RIETI Report March 2010

Cabinet Office's View on World Economic Trends: Sustainability of recovery and exit strategy

This month's RIETI report focuses on one of our recent BBL seminars. RIETI has hosted more than 60 seminars this fiscal year and the seminar on January 15, epitomized these gatherings which transcend the boundaries of industry, government, and academia. Tomoko HAYASHI, Director for Overseas Economies, Cabinet Office, Japan, led the seminar, which centered on the sustainability of the world economic recovery and exit strategies. Ms Hayashi discusses the main characteristics of the recovery in Asia, Europe, and the U.S.; covers the various exit strategies; and gives a brief run down of the economic outlook and risks facing each region.

This month's featured article

Cabinet Office's View on World Economic Trends: Sustainability of recovery and exit strategy

HAYASHI TomokoDirector for Overseas Economies, Cabinet Office

Sustainability of the world economic recovery

- Characteristics of the world economic recovery process -
The ongoing recovery of the world economy has three characteristics.

First, it is a policy-driven recovery. The ongoing recovery is greatly supported by the effects of government policies, i.e., fiscal expansion that is unprecedented in size and scale, monetary easing including unconventional policy measures, and so forth. Most notably, many countries moved to implement measures to promote automobile sales such as car scrapping incentives, generating demand in excess of 10 million vehicles from around the world. However, these types of support programs have already been brought to an end in some countries such as the United States and Germany, giving rise to a fear that these countries, and Germany in particular, may suffer a decrease in vehicle demand in the coming months in an adverse reaction to the artificially inflated demand.

Second, the recovery has been driven by Asia, particularly, China. Thanks partly to its 4 trillion yuan economic stimulus package and consumption-boosting measures, the Chinese economy bottomed out in early 2009 and has since been on the recovery track. With South Korea, Taiwan, and Japan following suit, Asia as a whole entered into a recovery phase in spring 2009. In the U.S. and Europe, which were the epicenter of the global financial crisis, the economic downturn has generally come to an end but there is concerned that the pace of recovery may be affected by the credit crunch that is continuing particularly in credit financing through financial intermediaries such as commercial banks.

Third, what started as a financial crisis is now evolving into an employment crisis. In the U.S. and Europe, where the jobless rate has risen to around 10%, there is concern that consumption may be damped by a further deterioration in the employment situation.

- Asia -
Asian economies generally hit the bottom and moved into a phase of recovery in spring 2009. The ongoing recovery of the Japanese economy is supported by two pillars, namely, an economic stimulus package and exports to China. Similar patterns are observed for South Korea and Taiwan. Meanwhile, some countries such as India and Indonesia have maintained fairly high growth - relative to other economies in Asia - thanks mainly to robust domestic demand.

China - particularly domestic demand in China - will be important in looking at the Asian economy in the coming years.

Before the global financial crisis, the Chinese economy had been essentially supported by both domestic and external demand, particularly in the forms of investments and exports. However, exports dropped sharply after the Lehman shock and returned to positive year-on-year growth only in December 2009. That is, exports have yet to recover to a point to serve as an engine of the Chinese economy. Thus, at the moment, the Chinese economy is propped up by the policy-driven recovery of domestic demand.

China's consumption has been increasing at a pace of 15 to 16% year on year, helped by the government's consumption-boosting measures. At the top of the consumer hit list in modern-day China are: a refrigerator, a color television, and a washing machine. The Chinese government has expressed its intention to maintain some of the consumption boosting measures in and after 2010, on an expanded scale. Furthermore, the employment trend is now heading toward improvement and so are the overall income situation and consumer sentiment. Given all these factors, China's consumption will likely maintain its robust growth in the foreseeable future.

In 2009, China recorded its biggest year-on-year increase in investments in 10 years, due partly to the implementation of the 4 trillion yuan package of domestic demand-boosting measures including infrastructure investments and post-disaster reconstruction projects. The growth trend of investments will likely continue because the fiscal stimulus is to be kept in place and the Chinese authorities are poised to continue the easy monetary policy. However, attention needs to be paid to the possibility of restrictions on investments in industries with overcapacity and/or monetary tightening against the backdrop of the growing concern over an asset price bubble.

Following the removal of the loan caps in November 2008, banks moved to boost new lending and China's money supply (measured in M2) rose sharply, recording a year-on-year increase of about 30%. The monetary situation in China has therefore eased considerably, which in turn raises the possibility that a real estate bubble may be in the making in Shanghai and some other urban areas. Probably because of this concern, the Chinese central bank seems to be moving toward monetary tightening, pondering the possibility of raising reserve requirements and rediscount rates for banks and/or issuing bills to absorb liquidity. Likewise, the government is moving toward stricter restrictions on land transactions.

A full-fledged recovery of Asia's exports will be difficult until its exports to the U.S. and Europe begin to pick up.

Over the past 20 years, the trade and production structure of East Asia has shifted from the intra-regional division of labor with Japan as its center to one built around China, from which to export to the U.S. and Europe. East Asian economies' imports are mostly intermediate goods such as parts and processed goods, which are typically further processed and/or assembled into finished goods in China and then exported to the places of final consumption, primarily, the U.S. and advanced European countries.

This sort of structure does not change overnight, meaning a full-fledged recovery of Asia's exports would have to wait until demand recovery is firmly in place in the U.S. and advanced European countries.

To achieve sustainable and self-sustaining steady development, Asia needs to establish a new pattern of growth driven by intra-regional demand and trade, departing from the current growth regime based on the intra-regional division of labor. In other words, Asia needs to transform itself from the "world's factory" into a "place of consumption" where people can savor the richness of the world or a structure in which people can broadly benefit from the affluence they have built to date. To achieve that end, China, for instance, needs to allow greater flexibility in its yuan currency, in addition to pursuing pension and medical reform as a way to reduce precautionary savings.

- U.S. -
The U.S. economy, measured in real gross domestic product (GDP), expanded 2.8% in the July-September quarter of 2009, of which 1.5 percentage points are attributable to automobile-related demand. The U.S. economic stimulus package implemented by the end of September 2009 consisted mainly of tax cuts and government transfers to individuals. Meanwhile, significant infrastructure investments are planned for fiscal 2010 (October 2009 through September 2010). The government stimulus spending thus planned for fiscal 2010 accounts for approximately half of the total stimulus package.

In the U.S., state and local governments are required to adhere to some form of balanced budget rule. Therefore, in the event of a revenue shortfall, these governments might be forced to cut back on public spending and/or increase taxes, which would add to the recessionary forces already at work. Although a decrease in tax revenue at state and local governments is compensated for by an increase in subsidies from the federal government, this does not warrant any significant increase in expenditures.

Lending to consumers has been generally on a declining trend with a particularly sharp drop observed for loans from nonbank consumer lending firms, which constitute the second largest lenders next to commercial banks. Also, lending to companies has been declining at an increasing rate.

The unemployment rate has been on the rise, reaching to the highest level since April 1983. Joblessness among the youth is in a serious state with the long-term unemployed increasing in number. Payroll adjustments are continuing in the service sector, signaling the possibility that the ongoing recovery may turn out to be another jobless recovery.

Considerable progress has been made on balance sheet adjustments in the household sector with the U.S. savings rate following an upward trend. But the pace of recovery in personal consumption is expected to be moderate.

- Europe -
In many countries, government support measures, such as "cash-for-clunkers" programs, have begun generating effects. But some countries, including the United Kingdom and Spain, have been slow to gain momentum in recovery as they continue to face structural problems. Banks' lending attitude remains extremely cautious and the overall employment situation is worsening across Europe. In addition, there is concern that Germany may suffer a drop in consumption as the effects of government policies wear off. One bright spot emerging against this backdrop is an increase in exports to Asia.

Strategy for exiting from the emergency measures

- Points to consider in planning exit strategy -
In planning an exit strategy, it is extremely important that policymakers carefully consider the timing at which the strategy should be implemented and ensure good communication with markets in doing so.

The U.S. fiscal deficit for fiscal 2009 stood at 10% of GDP. Meanwhile, many European countries failed to meet the key criteria for fiscal discipline - an annual budget deficit no higher than 3% of GDP and public debt lower than 60% of GDP - as prescribed by the Stability and Growth Pact of the European Union.

An exit strategy needs to ensure that: fiscal consolidation measures will be implemented at the right timing and paced in light of prospects for economic recovery; such measures will be implemented under a highly feasible and operable framework so as to win the trust of the market; and a certain degree of flexibility will be allowed for under the framework in case of an unexpected downturn.

The Obama administration aims to halve the fiscal deficit by 2013 but it may turn out to be an unreachable goal depending on how the economy plays out in the months ahead. In Europe, most countries are poised to start the process of fiscal consolidation in 2010. However, 2010 growth forecasts for those economies are generally modest at the 0 to 1 % level. Personally, I have some doubts about shifting gear to consolidation mode at this point of time.

- Exit strategy for monetary policy -
The U.S. Federal Reserve has been purchasing medium- and long-term Treasury securities in an amount equal to approximately half the amount of an increase in new issues. Likewise, the Bank of England has been purchasing medium- and long-term government securities at a pace exceeding that of new issues. Planning an exit strategy amid such circumstances is a huge challenge.

- Current status and future prospects of financial system stabilization -
Financial institutions managed to improve performance in certain areas, benefiting from less intense competition resulting from the restructuring and market exit of some players. Specifically, they achieved record earnings in such business segments as securities underwriting and own-account trading. But they continue to perform poorly in traditional commercial banking business, pointing to increasing polarization among major U.S. and European financial institutions in their business performance.

- framework for post-exit monetary policy and financial system stabilization measures -
There has been growing recognition that "macro-prudential" policy - a set of policy schemes implemented from the viewpoint of monitoring risks affecting the entire financial system - is essential in preventing the occurrence of a financial crisis. Indeed, both in the U.S. and Europe, efforts are being made to develop an institutional framework for implementing macro-prudential policy, for instance, by means of establishing a new consultative organization or mechanism for ensuring close cooperation between the central bank and financial regulatory authorities.

The U.S. is taking steps to rebuild the existing, somewhat disperse system, under which regulating and supervising authority is split among many different bodies, into a more comprehensive and stricter system. However, some issues remain to be addressed, for instance, as to how to ensure the enforceability of policy under the complex regulatory and supervisory mechanism.

An outlook for the global economy and risks therein

- U.S. economy -
In looking at the U.S. economy, special attention needs to be paid to possible episodes of credit contractions and changes in the overall employment situation. It should be also noted that the U.S. economic outlook is subject to substantial downside risks. In fact, commercial property prices are continuing to fall, resulting in the successive failure of small and medium financial institutions with loans associated with commercial property. The succession of bank failures could bring a significant impact on local economies.

- European economy -
The pace of economic recovery in Europe is expected to be very modest. The typical recovery pattern of the European economy is an export-led one, that is, exports would be the first engine to go into motion and spark up other segments of the economy. However, while exports have begun to pick up, other economic engines seem to be missing and the economic situations in the so-called peripheral nations in Europe remain dire.

Downside risks to the European economy include a possible delay in the disposal of bad assets. Also, there is a risk of a credit crunch resulting from various financial shocks including the Dubai shock. Banks in Austria and Sweden, which have significant loan exposure to Central and East European countries, are suffering a deterioration in earnings under the weight of mounting bad loans. Rising long-term interest rates as a consequence of growing fiscal deficits is no longer a risk but a reality. Another risk is a possible faltering of the ongoing recovery that may be triggered by the premature unwinding of emergency fiscal and monetary policies.

- Asian economy -
As a general trend, the Asian economy will likely continue on the recovery path. The possibility of an asset price bubble in China requires careful monitoring as a downside risk. On the other hand, a bigger-than-expected increase in household consumption is an upside risk.

- Global economy as a whole -
The global economy as a whole is expected to follow a moderate recovery in 2010, led by Asia. However, it is necessary to pay careful attention to a series of downside risks, namely, a possible faltering of the recovery resulting from a premature shift in fiscal and monetary policies, huge volatility in international financial markets, a sharp rise in crude oil prices, and so forth.

It is often said that 2010 is the year of sovereign risks. While governments around the world have massively expanded fiscal expenditures, economic and fiscal situations vary significantly across countries. So we need to pay attention to the risk of a massive sell-off of government bonds for certain countries.

It has been predicted that China will likely surpass Japan in GDP in 2010. When Japan loses its status as the world's No. 2 economic power, what strong points is it going to promote and what sort of country will it aim to become? I think that 2010 will be the year in which these questions will become crucial issues.

Commentator's remarks

(1) Thanks to fiscal and monetary stimulus measures implemented by governments around the world, it seems that we have managed to turn the corner. While the U.S. and Europe continue on their moderate recovery, emerging economies in Asia and elsewhere in the world are taking the lead. Such is the perception of the current status of the world economy. The year 2010 will be a crucial testing ground to determine whether or not the risk of sinking into a double-dip recession will materialize. In fact, I suspect that Japan may be the one that poses the greatest sovereign risk.

(2) It has now become a shared view among economists that the growth of emerging economies in Asia and elsewhere in the world - including China, India, Indonesia, and Vietnam - has been the engine of the global economic recovery. In the case of China, this is because a large-scale fiscal stimulus package, implemented against the backdrop of a relatively small fiscal deficit, served as a powerful engine or because the consumption appetite of "volume-zone" consumers or the massive middle class with potential demand did not wither probably with the help of fiscal stimulus measures. At the same time, however, it is also an undeniable fact that hot money is continuing to flow into emerging economies in Asia and other parts of the world. Thus, there exist certain aspects where bubble-related factors, exemplified by the risk of a sudden bubble burst in China, are inextricably linked with the growth in Asia.

(3) Global imbalance rapidly widened from 2000 onward under the global growth model in which the U.S. has been the global demand center with fund inflows from oil-producing countries as well as from China and other Asian countries helping finance (over-)consumption by Americans. This represents one of the events signaling dramatic changes in the world economy. Will structural changes in the U.S. economy actually occur? If they do, what adjustments will be made in the process? It would also raise medium- to long-term questions such as how we should consider the relationship with China, the world's largest exporter.



In reference to China, you said that, in addition to proceeding with the pension and medical system reform as a way to reduce precautionary savings, China needs to allow greater flexibility in its currency yuan. In this regard, I believe that there are many things Japan can do to induce Chinese people to shift their resources from savings to consumption. What is your view in this regard?


Maybe, your question asking what roles Japan can play in facilitating a shift from savings to consumption in China can be rephrased as: "What roles can Japan play in boosting intraregional demand in Asia?" In that case, I would say that Japan can become the consumption leader in the region, in addition to extending support to other Asian countries in the areas of infrastructure development and policymaking. For instance, those in the so-called creative industries can produce or present cool lifestyles, thereby stimulating consumer demand in China for goods and services associated with such lifestyles.

As to how we can link Japan's roles in Asia to the development of the Japanese economy, I think Japan will be able to boost domestic consumption by defining itself as Asia's cutting-edge frontier for consumption and technology and thereby attracting a number of visitors from overseas.

This report was edited by RIETI editorial staff based on RIETI BBL seminar No.627 held on January 15, 2010.

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