Structural Change in Japan : Macroeconomic Impact and Policy Challenges

Tamim Bayoumi, Guy Meredith, and Bijan Aghevli

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1998
• ISBN:
  9781557756961

NONE

1 Introduction

This conference volume is based on a one-day seminar on Japan held at the IMF in early 1997 that I chaired, in which the staff presented their views on various sectors of the Japanese economy and the results from current research on new topics. In addition to other members of the IMF, we were lucky to be able to invite an impressive list of outside experts on the Japanese economy, who contributed immensely to the quality of the discussion. From the local area, we had Drs. Ralph Bryant and Edward Lincoln from The Brookings Institution, Dr. Joseph Gagnon from the U.S. Federal Reserve, and Professor Junichi Goto, at that time at the World Bank on leave from the University of Kobe. We were also pleased to have three invitees from other parts of the United States, Professors Koichi Hamada from Yale University, Fumio Hayashi from Columbia University, and Gary Saxonhouse from the University of Michigan, as well as Dr. Jean-Claude Chouraqui from the Organization for Economic Cooperation and Development (OECD). And we were particularly honored to have a number of senior officials and academicians from Japan, including Dr. Haruhiko Kuroda from the Ministry of Finance, Dr. Masaru Yoshitomi from the Long-Term Credit Bank of Japan, Dr. Masahiko Takeda from the Bank of Japan, and Professors Kazuo Ueda and Masahiro Kawai, both from the University of Tokyo, whose presence helped make the event a success. Having so many learned experts on Japan together at one time to share their knowledge and insights with us was exciting indeed.

The genesis of this seminar was, to use a fashionable term, a desire for increased transparency in the IMF. We have been making considerable efforts recently to provide more information to the public. For example, where the authorities agree, we are now publishing much of the country-specific work associated with our regular consultations with our members. In those cases—the great majority of our members—we now offer our reports on members’ Recent Economic Developments, as well as background papers on more specific topics contained in our volumes on Selected Issues.

This seminar took the process of transparency one stage further. Currently, we generally publish the results of the staff’s analysis only after it has been completed. In this seminar, however, we initiated a discussion of staff views during their formulation. By opening the process of discussion and debate with outside experts, we gained insight and improved our current in-house policy analysis, and helped others understand the analytic basis of our thinking and recommendations.

Much has happened since early 1997 in both Asia in general and in Japan in particular. The crisis that enveloped the region during the later half of 1997 was not predicted at the time of the seminar and has clearly changed perceptions of short-term prospects in Asia dramatically. Fortunately, as the focus of the seminar was on underlying analysis of Japan by IMF staff rather than near-term issues, the work presented here has maintained its interest despite these events.

The Japanese economy faces issues as it recovers from recent weakness. In many ways, the day-to-day management of the standard levers of fiscal and monetary policy are interlinked with the more deep-seated structural issues, which pose the greatest challenges for the Japanese economy. These structural elements include the economic consequences of the aging population, the impact of globalization and increasing economic integration with the rest of East Asia, and the difficult and painful process of domestic deregulation and administrative reform. By shifting and destabilizing the underlying economic relationships and creating uncertainty, these structural changes complicate the task of policy analysis immensely. These complications cut across all external and domestic economic issues.

Accordingly, the papers are organized in four sessions. The first two sessions cover external issues (the yen exchange rate and the external current account), while the next two sessions cover internal issues (monetary and fiscal policies). Each session has a summary of the staff’s past analysis and policy advice on Japan, followed by a paper outlining ongoing research by the staff in each of the four areas, and then a summary of the comments on these papers from two discussants, well known for their knowledge of the Japanese economy, and the floor discussion. In some cases, additional papers pertinent to understanding the analysis of the staff are also included. The papers in each session provide an illustration of how research and policy analysis feed on each other in the IMF, and the staff’s continuing work on refining and expanding its underlying views on policy issues.

Appropriately for an organization called the International Monetary Fund, and mindful of our origins in the Bretton Woods exchange rate system, the first session considers staff views on the yen. A notable feature of the yen has been its trend real appreciation over the postwar period, which reflects the relatively large difference in productivity trends between traded and nontraded goods in Japan compared to its competitors, the so-called Balassa-Samuel-son effect. One issue is, therefore, whether this trend appreciation will continue. Certainly, this appears to be the prediction of financial markets, as interest differentials remain large compared with predictions about future levels of inflation.

Interesting as the trend appreciation in the yen is, however, recent fluctuations in the value of the yen around this trend have been even more striking. Since May 1995, the yen has depreciated from its peak value of just below 80 to the dollar to more than 130 to the dollar. It is hard to accept that this movement represents purely rational responses to long-term developments in both economies. Rather, these large and rapid movements in the exchange rate appear to some extent to represent market overreactions—and they in turn can cause significant disruption to the real economy. These unpredictable and disruptive exchange rate movements lead inevitably to the question of what is an appropriate framework for determining the correct underlying level for the yen. There has been considerable divergence of views among the IMF staff on the desirability of relying on a model-based approach to assessing the degree of overshooting in foreign exchange markets. The Japan team has been on the proactive side of this debate, as can be seen in the paper “The Yen: Past Movements and Future Prospects” in the first session.

In the subsequent session, we considered the related issue of the appropriate level of Japan’s current account surplus. As everyone is aware, Japan’s surplus has been a consistent source of tension with other industrial nations, most notably the United States. An important issue here is whether the surplus reflects underlying structural rigidities in the economy, including trade restrictions, or rather trends in saving and investment, which are related to macroeconomic and demographic trends.

One complication in this analysis is that the underlying relationship between macroeconomic variables and trade may not be stable, as the structural shifts that have taken place in Japanese industry over the past decade or so may have affected flows of trade and capital independently of aggregate demand and real exchange rates. In particular, the substantial move of manufacturing capacity offshore through outward foreign direct investment is often thought to have significantly affected trade patterns. The paper “Japanese Foreign Direct Investment and Regional Trade” by Tamim Bayoumi and Gabrielle Lipworth looks at these structural changes in more detail by focusing on the determinants of Japanese outward foreign direct investment (FDI) since the early 1980s and its link to trade flows.

The next session discusses the role of monetary policy in Japan. Here, the most immediate issue is when the current loose monetary stance should be tightened. With short-term interest rates of ½ of 1 percent a year, the Bank of Japan is providing as much assistance to the recovery as it can. The underlying issue is when the recovery will be sufficiently robust that the Bank of Japan should begin pushing short-term interest rates up from their current floors. For example, it appears in retrospect that the monetary authorities probably underestimated the impact of the appreciation of the yen between 1992 and early 1995 on the real side of the economy. Hence, monetary policy may have been loosened too slowly, jeopardizing the recovery.

To assist in the assessment of monetary policy, the staff has been developing indicators of overall monetary conditions and, more recently, of overall financial conditions. The intellectual background to this work is discussed in the background paper in the third session, “A Reexamination of Indicators of Monetary and Financial Conditions,” which describes and evaluates a “financial conditions index” that takes account of the impact on aggregate demand of movements in the interest rate, exchange rate, fiscal policy, and the stock market. All four elements in this cocktail have been rather unstable during the 1990s, which has significantly complicated the interpretation and operation of monetary policy.

As in most other industrial countries, the underlying relationships between the monetary instruments and real and nominal output have been unstable in Japan over time, further complicating the task of monetary management. The paper “Structural Change and Information Content of Financial Variables for Monetary Policy” by Christopher Towe, also in the third session, explores this issue in more detail by examining the stability of the relationship between financial variables and real output and inflation.

The fourth session deals with Japan’s fiscal policy, which is facing the unenviable challenge of dealing with two separate objectives. First, the government’s current fiscal deficit is clearly unsustainably large. The significant fiscal stimulus provided in recent years has increased the general government deficit (excluding social security) to 6½ percent of GDP in FY 1996 and, to make matters worse, population aging is expected to create substantial fiscal pressures over the medium term. But second, the large excess capacity in the economy limits the scope for too-rapid fiscal consolidation.

Although the debate on Japanese fiscal policy focuses on the overall stance of policy, the government of Prime Minister Hashimoto has also expressed an intention to pursue administrative reform. This reform will involve a thorough look at all aspects of government spending. In addition to direct outlays by the national government, including those on public works, this review will include the Fiscal Investment and Loan Program and the role of public corporations. Such a thorough overall of the existing fiscal system is an important initiative.

Given this interest in administrative reform, the paper “The Japanese Fiscal System and Fiscal Transparency” by Tamim Bayoumi, in the fourth session, focuses on a critical assessment of the overall fiscal system, using fiscal transparency as its underlying theme. Fiscal transparency has been an active area of research within the IMF for some time, reflecting a belief that eventual outcomes are affected by administrative processes as well as individual intentions. The willingness of the current government to consider radical changes to the fiscal system make this a particularly appropriate moment to consider the strengths and weaknesses of the Japanese fiscal system from this particular vantage point.

Stanley Fischer

First Deputy Managing Director

International Monetary Fund

I The Yen

2 The Yen: Summary of Staff Views

Bijan B. Aghevli

Sharp swings in the yen in recent years have had an important influence on the course of Japan’s downturn and subsequent recovery. In particular, the appreciation that began in late 1992 through mid-1993 weighed down aggregate demand, thereby amplifying the cyclical downturn in activity. In early 1995, as some of these recessionary pressures were beginning to unwind and initial signs of recovery were emerging, a further sharp jump in the yen caused equity prices to plunge, threatening to throw the economy back into recession. By contrast, the depreciation of the yen in 1996 and early 1997 provided support to activity.

The staff believes that these recent swings in the yen are too large to be explained by movements in fundamentals, implying significant deviations in the yen from its underlying equilibrium level. The conclusion that market exchange rates can deviate from their longer-term equilibrium levels underscores the need for the staff to have a methodology that provides an independent view of the level of the yen consistent with fundamentals. The possibility that misalignments may stem from “market failures” may also provide a rationale for offsetting policy actions.

The staff’s methodology for assessing misalignment in exchange markets involves comparing the external balance that would be generated by the current level of the yen—taking into account market expectations of its future path implied by interest-rate differentials—with the external balance consistent with Japan’s medium-term saving-investment patterns. To the extent that these two measures of the external balance are inconsistent, the staff’s view is that “tensions” are likely to emerge over the medium term that would tend to bring the yen back into line with fundamentals. As such, the analysis is not intended to provide a short-term forecast of exchange rate movements, but rather a longer-term assessment of potential inconsistencies between market expectations and economic fundamentals.

Looking at the events of the past few years, the sharp appreciation of the yen in the spring of 1995 took it to levels that appeared extraordinarily high in relation to the historical experience, even allowing for an upward long-term trend in the yen’s real value (reflecting Balassa-Samuelson effects). The staff’s analysis suggested that, if the yen were to continue to appreciate from this level at the rate suggested by interest-rate differentials between yen and foreign-currency assets, the external surplus would fall over the medium term to a level well below that implied by Japan’s underlying saving-investment patterns. Thus, the staff judged the yen to be substantially overvalued. Subsequently, the real effective value of the yen fell by about 35 percent as of early 1997, taking it below historical trends. If the yen were to appreciate from that level (¥127 per U.S. dollar) at the rate suggested by interest-rate differentials, the staff estimated that the external surplus would fall slightly over the medium term, but would end up somewhat above the level implied by saving-investment fundamentals.¹ This implies some undervaluation of the yen as of the spring of 1997, but the absolute magnitude was significantly smaller than the overvaluation in early 1995.

The authorities’ view has been that, while it is not possible to identify an appropriate level for the exchange rate, sharp movements are undesirable. While accepting the difficulties of accurately determining exchange rate misalignments, it also seems problematic to judge the appropriateness of movements in the exchange rate in the absence of a view as to the underlying equilibrium level. Thus, the staff believes that the sharp depreciation of the yen from the overvalued level in mid-1995 was justified, as it brought the exchange rate better in line with fundamentals, whereas the earlier steep rise was inappropriate.

Exchange rate misalignments may be of concern for a number of reasons, including their implications for future volatility in financial markets and the distortions they cause to trade and investment patterns. From the point of view of macroeconomic policies, the importance of these considerations must be judged against the background of cyclical policy requirements. In early 1995, the overvaluation of the yen clearly threatened to undermine a recovery that was already tentative. The staff believed that decisive stimulus measures, particularly on the monetary policy front, were called for to offset the effects of the surge in the yen on activity. In the event, significant reductions in interest rates by mid-year were associated with both a reversal of the yen’s appreciation and a recovery in interest-sensitive components of domestic spending. The situation in early 1997 was quite different in that the weakness of the yen was acting to support activity at a time when near-term growth prospects were uncertain, large margins of excess capacity remained in the economy, fiscal policy was turning toward consolidation, and there was limited scope for further monetary easing. In such an environment, policy actions to address yen under...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Acknowledgments
• 1 Introduction
• I. The Yen
• II. The External Sector
• III. Monetary Policy
• IV. Fiscal Policy
• V. Concluding Remarks
• Footnotes