Japans Economy Recovered

Can a changing Japan meet the productivity challenge in the long-run?

Canadian Embassy Tokyo
April 2006

Overview
Current Outlook and Issues
Macroeconomic situation, regional economies, business, banks and labour, monetary policy normalisation

Strengths
Size, wealth, technology, manufacturing, Asian integration

Productivity challenge
Demographics, LT structural change, efficiency, bureaucracy

Assessment
Is Japans economy recovering? What does this mean for Canada and the world?
2

Current trends and issues

Current macro outlook
Regional economies Business resurgence

Financial sector revival

Labour market upturn Hot topic: monetary policy normalisation
3

Economic growth:
Real GDP growth strong in 2005
2.7% growth in 05
After 2.3% in 04
3 2.5 2 1.5 1 0.5 0 01 02 03
Calendar year

Real GDP y/y % (05 preliminary)

2.7 2.3 1.8

Strong end to 05
05Q4: 5.4% q/q annualized 05Q4: 4% over 04Q4

06 and 07 forecast quite robust

Consensus of Japanese forecasters (for fiscal year ending in March):
- FY05: 3.4% - FY06: 2.6%, - FY07: 2.4%
Note: in 2005, Canadas economy grew 2.9%, with much faster population growth.

0.4 0.1 04 05

Source: Cabinet Office, Japan

GDP Growth:
More sustainable now
Private and Domestic Growth stimulus
Contributions to y/y real GDP growth % (05preliminary)
3 0.9 2.5

Tech bubble Real GDP

0.2 0.8

Domestic final sales (private cons. & invest. net 1.5 of inventory 1 changes) now 0.5 growth driver Unlike 90s, public 0 demand is weak: sharp cuts in -0.5 public works
2

0.5

0.6
2.1

1.1 1.8

0.6 2.3 1.8 0.7 1.1

0.3
0.7

1.2 0.8 0.4 -0.5 -0.5

1.1

0.1
-0.1 -0.3 -0.8

-0.5

-0.3

-1.9

-0.2

-0.1

95

96

97

98

99

00

01

02

03

04

05

Modest net export growth: Economy firing on all cylinders

-1

Calendar year
-1.5 -2 -0.1

Final domestic sales

Public demand

Source: Cabinet Office, Japan

Net Exports 5

Recovery by city and region:

Boom centered on industrial heartland, urban areas
Recovering strongly: robust growth overall; very tight
labour market; industry, services, real estate increasingly buoyant

Recovering: firm growth; tightening labour market;

industry and services solid

SAPPORO: Northern centre at heart of agri-food & tourism region

Recovering mildly: growth picking up; labour market,

Industry and services recovering, although picture is uneven

Signs of a turnaround: growth remains slow.

Labour market slack remains; modest pickup in some industries

Stagnant/Recession:
category at this time

no regions in this

HIROSHIMA: Dynamic regional centre

FUKUOKA: modern city with growing ties to NE Asia

TOKYO-YOKOHAMA: growing financial and economic metropolis; worlds biggest city with economy larger than Canadas

OSAKA-KYOTO-KOBE: re-emerging second urban region of Japan

NAGOYA: booming manufacturing centre

Source: Cabinet Office, Embassy estimations

Deflation:
Easingending?
Change in prices (y/y%)

CPI inflation now mildly positive

Core CPI 0.5% y/y Jan 06 Corp. goods prices GDP deflator
import prices key factor

1 0 0 -1

BoJ has called end of deflation:

Quantitative easing over:
BoJ now targetting 0% interest rate Interest rates will stay at or near zero this year

-2

-3 Q3 Q4 Q1 Q2 Q3 annual annual annual annual Q4

FY00 FY01 FY02 FY03

CY04

CY05

BoJ wants CPI at 0-2%

Core CPI CSPI

CGPI

GDP Deflator 7 Source: Bank of Japan

Business sector recovery

Non-financial firm profitability
(current profit/sales - 4Q moving average)
4.50% 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00%
IT Bubble Property bubble

Restructuring paying off, debt bubble gone

Corporate debt/GDP ratio now below 1980 level (HSBC)
Liab. / bal.sheet ratio lowest in 50 yrs. (Morgan Stanley)
debt repaid by non-financial corps: 40% of GDP!

Non-financial firms may be in best shape ever

Profitability at 50-year highs Q405: 14th consecutive Qtr. of y/y profit growth Confidence, return on equity at post-bubble high
8
2005 Jul.*Sep. 2004 Jan.*Mar. 2002 Jul.*Sep. 2001 Jan.*Mar. 1999 Jul.*Sep. 1998 Jan.*Mar. 1996 Jul.*Sep. 1995 Jan.*Mar. 1993 Jul.*Sep. 1992 Jan.*Mar. 1990 Jul.*Sep. 1989 Jan.*Mar. 1987 Jul.*Sep. 1986 Jan.*Mar. 1984 Jul.*Sep. 1983 Jan.*Mar. 1981 Jul.*Sep. 1980 Jan.*Mar.
Source: Ministry of Finance

Longest period since 1960s

Banking sector revival

Non-perfoming Loans (NPLs) at major banks 35
10.0%

NPL problem fixed

9.0% 8.0% 7.0%

8.7%
30 25

7.1% 5.7% 5.1% 2.9%

20 15 10 5 0

6.0% 5.0% 4.0%

Takenaka plan to halve 2001 NPLs by 2004 exceeded Capital adequacy, quality improved Banks repaying pub. funds

2.4% 3.0%
2.0% 1.0% 0.0%

Profit recovery is less certain

FY05H1 saw highest profits on record, but spreads tight and loan growth slow Key: fee-based financial services Rising interest rates will 9 help bank profits

End FY00

FY01

FY02

FY03

FY04 FY05H1

Total NPLs -- trillions of yen -- left scale NPLs as percentage of total

Source: Bank of Japan

Labour market upturn

Recovery may finally be spreading to the labour market
Restructuring = job cuts
Aging-driven labour force decline excess labour throughout 1990s

Full-time jobs up again

Growth had been in part-time jobs, full-time jobs were falling. This trend has reversed. Latest unemployment rate: 4.1%
Offers/applicant ration 1:1!

Firms now perceive labour shortage

Rising incomes key to recovery, deflation end

Source: Bank of Japan

Nominal employee compensation rose 2.6% in 05Q4 over 04Q4

10

Hot topic: monetary policy

What will the impact be of normalisation, rising i-rates?
overall in Japan Household (HH) assets = 4X HH debts
consumption boost offsets profit impact; banks benefit from better spreads BUT: govt has to pay higher interest; book value of bondholdings fall, overseas assets may suffer, possibly gold

What if rates increase?

Households, firms, banks benefit

Households gain Y7.8 trillion2

but, govt and JGBs, overseas spending rises assets fall.

Govt interest expense rises over time as debt rolled over (JGBs = 150% Of GDP, Held 95% In Japan) Book value of JGB holdings falls Overseas Assets Suffer as carry trade abates 11

Interest rates increase

Cons. spending Rises 0.8%1 Modest rise in profits2 Loan spreads improve

1%

1: Source: Nomura securities

2: Source: Goldman Sachs

Japans strengths

Size, wealth manufacturing productivity technology Asias rise and economic integration
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Size and wealth:

2nd biggest economy; biggest net creditor
Individual financial assets in Japan = $CAN 17 trillion (280% ofGDP) = 4 times household liabilities Despite govt debt, net foreign position was CAN$ 2.2 trillion (What Japan is owed) (what Japan owes) = (Canadas annual GDP X 2)

Japans GDP:
larger than rest of Asia equal to the combined economy of all US states west of the Mississippi

Kanto+Tokai
GDP larger than Germanys
but Tokyo-Nagoya distance is less than Montreal-Toronto
KANTO

= GDP larger than Chinas, twice Canadas

(Tokyo Metro Region)

TOKAI

= GDP larger than Indias or Brazils

(Nagoya-Shizuoka Region)

KANSAI

= GDP larger than Mexicos or Koreas

(Osaka-Kobe-Kyoto Region)

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Strengths:
Manufacturing productivity, leading industries
Leader in manufacturing productivity
Japanese manufacturing productivity is 20% higher than in US
This partly explains Japans trade surplus with the world.

Growing lead in key industrial sectors

E.g: PAX TOYOTA: it can be argued that Japanese automotive empires are dictating terms of global auto industry
Result is growing prosperity in the imperial capitals, the Japanese design and manufacturing centres (eg: Nagoya) Leadership brings obligation to maintain peace, avoid trade friction Strong investment in key markets, notably NAFTA Some restraint in pricing strategy to avoid crippling US cos

Strong leadership in others sectors: Japan HQs global finance and tech hubs, from chemicals to electronics
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Strengths:
Technology and R&D
Japan is R&D leader
Highest R&D/GDP ratio in G7 (over 3% in 2001) Canada 3rd lowest in 2001 (<2%)
3.5 3 2.5 2 1.5 1 0.5 0
* Source: OECD * Note: For Italy, the graph is based on the latest available data for 2000

R&D as Ratio of National GDP in G7 Countries (2001)

Japan US Germany France Canada UK Italy

Japanese R&D = Total investment in Canada Result is tech leadership

Old industries have gone high-tech (eg: chem., steel) Final assembly no longer key to value-added:
eg: digital appliances; according to METI:

Made in Japan (ie: final assembly in Japan) products: 27% of global market BUT, Japan supplies 51% of global high-tech parts and semiconductors, 54% of manufacturing devices, and 65% of high-tech materials

Higher energy efficiency than competitors (eg: US, Korea, China)

15

Strengths:
Japan a player in Asias rise and integration
Japan key to Asia growth pole
On the surface, US+EU becoming less important in Japans trade Japanese aid and FDI historically top source in many Asian countries
400 350 300 250 200 150 100 50
92 94 96 98 19 90 20 00 02

Japanese exports (1990=100)

China, ASEAN process Japans exports to US, EU; also products for Japanese market
Asia buys Japans tech. and capital
Japan trade surplus with China, Korea

Japans firms drive processing trade Dynamic means US growth still has twice impact on Japan as Chinas
Chinese export growth key to Japan

total east asia

US + EU china*
16

Will Japans firms reach the new Asian consumer?

Source: Ministry of Finance, Japan

Japans productivity challenge

Population decline Productivity acceleration? Long-term structural change Capital allocation improvements Remaining policy challenges Decline or opportunity?
17
Photos: Nikkei Weekly

Population decline
The demographic imperative for faster productivity growth Japans population is now falling:
2005 saw first slight overall pop. decline
Total Population (thousands)
140,000 120,000 100,000 83,200 80,000 60,000 40,000 20,000 0 2005 =127,757 100,593

By 2050:
Down to 100M 30 million less people of working age (15-64) 10M more people age 65 and over

f 40 20

50

60

70

80

90

00

10

20

30

19

19

19

19

19

20

20

20

20

Source: Ministry of Internal affairs and communications

20

18

50

Productivity acceleration?
Is the increase structural or temporary after slowdown?
GDP/hour worked y/y%
4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00%

3.40%

GDP/hour y/y growth slowed after bubble

GDP/hour y/y growth slower in 94-03 vs. 85-93 (OECD)

Has productivity growth picked up again?

GDP/hour y/y growth was well above trend in 2005

-0.50% -1.00%

Embassy Calculation based on Cabinet Office and Ministry of Labour data

Key question: is Japan different than during postbubble period in a structural way?
Source: Cabinet Office

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

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Long-term change
Despite stagnation -- major structural shifts occurred
Like in all advanced economies, the tertiary (services) sectors share is growing:
The share of services in GDP increased 10% between 1990 and 2002 The share of manufacturing has fallen by 9% of GDP
100% 80% 60% 40% 20% 0%
1990 1994 1998 2002 TERTIARY SECONDARY PRIMARY
20

Source: Cabinet Office

Increased openness to trade

Japanese markets are becoming more contestable
Share of trade in economy is growing:
Asian integration: growing two-way trade with China and other Asian economies
9.47% 7.10% 16.00% 14.76% 14.00% 12.00% 13.35% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00%
Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Long term may see a trade deficit

Recovery and aging: savings down, cons. up current acct will stay positive: foreign inv. income

Trade balance/GDP

Exports/GDP

Imports/GDP

Source: Cabinet Office

21

Capital allocation improving

Big problem in 1990s was poor allocation of capital
35.00%

30.00%

Overall, Japan is investing less as a share of GDP:

Less total investment Significant decrease in public investment

25.00%

20.00%

15.00%

Trend suggests I/GDP ratio is edging up:

Due entirely to strong growth in private investment Firms increasing their capital, productivity, to meet growing demand, face labour shortages
Source: Cabinet Office

10.00%

5.00%

0.00%

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Fixed capital formation/GDP Public Investment/GDP Private capital formation/GDP

22

Areas for further improvement:

Capital market, services, agriculture
Capital market efficiency is improving
Households: 50% in cash; but interest in risk assets is rising Corp. fin was too bank-led
Now: Cos borrowing less, issuing more stock, bonds Lending down from peak (20%), but may be on rise again: syndicated loan boom

Services need further reform

lag US productivity up to 40% Competition weak, but reforms progressing: prices falling (e.g:
utilities)

OECD: Japan ahead on privatization, limiting financial interventionism, lags in dereg

Corp. control more marketdriven, arms-length investors now lead M&A, private equity booming Efficiency was postal reform key motive

Agriculture too protected

Protection among highest in OECD Govt too slow to reform ag.
BUT, ag trade opportunities may spur new openness (eg: apples)
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Government:
Debt, deficit and bureaucratic inefficiency
Rising debt, large deficit
Net public debt (% of GDP)

100 90 80 70 60 50 40 30 20 10 0 1999 2000 2001 2002 Canada 2003 Japan 2004 2005f 2006f

95% of debt held in Japan Deficit 5-6% of GDP

balance not likely until 2010s Taxes among lowest in OECD

Aggressive cuts are risky

At odds with anti-deflation drive

Govt small, but inefficient

Red tape barrier to growth:
privatization accomplished, but deregulation a work in progress

Reform: better govt, not smaller

public works cuts, govt FI reform

Rising social security costs:

govt will get bigger (G/GDP)
24

Source: IMF

Aging and population decline:

Demographic challenge or opportunity?
Aging or greying a milestone of social progress
Older people living longer healthier lives
Japan asking what is place/role of elders beyond dependency?

Low birthrate (1.29) challenge, but also opportunity

Challenge: women not participating fully in paid economy
Men: participation rate highest in OECD; women: among the lowest

Can demog. decline mitigate social costs that plague Japan?

crowding, env. pressure, resource dependence

Key policy priority: reform to boost output, taxes per worker

social security costs will double in the next 20 years Capital reallocation + tech can increase productivity (labour,TFP)

Demog. decline does not mean lower living standard

per capita GDP growth > GDP growth (eg: GDP 2%; pop 0.5%)
25

Assessment
Are Japans economic woes over? What is the long-term future of Japans economy? What does this mean for Canada and the world?

26

Are Japans economic woes over?

What is Japans long-term economic future?
Japan recovered, resilient, but LT challenges remain
Shift from export-led growth to domestic demand well underway Last short-term challenge is to normalize monetary policy Falling population and fiscal constraint means Japan needs to boost its productivity growth again: the reform imperative remains

Sudden change not Japanese way, but Japan is evolving at an accelerating pace
China factor, Asian integration: Asia is Japans new strategic focus Demographic change and new generation with different values Stronger private sector, a government forced to change by finances, households taking risks once again If handled right, the Japan that evolves will be fundamentally stronger than the bubble economy that was so feared in the 80s; Japanese firms may already be in the best financial shape ever
27

The future will not be like the past

Short-term outlook: main risks

Downside: Global economy, the US dollar and global imbalances, higher oil prices
Chinese economy stumbles hard and cuts off export growth US looks good, but housing bubble bursting is a risk US dollar fall would cause rapid yen rise and slow exports Japan is energy efficient, so direct effect of high oil is lessened, but may slow growth in key export markets

Upside: stronger than expected consumer revival, productivity growth

Labour market tighter; companies are increasing bonuses, dividends and starting raise wages
Domestic demand may continue to surprise to the upside

Improved capital allocation, labour shortages: more productive investment and rising productivity is possible
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Assessment
What does this mean for the world?
Japan is contributing to global growth again
The worlds second largest economy is integral part of Asian growth pole, and imports are gaining as a share of GDP

Emerging Japan-US-China economic triangle

Imbalance or a deepening of global integration? Japan a big market, but is increasingly hub of investment and tech. How does Canada plug in to the network?

Japanese government must change its relationship with its people, but also with the world:
less aid, more trade applying both at home and abroad Chequebook politics and diplomacy too expensive now: Japan will seek influence through other means
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Assessment
What does this mean for Canada?
Opportunities for trade in traditional & emerging sectors
Resources, housing, agriculture Innovation and science partner: IT, environmental technologies, nanotechnology, robotics, biotechnology, pharmaceuticals Investment partner

Prospects for new partnerships in technology, services and investment, key areas of future growth Demographics mean significant change in consumption patterns, new opportunities particularly in services Canadian companies can take advantage of Japans central place in the booming Asian economy
We must see Japan as Asias financial and tech hub, very much complementary to Asian high growth economies. New International Policy Statement recognizes this.
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The Canadian Embassy in Tokyo, Japan

7-3-38 Akasaka, Minato-ku, Tokyo 107-8503 Tel: (81) 3 5412-6200 Web: http://www.dfait-maeci.gc.ca/ni-ka
Contact: Laurence Blandford First Secretary, Finance and Economy Email: laurence.blandford@international.gc.ca

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