Bank of Japan's annual review of monetary and economic developments
Central bank: boj | Type: speech | Date: 1998-09-15

## Bank of Japan's annual review of monetary and economic developments BANK OF JAPAN COMMUNICATION, the Bank of Japan Annual Review 1998.

## Annual Review of Monetary and Economic Developments in Fiscal 1997

## SummaryJapan's economic growth slowed during fiscal 1997. 1 The economy, which had been on

a recovery path, began to decelerate with the turn of the new fiscal year in April became increasingly sluggish toward the end of the fiscal year.Final demand deteriorated toward the end of fiscal 1997.

Until recently, net generally followed an upward trend and underpinned Japanese economic activities.

In deta exports expanded, reflecting firm business conditions overseas - particularly in Europ United States - and also by the depreciation of the yen, while real imports remained unchanged.

However, net exports peaked out toward the end of fiscal 1997, owing to a decr exports to other Asian countries against the background of the ongoing economic adjustment region.

Meanwhile, public-sector investment basically trended downward because of tight bud both the central and the local government levels.

Business fixed investment maintained a increase during the first half of fiscal 1997, particularly in the manufacturing industry. the second half of the fiscal year, it seemed to have peaked out reflecting factor deterioration in corporate profits.

Private consumption and housing investment were depres April 1997 mainly in reaction to the surge in demand ahead of the rise in the consumption from 3 to 5 percent. 2The stagnation became evident from autumn 1997 partly against the background the deterioration in household confidence despite a moderate recovery temporarily observed summer 1997.

The stagnation in final demand adversely affected production, corporate prof employment condition.

Accumulation of inventories was followed by an adjustment in produc resulting in a decrease in output in the last two quarters of fiscal 1997.

Inventories in goods, including construction goods and consumer durables, began to accumulate in spring and this development expanded to producer goods in autumn 1997.

Corporate profits plunged second half of fiscal 1997 resulting in a turn to decline for the fiscal year as a whole.

P even at large manufacturing firms that had maintained steady growth up until that time.

Un circumstances, corporate sentiment worsened rapidly across a wide range of firms especiall the second half of the fiscal year, as indicated by the Bank's Tankan - Short-Term Economic Survey of Enterprises in Japan and other statistics.

Labor market conditions deteriorated in fisc number of new job offers turned to a decline particularly in the manufacturing and con industries.

The unemployment rate reached and remained around a historically high level in the increase in involuntary unemployment.

In the meantime, the growth in wages and sa particularly overtime compensation and bonuses, decelerated, reflecting reduced product worsening corporate profits.Consequently, the positive cycle of production, income, and expenditures tha supported the economic recovery during fiscal 1996 weakened from the beginning of fiscal exerting downward pressure on the overall Japanese economy.

With respect to final de components, the primary factor that weakened this positive cycle was the sluggishness of h expenditures.1 Fiscal year starting in April and ending in March.2 The consumption tax rate was raised on April 1, 1997.Household expenditures began to show a clear downward trend in early autumn 19 despite a slight rebound in summer 1997 after fluctuations resulted from the rise in the c tax rate in April 1997.

The decline in real disposable income due to the rise in the cons rate and the discontinuation of the special income tax reduction can be cited as a factor sluggish household expenditures.

In the past, when constraints on household income inten mechanism often functioned whereby growth in expenditures was maintained by the increase i households' propensity to consume (the ratio of expenditures to household income).

Thi however, household expenditures were restrained reflecting cautious household sentiment, added to the sluggishness in final demand, leading to excessive inventory and its adjustm corporate sector.

This development worsened labor market and income conditions in the hou sector.

It is difficult to quantify and verify the factors that have weakened household However, it is likely that the following factors contributed: (1) mounting anxiety regardin employment and income conditions as a result of a series of large financial institution f (2) growing uncertainty regarding the future burden on households amid the recent active d the budget deficit and the reform of national pension systems.The stagnation of household expenditures also affected corporate sentiment business fixed investment through the sluggish domestic final demand and deteriorating c profits due to inventory adjustment.

Prior to the collapse of the 'bubble' economy, brief stagnant domestic demand were overcome through (1) active export drives by firms especia manufacturing industry, which compensated for the weak domestic demand; and (2) an improvem in cash flow as a result of monetary easing and the positive lending attitude of financial which facilitated corporate financing and business fixed investment especially in nonmanuf industry.

However, after autumn 1997, business conditions became severe due to the eco turmoil in other Asian economies, especially in Korea and the ASEAN nations, and the ca lending attitude of financial institutions, due in part to weak stock prices and mark regarding credit risk. 3In addition to the weak household expenditures, various strong and persi structural adjustment pressures on the economy can be cited as another fundamental facto economic stagnation.

With such pressures, the economy, unable to resume a self-sustained r which started in fiscal 1996, stagnated, a result that was triggered directly by factors restraint and cautious household sentiment.

The attitude toward expenditure and investment manufacturing firms facing so-called 'mega-competition' remained selective.

Nonmanufactu firms were pressed to boost their productivity - which was said to be behind that manufacturing sector - amid the ongoing deregulation in addition to the balance-sheet ad following the collapse of the 'bubble' economy.

Turning to the industrial structure, the economy seemed to be still in the process of transition.

There appeared to be no leadin raising productivity and thereby creating additional employment, while in some ind employment adjustment pressure was intensifying.Prices (excluding the effects from the rise in the consumption tax rate) r stable on the whole during fiscal 1997, although they softened slightly during the sec 4 Import prices rose sharply in 1996 but turned to a decline in the first half of 1997 r fluctuations in crude oil prices and the exchange rate of the yen.

The prices remained stable until the end of 1997, but began to trend downward once again reflecting the weak international commodity prices due to the economic crisis in Asian economies.

Domestic who prices seemed to be bottoming out during the second half of 1996 and the first half of 19 then softened from summer 1997, reflecting the weakening market conditions in materials-3 ASEAN comprises Thailand, Malaysia, Singapore, Indonesia, the Philippines, Brunei, Vietnam, Cambodia, and Laos.4 Price data presented in this report exclude the effects of the rise of the consumption tax rate from 3 to 5 perce from April 1, 1997.goods due to stagnant domestic final demand and the accumulation of inventories, in additi fall in import prices.

Corporate service prices in fiscal 1997 narrowed their rate of decl the ongoing downward trend and have recently moved around zero compared to the level of a earlier.

Consumer prices (nationwide, excluding perishables) increased at a slightly h during the first half of fiscal 1997.

This is because commodity prices declined more sl result of a decelerated influx of low-priced foreign goods.

In the second half of fiscal 19 the softening of commodity prices reflecting the decline in domestic wholesale prices damp increase.

Furthermore, the 12-month increase in consumer prices has recently fallen almost excluding the effects of the rise in medical service charges caused by the medical insura reform of September 1997.With respect to factors affecting prices, the price decline phase of the seco fiscal 1997 differed from that of around 1994-1995.

During the 1994-1995 period, down pressure on the overall prices of import-competing domestic goods intensified owing to t increase in the penetration ratio of imports, particularly in manufactured goods.

Thi against the background of the industrialization of Asian countries other than Japan and the appreciation of the yen.

On the other hand, in the second half of fiscal 1997, downward p overall prices resulted mainly from the stagnant domestic final demand.

There did exist d pressure on domestic wholesale prices caused by the drop in import prices, owing to t declines in international commodity markets triggered by the crisis in Asian economies. the penetration ratio of imports did not increase since the value of the yen was significan the whole than it was in 1994-1995.

As for the effects of price declines on corporate ac decline in the prices of crude oil and other raw materials in international commodity mar second half of 1997 worked rather favorably for Japanese firms by improving their terms unlike the first period during which the import penetration ratio of final goods increased. noted, however, that there were signs of a squeeze on corporate profits as unit labor costs relative share in income distribution increased against the background of the exceptio nominal GDP growth rate, and the expansion of the domestic output gap accelerated due stagnation of final demand.

It therefore became important to carefully monitor the effe sluggish domestic demand on corporate activities and employment conditions.As for land prices, commercial land prices generally showed a smaller declin clear distinction in profitability existed between land whose price had stopped fallin whose value continued to fall from fiscal 1996 through the first half of fiscal 1997. residential land prices virtually stopped declining.

In the second half of fiscal 199 commercial and residential land prices both began to weaken slightly once again, refle stagnant economy.As for financial developments, while the Bank maintained its easy stance in mon policy, some disturbances occurred in the financial system.

Causes of the disturbances in further drop in stock prices affected by a number of failures of banks and securities co November against the background of the prolongation of the efforts to dispose of nonper loans.

As a result, there were some unstable developments in the market such as the ris interest rates reflecting pressure coming from intensified market concerns over credit an risks.

Around the fiscal year-end, however, the market gradually regained stability as a ample supply of funds injected by the Bank and implementation of financial system stabi measures involving the use of public funds worth ¥ 30 trillion.Developments in market interest rates showed that both short and long-term in rates increased slightly for a while after the beginning of the fiscal year and then turne through the summer, as the outlook for the economy became increasingly unclear.

The November 1997, market awareness of credit risk heightened sharply with a number of failubanks and securities companies.

Fund-raising costs of private-sector institutions - name rates on CDs and CP in the markets, and corporate bond yields in the capital markets reflecting the expansion of the risk premium.

On the other hand, yields on safer asset government bonds declined.

The difference between rates offered in the interbank marke expanded according to banks' creditworthiness, and the so-called 'Japan premium' was impos Japanese banks in overseas markets.

In response to such a rapid rise in interest rates provided ample funds to the market in an effort to stabilize interest rates through variou including the new bond-borrowing ('repo') operations introduced in late November.

As a res overnight call rate (uncollateralized, weighted average) regained stability at the end o and interest rates on term instruments began to decline from late February.

Yields on government bonds, on the other hand, declined to a historical low of 1.49 percent in l reflecting releases of weak economic indicators.

During the same period, stock prices (Ni Stock Average) fell around early January once marking ¥ 14,664, reflecting the cautious economic outlook and mounting uncertainty about the future.

Stock prices later rebounded with flu and recovered to ¥ 16,527 at the end of March 1998, reflecting implementation of the governme stimulus measures including the use of public funds.Financial indicators such as monetary aggregates and lending also showed er movements after November 1997 reflecting intensified awareness of credit and liquidity risk firms and households.

The growth of M 2 +CDs, a representative indicator of monetary aggregates i Japan, remained stable at around the annual growth rate of 3 percent until early autumn, sharply after November, marking an annual increase of 5 percent in February 1998, the firs the approximately seven years. 5 This reflected the shift of funds into M 2 +CDs from financial assets outside M 2 +CDs such as investment trusts, and also the buildup of corporate deposits as deposited the funds raised in advance by bonds and CP to secure liquid funds.

From early however, the annual growth in M 2 +CDs fell slightly.

Meanwhile, private-sector financial institu showed stronger movement to reduce risk assets including lending in the second half of fis as capital constraints were intensified by the fall in stock prices just when risk mana being strengthened prior to the introduction of the Prompt Corrective Action.

Neverth massive reduction in lending did not occur with a slight pickup in stock prices and the d the injection of public funds toward the end of the fiscal year.

The amount outstanding bank lending, however, decreased substantially after March, partly due to loan writeliquidation.With respect to corporate financing, a rapid contraction in overall fund-ra firms did not occur owing partly to the increase in fund-raising in the capital markets b good business performances.

However, from a microeconomic perspective, the unbalanc allocation of funds among firms intensified.

In particular, firms with low ratings and smal are usually unable to access the capital market were considered to have experienced tighte conditions partly due to deteriorating business performances reflecting the staggering ec for lending by private-sector financial institutions, the lending attitude became i restrictive due partly to intensified constraints on capital in view of capital adequacy and as a result exerted downward pressures on the economy through its effects on co sentiment and firms' investment and spending activities.

The significant influence of factors on the economy was one of the characteristics of the economic developments in fisca5 M 2+CDs = cash currency in circulation + deposit money + quasi-money + certificates of deposit.(Cash currency in circulation = the amount of bank notes issued and coins in circulation - the amount of cash curr financial institutions surveyed.Deposit money = the total of demand deposits among private and public deposits with financial institutions surveyed s and bills held by these institutions.Quasi-money = the total of private deposits, public deposits less demand deposits with financial institutions surveyCertificates of deposit = those of private corporations, individuals and the public with financial institutions survIn the 'Annual Review of Monetary and Economic Developments in Fiscal 1996,' the Bank pointed out that the momentum of the economic recovery firmed gradually during 1996, but this was not necessarily accompanied by an improvement in private-sector confide 6 In fiscal 1997, in addition to the fiscal drag, the Japanese economy experienced diverse impacts such as failures in the financial system and the financial and economic crises economies.

Thus, the recovery which had been proceeding since the end of 1993 was interrup cannot be denied that economic entities' confidence was damaged further.

Results of business surveys indicated that the recovery of economic entities' confidence was further Factors behind the weak recovery in the private sector's confidence were anxiety and un regarding the economic and social systems of the country, in addition to factors related t aftereffects of the collapse of the 'bubble' economy such as the financial inst nonperforming-loan problem.

The anxiety related to whether the current systems can adapt major structural changes facing the Japanese economy - such as intensified global competi demographic changes in Japan toward fewer children and an increasing aged population - a growing uncertainty caused by the unclear direction of future economic developments.In light of the above, there are several issues which must be dealt with Japanese economy to regain a self-sustaining growth.

First, the critical task for th economy to be dealt with without delay is to avoid falling into a deflationary spiral decrease in demand.

In view of this aim, the government set out a comprehensive economic p on April 24, 1998 including special income tax reductions.

Expeditious implementation o measures and significant results are expected.The second task is to solve various problems that surfaced after the burstin economic 'bubble' as quickly as possible and to restructure and enhance the mechanism of financial system.

During fiscal 1997, the government implemented measures to stabili Japanese financial system, which included the use of public funds.

In addition, the announced comprehensive economic stimulus package incorporated measures to enhance ass securitization and real estate liquidation, and a systematic framework for the di nonperforming loans was consolidated.

Also, the Japanese 'Big Bang' financial deregulat being implemented beginning with the amendment of the law on foreign exchange and foreign t which came into effect on April 1, 1998.

Under these circumstances, it is imperative for institutions to dispose expeditiously of their nonperforming loans as well as to real resources, in order to efficiently provide financial services that meet the needs of households.

Along with the efforts to review and to improve the indirect financing syst necessary to reinforce direct financing through the expansion of risk capital offered in markets, thereby encouraging the optimal allocation of funds in the economy.

Thus infrastructure for corporate accounting, disclosure of information, the system of taxation services, and payment and settlement systems must be reviewed and improved expeditiously.The third task is to make steady progress in the reform of Japan's economic st through measures such as deregulation and revision of the taxation system.

The relaxat abolition of various economic regulations would bring about higher productivity and ec growth rates in the long run by creating demand and promoting effective resource allocatio industries and firms.

Also, a revision of the taxation system aimed at improving the investment and supporting the optimal allocation of capital should have positive effec overall economy.

Restructuring of other economic systems is also required in order to smoot resources.

For example, the current employment system should be reviewed to promote mobil the labor market.

In addition, while efforts should be made to achieve greater efficiency i6 For details, see 'Annual Review of Monetary and Economic Developments in Fiscal 1996' in the Bank of Japan's Annual Review 1997.sector, a nationwide consensus regarding the direction of the social security system reform reached as quickly as possible to ease the deep-rooted concerns in the household sector future burden of social security costs.The diverse events that the Japanese economy experienced in fiscal 1 demonstrated the importance of influencing expectations of various economic entities and confidence among market participants in managing economic policy.

In this regard, policy should strive to reduce the uncertainty concerning the outlook for the economy through i transparency and consistency in their policy, while initiating effective measures in orde economic activities of private-sector entities.