THE ECONOMY Contraction, Rise in Unemployment Ahead

Back to Contents of Issue: January 2003

-- Peter J. Morgan, Ph.D. and chief economist of HSBC Securities (Japan)

THE JAPANESE ECONOMY ENJOYED a modest recovery in 2001 due to a sharp rebound in global growth and exports, but exports now show signs of peaking out. Although the global economy is expected to show sluggish growth next year, this may not be enough to prevent the economy from tipping back into recession. As a result, the economy is likely to shrink for the third year in a row on a calendar year basis, and the unemployment rate will start to rise again.

The economy suffers from numerous problems. First, HSBC estimates that the output gap -- the difference between actual and full-employment (potential) GDP -- is about 5 percent, by far the largest for developed countries. This is the primary reason for the persistent deflation that the economy has experienced over the past four years. In order to end deflation, the gap would have to be reduced by about 3 percentage points of GDP.

Second, private debt levels remain very high by international comparison, mainly a legacy of the binge of borrowing during the bubble period. Although the ratio of corporate debt to GDP has fallen dramatically from 151 percent of GDP in 1995 to about 115 percent currently, this still compares unfavorably with ratios of about 70 percent for the US and major European countries. The steady reduction of debt by the corporate sector and the accompanying decline of private capital investment have been key reasons for weak demand for credit. Household debt has been more stable at about 67 percent of GDP, but debt-servicing costs have tended to depress consumer spending and borrowing as well.

Third, Japan suffers from poor capital allocation, due to inadequate corporate governance and excessive protection of weak companies. In the face of increased competition from low-cost producers such as China, the share of manufacturing in total output needs to shrink, and capital and labor need to shift to higher productivity areas, mainly in services. The main winner in the Japanese economy over the past decade has been miscellaneous services. Corporate restructuring has continued to shrink employment in construc- tion and manufacturing, and this trend is likely to continue.

Fourth, the combination of high debt levels and a weak economy has led to high levels of bad loans, estimated by HSBC at roughly 15 percent of GDP, far higher than the 4 percent of GDP experienced by the US during the savings and loan crisis in the early 1990s. This has impaired the ability of banks to lend to creditworthy customers and has undermined confidence in the financial system.

As a result, the economy has fallen into a "liquidity trap" type situation, where monetary policy is relatively ineffective. Although the Bank of Japan has cut rates to zero and base money is growing strongly, this has had no observable impact on bank lending or growth. Loan demand will only recover when debt levels have fallen enough and the capital position of the banking sector has been strengthened. We have not cited government debt as a problem, despite its high level of 140 percent of GDP and climbing. As long as Japan maintains a current account surplus, the debt is domestically held and hence not a net burden on the economy. Moreover, there is no limit on the ability of the Bank of Japan to buy (monetize) the debt. In this case, the classical prescription is to expand fiscal policy to reduce the output gap, either by raising expenditures or cutting taxes, and to accommodate this monetarily by having the BOJ buy the debt. Unfortunately, the government has maintained a policy of fiscal consolidation in the past three years, which has simply added to deflationary pressures.

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