Japan at the Brink

Toyoo GYOHTEN (President, Institute for International Monetary Affairs)

(This article was presented in the panel session "Japan at the Brink" at the Goldman Sachs 2003 CIO Conference in Rome on March 20, 2003)

The Japanese economy as a whole is still in the process of a slow recovery. Last year GDP grew at about 1.0%. Growth this year is expected to be more or less the same. On the positive side, corporate profits recovered due mainly to restructuring and investment is picking up. Exports are still strong. However, on the negative side, consumption and employment are weak. Industrial production is declining. The GDP deflator is continuing to fall by 2% per annum. The NPL held by banks are still large. The property market continues to be weak. Equity markets are suffering heavy losses just like any other markets in the world. The fiscal situation has not started to improve.

Two years ago the Japanese situation as such contrasted quite bleakly with other industrialized economies, particularly the buoyant US economy. As a result of the global worsening of economic prospects, Japan's misery today is not as stark as it used to be.

However, this should not provide any consolation at all, because the Japanese economy is faced with some serious problems, not all of which are shared by other industrial economies. These include deflation, the balance sheet problem of financial institutions, and government debt. They are like time bombs implanted in the economy. None of them will explode tomorrow, but unless we remove the detonating cap properly and quickly, the risk of explosion will get dangerously high.

The Japanese economy is in deflation. Industrial prices have been falling for 15 years and consumer prices for four years, though at a moderate pace. The aggregate fall of CPI is 3%. The cause of such prolonged deflation is not easily singled out. I would argue that the excess of supply and the shortage of demand are both contributing to deflation. The focal point in the heated debate in Japan now on how best to stem deflation is which problem should be considered the most urgent. Some argue that deflation is a monetary phenomenon, therefore liquidity should be injected abundantly and persistently so that the deflationary expectation can be replaced by inflationary expectation. Then people will shift from holding money to holding assets. Such monetarists urge the Bank of Japan to adopt an inflation-targeting policy to show its commitment to stop deflation. They recommend the BOJ to purchase unlimited amounts of JGB, equities and real estate. They even suggest taxing currencies and deposits. It should be noted that those who advocate such strong anti-deflationary policy are convinced that unless deflation is stopped, the Japanese economy is doomed to collapse for sure. Therefore, every conceivable policy, no matter how unconventional it may be, should be employed.

Those who oppose the monetarists argue that the anti-deflationary policies proposed by the monetarists are undoable, ineffective and harmful. According to them, the reason people don't consume and companies don't invest is not because they are short of money but because they are not confident about the future of the economy, which is still troubled by so many structural impediments on the supply side. Indiscreet injection of liquidity will undermine the credibility of the Central Bank, encourage moral hazard and end up in uncontrollable inflation.

Prime Minister Koizumi has steadfastly argued there will be no economic recovery unless we carry out needed structural reforms. As economic stagnation continues, however, he has been obliged to admit that deflation must be arrested. He urged the new Governor of the BOJ to be committed to more anti-deflationary policy. It is yet to be seen to what extent the BOJ will change its policy. My hunch is that the BOJ will introduce certain inflationary policies such as the increased purchase of JGB or some form of the purchase of equities or assets. However, the BOJ would not go to the extent of committing to a certain level of inflation in a certain fixed time-frame. In any event, it is most likely that deflation will continue for another two or three years until the ongoing restructuring of the supply side starts to improve the profitability of banks and business corporations.

Solution of the NPL problem of banks is indeed making considerable progress, albeit slowly. Banks are running short of reserves to write off NPLs drastically. Yet banks are strongly opposing the further injection of public funds because they are scared of nationalization. They are trying hard to strengthen their capital base by issuing new stocks. They can certainly buy time, but it still depends on how quickly they can enhance their earning capacity. I think the coming twelve months will be critical for them to prove their ability.

The heavy burden of government debt is another structural problem. The outstanding amount of JGB is now equal to the total GDP and is still growing. Any major decline of its price, i.e. a sharp rise of the long-term rate, will deal a severe blow to institutional investors and business corporations. It is a real time-bomb. It is absolutely necessary for the government to implement a credible long-term program to contain the increase of government debt and eventually restore the primary balance in its budget. It is indeed true that the holding structure of JGB is quite unique. All JGB is denominated in the yen. 38% is held by the government and other public agencies, 16% by the BOJ, and 30% by private financial institutions. Only 3.7% is held by overseas investors and 2.6% by households. Until now, there has been a strong propensity among domestic investors to prefer JGB to other types of instruments, and as a result the price went up and the long-term rate declined. There is a certain similarity between Japanese government debt and American external debt. Both are viewed as intractable and unsustainable, and there have always been dooms-sayers. However, there was neither the collapse of the dollar nor the collapse of JGB because international investors somehow trusted the dollar and the Japanese investors somehow trusted JGB. After all, I believe that a credible medium-term prospect of a gradual adjustment is the key for a soft-landing in both cases.

The exchange rate is another issue which is considered to have a significant implication for the future of the Japanese economy. Recently in Japan there has been a growing voice asking for a weakening of the yen vis-à-vis the dollar and the Chinese Renminbi. It is argued that, based on purchasing power parity, the yen is overvalued and needs to be devalued by at least 20%. The weaker yen is also considered favourable to stimulate the domestic economy and to alleviate deflation. However, the exchange rate is a matter of two currencies. Therefore one has to assess the likely development of each currency and then the combined momentum of two developments. If the Iraqi situation is stabilized quickly and the US economy resumes a higher growth while the Japanese economy continues the muddling-through process, then the yen may weaken vis-à-vis the dollar in the near term. In the long-term, however, in view of the need of a gradual adjustment of the external imbalance of the US, the dollar will be subject to downward pressure.

As to the Renminbi, when one considers the domestic price level and the external balance, it is obvious that the Renminbi is considerably undervalued. The damaging effect of the situation is felt strongly by other Asian countries, Japan and other trading partners. In that sense, the undervalued Renminbi is becoming a global issue. However China, for domestic reasons, will surely try to maintain its current peg to the dollar as long as possible. For geopolitical reasons the US will be reluctant, at least for the time-being, to apply pressure on China to revalue. My guess is that China will grudgingly introduce some wider flexibility of the Renminbi around the current central rate, but will maintain the central rate at 8.3 Renminbi hopefully for another few years. It is inevitable, however, that international pressure will mount.

All in all, the Japanese economy will continue the muddling-through process for another two to three years. It is true that progress is being made in such critical areas as the strengthening of financial systems, the restructuring of industries, deregulation and other structural reforms, but the speed of progress has been slow. I am one who hopes to see the momentum enhanced and the speed increased. I believe it is not impossible because the force of the market is working its way through in many instances, defying resistance by vested interest groups, and as a result a sense of urgency is mounting in the society as a whole.