Issues Facing the Japanese Economy in 2012 (January 2012)

Projecting the Japanese Economy in 2012

FUKAO Mitsuhiro
Faculty Fellow, RIETI

Recovery with a large inherent risk

Absent any external shock, the Japanese economy in 2012 should be able to expect a reasonable growth of about 2%, owing to the relatively large reconstruction budget that the Noda administration has put forward. A major part of the reconstruction outlays, backed by increased public expenditure and financing, is expected to be spent in the first half of 2012. Therefore, the first half of the year should see relatively stable growth, which may slow down to some extent in the second half. If this scenario holds up, the business sentiment in Japan should show gradual improvement. On the other hand, caution is required, because there is a 20%-30% chance that a downward pressure equaling the impact of the global financial crisis, triggered by the collapse of Lehman Brothers, will be exerted on the economy, with Europe as its epicenter. In that case, due to a significant worsening of the environment surrounding exports, the Japanese economy is expected to experience a negative growth of about 2% from the previous year, together with increased unemployment and worsening deflation. In the rest of this column, the cause of the risk scenario is analyzed.

Peripheral eurozone countries losing international competitiveness

Among the countries of the European Union (EU), 11 of them, including Germany, France, Italy, and Spain, introduced the unified currency, the euro, in January 1999, while Greece adopted it two years later in 2001. The countries in the eurozone can be broadly divided into developed countries with more mature economies, such as Germany, France, and the Netherlands, and countries with economies at a relatively lower stage of development such as Portugal, Italy, Ireland, Greece, and Spain (the so-called PIIGS countries). Because the developed countries have low potential growth rates, a low interest rate fits their economies. In contrast, the PIIGS countries historically have had high inflation rates and greater potential growth rates, so a high interest rate suits their economies. But the European Central Bank (ECB) can operate only on a single interest rate policy, so the actual interest rate was set at a level too high for the developed countries and too low for the PIIGS countries.

As a result, the economies of the PIIGS countries gradually overheated, and a bubble-style business expansion ensued with not only the wages and prices rising but also the real estate prices. Conversely, the developed economies were faced with high real interest rates which lead to relatively weak domestic demand and low price increases. With this situation continuing for as much as 10 years since the start of currency unification, a structure came to be established wherein the PIIGS countries, losing their international competitiveness with the developed countries, generated current account deficits which they financed by borrowing from the developed countries. Annual consumer price increases of the peripheral countries of the eurozone exceeded those of Germany by about 2%, thus resulting in a 15%-20% price difference with Germany by 2008 with their international competitiveness diminished by that difference. Behind the growing fiscal deficits and the difficult economies of the PIIGS countries are reduced competitiveness caused by the rise in prices and the worsening performance of banks due to the bursting of the bubble.

The crisis of the PIIGS countries will persist

In order to consider the future of the PIIGS countries, the situation of Greece, presently the most serious among them, is explored. The International Monetary Fund (IMF) together with the European Financial Stability Facility (EFCF), set up by the eurozone countries, are providing loans to Greece on the condition that it reduces its fiscal deficit very quickly by raising taxes and cutting public expenditures. But because Greece has adopted the euro in the currency unification process and does not have its own currency or central bank, it cannot stimulate its depressed economy by depreciating its currency. The sharp fall in Greek government bond prices has diminished the credibility of its financial institutions, which are forced to curtail their lending because of reasons such as deposit outflows. As a result, its GDP is expected to show a negative growth of as large as 13% in the three years from 2010 to 2012 with no recovery in sight. Under such circumstances, even though the Greek government is trying very hard to cut fiscal spending and raise tax rates, the fiscal deficit reduction target has been difficult to achieve because of the worsening economy.

As the government is coming up with successive fiscal spending cuts, reduction in the number of public employees, and tax increases, amid no prospect of an economic upturn, the frustration of the population has been reaching an extremely high level; frequent strikes, riots, and worsening public safety have put tourism, an important industry for Greece, teetering on the verge of crisis. Such increase in social unrest has added impetus to the decline of credibility of the Greek government, thereby creating a vicious circle worsening the sovereign crisis.

The decline of Greece's international competitiveness has been equally alarming. Although it is in a very serious recession, the current account deficit continues to be at a very high level of around 10% of GDP. Unable to depreciate its currency, the only ways for Greece to regain international competitiveness are either for Germany and the Netherlands to inflate their economies or for Greece to reduce the cost of production by more than 20%. But given the constraint whereby each individual country is unable to use its own monetary policy, the policy tools available to the Greek government are limited to such actions as fiscal tightening, reducing public employees' wages, and lowering the minimum wages. It is almost impossible to cut directly the wages of the large majority of workers who work in the private sector. Also, if past international payment adjustment cases are a guide, deflation was very difficult to implement, and currency depreciation was the usual resort.

If Greece's international competitiveness does not recover and the current account deficit continues, the core countries of the eurozone such as Germany will have to continue providing huge funding support for a long period of time. It is very likely that this will shift the German public opinion toward opposing support for Greece, which will further deepen the crisis.

Will the eurozone suffer a serious recession?

If the Greek government is unable to meet its fiscal deficit reduction target due to economic downturn or resistance from the general public, and therefore cannot obtain low interest rate loans from the EFSF or IMF, Greek government bonds will default. Banks and other financial institutions in Greece holding Greek government bonds will suffer large losses. The deposit insurance scheme of Greece is a part of the Greek government and will not be able to protect sufficiently the depositors from bank collapses. Additionally, other banks in Europe, such as German and French, the ECB, and the EFSF will also suffer losses from the defaults by the Greek government and the Greek banks. If only Greece defaults, then the losses of non-Greek banks will be limited, and they may be able to absorb the losses with their capital. But the default by Greece and the ensuing financial crisis have a high likelihood of triggering a decline in government bond prices and runs on banks in other PIIGS countries such as Portugal, Italy, and Spain. While a crisis in Portugal, with a smaller economy, may be manageable, if the financial crisis expands to either Spain or Italy, the funding requirement will become too large for the EFSF to support. As a result, the financial systems of the core EU countries will also face a grave crisis. In that case, the eurozone will experience an economic downturn more serious than the one caused by the global financial crisis, triggered by the collapse of the Lehman Brothers. Japan will thus also experience substantial negative growth.

December 28, 2011

December 28, 2011

Article(s) by this author