SEMINARS

Training and education in international affairs:
Japan, Palestine and the Middle East (1999)

 Economic Development in Japan in 1990s

A Brief Review of Developments in the 1990s

Growth with constant government support

Japan’s growth performance in the 1990s has been disappointing. After peaking in February 1991, following a 51-month expansion, the Japa­nese economy went through an unusually long recession that lasted 32 months and then a very modest expansion, which ended in March 1997. The 1991-1993 downturn was the second longest in the post-war period, the average length of re­cessions being about 15 months. Moreover, the subsequent 31-month upturn was clearly lacking in vigor. The output gap swung from an esti­mated negative 3.1 percent in 1991, (i.e., over-utiliza­tion of capacity), to a positive 0.7 per­cent in 1993 and then continued to widen to 2.4 percent in 1995. Until the latest downturn, how­ever, growth outcomes had been only slightly worse than those of the OECD as a whole had been and similar to those in Europe. Such inter­national comparisons show that it was only in housing investment and, to a lesser ex­tent, in exports that Japan’s pattern of spending growth was notably sub-par. The government made vig­orous efforts to reactivate the economy, imple­menting seven fiscal stimulus packages in the four years from 1992 to 1995. Moreover, the Bank of Japan cut the official discount rate to 0.5 percent in 1995 and has since kept it at this his­torically low level.

 

The government also undertook a major tax re­form in 1994 in order to make the tax system more suitable for a rapidly aging society. Its ma­jor thrust was to shift the tax base from income toward consumption: personal income taxes were reduced by changes in the tax schedule and an increase in standard personal and employ­ment income deductions, and the consumption tax rate was raised from three to five percent in 1997. Al­though the reform was intended to be revenue-neutral, it had some positive effects on the econ­omy from 1994 to 1997 because the income tax re­duction preceded the rise in the consumption tax rate.

As a result of these various moves, the general government structural deficit increased by about six percentage points of potential GDP from 1991 to 1996. Mundell Fleming effects (in which net exports are squeezed by an induced currency appreciation due to a high interest rate) may well have restrained the foreign balance contribution. In other words, it appears that private sector agents were unresponsive to the stimulus.

 

Lack of dynamism in business fixed investment

 

One of the reasons for the sluggish business in­vestment was the build up of a physical capital stock that was excessive in relation to require­ments and for the 1990s. This depressed the need for business fixed investment, and spending fell in the period 1992-1994. The amount of excess capacity reported by Tankan respondents peaked in 1994 and fell in 1995, when the capital stock adjustment was considered to be almost at an end, judging by average historical outcomes. In fact, the manufacturing industry increased in­vestment in 1995 and 1996, and this investment recovery provided a basis for judging that the economy was back on the path of self-sustaining expan­sion. However, the investment boom, largely con­fined to a few machinery sectors, which re­sponded to an increase in demand for informa­tion technol­ogy, was short-lived. At the same time, invest­ment spending by firms in the con­struction and real estate sectors continued to stagnate, reflecting their deteriorated balance sheets, especially among small and medium-sized enterprises (SMEs). These SMEs went for in­creased land-related in­vestment in the late 1980s, financed by loans from banks that were in search of new clients as major companies be­come pro­gressively less de­pendent on their loans. The delayed adjustment of dynamism in their invest­ment continued in the 1990s. On the other hand, it is increased reloca­tion of produc­tion to facto­ries overseas that accounted for an upsurge of investment by small manufacturing firms.

Sluggish household spending

The sluggishness of the household consumption growth in the 1990s reflected not only the weak state of the economy in general, but also adverse wealth effects and factors such as the effects of the changes in labor markets and the aging soci­ety.

Perhaps the most relevant aspect of the changes in labor markets in this regard is the significant rise in unemployment - which in­creased from 2.1 percent in 1990 to 3.4 percent in 1997 - which raised concerns about job secu­rity and reduced the propensity to consume. Breaking the unemploy­ment rate down into age groups reveals a re­markable increase in jobless­ness among young and elderly workers, the for­mer caused mainly by an increase in voluntary un­employment and the latter by corporate re­structuring. A study by the Economic Planning Agency (1997) shows that the propensity to con­sume is affected by the share of private sector employees who have experi­enced either an em­ployer-ordered job change, paid suspension of employment or encourage­ment to take voluntary retirement and accep­tance thereof, in addition to wealth and other variables. Concerns about post-retirement incomes might also have discouraged spending, as people were beginning to under­stand the future financial diffi­culties of the pen­sion system. According to a recent survey, more and more people, not only the elderly but younger people as well, now worry about their old-age in­comes. Therefore, house­holds might cut spend­ing to provide for their retirement re­gardless of their current age.

 

Similar factors also restrained residential invest­ment. Eroded confidence seems to have had a sig­nificant impact, since the capital cost of hous­ing investment fell as a result of lower land prices, construction costs and interest rates. In addition, the stock adjustment mechanism de­pressed rental housing construction in particu­lar, which continued to decline except for during a two-year period, when it was affected by tempo­rary factors. Because rental housing is a kind of ‘inferior good’ (relative to owner-occupied hous­ing) in Japan, most rental units are occupied by younger people. Expectations of a shrinking popu­lation of young people might have made the ad­justment more severe. Owner-occupied hous­ing construction might also have been affected by demographic factors: the population of house-buying age (taken here to be 34 to 43 years) fell by 19.1 percent between 1990 and 1996. The low number of new houses being built caused the secondhand housing market to be much thinner, with an increasing concentration of all transac­tions involving cheaper structures.

 

The magnitude of capital losses

 

The speculative build-up in asset prices that oc­curred toward the end of the 1980s was arguably

the greatest such ‘bubble’ in any OECD member country in the post-war era. As such, it is by no means surprising that reversing it has caused so much distress and dislocation to the economy. Overall, the nation has had to confront cumula­tive capital losses of around one quadrillion yen (about US$7 trillion), which represents some two full years’ worth of Japanese GDP and over 14 percent of the value of the nation’s total as­sets at the end of 1989. Around two thirds of the total loss was seen in the value of real estate, which had fallen by around 27 percent from the peak by March 1997. Most of the remainder occurred in equities markets, which plunged by just over half, while other assets, when com­bined, have risen in value. Little of the decline in asset values has been matched by corresponding falls in li­abilities, which have dropped by only a little more than 100 trillion yen. Thus, net worth has been reduced in a largely corresponding way. Most of the correction was experienced earlier in the dec­ade, thereby helping to bring about Japan’s ninth post-war recession (by its own reckoning) in 1991-1993. What is remark­able is that the eco­nomic recovery in 1994-1997 was not suffi­cient to stabilize asset prices and bring to a close the persistent asset price defla­tion.

 

Problems in the financial system

 

Financial institutions have traditionally held a combination of securities issued by their bor­rowing corporate customers. Substantial capital gains were earned on these holdings in the 1970s and 1980s, but the ‘hidden reserves’ that were established have since been largely wiped out through the following:

 

·        The steady erosion of market values;

·        Their rising book value resulting from the banks’ willingness to realize some of the capital gains in order to meet capital ade­quacy requirements; and

·        The unwinding of these often interlocking shareholdings and the diminishing role of the main bank in Japanese corporate governance more generally.

 

They have also suffered to the extent that the value of the collateral - mostly land - which they hold against their loan sales expectations formed in the bubble era has developed to generate a bad-loans problem. The uncertain size of this problem has been plaguing analysts and policy-makers alike for much of the decade.

The financial positions of banks in the 1990s have been adversely influenced by a number of factors other than the direct effects of domestic asset price deflation. First, the increasing level of com­peti­tion brought about by the slow but steady pro­cess of financial liberalization when combined with market shrinkage and minimal exit has brought about extremely narrow lending margins. Second, even if the unanticipated de­cline in un­der­lying in­flation has provided a capital gain to all net credi­tors, including banks, it has harmed banks’ cus­tomers, their real net worth in particu­lar. This, along with their capital losses on their asset hold­ings, has thereby wors­ened the prob­lems of ad­verse selection and moral hazard, which are innate in banking mar­kets. Further, these problems ema­nating from asymmetric in­for­mation have also been ampli­fied by the height­ened uncertainty resulting from the asset price deflation, the 1991-1993 and 1997-1998 reces­sions and the financial failures, which have mul­tiplied in the recent past. In Ja­pan’s case, the in­formational problems have not been overcome, as the regulatory authorities have, up until quite re­cently, generally main­tained an attitude of regu­latory forbearance (of­ten la­beled the ‘convoy’ system), whereby insol­vent in­sti­tu­tions have been kept afloat by a lack of dis­clo­sure or have been merged forcibly with a health­ier rival. In any case, banks had no in­cen­tive to de­velop any ex­pertise in the areas of risk analysis and manage­ment with the official strategy of complacency.

 

 

Reinvigorating Business Sector Dynamism

 

Not many years ago, Japanese corporations were frequently regarded as model performers. There are reasons to think that they lost some of their dynamism of earlier decades. The manufacturing sector has come to the end of the catch-up proc­ess and many of the non-manufacturing indus­tries, which have long operated in a regulated environment, have become inefficient. More gen­erally, weak business performance has led some to question the appropriateness of the Japanese corporate system in an environment that requires rapid decision-making and calcu­lated risk-taking to achieve high rates of return.

 

Waning business dynamism: indicators and possible reasons

 

There are indicators that the Japanese business sec­tor has lost some of its dynamism of earlier dec­ades. One of the most worrying trends has been a declining rate of new company formation combined with a rising rate of company closure

A rise in the rate of company closure as such should not be a matter for concern to the extent that closures represent an elimination of the inef­ficient. The birth rate had been over six percent until the end of the 1970s but fell to about four percent by the mid 1990s whereas the death rate rose from the three to four percent range to about five percent over the same period, thus surpass­ing the birth rate. These trends are more marked for the manufacturing sector where the birth rate came down to about three percent, compared with the situation in the service sector where the birth rate still remains at around five percent. This gap in rates between the two sectors is commonly ob­served among the advanced indus­trial countries and reflects a trend shift toward services produc­tion as well as the relatively lower capital require­ments in setting up a service operation. While in­ternational comparison is dif­ficult both the birth and the death rates are lower in Japan than in many other OECD coun­tries, notably the United States where the rates are two to three times higher even after adjusting for acquisitions. This suggests that the pace of meta­bolic change in business activity, a measure of the Schumpeterian process of creative de­struc­tion, is lower in Japan and has been declin­ing.

 

Profitability in the business sector has continued to decline. The ratio of current profits to total as­sets in non-financial corporations declined from an average of 4.3 percent during the period from 1986 to 1995. A similar trend has been ob­served for the manufacturing sector, which saw this meas­ure of profitability fall from 5.2 per­cent to 4.1 percent in the same dec­ade. As this is the sector that has been ex­posed to strong competi­tive pressure, often on a global scale, the declin­ing profitability trend can be in­terpreted as an indication of weakening business dynamism.

 

Possible Reasons Behind the Loss of Dynamism

 

The end of the catching up process

 

Cross-country comparison indicates that overall the manufacturing sector in Japan has broadly at­tained the levels of productivity found in other high-income countries. This would generally mean that Japanese manufacturing companies cannot be expected to improve productivity any more by merely ‘catching up’ with those in the more ad­vanced countries. Within the manufac­turing sec­tor, however, the picture varies greatly across sub-sectors. Whereas Japan has been a leader in basic metals and transport equipment, it has lagged

substantially in several other areas, in­clud­ing food, textiles, wood products and pulp and paper indus­tries. The gap varies much more in Japan than in the United States or other An­glo-Saxon countries. This suggests a strong presence of country-spe­cific characteristics in consumer preferences and entry barriers and protective meas­ures in the Japa­nese market for those sec­tors with low relative productivity. These sectors can enhance produc­tivity given the catch-up po­tential. However, for most other in­dustries in­cumbent companies will have to un­dertake greater innovation efforts, even if many remain competitive owing to their supe­rior tech­nical know-how pertaining to the produc­tion process, which has been the traditional strength of Japa­nese manufacturing companies.

 

Some lacunae in the corporate system

 

While the legal features of Japan’s corporate sys­tem are similar to those in other OECD countries, direct incentives for managers to en­hance share­holder value have been lower, and this is likely to have weakened business dyna­mism. Most of the members of the board of di­rectors are pro­moted from inside, having made a career in the company, and sanctions through the market for corporate control are extremely lim­ited.

 

Cross-shareholding has resulted in only about 20 to 40 percent of shares of keiretsu companies cor­porate groups being actively traded on the stock exchange. This arrangement is said to have insu­lated the firms from hostile takeovers and man­age­ment from pressure to achieve short-term profit, thereby promoting more strategic deci­sion-mak­ing from a long-term perspective. This has also meant, however, that the board of di­rectors can­not func­tion as an impartial monitor of the per­formance of senior corporate execu­tives who themselves are board members and appoint other directors. In addition, with direc­torship widely re­garded as a reward for dedi­cation to a com­pany, the board has grown in size, with some com­panies having as many as 40 directors, and ceased to be an effective body for making strategic decisions.

 

The key institutional shareholder that exerts pri­mary control over managers is the so-called main bank, which also is a principal lender. Strong bonds between banks and companies have been formed through the dependence on bank loans rather than equity markets throughout most of the post-war period. Long-term relations between them have meant that tradition­ally, loans granted to companies by banks have been secured by real estate collateral, and that there has been rela­tively

little proj­ect finance, which requires assessment of busi­ness risks. The main bank is commonly be­lieved to monitor managerial performance, thereby reducing the monitoring costs to other share­holders, and, if necessary, to discipline man­agers - as a substitute for the open market for corpo­rate control. Another often-cited ad­vantage of main banks is lower costs of dealing with fi­nan­cial distress in comparison with going through a protracted formal bankruptcy proce­dure. It has often been claimed that these fea­tures of the corporate governance arrangements contribute to reducing the cost of capital to com­panies.

 

These corporate governance arrangements are, however, likely to have contributed to manage­rial aversion to large risks: directors promoted from within tend to favor continuity over change, and the reliance on banks as the chief corporate moni­tor is likely to have resulted in managerial orien­tation towards low-risk options. The absence of a significant change in the com­position of busi­ness investment towards innova­tion and new product development seems to be consistent with such a conjecture. This manage­rial risk aversion is a plau­sible explanation for reduced business dynamism.

 

The ROE revolution

 

Back in the ‘good old days’ when capital was plen­tiful and cheap, pursuing a higher market share was the central focus of Japanese business, and weighing down both sides of the balance sheet with loans and depreciable assets made sense from a tax liability perspective. Return on equity (ROE) was an inconsequential issue be­cause banks were willing to lend regardless of firms’ profitability.

 

The weak balance sheets of banks, caused by their bad debt problems, combined with the fact that under the old system the banks never really developed the capacity to evaluate risk, have made banks unwilling to lend. These domestic changes, along with increased economic and fi­nancial globalization, have thrown Japanese firms into a harsh new world. Cut off from their tradi­tional source of financing, companies have to go to the commercial paper and bond markets or look to foreign banks. Credit ratings have sud­denly become the determining factor of Japanese corporations’ access to capital financing costs.

               

The global standard for determining credit rat­ings is, of course, ROE. Since Japanese corpora­tions, for the reasons explained above, have no­tori­ously

low ROEs, they are being forced to pay rates significantly higher than the rates to which they are accustomed. This is why the raising of ROE has recently taken on unprecedented sig­nifi­cance in the minds of Japanese corporate managers.

 

Moreover, along with the financial pressure to increase ROE, the start of Japan’s big bang de­regulation process has encouraged the estab­lishment of better corporate governance and the strengthening of shareholders’ rights. As share­holders become more influential and their voice in management decision-making strengthens, the pursuit of higher ROE is rapidly becoming the top priority of corporate management. However, opportunities for earnings growth will continue to be meager until structural reform is complete. Corporate Japan therefore has no alternative but to raise profitability through the rapid correction of excess investment and employment.

 

The fact that the average employment levels in Japan are excessive is highlighted by the rising trend in the labor expense ratio, or labor share, defined as personnel expenses in proportion to added value. Labor share for all Japanese indus­tries has steadily increased to an average of 68.8 percent for the period fiscal year 1994 to fiscal year 1997, compared with an average of 64.9 per­cent for fiscal year 1990 to fiscal year 1993. The recent change in corporate focus towards raising profitability means that even if the labor expense ratio falls back to the level of the early 1990s, further employment cuts will clearly be necessary.

 

Analysis across economies of investment ratios and growth rates gives further evidence of Ja­pan’s need to invest more wisely. Whereas Ja­pan’s ratio of gross fixed capital formation to GDP in 1997 was 28.3 percent, substantially higher than the G7 average of 17 percent, real growth of Japanese GDP during the 1990s has averaged only 0.9 percent. This unique combi­nation of significantly lower returns from a sub­stantially higher level of investment illustrates how Japan has used capital with spectacular in­efficiency.

 

Further analysis of investment ratios and profit­ability by firm size and by sector within the Japa­nese economy highlights where investment ex­cesses have been worst. According to the Finance Ministry’s statistics on incorporated enterprises, for all firms between fiscal year 1997, before-tax ROE (current profit as a ratio of share­holders’ equity) averaged 11.5 percent. For large firms (firms with paid-in capital of more than one bil­lion yen), although capital invest­ment averaged

31.1 percent of added value, be­fore-tax ROE averaged only 8.8 percent. Smaller firms (firms with paid-in capital of ten million yen), in con­trast, posted an average ROE of 16.8 percent. By sector, large non-manufacturers had the highest investment ratio of 39.3 percent, but still re­corded an average ROE of only 8.8 per­cent.

 

A closer look at the non-manufacturing sector re­veals that large firms in the communications in­dustry have been the least efficient investors of all. Their investment ratio between fiscal year 1994 and fiscal year 1997 was 55 percent while their average ROE was only 6.4 percent. It is true that telecommunications is a promising in­dustry with high growth potential in the infor­mation age, but there is still no justification for the huge amounts of money these firms seem to have in­vested without pausing to consider return on investment.

 

Orders from the communications industry make up 17.3 percent of total machinery orders, the largest share of any industry, and it was mainly capital investment from the communications in­dus­try that fueled the mini-recovery seen be­tween 1995 and 1997. Thus, on the one hand, it is ominous for Japan’s short-term economic prog­nosis that recent data for machinery orders indi­cate that the second phase of capital invest­ment adjustment is being led by the communica­tions sector. On the other hand, the fact that communi­cations orders are now falling rapidly is a wel­come development from the standpoint of Japan’s long-term recovery prospects, as it sug­gests that the capital investment adjustment has finally shifted into top gear.

 

 

Enhancing Structural Reform

 

The overall reform strategy: careful planning but slow implementation

 

A renewed impetus was given to structural re­forms when in 1996 the Hashimoto government designated six priority areas (administration, fis­cal structure, social security, economic struc­ture, financial system and education) and an­nounced that achieving significant process in these areas was one of the most important tasks of the government. The pace of reform appears to have picked up since this announcement. Three factors can account for this acceleration. First, under-performance of the economy in the 1990s made people realize that reforms must be undertaken more quickly. In fact, the good growth outcome in 1996 did not discourage re­form efforts, probably because people had be­come convinced

of the necessity of the reforms. Second, the government’s strategy of simultane­ously dealing with many issues probably made it easier to per­suade interest groups to support the program. Third, Mr. Hashimoto showed strong leadership in advancing the agenda. The reform process in Japan is often said to be slow and cumbersome due to the ever-present need for consensus build­ing prior to action and lengthy delays be­tween agreement and implementation. Although this observation still seems valid, the pick-up in the pace in 1996 and 1997 is encour­aging. For ex­ample, in the case of the adminis­trative reform it took only about 18 months from the time that a council entered discussions to legislate a basic law to restructure ministries and agencies. This shows that the pace of reform can be speeded up if there is strong political leader­ship. However, there remains such a tremendous amount of ad­min­istrative discretion about the timing, scope and detail of reforms that overall progress is very much hostage to continued po­litical leadership.

 

Reform of the public sector - often referred to in Japan as ‘administrative reform’ - is one of the key objectives of the current government. Two basic ideas are to shift from discretionary to regu­latory administration and to separate policy plan­ning from implementation. Sweeping pro­posals were made in 1997, but the final Admin­istrative Reform Bill, passed in June 1998, did not con­tain some of the more significant ele­ments previ­ously suggested. For example, the privatiza­tion of the postal savings and insurance schemes was dropped: instead responsibility for the pro­vision of services by the post office, in­cluding its saving and insurance schemes, will be trans­ferred to a new Postal Service Agency at some point be­tween 2001 and 2003, which will then be corporatized.

 

Public Sector Reform: Streamlining but Not Change in Bureaucratic Incentives

 

Such a large institution, in competition with pri­vate sector financial institutions in a deregulated, market-based system should be operated without any cross-subsidization from other services. Postal savings funds will no longer automati­cally be transferred to the Ministry of Finance’s Trust Fund Bureau to be invested in the govern­ment’s Fiscal Investment and Loan Program, while the postal life insurance fund has had sub­stantial discretion in portfolio investment deci­sions since its establish­ment.

 

Second, the bill contained no clear separation of the financial and fiscal responsibilities of the Ministry of Finance, despite the demonstrated risks of an over-concentration of power in one ministry. While the ministry’s supervisory role was transferred to the new Financial Supervisory Agency (FSA) in June 1998, there had been calls for financial planning functions to go with it, as there had been suggestions that the national tax administration should be separated from the ministry. In the autumn, however, an agreement was reached with the opposition parties to pres­ent a bill in the next Diet session to transfer all responsibility for financial regulation from the ministry to a new Financial Reconstruction Commission (which would also oversee the FSA) by the end of 1999. In the interim the ministry will retain joint responsibility (with the FSA) for financial crisis management.

 

The bill did make some useful changes, how­ever, by providing for the streamlining of the existing 22 government departments into a sin­gle-cabinet office and 12 ministries and agen­cies, together with a reduction in the number of bureaus from 128 to around 90 by 2001. It also called for a ten percent reduction in the civil services, whose current size is around 510,000. Finally, it gives greater power to the Prime Min­ster, who will be able to propose fundamental national policies at cabinet meetings, and the cabinet secretariat will be responsible for the design of basic budget, macroeconomic, and security policies. This may clarify the lines of power. Any improvement in efficiency may be limited, however, unless regulatory incentives, bureaucratic discretion and the lack of account­ability and transparency in the decision-making process are changed.