Launch of OECD Economic Outlook 2014: Macroeconomic Analysis and Policy Recommendations for Japan

The current global economy is stuck in low gear. From 2000 to 2007, the world economy was growing at about 4% per year. Since the crisis in 2008, this has declined to about 3%. One factor is weak trade growth. Trade intensity has slackened in all of the major regions, including BRICS (Brazil, Russia, India, China, and South Africa). Trade specialists give a number of reasons for this. First, foreign direct investment (FDI) has been relatively weak, and FDI creates global value chains which drive trade. Second, some protectionism has emerged since the crisis as countries try to protect vulnerable industries. Another factor is that business investment has been weak in a number of countries, including Europe and the United States, and investment has been very import-intensive. The slowdown in trade increases the importance of initiatives such as the Trans-Pacific Partnership (TPP) that seek to reduce trade barriers.

Another major concern is the sharp rise in unemployment since 2007. In 2007, there were 34 million unemployed in the 34 OECD member countries. The number is now 45 million. Even worse is the fact that half of these people are long-term unemployed (unemployed for more than one year). This greatly increases the difficulty of rejoining the labor market because experience and skills tend to deteriorate. We are concerned that some of these people may never work again. In Japan, the unemployment rate is very low, partly reflecting the very rapid decline in the working age population. However, even in Japan, the share of long-term unemployed has risen from about 25% in 2007 to about 40%.

While Japan's overall figures are unimpressive, they are more favorable on a per capita basis. Private consumption was stronger in Japan than in the United States or the European Union (EU) until the consumption tax hike. Business investment was increasingly strong until April 2014 as well. Japan's performance on a per capita basis—which is really key to objective living standards—has been better.

Our overall forecast is for growth in the world economy to increase from about 3% toward 4%. This is based on an increase in rural trade from about 3.5% toward 5%. We expect growth in the United States to increase from 2.2% to 3%. The United States has completed its fiscal consolidation mostly, its budget deficit is fairly low, the household sector has deleveraged, and prices are now rising. The household sector is positioned well to start consuming. The EU will remain weak.

China is experiencing what is called an orderly slowdown. It has been growing at almost 8% per year and is now declining to about 7%. We think this is positive and necessary because of certain excess capacity in the property markets and property-related industries.

We are optimistic about India given the pro-growth reforms that the new government is implementing. FDI is increasing and fiscal and monetary policy is tight.

Russia is a major concern although it seems to have avoided a recession. The economy is flat and the ruble is down 35% over the past year as a result of oil prices and Ukraine-related sanctions.

Turning to the risks associated with our forecast: the EU is weak. Countries that had sovereign debt issues and were weak are now doing better, and the countries that had been strong, for example, Germany and France, are not. Inflation is too low and some countries are in deflation. We expect growth to pick up this year because the European Central Bank (ECB) is planning to do larger scale quantitative easing and the fiscal consolidation that started in 2010 is ending. The unemployment rate in Europe is still around 12%. Another risk is that capital flows will change as U.S. monetary policy tightens. During the past five or six years, there have been large flows, excluding China. We expect the United States to start raising interest rates in 2015, which will attract capital to it and away from BRICS.

A third risk is the level of debt. In Japan, the majority of debt is government debt. In Europe, there is less government debt but there are high levels of household debt, constraining consumption. Lending has greatly increased in China. Outstanding debt will depress economic growth. Potential growth has also fallen, reflecting unemployment and the growth constraining effect of weak business investment and flat capital stock, so we see a downward trend in potential growth in the United States, EU, Japan, and some of the emerging economies as well.

We need monetary, fiscal and structural policies to sustain growth. Monetary policy should remain accommodative in Europe and Japan, and it is very important to maintain inflation at an appropriate level. Structural reforms are very difficult. Japan, the United States, and Europe all have had trouble implementing the regulatory reforms that everyone knows are necessary.

Given the negative third quarter, our projection for Japan through 2016 is output growth in 2014 of 0.4%. The economy will pick up to about 1% in 2016. This will be driven by export growth of around 6%. Given the depreciation of the yen by about 25% since late 2012, we could see even faster export growth. With trade growth picking up, Japanese exports will increase. Export growth may have been constrained by companies focusing on profits rather than market share. With the very high profitability in Japan, we expect a greater future emphasis on market share. Consumption has been negative in 2014 due to the consumption tax. We think consumption will pick up based on wages, which play a key role in our outlook. Business investment will follow exports and consumption. The business sector is very strong. Profits are high; the corporate income tax rate has been reduced from 37% to below 35% with plans to take it below 30%. Business investment should be positive. Even though the Tankan survey showed that business sentiment was impacted negatively by the tax hike, it remains high in Japan; as high as it was before the collapse of Lehman Brothers. Even small businesses have seen a big improvement in sentiment. We think that this will help sustain business investment when coupled with corporate profits and labor shortages.

In terms of the key concern—wages—we have seen a decline in real wages every month since March 2013. Nominal wage growth has been increasing but lags behind inflation, meaning that real wages have fallen and households have lost purchasing power. Looking ahead, we see labor shortages. Some regions of Japan, notably Tohoku, face shortages.

We see inflation of about 1.6% in 2016. Inflation picked up to about 1.5% in early 2014, followed by a period of negative growth in the second and third quarters. Oil and commodity prices have declined, thus inflation is down to about 1.1% disregarding the consumption tax effect. We see it increasing to approach 2%.

We see the government budget deficit coming down but not as fast as previously envisioned given the delayed tax hike. The first tier of Abenomics seems very supportive of growth. On October 31, 2014, Japan announced a higher target for the monetary base based on Japanese government bond (JGB) purchases, so the expansion of quantitative and qualitative easing will help Japan move toward a 2% inflation target.

With regard to the second arrow, the United States has reduced its primary deficit by 6% of gross domestic product (GDP) and Europe by 4%. Japan has not made much progress partly because of the Great East Japan Earthquake. Japan is spending about 5% of its GDP on reconstruction so there has been relatively little progress on consolidation. Over the next two years, we foresee about a 1.5-percentage-point improvement, reflecting the April 2014 tax hike and reductions in government spending as re-construction is completed.

Japan had a balanced budget in 1992. Since then, expenditures have risen, which is mostly the result of greater social spending, while revenues have remained fairly stagnant. Japan spends about 23% of its GDP on public social spending. For comparison, in Europe, some countries such as Sweden spend closer to 30%; France spends about 29%. In Japan, social spending on the working age population is relatively low, being focused primarily on the elderly. This will continue to rise over the next 25-30 years.

We project a 5.4% primary deficit for Japan in 2016. The target is to have a primary surplus by 2020. Our projections suggest that this would require an annual deficit reduction of about 1.3% per year. Abenomics has had some very positive effects. The exchange rate depreciated by 25%, the stock market went up by 57%, and confidence increased. It's important to meet the 2020 target as public debt has reached a worrisome level. In 2014, it reached 230% of GDP. Stabilizing and reducing this ratio will require three things. The first is the planned tax hike in 2017 and further tax hikes, and revenue increases and spending reductions by making long-term care and healthcare more efficient. The second is 2% inflation because the nominal GDP has been in decline since 1997 due to deflation. The third is more productivity growth.

In 1991-1992, Japan's per capita income was the same as the top 17 OECD countries, but it has fallen behind since. This is surprising because Japan has many advantages, among them an excellent education system, high research and development (R&D) spending, leading technology, ample social capital, and a very safe and stable economy. Japan has the scope to narrow the gap in the future by resolving the fiscal situation and improving the standard of living for its population.

In recent years, Japan's share of world exports has fallen substantially. Japan's share of OECD exports that are classified as high-tech has fallen from about 22% to 11%. Meanwhile, that of South Korea has gone from 4% to 11%. Japan seems to be losing some of its comparative advantages in high-tech exports.

In 1997-1998, the working population began to fall in Japan. Labor productivity contribution has fallen over time as well. Japan's potential growth, by our latest estimate for 2013, is about 0.7% per year.

To achieve 2% growth, Japan needs to limit the contraction in the labor force and employment and increase labor productivity. Labor productivity growth in Japan has been about 0.9% over the past decade or so, not too far from the OECD average, but the government growth target would require that this be increased above 2%.

A key problem is services. Overall, manufacturing continues to see total factor productivity (TFP) growth whereas the service sector has much lower productivity growth. The gap between the two has widened.

Looking at knowledge-based capital, Japan has a fairly large investment, which we have found to be a very key determinant. The contribution of knowledge-based capital to growth is rather low in Japan, and should be increased.

The first issue is corporate governance. Japan has relatively low profitability despite the fact that companies have a great deal of capital and technology and large amounts of cash—about 300 trillion yen or 60% of GDP. Corporate governance—shareholders demanding higher returns—would encourage management to put this money to use through more investment, helping start-up companies, wage increases for workers, and/or larger dividend payments to shareholders.

A second area is restrictive market regulations.

The third area would be boosting international competition, attracting more FDI, participation in economic partnership agreements (EPA), and the TPP. Japan has targeted raising the share of exports covered by EPAs from about 18% to 70%. Finally, labor mobility is an important issue. Japan needs a reallocation of capital and labor to higher growth areas.

On regulation, Japan is better than average, but it has much more regulation than some leading countries.

Abenomics talks about raising the birth rate and death rate of firms from about 5% to closer to the 10% that we see in the United States. It's striking that the number of bankruptcies has been trending downward despite crises. That implies that the reallocation of resources from weak companies to strong companies is insufficient. One reason is the high guarantees for small and medium-sized enterprises (SME) compared with other countries.

Japan has the lowest amount of inward FDI. Its outward FDI is close to the OECD average. Under former Prime Minister Junichiro Koizumi, there was a plan to double FDI, and there is now another such plan under Prime Minister Shinzo Abe. Factors cited by foreign businessmen include mergers and acquisitions (M&As) being difficult in Japan, the tax system, high corporate tax rates in Japan, corporate governance issues, and the regulatory environment.

Agriculture is an issue for Japan in joining the TPP or other trade agreements. Japan has the second highest level of agricultural support in the OECD. The resulting higher prices are a large burden for consumers. The price of food in Japan is about twice as high as it would be without agricultural support. This is a good moment for reform. The farm workforce is aging, and many farmers are part-time and lack successors. Japan needs larger farms and more market-oriented farm policy. Japan doesn't have a good comparative advantage in producing grains, which depend on economies of scale achieved by large-scale farming. Japanese farmers are competitive in high value added products such as vegetables. We need to remove commodity-specific support that keeps farmers growing rice so that they can move into areas where they are competitive. This will help Japan join trade agreements that require opening all of its markets.

Japan has a high level of business R&D, but TFP growth is relatively weak. Universities in Japan don't rank high internationally. We need more linkages in R&D and patenting, and universities should have a bigger role in the R&D system.

In terms of internationalization, the share of R&D or products jointly produced with international coauthors or international patents is very low. It's important to bring Japan into international networks to enable it to benefit fully from what's happening elsewhere. Less than 1% of R&D financing comes from overseas. Only 2.7% of the R&D performed by universities is financed by the business sector. The university sector, which has about 80% of Japan's Ph.D. holders, is not really integrated into the business R&D process. That's partly due to the lack of labor mobility, which causes researchers to tend to spend their entire lives either at government research institutes, universities, or business R&D centers. Integrating the university sector into the R&D system would be beneficial.

Non-regular workers are both a social and economic problem. The share of non-regular workers has continued to increase. This creates a parallel labor market in which some workers are low-paid and have little job security and social insurance coverage. The low wage growth is due partly to increased non-regular employment. There is a wide gap between the household incomes of regular and non-regular workers, and there is an impact on marriage—non-regular workers tend to be single because they don't earn enough to have the confidence to create a family. This in turn impacts fertility. As women's participation in the labor force has risen, fertility has fallen. However, there's no reason for high female labor participation to be accompanied by a low level of births.

Japan spends only about one-third of what countries such as France spend on childcare, which discourages women from working. Japanese women are highly educated, but the participation of Japanese women with university degrees in the labor force is very low. After women leave the workforce to have children, they aren't given the opportunity to resume regular employment, and non-regular employment is less attractive so they don't return. If the female participation rate were to rise to the same level as for men, the labor force would stay relatively constant over the next 20 years. This is very important for Japan's future.

Q1. On the Japanese exchange rate movement, some are worried about the depreciation of the yen as it played a part in the 1997-1998 Asian financial crisis. Do you have any comments?

Randall S. JONES
In our projection, we assumed a fixed exchange rate. In my view, monetary policy in Japan has to focus on the 2% inflation target. The quantitative easing and the determination to get to 2% have been very positive, and the depreciation of the yen is a byproduct of this. The exchange rate doesn't have a big impact on Japan compared to many countries, so that's not the best channel for promoting inflation. The exchange rate issue should benefit from exports going ahead.

Q2. Could you explain the OECD numbers mentioned in your speech for Russia?

Randall S. JONES
Our projection is based on a fairly constant oil price. We had a big drop in the fourth quarter, but after that we assume it will stay roughly where it is. Russia was on track to join the OECD, but now things have cooled off because of all of the tension. One of its driving forces is that, with the 35% depreciation of the ruble, Russia will be able to increase exports substantially. So far, we haven't seen much in terms of import substitution—imports from Europe are down and people are waiting for the Russian supply side to come back. Over the next couple of years, with this depreciation, Russia will be able to export more, and that will favor domestic producers.

Q3. Could you mention some of the risks that can lead to downward revision for the world and Japanese economies in the future?

Randall S. JONES
The biggest risk is geopolitical instability. If Europe doesn't address its falling inflation, deflation in Europe will be a risk. The other issue is wage growth. U.S. wage growth is disappointing and lags behind productivity, so Japan is not the only country experiencing this. If the labor share declines, private consumption will weaken.

Q4. The Japanese government is trying to cut corporate taxes, but Japanese companies have much money and don't know what to do with it. Do you think it is the right moment for the government to lower that tax and raise the consumption tax? The Financial Times argued completely the contrary: it's time for the Japanese government to increase taxes on corporate savings. That makes more sense to me than reducing corporate taxes. What are your views on that?

Randall S. JONES
The idea of taxing corporate savings is very interesting. South Korea will be implementing such a tax in January. I'm very interested to see whether this is effective in encouraging companies to utilize these resources. In terms of corporate income tax, I agree with your idea. Studies show that FDI is sensitive to corporate tax rates. Trying to increase FDI with a lower tax rate might be more effective. In Japan, where only one in three firms actually pays corporate income tax, having a broader base that makes more firms pay a lower rate would be positive. It's very important not to lose revenue, so it needs to be accompanied by base broadening to increase efficiency.

Q5. Could you talk more about Japan's consumption tax hike? Is it positive for the Japanese economy? Do you or the OECD have a specific figure in mind as to how high the tax should rise?

Randall S. JONES
In Europe, the average value added tax (VAT) is 22%. Japan can't supply pensions, healthcare, long-term care, and unemployment insurance with an 8% VAT. If Japan is going to maintain the social safety net upon which the elderly depend, it needs to finance it, which Japan has been doing basically by borrowing for the last 20 years. This has worked because in a deflationary environment, many people are happy to buy JGBs with positive returns and no risk. If we move away from deflation, fewer people will want to buy JGBs at 50 basis points. Japan must take steps to correct this imbalance that started 20 years ago. In Japan, the pension contribution rate is rising to about 17%. Continued reliance on personal income tax and payroll tax will discourage employment which would be bad for the economy. Property tax puts downward pressure on real estate which is undesirable. That leaves us with the consumption tax.

Q6. TFP is slowing down around the world. Some link this to a decline in the economic benefits of technological progress. Do you share this view? Do you believe that 2% growth is achievable?

Randall S. JONES
I think the 2008 economic crisis lowered overall potential, including business investment, capital stock, and R&D. It has also made people more risk-averse. The G20 process is trying to promote global regulatory reform to boost growth. For Japan, employment is making a negative contribution, which implies a need for greater than 2% productivity growth. Looking at OECD countries, there isn't that kind of growth except in some emerging economies. The payoff from reform will not come overnight. If Japan can join an effective TPP and become more integrated, that would benefit these R&D linkages internationally, FDI, promote competition to boost productivity, etc. International openness could have a big effect.

Q7. In the previous survey on Japan, it was mentioned that even though the share of agriculture in the economy is quite small, the benefits of transforming agriculture would be very large. Could you elaborate on this? Also, last year, you were very positive about the government's agricultural reform efforts. What are your observations now that some steps have been taken?

Randall S. JONES
Rice is the main area where we see reform. Ending the production quotas for rice and the special payments for table rice would be very effective. The problem is that payments for other products are continuing. Food self-sufficiency is an important topic. Japan imports 85% of its energy. Its real vulnerability is energy; without energy, there is no agriculture. Japan is around 42% food self-sufficient in calorie terms. Raising that share would require even greater agricultural protection. There should be an efficient agricultural sector, TPP and bilateral agreements with food exporters are necessary, relationships with countries with surplus food should be promoted, and sufficient paddy land should be maintained—in times of crisis that might need to be brought back (stockpiling rice). A more balanced approach should be taken to food security, not just in terms of what percentage of rice is produced domestically.

If twice as much is spent on food as would be otherwise, reducing prices would allow that money to be used for other things, creating demand for services and products. People would spend money on other things, creating a chain reaction. The impact of reform on household budgets would be of significant benefit.