Japanese Recovery Could Begin Shortly If Bank Sector Doesn't Worsen

For further information: Gail D. Fosler
(212) 339-0300
The Conference Board

For Release Monday, July 13, 1998 at 6:30 PM ET Release #4427A

JAPANESE RECOVERY COULD BEGIN SHORTLY IF BANK SECTOR DOESN'T WORSEN Yen Has Seen Its Low Against Dollar

If the credit problem in Japan's banks doesn't worsen, the Japanese economy will begin to recover in the third quarter of 1998, according to an analysis released today by The Conference Board.

"Japan's banking sector is a central player in the Japanese recession to be sure," says Gail D. Fosler, senior vice president and chief economist of The Conference Board in the latest issue of her newsletter, StraightTalk, prepared exclusively for Conference Board associates. "However, the cyclical forces are an effective counterweight, if some of the most serious problems in the banking sector can be resolved."

The analysis shows that the preconditions for a cyclical recovery are in place. Japan's fiscal stimulus package coincides with the end of the production and inventory correction provoked by the Asian crisis and, unless the credit contraction offsets both forces, the Japanese Gross Domestic Product will turn positive in the third quarter.

"The history of Japanese growth is one of a rapidly developing emerging market that has slowed in recent years as the economy matures and becomes subject to the intense global competition and restructuring common in other high-wage industrial countries," Fosler adds. "Japan is in a developmental cul-de-sac and lacks the benefits of output and employment growth in a competitive service sector to offset losses in manufacturing."

THE YEN HAS SEEN ITS LOW

Fosler predicts that the yen has seen its low against the dollar. The Conference Board analysis notes that

the benign neglect of the dollar/yen rate by the G7 countries has encouraged markets to test the potential limits of the dollar strength against the yen and has proven highly unproductive both to the Japanese recovery and to the recession in Asia.

While a weak yen benefits the profitability of Japanese business, a free-falling currency also encourages capital outflows at a time when the economy urgently needs its capital base to support domestic financial markets and institutions. The fall in the yen has also pushed down financial markets and currencies and increased interest rates in the rest of the Asian crisis countries.

But the long-term outlook for the yen depends on Japan's choices with respect to its long-term growth. Events during the past year suggest that the Japanese economy will be structurally more cyclical at low growth rates than in the past, with recession a frequent reality. Fosler says it is unlikely that Japan's manufacturing sector alone can create the extraordinary profitability the country experienced in the '80s in a global economy with many more emerging market competitors. Despite becoming one of the major international currencies appreciating against the dollar, the yen has stabilized and its recent decline suggests that a new depreciating trend could be evolving.

"If Japan does not advance the development of its market economy and its financial institutions, the yen may begin to trade like an emerging market currency, with all of the volatility and depreciation that comes with it," says Fosler.

ROOTS OF THE PROBLEM

The sources of the stagnation in the Japanese economy are a result of fiscal restraint, credit contraction, restructuring of Japanese manufacturing, the undeveloped nature of the Japanese service sector, and the long-term concern about the fiscal requirements of an aging population. The cyclical slowing of the economy, which produced the 1992 recession, was quickly followed by an aggressive effort to restructure manufacturing, which has reduced total manufacturing employment in Japan by more than 10 percent. The economic impact of this restructuring was made worse by the lack of vitality in the service sector to offset job losses in manufacturing.

Japanese resistance to personal tax cuts is also rooted in the dynamics of its business cycle. The Japanese cycle tends to be driven by corporate profitability and investment rather than by consumer spending, like in the U.S. During times of reasonable growth in Japan, consumer spending usually trails, rather than supplements, overall GDP growth.

The restructuring of the early '90s in Japan resulted in a 15% to 20% increase in Japanese business profits during 1994 to 1996. Higher profits set in motion an investment cycle that produced the first cyclical rebound of the decade. Unfortunately, the Japanese government misinterpreted the underlying strength in the economy and raised the value-added tax in April 1997 from 3% to 5% in order to reduce its long-term budget deficit. The impact of the VAT increase, which reduced GDP at a 10.8% annual rate in the second quarter of 1997, was actually greater than the impact of the Asian crisis, which brought GDP down 5.3% in the first quarter of 1998. The current recession is the result of the structural degeneration of economic performance compounded by fiscal mismanagement.

JAPAN'S REAL DILEMMA

Japan has depended on a very narrow segment of its economy to support its growth and competitiveness. The nation has created a highly successful multinational sector concentrated in autos, electronics, and machinery. But such superior performance is not matched throughout the manufacturing sector, especially in small- and medium-size businesses.

"This poor productivity performance is largely because much of the Japanese economy is highly subsidized and regulated and not open to the opportunities for innovation and growth that come from international competition," says Fosler. "Japan is like a developing country in many ways because its labor productivity gains for many of its economic sectors are limited, and therefore so is the chance for the economy as a whole to grow. Japan's dilemma is that historically, more often than not, countries plateau in their economic progress and slip to levels that are only a fraction of their former less-developed competitors."

Source: StraightTalk, The Conference Board, Volume 9, Number 6

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