Kazumasa Iwata: Japan's economy under demographic changes
Summary of a speech by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at the
AustraliaJapan Economic Outlook Conference, Sydney, 7 December 2004.
The references can be found on the Bank of Japan's website.
* * *
1. Introduction
Japan is one of the most rapidly ageing countries in the world. The ageing process has been
promoted by a lower fertility rate, preceded by a lower mortality rate and a higher life expectancy. This
pattern is common to the ageing process in other countries. The higher life expectancy reflects
improved living conditions, and thus can be regarded as a success in terms of economic development.
It also implies the market expansion of new services for the elderly.
On the other hand, the lower fertility rate implies a diminishing market size due to the decreasing
population, if it falls below the threshold of the reproduction rate, which is 2.1. The ageing process
brings about not only a sharp increase in the dependency ratio, but also a sharp decline in the
working-age population as well as the total population. The total population is forecast to peak at
128 million in 2006 and decline to 100 million in 2050. It will diminish to about 40 percent of the current
size in 2200, with aged persons above 65 years old exceeding 30 percent of the total population.
Japan thus faces two problems: not only an increase in the proportion of retired elderly people, but
also a decreasing population.
The share of the working-age population had already peaked out in the early 1990s. Furthermore, if in
the future the fertility rate remains at the current level (which is 1.29), then "the last baby will be born in
about eight hundred years".1 South Korea, Taiwan, China and Australia will follow a similar process in
the absence of immigration, although the speed of their ageing process is divergent (Figure 1).
2. Effects on the macroeconomy
To start with the issue of the decrease in the working-age population, it is clear that the economic
growth rate will fall due to the decline in labor input. Krugman (1998) argued that the expected
negative growth rate due to ageing is the basic cause of deflation in Japan, given the condition that
the real interest rate cannot fall below zero under the constraint of a zero interest rate combined with
persistent deflation. Nevertheless, the actual average economic growth rate since the bursting of the
bubble economy has not been negative, and the expected growth rate cited by corporate managers
has returned to slightly above 1 percent.
There are three ways to prevent a decline in the economic growth rate. One is to raise the fertility rate.
The second is to raise the labor participation rate of women and the elderly. The third way is to
increase labor productivity, namely, the increase of labor input in the efficiency unit.
In order to raise the fertility rate, several countries such as France and Sweden have introduced
special tax measures to promote child-raising. Yet in Japan, government intervention to raise the
fertility rate is unpopular due to lingering memories of efforts to promote a higher birth rate before and
during World War II. The labor participation rate of women in Japan is still low, as compared with the
United States and Australia (Figure 2), and there is room to expand job opportunities for women.
Furthermore, it seems possible to maintain or raise the fertility rate by improving the working
conditions for women and men to facilitate child-raising, while at the same time increasing the
participation rate of women. In addition, there may be room to raise the participation rate of the elderly
by changing the incentives for retirement and adopting new employment practices on the side of
corporate management, even though the participation rate of the elderly in Japan is relatively high by
international standards and has shown a declining trend in recent years.
Let me turn to the third way, namely, the increase in labor productivity. It is important to recognize that
what is important in terms of individual welfare is the level of per capita consumption, not the GDP
growth rate. Thus, we can pose the question whether the decreasing working-age population or
smaller size of the labor force will lower per capita consumption. The neoclassical growth model
predicts, although it is somewhat counterintuitive, that per capita consumption will increase, because
capital equipment per worker will rise due to the diminishing number of workers, given the existing
capital stock. Nevertheless, this conclusion is flawed, as the neoclassical model overlooks the
existence of retired elderly people. They live on revenue arising from the return on savings which are
accumulated during their working lives. The increase in capital intensity may induce a lower rate of
return on real capital stock and thus savings, due to the law of decreasing marginal productivity of
capital. This leads to a reduction in the per capita consumption of elderly people.
For the retired elderly, it is crucially important to secure a higher rate of return on savings. In order to
prevent a decline in the rate of return on capital, it is necessary to increase the labor input. In the
absence of a change in the participation rate in the labor market and immigration, it is impossible to
augment the labor input. However, it is possible to increase the labor input in the efficiency unit by
raising labor productivity. It is well known that per capita consumption is maximized on the path where
the economic growth rate is equal to rate of return on capital (called the "golden rule" growth path).
The economic growth rate can be decomposed into labor productivity growth and the rate of increase
in the labor input. This implies that in Japan, where the labor input will decline, the desirable increase
in labor productivity should be larger than the rate of return on capital, if the nation seeks the
maximum per capita consumption growth path.2
The next question, then, is how to increase labor productivity. There are two ways. One is to promote
technological innovation and more efficient allocation of resources: that is, to increase the total factor
productivity. The other is to increase capital intensity. Yet an increase in capital intensity is
accompanied by a decline in the rate of return on capital stock. Therefore, what we should seek to
attain is an increase in total factor productivity. It is interesting to note that the Japanese economy has
suffered from distortions in resource allocation created during the bubble period. The size of the
distortions is estimated by the Bank of Japan's staff to be equivalent to nearly 0.5 percent of GDP
growth (Figure 3). It is reasonable to assume that the final disposal of nonperforming assets by the
banking sector implies the restructuring and reorganization of the corporate sector; this would lead to
more efficient allocation of resources and thus the removal of such distortions. Furthermore, there
exists a wide gap in labor productivity between the manufacturing and the non-manufacturing sectors.
The labor productivity of the latter is less than half that of the United States. This points to the potential
to raise productivity of the non-manufacturing sector through the application of advanced information
technology and the more efficient management of firms.
The wide productivity gap between the manufacturing and the non-manufacturing sectors has been a
basic feature of the Japanese development process after the Meiji Restoration. It has caused mild
inflation in the high-growth era under the fixed exchange rate system, and given rise to the
internalexternal price differential problem under the flexible exchange rate system. I am inclined to the view
that one of the aims of structural reform after the Plaza Accord in 1985 was to narrow the productivity
gap. The effort to raise labor productivity in the non-manufacturing sector to the level of the
manufacturing sector will result in a higher economic growth rate over the coming decade, although it
works to delay the timing in overcoming deflation in terms of the core consumer price index, due to
sustained downward pressure on the unit labor cost. The rise in productivity will nevertheless tend to
increase the natural interest rate; that is, the equilibrium rate of return on capital stock in the absence
of monetary disturbance. If it exceeds the real long-term market interest rate, then deflation will cease
to exist. This doctrine was elaborated about one hundred years ago by the Swedish economist Knut
Wicksell. His proposition can be summarized as "the higher the expected growth rate, the easier it is to
exit deflation." Krugman's argument can be regarded as a corollary to this proposition. In this sense,
the sustainability of recovery is the key to overcoming deflation.
On the demand side of capital stock in the process of the ageing population, the decreasing
working-age population leads to diminished demand for productive investment, because the capital
stock required to maintain the capital equipment per worker decreases. In many countries, we observe
that the change in the share of the working-age population in the total population is associated
positively with the productive investment ratio. According to the study by Poterba (2001), this positive
association can also be observed with respect to the level of asset prices (measured by the
dividendprice ratio), although the relationship between the rates of return on various assets and the
working-age population share is ambiguous.3 Several experts in demography argue that economic
miracles such as those in Asia and Ireland are simply due to the rise in the share of the working-age
population. In the case of Japan, the working-age population ratio increased from about 60 percent to
about 70 percent in the high-growth era (from 1955 to 1970). In China, the working-age population
ratio increased from 55 percent in 1975 to 60 percent in the early 2000s, and is expected to surpass
70 percent by 2010.
Now I will turn to an example with respect to asset prices in Japan. Looking at the relationship
between the nation's asset prices and the working-age population, land prices continued to slide for
more than ten years after the bubble burst, although land prices in the Tokyo metropolitan area seem
currently to have stopped declining. The ratio of total value of land to nominal GDP, 2.8, has returned
to the level of the pre-bubble period (Figure 4). The fundamental price of land in the long run can be
formulated as determined by the land rent, the discount rate (that is, the rate of time preference) and
the expected growth rate of the population. It seems likely that elderly people have a shorter time
horizon and a greater mortality risk than younger ones, and thus a higher discount rate on future rent
revenue. Therefore, the combination of a decreasing population and a rising discount rate in the
ageing process implies a lower ratio of total land value to nominal GDP. In my estimate, the
decreasing size of the working-age population (minus 0.5 percent) coupled with a lower discount rate,
is likely to further depress the ratio, to a new equilibrium ratio which is 2 in my calculation. It will take
several years to reach a new equilibrium ratio of the nationwide total land value to nominal GDP.
At the same time, it is encouraging to see that the market for land and real estate has revived during
the process of corporate restructuring and final disposal of nonperforming assets. Prices are now
based more closely on the future return on real estate, while investment in real estate by the corporate
sector has begun to increase. This may suggest the start of an expansion in construction investment,
which was subdued for a long time following the bubble period. As such, it constitutes one of the
brighter aspects of the current recovery phase.
Turning to the supply side of capital stock, the ageing process entails the decline of the household
saving rate due to greater dissaving by the retired elderly. In the early 1970s, the household saving
rate in Japan was more than 20 percent, yet it is now about 6 percent. The rate showed a particularly
notable decline after 1998.4 Its current level seems to almost correspond to a new equilibrium rate
under the decreasing size of the population.
On the other hand, corporate saving has increased significantly in the recovery phase that started in
early 2002. The corporate sector is enjoying a profit boom which is equivalent to the bubble period in
the latter half of the 1980s. This is another encouraging aspect of the current recovery phase, in terms
of its sustainability. The current account in the international balance of payments has registered a
surplus in the face of the large government deficit (8 percent of nominal GDP) and the declining
household saving rate. It is not excluded that the current account surplus may continue, even though
the household saving rate will remain at a low level due to ageing, as investment demand also shrinks
due to the decrease in the working-age population.5
3. Effects on the social security system and the financial system
Now let me turn to issues involving the effects of ageing on Japan's social security system and the
financial system. The rapid ageing process may have a significant impact on the sustainability of the
social security system. The existing public pension system in Japan consists of two parts: the National
Pension System, which provides a flat benefit to all persons, and the Employees' Pension Insurance
System, which is an earnings-related benefit plan. They are unfunded based on a defined benefit
scheme. The cap on the insurance premium was introduced at 18.3 percent in the most recent
pension reform. Yet further reform is needed to sustain the public pension fund and correct the
widening intergenerational inequality of burden sharing under the existing public pension system.6 I
have argued that it is desirable to privatize the earnings-related portion of the public pension fund.
Privatization would work to prevent an excessive fall in the household saving rate and to correct the
intergenerational inequality of burden sharing.
In addition to the public pension system, there are private pension funds such as unfunded severance
benefit plans, the Employee Pension Funds, the Tax-Qualified Pension Plans and a new defined
contribution plan similar to the 401(k) plan in the United States. They are funded based on a defined
contribution scheme. If Japan moves further in a direction weighted toward a defined contribution
scheme based on a funded system, then it becomes extremely important to secure a high rate of
return on pension funds. The efficient function of the capital market mechanism is a precondition for
the efficient management of public and private pension funds. It is unfortunate that the rate of return
on assets at the corporate level is relatively low in the Japanese capital market, although a tendency
toward recovery has been seen in recent years. Market-based corporate governance may strengthen
the monitoring mechanism and market discipline in corporate management.
In postwar Japan, the financial system has functioned on the basis of bank-based corporate
governance. As a result, bank loans provided by main banks could be interpreted as subordinated
debt or quasi-equity for the borrowing firms. Thus, economic risks have tended to be concentrated in
the banking sector. This has made the disposal of nonperforming assets all the more difficult and
gradual.
Since Japan's Big Bang in 1996, the nation's financial system has been in transition to a market-based
indirect financial system from a bank-based one. The major banks are in the process of transformation
from corporate-finance oriented bank management to providers of comprehensive financial services.
In this regard, it seems promising for them to extend their banking business to cover risk management
of individuals' assets, including human capital, over the life cycle as well as the assets of firms.
In Japan, the major portion of household savings is held by the elderly, that is, people over 60 years
old. It is well known that labor supply flexibility creates a kind of insurance against the risk of financial
investment. Young people have greater labor supply flexibility and thus may take larger financial
investment risks than the elderly.7 The preference for safe assets among Japanese households can
be partly explained by the labor supply inflexibility of the elderly and the lower labor mobility.
More specifically, the lifetime employment system combined with the seniority wage system has
implied that workers invest in equity of the employed company by the difference between the received
wage and the marginal productivity of labor when they are young. In old age, the workers receive a
higher wage than marginal productivity and the severance payment at retirement. Therefore, there is
much less need for young households to hold risky financial assets such as shares and investment
trusts, because the return on human capital over the life cycle is associated positively with the return
on risky financial assets. The long-term profit-sharing aspect of wage payment has been reinforced by
employees' deposits at their companies during the high-growth era and employees' stockholding in
more recent decades. Other factors bringing about a smaller share of risky financial assets held in the
Japanese household portfolio balance may be the borrowing constraint and the relatively high share of
risky real asset holding (housing and real estate). It may be noted that, in Japan, there is no system
such as the "home equity loan" in the United States that promotes borrowing, consumption and equity
investment when housing prices rise.
The demographic changes are working to transform the traditional employment system into a new
one. The structural changes in the Japanese labor market have tended to cause a shift from a
seniority wage system to a performance-based system. The lifetime employment system has been
eroded significantly by the increasing share of part-time and temporary workers. The delinking
between the return on human capital and equity investment may enhance the tendency for the
household sector to hold more risky financial assets such as shares and investment trusts in the
future. It is accompanied by changes in the incentive structure for young workers; namely, an
increasing number of young non-regular part-time employees (known as "freeters") totaling nearly
4.2 million and 0.52 million discouraged young people who are not in education, employment or
training (known as "NEET"). For these young people, it is difficult to form a long-term life plan and thus
raise children. This aggravates the problem of fewer children and the decreasing population size.
Finally, asset decumulation by baby boomers may exert an impact on the asset market. The public
pension fund has accumulated about 130 trillion yen, which will be paid out as pension benefits for the
baby boomers. Furthermore, the privatization of the postal saving and insurance system may
complicate the debt management policy. It seems likely that a decline in the functioning of the asset
market due to the decumulation of assets can be avoided by the gradual shifts in asset demand as
well as the globalization of the financial market.
Nevertheless, it seems important to develop the market for asset decumulation: that is, to transform
the real capital stock held by the elderly into income streams. In Japan, the market for reverse
mortgages has yet to be developed. The risk related to longevity and land price declines, in addition to
underdevelopment of the secondary market for housing, impedes the development of the reverse
mortgage market. It seems necessary not only to implement adequate assessment of the market value
of housing stock, but also to improve the quality of housing stock, in order to increase the
marketability. The securitization of housing loans seems to be the key to transform the financial
system into a market-based one and to develop the market of released equities. In this regard, it is
encouraging to see the recent expansion of real estate investment trusts, private real estate funds,
asset-backed commercial paper, asset-backed securities, mortgage-backed securities and
collateralized debt obligations. The Bank has contributed to the development of the securitization
market by introducing the purchase of asset-backed commercial paper and asset-backed securities
after July 2003 and initiating a survey related to securitized instruments.
4. Conclusion
To conclude, the ageing process in Japan is accompanied by systemic social changes including the
employment system, the social security system and the financial system. For the central bank that is
striving to overcome deflation, the ageing issue of society presents a challenging task, because it
requires the establishment of a more efficient financial system to secure a higher rate of return on
savings, while maintaining price stability and avoiding the risks of inflation as well as deflation.