Financial Sector

December 2001

Japan's economy continues to deteriorate as corporate profits dive and prices fall faster, the government said, suggesting that Japan is near a deflationary spiral and putting more pressure on the central bank to ease credit further. "The economy continues to deteriorate," the Cabinet Office said in its December report, leaving unchanged its overall assessment. The report highlighted the beating companies have taken amid slack demand overseas and deepening recession at home. Harsh conditions in the corporate sector continue to hurt employment and could chill weakening consumer spending ever further. Corporate profits are falling sharply, cutting its assessment from last month. Business sentiment soured even more, as gloom spread beyond Japan's export-dependent manufacturers to the non-manufacturing sector, with small companies bleeding more red ink. The government reported earlier this month that Japan had slipped into recession once again -its fourth in a decade-, as the economy shrank 0.5% on quarter in the three months to September, the second straight period of contraction. The sharp and broadbased deterioration in recent months suggests the economy is sliding deeper into recession at an extraordinary pace. Deflation has intensified as the economy tips downward. Wholesale prices are falling at a slightly faster pace, a downgrade from last month's view that they were weakening. The WPI dropped 1.4% on year in November, gaining speed from a 1.1% decline in October. The report puts ever more pressure on the Bank of Japan to take aggressive steps to stamp out deflation. Consumer prices have been falling for more than two years despite the BOJ having pushed rates down near zero by flooding the financial system with more money than Japan's wobbly banks can lend or anemic companies will borrow. With the BOJ's policies so far having done little to fight deflation, politicians are turning up the heat once again on the central bank to consider more aggressive steps. Some policy board members have suggested buying corporate bonds could be a policy option. Other critics have called on the BOJ to buy foreign bonds, a controversial move that would ease monetary conditions by weakening the yen, but it would involve the Ministry of Finance, which is responsible for Japan's foreign exchange policy. Speculation the bank is moving in that direction, however, has helped to push the dollar sharply higher in recent weeks, with the U.S. currency cresting just above 128 Yen, its highest level in more than three years. BOJ Governor Masaru Hayami said that the bank is taking unprecedented measures and providing ample liquidity to the economy. There is no need to increase monthly outright purchases of government bonds or adopt inflation targeting policies. Personal consumption, which accounts for more than half of the gross domestic product, is "weakening." Employment conditions are getting more severe with the jobless rate is at a record 5.4%, as companies slash payrolls to cut costs, pointing to worse times ahead for consumers. The outlook for business investment, the other engine of private sector growth, is also dim. Core machinery orders, a leading indicator of private capital expenditure, fell to a 14-year low in October. Exports, which have been in a tailspin all year as demand for Japanese products suffers from the global IT slump and the economic downturn in the U.S., aren't falling as fast as before. As a result, the government upgraded its assessment of exports. The fall in exports had been extraordinary until now. Exports are still falling but the pace has slowed. The government appears to have its hopes pinned on exports bottoming out before too long. If the U.S. economy stages a recovery next summer, demand for Japanese products would pick up, helping to support the economy later in the year. It will depend on (economic activity) in Asia and the U.S to see whether exports will stop declining and start to increase. The Cabinet Office is moving to set the government's forecast for economic growth next fiscal year around flat to 0.1% growth, local media have reported. That view is largely based on the premise the U.S. economy stages a quick comeback. The government is expected to formalize its growth target for fiscal next fiscal later this week. (December 17, Dow Jones)

The fiscal 2002 tax system overhaul endorsed by the ruling coalition falls far short of the fundamental reforms needed to revitalize the nation's ailing economy.　　Although the policy-makers did decide to introduce consolidated corporate taxation, a measure widely expected to aid corporate restructuring, they were shackled by the need to plug tax revenue shortfalls. Prime Minister Koizumi has indicated that he will grapple with a structural reform of the tax system early next year. If fiscal requirements take precedence, then the reform drive will go nowhere. Now is the time to start thinking about a tax system that works for the economy instead of taxation at the economy's expense. Given the Koizumi cabinet's overarching goal of limiting new government bond issuance to 30 trillion Yen, the debate inside the LDP's influential Research Commission on the Tax System was confined to a "small playing field." As a result, the final blueprint ended up with no large tax increases, but no large cuts, either. While taxes are a bill for the public services provided by the central and local governments, taxation can be an effective tool to bolster the economy. The introduction of consolidated corporate taxation is a good example of using the tax system as a policy tool. Although the adoption of a surcharge on companies that opt for group taxation will dilute its effectiveness, the system will still make it easier for firms to split off unprofitable divisions and take other corporate restructuring steps. When Koizumi's Council on Economic and Fiscal Policy tackles the issue of tax reform next year, one of its major themes should be how to adjust the tax system to support the activities of companies exposed to global competition. Reforming land taxation will be another key issue. Setting aside tax rates themselves, simply streamlining the three layers of taxes that hit buying, owning and selling land should help not only to facilitate the cleanup of bad loans, but also to encourage private-sector investment in urban redevelopment. It will also be vital to zero in on securities taxation, making for fundamental changes to encourage investment in new industries and attract personal financial assets to the stock market. The elimination of a tax break on interest income earned by senior citizens marks a step in the right direction. But the Koizumi government will have to keep moving forward toward shifting the tax incentives from savings to investment. (December 15, the Nihon Keizai Shimbun)

The three-party ruling coalition has agreed on a broad framework for the fiscal 2002 tax reform package. The plan includes a system that relieves individual investors of the burden of filing income tax returns on capital gains. However, many fundamental reforms, including preferential tax treatment for investment trusts and a reduced tax rate on dividend income, have been postponed. The new tax reporting system is designed to prevent investors from shunning stock trading after the elimination of the system of separate taxation at source at the end of next year. Under the new system, individual investors will set up dedicated accounts at securities firms, which will then calculate capital gains or losses for their customers. If their stock trading yields gains, securities firms will pay taxes each month on their behalf. Investors, however, will still have to complete formalities on their own to claim tax refunds at the end of the year if they overpaid taxes for the year. They will also be able to claim tax refunds if they are eligible for preferential treatment allowing capital gains of up to 1 million Yen to be tax-exempt. The coalition parties are still ironing out differences on the issue of eliminating a tax exemption granted to income from interest on bank and postal deposits by senior citizens aged 65 and older. (December 13, the Nihon Keizai Shimbun)

A government advisory panel on deregulation targets 15 areas for reform, allowing banks to sell exchange-traded funds and making it easier for stock companies to start agricultural businesses in a new report. The report charts a reform course in 15 different areas that are expected to contribute to the revitalization of Japan's slumping economy, including finance, education, health care and labor. The report was prepared by the Council for Regulatory Reform, a new panel set up by Koizumi in April and headed by Orix Corp. Chairman Yoshihiko Miyauchi. After the cabinet's approval, the government will incorporate it into its 3-year deregulatory promotion plan slated for release in March next year. One of the striking features of the reform blueprint is that it grapples seriously for the first time with deregulation in health care, labor, education and other areas of society in which a loosening of restrictions has lagged behind business deregulation. However, the council left most of the key details of its proposals sketchy, avoiding a top-down approach and leaving room for negotiation with the various ministries and agencies involved. Miyauchi called the report a "big step" in the right direction, although he conceded that it does not contain everything that he had hoped for. The panel proposes lifting restrictions that effectively prohibit banks from selling exchange-traded funds. Making it easier for individual investors to purchase these funds will give a boost to the ailing stock market. But the panel ended up dropping the idea of allowing banks to sell real estate investment trusts, or REITs. The council also wants to remove restrictions that make it extremely difficult for stock companies to enter the agricultural field. More open entry for stock companies is expected to help raise the efficiency of Japanese farming by introducing management expertise from other industries. In education, the panel calls for a system that would allow children to attend public elementary and middle schools of their choice. The system is already in place in certain cities. (December 12, the Nihon Keizai Shimbun)

In a move aimed at facilitating corporate reorganization, a panel on regulatory reform will urge the government to lift restrictions on the asset size of holding companies. In July, the Council for Regulatory Reform unveiled deregulatory proposals for six key areas including medical care, social welfare and urban renewal. The final version, to be submitted to Prime Minister, will contain regulatory reforms for nine additional areas such as competitive policies, energy, finance and law. The panel is calling on the government to revise existing holding company restrictions, which prohibit a corporate group from setting up a holding company if total group assets exceed 15 trillion Yen, next fiscal year. The restrictions are to prevent the emergence of a large corporate group that wields strong influence in a particular industry. The panel believes easing the restrictions will help companies consolidate operations to boost their international competitiveness. Also, the panel seeks to eliminate current rules stipulating that major companies' shareholdings must be kept within their capitalization or net asset total. In addition, the panel is arguing that the Fair Trade Commission's structure should be strengthened through deregulation to prevent monopolies by major companies. In particular, the panel is calling on the government to strengthen the investigative power of the FTC. As for reform proposals in the energy sector, the council is urging the splitting up of electric transmission and generation divisions at electric power companies. The panel plans to come up with a conclusion next fiscal year. By opening up power line networks currently managed by power companies by region, the panel seeks to encourage new market entrants and bolster competition among existing market members. In the process, it aims to link deregulation to lower electricity fees. For the financial sector, the council is proposing that insurance sales at banks, which are currently limited to selling some nonlife insurance, be opened up to other types of policies. Not only will this result in greater convenience for policyholders, but it could potentially encourage competition among financial institutions through the diversification of products. The council is also urging changes in the distribution industry so that service firms will be required to disclose information and provide a full explanation when franchise chain contracts are signed. (December 6, the Nihon Keizai Shimbun)     

The Cabinet endorsed guidelines for the fiscal 2002 budget, in which a 30 trillion Yen cap on new government bonds forms the centerpiece of Prime Minister Koizumi's structural reforms. Based on the outline drafted by the Council of Fiscal and Economic Policy, the budget-making process will enter the final phase toward compilation by the end of the year. After incorporating demands by the ruling parties, however, the outline appears to lack the boldness of what Koizumi had initially planned. The council had hoped to increase the share of medical bills that salaried workers must pay from 20% to 30% as a means to curb government expenditure. The endorsed outline, however, simply says that such an increase should be implemented when necessary. The framework also modifies the council's initial proposal that revenue from the auto weight tax, which is funneled into road construction, should be divided into general purposes as a part of fiscal reform measures. The outline calls for strictly scrutinizing public works projects and promoting private finance initiatives to cut public works, spending 10% from the last year's budget. It also urges the government to avoid wasteful spending and boost funds for seven key areas: information technology, urban redevelopment, the environment, the aging population, revitalization of local communities, science and technology, and human resources development. If the reforms succeed, the government's primary balance, expenditures excluding debt-servicing costs and income excluding bond issues, would move into the black early in the 2010s. (December 5, the Japan times, the Nihon Keizai Shimbun)

Strategic spending is needed to stimulate growth. The government has outlined its reform-oriented budget policy for fiscal 2002 amid ardent and constant warnings about Japan's potential fiscal nightmare. As the Council on Economic and Fiscal Policy has decided, the budget should focus on a radical change in fiscal spending priorities. The rest of the world is taking an increasingly pessimistic view of Japan's public finances, as highlighted by recent downgrades of Japan's sovereign debt by Moody's Investors Service Inc. and two other rating agencies. Alarms sounding over Tokyo's debt trap, including numerous forecasts of red ink for the foreseeable future, have influenced the administration of Koizumi Cabinet to promise bold changes in budget allocations to remold the nation's economic structure. Budget guidelines set by the council call for public works projects to be subject to a rigorous priority review. This step is important for funneling limited fiscal resources into projects that can stoke the growth engine and prop up the economy. The focus should be on shifting budget priorities. Capping government bond issues at 30 trillion Yen, a policy obsession for Koizumi, is not the goal of fiscal reform. Delaying steps like the introduction of a consolidated taxation system to achieve the 30 trillion Yen target will do little to revive the economy, just as slashing appropriations across the board to curb bond issues will not amount to meaningful reform. Rules and conventions serving vested interests, such as earmarking certain tax revenue for road construction, must be eliminated. If necessary, Koizumi will have to be uncompromising on this front to crush the resisting forces within his Liberal Democratic Party. The prime minister needs to exert strong leadership to ensure the budget is compiled according to the council's guidelines. Number-crunching bureaucrats at the Finance Ministry and pork-barrel politicians in the LDP should not be allowed to tamper with the guidelines. Medium-term fiscal and economic projections should be added to put the budget in perspective. A convincing scenario for reforming the budget and restoring fiscal health would help allay public anxiety about snowballing debt. It is reasonable to set a fiscal policy target to put the primary balance into the black in 10 years. A spending cap is also a logical approach to achieve improved fiscal discipline. However, the challenge is to design effective priority-based allocations for growth regeneration, rather than overall spending cuts. (December 5, the Nihon Keizai Shimbun)

The annual report on the state of the economy and fiscal policy announced by the Cabinet Office reiterates the government's commitment to structural reforms for reviving the economy. The report specifically focuses on deflation, the government's snowballing deficit, and bad loans weighing heavily on the banking sector. Weak demand and an increase in cheap imports are aggravating deflation, which stunts corporate earnings growth, increases pressure for companies to repay debts, and inhibits capital investment. Households also tend to curb spending in order to pay mortgages. With regard to the banking crisis, the report notes that nonperforming loans and excessive debt weighing on companies continue to hamper the economy. The report also notes that considerable corporate resources including workers, capital and land are still stuck in unprofitable businesses and areas of low productivity. The rise in productivity at firms relying on bank loans has been lower than overall economic growth since the mid-1980s, according to the report. This finding suggests that banks continued lending money to struggling firms to keep them afloat and prevent loans from going bad. The report estimates that more than 80% of the government deficit will not be eliminated even if the economy improves; most of it is linked to Japan's demographics, fewer children and a growing elderly population. If it is to avert a sharp rise in long-term interest rates, which could be triggered by market fears of a possible default on government bonds, the government should strive to achieve a surplus on the primary balance and engineer economic growth underpinned by the strength of the private sector. A primary balance refers to a condition in which government revenue excluding bond proceeds matches total expenditures minus debt-servicing costs. The report argues that increased fiscal spending to boost demand will not solve the problems that lie at the heart of Japan's current economic woes. However, the Japanese economy can achieve an annual average of about 2% growth over the medium and long term, if companies shift resources to more productive areas, banks quickly dispose of bad loans, and the government carries out further deregulation and gives more support to entrepreneurs. The report, however, had little to offer on how to fight deflation and deal with a mountain of bad debt. (December 4, the Nihon Keizai Shimbun)