Priorities for the Japanese Economy in 2018 (January 2018)

New Ceiling on International Balance of Payments for Japan: Process innovation and cultivation of growth frontiers are necessary

Chairman, RIETI

Recovering world economy and signs of trade friction

In 2017, the world economy made a gradual recovery. The robustness of both the United States and China's economic growth significantly contributed to this, and the continuation of monetary easing policies in major countries, low inflation and low interest rates worldwide, and a gradual rising of crude oil and resource prices were also significant factors that supported the growth of the world economy. Many emerging countries are resource-rich countries, thus the rally in oil and resource prices was a significant positive factor in the economic recovery.

A considerable increase in the sales of high tech products was another positive factor. Global semiconductor sales and Japanese robot shipment value rapidly increased to record high levels. This was due to factors such as the launches of new smartphones and the brisk advancement of digitization and informatization with regard to automobiles and so on.

It appears as if this trend will continue through 2018. It is expected that monetary easing policies in major countries, and hence low interest rates, will continue. Furthermore, while there are geopolitical risks, it is anticipated that oil and resource prices will remain steady against the backdrop of moderate world economic growth. As for demand for high tech products, as the era of artificial intelligence (AI) approaches, a further upsurge in sales related to Internet of Things (IoT), robots, and so on is expected.

Along with the recovery of the world economy, exports by both developed and emerging countries have been increasing (Figure 1). For emerging countries, the growth of exports to developed countries has been a major engine for economic growth, and this indicates that the economies of both developed and emerging countries have been recovering.

Figure 1. World Economy: Nominal GDP Growth and Trade Growth
Figure 1. World Economy: Nominal GDP Growth and Trade Growth
Note: Nominal, year-on-year basis.
Source: IMF, Oxford Economics

There was a rapid rise in the first decade of the 21st century in the proportion of emerging countries that contributed to world trade, but that proportion is now decreasing (Figure 2). Nevertheless, as can be seen in Figure 1, the export growth rate of emerging countries exceeded that of developed countries for the first time in 2.5 years in the second quarter of 2017, so it is a matter of time before the share of world trade accounted for by emerging countries starts increasing.

Figure 2. World Economy: Share of Emerging Economies
Figure 2. World Economy: Share of Emerging Economies
Source: IMF

The growth of exports by emerging countries is not necessarily entirely desirable. This is because if there are rising concerns in developed countries that increases in imports from emerging countries will cause the hollowing-out of domestic industries and loss of employment, the long-awaited economic recovery in the emerging countries could become destabilized.

Looking at the examples of China, Japan, South Korea, Germany, and Switzerland, which are on the "monitoring list" in the Semiannual Report on International Economic and Exchange Rate Policies of the United States, the trade deficit ratio of the United States with regard to each of these economies has not been growing, and it currently appears as though the United States does not have much reason to push for the correction of trade imbalances. Nevertheless, there are signs that the United States may increase its pressure on such economies to correct trade imbalances.

For example, the percentage of consumer goods imports of the United States accounted for by China not only continues to be at a high level, but also has started rising again (Figure 3). Tax reforms are currently being established with the intention of significantly lowering taxes, so while it does not appear that the United States will immediately fall into an economic recession, if its economy starts slowing down and calls for a return to domestic production, the appreciation of the yuan could grow stronger and be tricky to address.

Figure 3. United States: Percentage of Consumer Goods Imports Accounted for by China
Figure 3. United States: Percentage of Consumer Goods Imports Accounted for by China
Note: Consumer goods do not include food products and automobiles. The percentage of imports from China is the ratio of consumer goods imports to the United States accounted for by imports from China, and is a 4 quarterly moving average.
Source: BEA

Challenge for Japan: Overcoming a new "ceiling on international balance of payments"

According to the standards of the United States, Japan's international balance of payments is also at a relative high level. While it is assuring that Japan's current account surplus as a percentage of gross domestic product (GDP) among the five economies listed in the monitoring list is the lowest after China's, and that the trade deficit of the United States with Japan has stabilized, Japan is the only country among the five named in the exchange rate policy report of the United States to have a current account surplus that has been in an upward trend since the beginning of 2017 (Figure 4).

Figure 4. Current Account to GDP (2000-2017)
Figure 4. Current Account to GDP (2000-2017)
Note: Seasonally adjusted.
Source: National statistics.

Incidentally, measuring how much trade friction factors were underlying the strong yen exchange rate in the first half of the 1990s when trade friction between Japan and the United States was deepening, yields a surprisingly large result: just below 30 yen (Figure 5). The economic environment surrounding Japan and the United States is obviously different now than it was then, and the impact on exchange rates certainly differs greatly depending on the degree of the economic situation and trade friction. Nevertheless, it seems to be necessary to keep in mind that the yen market is sensitive to trade friction.

Figure 5. Dollar-Yen Market: Estimation in Case of Continuation of Trade Friction
Figure 5. Dollar-Yen Market: Estimation in Case of Continuation of Trade Friction
Note: The explanatory variables are yen and dollar interest rates, crude oil price, stock prices in Japan and the United States, Japan's trade balance, trade balance of the United States with Japan, and trade friction dummy.
Source: Ministry of Finance, Bank of Japan, Nikkei, U.S. Department of Energy, U.S. Census Bureau, Dow Jones, Thomson Reuters

Currently, the economies of developed countries are generally in good shape, and there does not appear to be much further spreading of protectionism, even with regard to increases in exports by emerging countries. Nonetheless, taking into consideration the fact that there appear to be several signs that could trigger such situation, Japan cannot feel assured.

In order to prevent the spreading of economic and trade friction, in principle, reduction of the imbalance of international balance of payments and exchange rate stability are crucial. For Japan, it is essential to shift from growth that is dependent on the economic growth of the world economy toward economic growth that is focused on domestic demand, using lessons from the labor shortage.

The population is decreasing and markets are becoming saturated so that growth centering on domestic demand is obviously no longer easy. Nevertheless, against the backdrop of technological innovation, in the United States and China, a series of new business models and services have been emerging and spreading, such as the "sharing economy" in which automobiles, accommodations, and so on are lent out, and cashless payments are made with smartphones. This means that process innovation consisting of major innovations is taking place, and the creation of completely new demand is leading to the cultivation of new growth frontiers.

The current recovery of the Japanese economy appears to have continued through December 2017, and, if this is the case, it indicates that economic expansion has continued for 61 straight months. This is the longest period of postwar economic expansion after the 73-month long "Izanami boom" (from February 2002 through February 2008), and many expect it to continue in 2018 as well.

Nonetheless, it is necessary to recognize that a new ceiling on the international balance of payments is waiting. This will not involve insufficient foreign exchange reserves putting a ceiling on economic growth as it did in the past in Japan. On the contrary, this is a situation in which if the international balance of payments surplus with regard to, for example, exports to and foreign direct investment in the United States becomes too large and goes beyond a certain range, economic growth could be inhibited by trade friction and domestic currency appreciation.

The growth of the Japanese economy in 2018 will depend on how the limitations of the new ceiling on the international balance of payments are faced and overcome. The direction for this lies in realizing domestic demand-led economic growth in which wage increases of companies bring about the expansion of consumption, and lies in promoting domestic process innovation and realizing the cultivation of growth frontiers and growth.

January 4, 2018

January 19, 2018