Japan

OECD Economic Outlook, Dec, 2008

External shocks from the run-up in commodity prices and then international financial turbulence have brought Japan's expansion to an end. Equity prices have plummeted and the yen has appreciated substantially. With falling exports, activity is projected to remain weak through 2009, pushing up unemployment and reducing headline inflation to near zero. A recovery in domestic demand is projected to lift output growth to around 1% during 2010, still short of the growth of potential.

The cut in the policy interest rate by the Bank of Japan should be accompanied by measures to support activity by providing sufficient liquidity to the market to limit the impact of financial stress and mitigate deflationary pressures. While the fiscal stimulus announced in late October will cushion the downturn in 2009, it will be important to focus again on fiscal consolidation as the economy stabilises, given the very high public debt ratio and the costs of ageing. Structural reforms to boost productivity, particularly in the service sector, remain a priority to improve living standards in the face of a shrinking working-age population.

The negative impact of the terms-of-trade shock ...

The expansion--the longest in Japan's post-war history--came to an end around mid-2008 with a sharp contraction in exports, reflecting the slowdown in world trade and marked yen appreciation. Weak exports are, in turn, reducing business investment, the second major driver of the expansion. The commodity price shock also lowered profitability as firms have had difficulty in fully passing on their higher costs. The rise in headline consumer price inflation, to a peak of 2.2% (year-on-year) in the third quarter of 2008, reduced household real income, thus damping private consumption. Household income was also negatively affected by deteriorating labour market conditions, as employment growth slowed, the job-offer-to-applicant ratio fell well below parity and wage growth stalled.

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... was aggravated by the global financial crisis

The global financial market crisis is further worsening economic conditions. Business confidence dropped to its lowest level in five years in September 2008, especially among small manufacturing companies, and firms have revised down their investment plans. The appreciation of the yen, by 16% in trade-weighted terms since July 2008, further dims the outlook for exports. Equity prices have dropped steeply--by 24% in October alone--leading to tighter financial conditions and reducing household wealth. The collapse of a real estate investment trust and a life insurance company in October 2008 raises concerns that Japan's financial market, which thus far has been largely untouched by the turmoil sweeping through world financial markets, may be negatively affected. In addition, the interest rate spread between government and corporate bonds has widened since mid-September and the number of corporate bond issues has declined.

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Fiscal stimulus is being used to limit the downturn ...

Output growth is likely to be sustained in the first half of 2009--albeit at low rates--by residential investment and fiscal stimulus. Housing starts (in terms of area), which collapsed in the second half of 2007 following a revision in the Building Standards Law, have been on an upward trend. The two economic stimulus packages introduced in autumn 2008 will boost public spending by about 1% of GDP, with lump-sum payments to households accounting for almost half of the total. The fiscal stimulus will reverse the downward trend in the primary budget deficit, which had fallen from 6.4% of GDP in 2004 to an estimated 2% in 2008 on a general government basis, excluding one-off factors. In 2009, it is projected to rise to around 3%, making it difficult to achieve the government's fiscal year 2011 target of a primary surplus for the combined central and local governments. Meeting this objective, even if a little later, is a necessary first step to reducing the government debt ratio, which at over 170% is now the highest ever recorded in the OECD area, during the 2010s.

... and the policy interest rate has been cut

Given mounting deflationary pressures and turbulence in international financial markets, the Bank of Japan lowered its policy interest rate from 0.5% to 0.3% in October 2008, the first cut in seven years. Headline inflation is falling from its summer 2008 peak, reflecting the recent decline in oil prices and a stronger yen. Meanwhile, core consumer price inflation (excluding energy and food) has remained around zero since 2007. With rising unemployment, anaemic wage growth and falling unit labour costs, headline and core consumer price inflation are likely to turn slightly negative in 2009. In addition, residential land prices, which stabilised in 2006 after 15 years of decline, appear to have started falling again.

Economic growth is projected to remain sluggish during 2009 ...

As the fiscal stimulus fades, output growth is projected to stall in the second half of 2009 before picking up in 2010. The external sector is expected to remain a significant drag on activity through 2010, assuming a constant exchange rate. Domestic demand, however, should lead a modest rebound in output growth to around 1% by mid-2010. Consumption spending will be underpinned by gains in real household income in a context of stable prices, smaller falls in employment and a pick-up in wage growth. In addition, the shift to lower-paid part-time workers is likely to end, thus removing a significant drag on wage gains. Moreover, the terms of trade are likely to improve in 2009, for the first time in a decade, and then stabilise in 2010. Stronger consumption growth would in due course help reverse the fall in business investment, which is projected to decline for five consecutive quarters through mid-2009. The continued normalisation of the housing market should make a positive contribution to growth in both 2009 and 2010. Nevertheless, output growth is projected to remain below potential through 2010, with the unemployment rate around 4 1/2 per cent. Consequently, inflation is expected to stay steady at around zero.