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The Outlook for Japan and its Global Implications -- Address by Shigemitsu Sugisaki
July 14, 1998
It is a great pleasure for me to open this symposium—along with Mr. Crockett—and to speak on a topic that is intensively debated not only in Japan but in the IMF and the rest of the world. Today, I would first like to talk about the outlook for the global and regional economy and why a resolution of Japan’s current problems is so important. I will then turn to what we in the IMF see as necessary for a sustainable recovery in Japan, including the essential elements of a solution to Japan’s financial sector problems. During recent months, we have had several vivid reminders that the "Asian" crisis is still with us. We have seen pressures spreading from many of the emerging economies of Asia, but also from Russia and, of course, from Japan itself. And we have begun to see data showing the magnitude of the economic downturns that many of the countries in the region are suffering. It will take determined policies to achieve a turnaround in Asia and relieve these threats to the global economy. In this context, the emphasis of this symposium on the global implications of a sound banking system in Japan is especially apt. As the second largest advanced economy in the world, the biggest market in Asia, and the largest supplier of financing to its regional partners, Japan will play a critical role.
I. Asia and the Global Outlook
Much of Asia has been in the grips of financial turmoil for a full year now. The crisis has occurred against the backdrop of a relatively robust world economy. As a result, the current global economic slowdown is still expected to be less severe than those following the first oil price shock or that of the early 1980s. This still appears to be the case even though the review of the IMF’s world economic projections currently underway seems likely to lead to significant downward revisions to projected global growth in 1998 and 1999 compared to the outlook we released three months ago. The downward revisions seem likely to be concentrated in Asia, including Japan, and some emerging market economies in other regions. For the industrial countries of North America and Western Europe, the outlook generally continues to be one of buoyant growth. In the United States, some of the first quarter surge in activity is likely to be transitory and the impact of the downturn in Asia is being felt in parts of the economy. Nevertheless, domestic spending should remain firm given buoyant financial and labor markets. Recoveries are generally on track in the countries of the European Union, with higher business and consumer confidence in the prospective euro area pointing to strengthening domestic demand. But whether the global outlook remains relatively favorable depends in large part on how Japan and other countries of Asia respond to their current difficulties.
The adverse impact on real activity of the prolonged financial strains are increasingly being felt throughout Asia as the sharp falls in currencies and stock markets lower private wealth and confidence. It now seems inevitable that output will contract at a double-digit rate this year in Indonesia, with substantial declines also in prospect for Korea, Thailand, and, to a lesser extent, Malaysia, and Hong Kong. Growth is also slowing in China. So the crisis is exacting a heavy toll on economic activity and human welfare. In Japan itself, the weak spending and production data and rising unemployment for the first half of the year show an economy in recession. Activity should pick up in the second half as the recent fiscal stimulus measures take effect, but output is likely to contract for 1998 as a whole.
On the positive side, many of the Asian "crisis" countries have been broadly successful in implementing reform programs and, in most cases, currency stability is being slowly restored. Except for the rupiah, currencies have recovered partially from their January lows—by 15–35 percent in nominal effective terms in Thailand and Korea. While this required an initial tightening of monetary policy, together with temporary increases of interest rates, there has been a cautious reduction of rates over the past few months as countries have been able to restore a measure of stability. As confidence returns, and exchange markets continue to stabilize, it should be possible gradually to reduce interest rates further. Inflation has also remained remarkably subdued (except in Indonesia), with annualized rates of inflation currently in the range of 4–10 percent.
At the same time, the fast turnaround in the trade and current account positions has continued; the combined merchandise trade balance of the Asian-5 countries—Indonesia, Korea, Malaysia, Philippines, and Thailand—has improved by some $130 billion, on an annualized basis, since early 1997. Korea and Thailand have shifted to large current account surpluses. So far, this turnaround reflects primarily a shrinking of imports rather than an acceleration of exports. But the improved competitive position of the countries most affected by the crisis should soon feed through into their export revenues and should help cushion the contraction in domestic demand. So if these countries stick to their reform programs, growth should return toward the end of this year or early next year.
We already see signs of more buoyant growth in these countries’ exports to the United States and Europe. Unfortunately, exports to Japan have been falling. In early 1998, exports from Korea, Thailand, and Malaysia to Japan were down by between 15–20 percent, in U.S. dollar terms, from a year earlier. Of course, Japan’s exports to these countries have also been falling sharply. The weakness of intra-regional trade seems large even after taking account of the slowdown in Japanese domestic demand and the depreciation of the yen. Falling commodity prices, sharply declining demand for construction materials, as well as a decline in outsourcing of components by Japanese manufacturers cutting back production also appear to be important.
The key challenge now is to follow through on the difficult structural reforms that are critical to restoring the long-term health of these economies. The hardest parts of these reforms will be accelerated financial and corporate sector restructuring, which are now firmly at the top of the immediate agenda in Korea and Thailand. As for Indonesia, political turmoil and policy slippages have exacted a substantial economic price, but a revised and much strengthened economic program has now been put in place. Moreover, macroeconomic programs should be, and are being, adjusted in all these countries to reflect changing economic circumstances. In particular, the IMF has supported a relaxation of fiscal targets to allow automatic stabilizers to work and incorporate social safety nets.
Other factors will also be important to the restoration of stability in regional markets. China’s determination to hold its exchange rate steady has rightly been commended by the international community. Any devaluation of the renminbi would risk setting off another round of devaluations in the region, thereby further destabilizing foreign exchange markets.
But, difficult as adjustment undoubtedly will be in the economies most affected by the crisis, it will be much harder if undertaken in an environment of stagnating demand for their exports and declining flows of financing. And it is in these areas that Japanese economic policies will have a crucial influence.
II. Japan and Asia
The economic challenges that Japan faces today are perhaps the most difficult since the immediate post-war period. How well these challenges are addressed is, of course, of major domestic concern. But Japan’s economic weight is so large that it also has a major impact on prospects for the entire global economy and especially for Asia:
• With a little over 2 percent of the world’s population, Japan accounts (at market prices) for about 14 percent of world GDP and for over half of Asia’s GDP.2
• Japan is one of the most important markets for Asia’s exports—accounting for about 17 percent of exports from the Asia-5 countries and China. Exports to Japan represent a remarkable 12 percent of Malaysia’s GDP and 4–7 percent of that of Indonesia, Thailand, and South Korea.
• Japan’s banks have been the largest lenders to the region—accounting for about one third (around $97 billion) of total BIS exposure to the Asia-5 countries at the start of the crisis in mid-1997, and a similar proportion to China. Japanese banks are especially important in Thailand, accounting for over half of all international bank lending.
• Japan is the largest single source of foreign direct investment inflows into East Asia ($6 billion a year on average during the 1990s, or about one fifth of the total).
Reflecting these close linkages, spillover effects from the economic downturn in Japan are already affecting recovery prospects more broadly in Asia. IMF staff estimates suggest that the downturn in Japanese domestic demand and the depreciation of the yen against the dollar could lower GDP in the Asia-5 countries by almost 1 percent in 1998. On the other hand, the Asia crisis is estimated to lower Japan’s GDP by 1–1¼ percent in 1998.
Capital flows within the region have also been adversely affected by the financial strains in both Japan and the recipient countries. Japanese bank loans to the Asia-5 countries fell by 10 percent (or about $10 billion) in the second half of 1997. This was a much sharper decline than from other BIS-area banks (where the decline was about 3 percent). If Japanese banks are not swiftly restored to financial health, these trends are likely to continue, reducing their ability to finance new projects and regional trade. So far foreign direct investment flows have been less affected. However, there appears to be a well-established link between FDI outflows from Japan and the real exchange rate, suggesting that a weaker yen could dampen such outflows.
III. Fostering a Sustainable Recovery in Japan
So what is needed to foster a sustainable recovery in Japan? There is broad agreement on the critical steps, and the Government has already begun action on many of them. At the heart of Japan’s protracted economic slowdown are structural problems associated with the financial system that were first revealed by the bursting of the asset price bubble. So the central task is to deal decisively with the problems in the banking sector. The recent further weakening of the economy reinforces the urgency of this task but also suggests that additional macroeconomic stimulus is needed to provide adequate short-term support to the economy.
In Japan’s present circumstances, there is little alternative to the use of fiscal policy to provide such a stimulus. So the government is correct to implement as quickly as possible the recently approved fiscal stimulus package, including about ¥12 trillion of "real water" measures that will have a direct impact on aggregate demand. Indeed, in view of the continuing signs of weakness of aggregate demand, there now seems little scope for a withdrawal of fiscal stimulus next year. So longer-term fiscal consolidation, while still necessary, will have to be temporarily postponed. One useful way of achieving the necessary fiscal stimulus would be through up-front cuts in tax-rates, rather than a further extension of temporary tax rebates. High marginal tax rates on both individuals and corporations could be lowered, while announcing a multi-year commitment to gradual base broadening.
But fiscal action will only provide temporary relief unless the underlying banking sector problems are addressed decisively to restore public confidence and to ensure that banks can play an effective role in financial intermediation. An aggressive, far-reaching strategy is needed. Fortunately, there now appears to be a clear recognition by the government of the need for a decisive break with the past. Earlier this month, the second report on the Plan for Financial Restructuring announced a number of welcome initiatives that represent further important steps toward a comprehensive approach. Let me briefly summarize what, in the IMF’s view, are the necessary ingredients of the overall strategy, a number of which are now underway.
• The self-assessment framework is the right approach for recognizing the full extent of bad loans, but will need to be rigorously enforced by supervisors. The forthcoming, intensive inspections of the 19 major banks to be carried out by the Financial Supervision Agency (FSA), in conjunction with the Bank of Japan, will be an important test of this framework and one which markets will be watching carefully.
• The recently approved bridge bank facility provides a potentially valuable means for resolving insolvent institutions in an orderly manner that preserves values and avoids disrupting credit relations. To be effective, however, the approach will require clear procedures to ensure that bad assets are identified, assets are subject to proper valuation, and that new loans are only provided on prudent commercial criteria. Private sector buyers for the bridge banks will also need to be identified quickly.
• The proposed bridge bank scheme is a mechanism for dealing with failed institutions only. However, it is just as important to advance the restructuring of those major banks that are undercapitalized but that may be solvent. As part of this effort, injections of public funds will be needed to avoid a contraction of credit that would further weaken the economy. The use of public funds should be linked to strong restructuring plans. A mechanism needs to be put in place to ensure that banks are coming forward and tapping the restructuring funds.
• Aggressive efforts are needed to dispose of problem loans in all banks and to improve the institutional mechanisms for debt workouts.
• Finally, the FSA should be given increased independence, authority and staff resources.
None of this will be easy. It is an ambitious agenda. But there is no advantage to further delay: the problems will only become more difficult. Now, more than at any time, Japan’s leadership needs to take strong action to ensure that Japan gets back on the path of high growth it enjoyed in the past. I trust that the Japanese government will grasp this opportunity to press forward forcefully with radical plans to transform the financial sector as outlined above. Early action will help improve the health of not only the Japanese economy, but that of Asia and the world.
2 On a purchasing power parity basis Japan 's share is about 8 percent of world GDP and over one fifth of Asia 's GDP.
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