extend loans, and therefore firms' funding costs remain low. Demand for credit, which temporarily surged around the time when the Bank decided to raise the policy interest rate in July, has been stable as long-term interest rates have in fact declined since the rate rise.
II.Conduct of Monetary Policy
My last topic today is the Bank's conduct of monetary policy.
A.Policy Change and Restoration of the Market Functioning
In July this year, the Bank raised its policy target rate -- the uncollateralized overnight call rate -- to 0.25 percent, bringing the zero interest rate environment to an end. Following five years during which transactions in the call money market earned hardly any interest, they now offer positive, albeit marginal, interest rates again and market participants are gradually investing their surplus funds in the market. Trading has become smooth as financial institutions established and raised credit lines. Arbitrage transactions across different markets have also increased, for example between the call money market and the Euroyen market or the foreign exchange swap market. These developments illustrate that the functioning of money markets is being restored as expected.
B.Importance of Sustainable Economic Growth under Price Stability
The current phase of economic expansion will have lasted for 58 months by the end of November, exceeding the Izanagi boom, the longest postwar economic expansion (57 months during 1965-70). Sustainable economic growth under price stability is a goal that not only the central bank strives for but that is also shared by firms and the government. Firms benefit from this goal through a more sustainable growth in earnings since it reduces the uncertainty associated with future business operations. Meanwhile, the government benefits because achieving the goal leads to a reduction in interest payments on government debt as the inflation risk premium is contained; in addition, the government can also expect a sustainable increase in tax revenues.
It has been pointed out that, in the current phase of economic expansion, the pace of growth differs by region. In the October 2006 issue of the Regional Economic Report, which the Bank compiles on a quarterly basis, our assessment was that although there were regional differences, the economy was improving in all nine regions of Japan. It is expected that as this sustained growth continues, the economic recovery will become more robust in a broader range of regions and regional differences in economic conditions will narrow.
The United Kingdom and the United States have achieved and enjoyed sustainable economic growth under price stability for the past 15 years. Japan should not be complacent with the current economic situation and should aim for a long-lasting economic expansion under price stability. Unlike the Izanagi boom, when demand both in the private and the public sector was strong, the current phase of expansion is driven solely by the private sector. Firms -- the primary driver of growth in private demand -- have not grown complacent about their current performance and are striving to expand their business both at home and abroad through innovation and by carrying out mergers and acquisitions. However, they are doing so with careful risk management measures in place based on lessons drawn from the bursting of the asset price bubble. Given that in the current phase of expansion, firms are subject to greater market discipline and public-sector demand cannot be expected to act as a driving force, the economy is unlikely to achieve growth rates as high as at the time of the Izanagi boom, but I believe a more self-sustaining and lasting economic expansion is possible.
However, in striving for sustainable growth, we must also be aware that although Japan's growth rate currently is only around 2 percent, not only prices of goods and services, but also those of assets may be affected if the economic expansion continues over a long period. The United Kingdom, Australia, and the United States, all of which have achieved sustained growth in recent years, have experienced sharp swings in asset prices, but have responded successfully based on lessons learned from their own painful experiences. Governor Kohn, the Vice Chairman of the Board of Governors of the Federal Reserve System, said that one of the important lessons drawn from financial crises -- such as Black Monday in 1987 and the failure of Long-Term Capital Management in 1998 -- is that "an ounce of prevention is worth many pounds of cure."
Japan also has a bitter history of asset price swings. For example, Japan underwent severe adjustments during the period following the Nixon Shock in 1971, when the United States abandoned the gold standard, and during the years after the 1985 Plaza Accord, and it took Japan more than a decade to overcome the consequences of these swings, i.e., to resolve the "three excesses" in the corporate sector, namely production capacity, employment, and debt, and to clean up firms' and financial institutions' balance sheets.
Recent developments in Japan's real estate market show that although some transactions are of a speculative nature, prices agreed in the market generally seem to be consistent with the expected return. Furthermore, the market is not entirely bullish judging from for example, the fact that some financial institutions have started selling non-recourse real estate loans early to lock in profits. These facts suggest that there is no imminent risk associated with asset prices, but they should continue to be watched carefully.
Recently, Japanese firms and financial institutions have exercised greater self-discipline in risk management in a new environment in which they are required to strengthen internal controls in response to the Japanese equivalent of the Sarbanes-Oxley Act and bring their accounting standards in line with international practice. Financial institutions, moreover, have been taking measures in preparation for the implementation of Basel II, which requires more advanced risk management than the present Basel Accord. In addition to firms' and financial institutions' own greater discipline, market discipline through information disclosure is playing its part, as we can see from sound trading in, for example, real estate investment trusts (REITs). I hope that firms and financial institutions will conduct appropriate risk management in their operations, making the most of the newly imposed discipline.
C. Assessment Based on the New Framework for the Conduct of Monetary Policy
The Bank introduced a new framework for the conduct of monetary policy with the aim of ensuring the transparency of its policy conduct when it terminated the quantitative easing policy and shifted the operating target of money market operations from the outstanding balance of current accounts at the Bank to the interest rate. Under this framework and based on the "understanding of medium- to long-term price stability," which is interpreted as a year-on-year rate of change in the CPI of approximately 0 to 2 percent, the Bank assesses economic activity and prices from two perspectives and on this basis outlines and makes public its view on the future course of monetary policy.
The Bank has outlined its assessment of economic activity and prices in the October Outlook Report. From the first perspective, which relates to the outlook that the Bank deems most likely for economic activity and prices through fiscal 2007, the assessment is that, as I discussed today, Japan's economy is likely to achieve sustainable growth under price stability.
From the second perspective, the Bank makes an assessment of the risks considered most relevant to conducting monetary policy, looking over a longer time horizon and taking account of the cost incurred should risks materialize, however improbable they might be. These include risks that economic activity and prices deviate either upward or downward from their expected trajectory. For instance, it should be noted that although there may be no imminent risk of asset inflation, once it materializes, there is a risk in the medium to long term of large economic swings. Meanwhile, it should also be noted that depending on future developments, the economic expansion and the rise in prices may stall.
D.Future Conduct of Monetary Policy
With regard to the future course of monetary policy, I have no predetermined conclusions. Rather, the conduct of policy will be data dependent, and I will carefully assess economic activity and prices from the two perspectives that I have mentioned, while communicating closely with market participants.