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Figure 14. Budget balance and public debt
OECD Economic Surveys: Japan
debt makes it a serious concern, the scope for reducing the budget deficit in the
current economic environment is limited as it could deal a serious blow to growth
prospects. On the tax side, receipts from income taxes on households and firms
have fallen significantly in absolute terms during the past decade, reflecting both
tax cuts and slow economic growth. Consequently, the share of tax and non-tax
revenue in GDP in 2001 was below 32 per cent, the second lowest in the OECD
area. While higher revenues will certainly be necessary to achieve fiscal sustainability, a significant increase at present risks curtailing the economic expansion.
Spending pressures also complicate the task of reducing the government
budget deficit. Perhaps most important is the rapid ageing of the population.
Under the current social security system, outlays for pension, medical care and
welfare programmes are projected to rise by a third over the next seven years. The
contingent liabilities of government corporations might also increase public spending. The debt of such corporations, some of which are scheduled for reform, exceeds
total GDP. The financial sector is another area where potential outlays may be
necessary. Since all bank deposits were fully guaranteed until April 2002, 18 trillion
yen (3.6 per cent of GDP) of public funds have been used to cover the cost of failure
of 16 commercial banks and 152 commercial cooperatives between 1996 and
March 2003. In addition, the recent injection of 2 trillion yen into a troubled bank
and the new framework governing such injections may lead to higher outlays in
this area, which would hopefully help restore the credit channel. Given these significant spending pressures, maintaining government expenditures at a constant
share of GDP will require major cuts in discretionary outlays, particularly public
investment. The importance of such spending in many regional economies
suggests that the economic impact could be substantial.
Enhancing competition to boost growth
While increasing the intensity of competition would significantly boost
output – by around 6 per cent according to Secretariat estimates – there are many
obstacles to achieving this objective. Most serious is the insufficient strength of
the Fair Trade Commission (FTC), which was created in 1947 but has played a limited
role, reflecting in part the dominance of line ministries in supporting the development of specific sectors. Strengthening the FTC will require measures to expand
both its resources and its independence, in part through ending its reliance on
retired civil servants from other ministries and creating a career path within the
Commission. Low sanctions for violators of the Anti-Monopoly Act limit its deterrent effect and reduce the scope for an effective leniency programme to encourage whistleblowers. The prominent role and high number of trade associations in
Japan, which aim to promote flows of information and friendship among their
members, is another challenge to preventing collusion and strengthening competition. Reducing the FTC’s emphasis on “unjust low prices”, which involve an
important degree of industry self-regulation, would also help encourage competition.
© OECD 2004
Macroeconomic developments and key economic challenges
Strengthening competition will also require overcoming difficult problems
in network industries, where the progress in deregulation is still in its infancy
compared to most other OECD countries. One deficiency is the lack of independent sector regulators to ensure pro-active ex ante regulation. Vertically-integrated
industry structures in some sectors, such as electricity and natural gas, have
hampered competition. The resulting lack of frameworks for physical interconnection and non-discriminatory access charges and conditions, as well as for vertical
unbundling of activities, is a serious problem. In other sectors, such as transport,
competition is limited by tight regulation of charges for facilities and related
services. In sum, boosting competition will require many reforms to strengthen the
FTC and to change the structure of network industries.
Other structural reforms to enhance potential growth
Progress in regulatory reform – another important aspect of enhancing
competition – has been disappointing in many respects. The Council for Regulatory
Reform, which consists of private-sector experts, has been unable to overcome the
opposition of various ministries to its recommendations, despite the Council’s
location in the Prime Minister’s office. Consequently, proposals to open key
sectors, including agriculture, health care and education, to joint-stock companies
have not been accepted. Barriers to entry thus remain important in many sectors.
Perhaps more important is the cost of failure, which tends to discourage business
start-ups, a key factor for productivity growth. Moreover, there is no institution
with the power to screen new regulations. Japan is also relatively closed to international trade and inflows of direct investment, important sources of competitive
pressures. To some extent, this represents Japan’s exclusion from regional trade
agreements, primarily due to its preference to maintain high levels of protection
for agriculture. The failure to boost direct investment, despite a number of
measures to encourage such inflows, appears to reflect concerns on the part of
potential investors about a difficult business climate and weak growth prospects.
The under-development of labour markets external to firms hinders the increased
labour mobility that needs to accompany the restructuring of the corporate sector.
Finally, the declining working-age population and increased unemployment
among young adults are important challenges that need to be met to sustain
Japan’s growth potential.
© OECD 2004
Bringing deflation to an end
Faced with the zero constraint on nominal interest rates, the Bank of Japan
has substantially increased the quantity of base money through its quantitative
easing policy. In addition, the scope of this policy has been expanded by broadening the range of assets purchased by providing credits directly to small and
medium-sized enterprises. At the same time, intervention in the foreign exchange
market has limited the appreciation of the yen, effectively supporting the recovery
of exports. These monetary policy measures have been successful in maintaining
financial-market stability and accommodating the current economic recovery.
Nonetheless, the central bank has failed to achieve the objective of sustained
growth in nominal income as deflation, as measured by the GDP deflator,
remained persistent at an annual rate of 3 per cent in the first half of 2003. Moreover, the current policy has serious negative side effects that will complicate the
exit from the current situation. Given the corrosive impact of deflation on economic
prospects and the risk of a deflationary spiral, achieving a positive rate of inflation
is a key priority. This chapter begins by outlining recent developments in monetary
policy and the reasons why it has failed thus far to fully achieve the desired
impact. It then outlines policy changes that will help bring deflation to an end.
One necessary condition is to resolve the problems in the banking sector, which
have closed the credit transmission mechanism. The chapter analyses the factors
responsible for the fragile banking industry and suggests measures to help restore
it to financial health, before offering an overall conclusion.
Monetary policy in the quantitative easing framework
During the past year, the Bank of Japan (BOJ) has been trying to ease monetary conditions further under the “quantitative easing” framework, which was
initially announced in March 2001 and has been evolving since then. With shortterm interest rates fixed near zero, the central bank conducts monetary policy by
setting a target for current account balances at the central bank. The policy target
was initially set at 5 trillion yen in March 2001 and eventually raised in
October 2003 to 27 to 32 trillion yen – around 6 per cent of GDP and more than five
times greater than the level of legally-mandated reserves (Figure 15). The quantitative approach has resulted in a 50 per cent cumulative increase in base money
© OECD 2004
OECD Economic Surveys: Japan
Figure 15. Outstanding current account balances at the Bank of Japan
Note: Dotted lines show the Bank of Japan’s target.
during the past two years. To achieve the current account target, the BOJ purchases 1.2 trillion yen of Japanese Government Bonds (JGBs) per month, which
implies that about a third of the general government deficit is effectively financed
by the central bank. The BOJ is publicly committed to continuing quantitative easing
until the Consumer Price Index (CPI) measure of inflation, excluding fresh food,
registers zero or positive in a stable manner. Monetary policy also aims at
preventing an accidental shortage of liquidity in the short-term money markets,
such as the one that triggered the collapse of some major financial institutions
in 1998. On top of the ample provision of liquidity, the central bank has set up a
standby “Lombard-type” lending facility through which it can extend loans at the
official discount rate (currently 0.10 per cent) at the request of financial institutions.
Recent measures to ease monetary conditions
The BOJ left its policy target unchanged from the beginning of 2002
through October in the expectation that the cyclical recovery would continue.
However, it has played a more aggressive role since the autumn of 2002 to reduce
the risk of financial instability arising from the weakness of the banking sector.
With the stock market falling from July 2002 (Figure 16), there was concern about
the impact of lower share prices on the balance sheets of banks, whose shareholdings exceed their tier I capital. To reduce the risk associated with large shareholdings,
the central bank announced a scheme in September 2002 to purchase some of those
© OECD 2004