toshiro muto : challenges facing japan ’ s economy – a case for structural reform speech by mr toshiro muto, deputy governor of the bank of japan, at the japan society, london, 7 september 2007. * * * it is my great honor to speak to you today, the esteemed members of the japan society. when i was last invited to speak here in 2004, the japanese economy was just coming out of a protracted downturn after the collapse of the bubble and was at last moving onto a fullfledged recovery path. japan's economy has since continued its growth and i am happy to report to you today that the recovery, which started in 2002, is now in its sixth year and has become the longest in the postwar era. i. current economic situation in japan first, let me briefly discuss the current japanese economic situation. japan's economy has been experiencing a sustained period of growth at the rate of around 2 percent, which is slightly above the potential growth rate, supported by strong external demand and stable domestic demand. conditions in the corporate sector are particularly good. according to the tankan ( shortterm economic survey of enterprises in japan ), a business survey conducted by the bank of japan, the ratio of firms'current profits to sales is at a record high and corporate fixed investment this fiscal year is likely to register its fifth consecutive year of growth. those favorable conditions in the corporate sector are gradually but steadily feeding through to the household sector. although wages are not yet rising, as i will discuss in more detail later, household income is trending upward via several channels, for example, increases in the number of employees and in dividends, and private consumption is steady. under those circumstances, the utilization of resources such as production capacity and labor is increasing. the unemployment rate has come down to 3. 6 percent for the first time in nine years. there are two main factors behind japan's continued economic growth. the first is growth in exports on the back of the global economic expansion. the extension and deepening of the international division of the production process, particularly in asia, along with rapid growth in newly industrialized economies, have together greatly contributed to the growth of our economy. the second is the recovery of strength in the corporate sector along with the restoration of stability in the financial system. from the latter half of the 1980s, the formation and subsequent collapse of the economic bubble left firms burdened with excesses in debt, production capacity

and labor, and financial institutions with significant holdings of nonperforming loans. firms have since restructured their business lines and improved their financial standing, while the rate of banks'nonperforming loans has been reduced from a peak of above 8 percent to below 3 percent. i think it is fair to say that those impediments have now mostly been removed. ii. the price situation on the price front, there is not yet any evidence of inflationary pressure despite steady growth in the economy. the annual rate of change in consumer prices ( excluding fresh food ) stayed negative from fiscal 1998 through 2004. although small but positive in both fiscal 2005 and 2006, the recent figures are again negative, albeit marginally. the absence of inflationary pressure despite steady growth in the economy is one of the distinctive features of the current recovery and also a somewhat puzzling phenomenon. behind it, i believe, lie three changes affecting the formation of prices and wage - setting. the first is the advance of economic globalization. as globalization proceeds, competition with newly industrialized economies that enjoy lower labor costs has been compelling firms to raise productivity and to retain their restrictive stance on labor costs, together with greater exposure to the discipline of the capital market. the second is the influence of deregulation. even nonmanufacturing firms, which are relatively unexposed to the global market, find themselves in a fiercely competitive environment as deregulation and realignment of the industry continues. attitudes on the part of employees could be listed as the third change. employees, having experienced a protracted period when the employment situation was severe, still tend to prefer stable employment to wage increases. taking a rather longer perspective, however, the environment surrounding prices is likely to change gradually. first, with the economy continuing to grow steadily, overall supply and demand conditions are likely to tighten. second, labor market conditions are becoming tighter, as indicated by the decline in the unemployment rate. that will eventually lead to rising wages although this may be gradual. third, surveys of inflation expectations in the private sector suggest moderate rises in prices ahead. given those factors, the annual rate of change in our consumer prices is expected to be around 0 percent in the short run, but gradually to rise in the longer run. iii. the conduct of monetary policy i will now turn to the conduct of monetary policy. in a situation where prices are not rising while the economy is growing steadily, the bank has been adjusting the level of interest rates in a