Country Report September 2003

Japan

Japan at a glance: 2003-04

OVERVIEW The prime minister, Junichiro Koizumi, should win the September Liberal Democratic Party (LDP) leadership election, although a small margin of victory may reduce his political authority within the party. The LDP is likely to win the next lower house election, reflecting both Mr Koizumi!s public popularity and the party!s well-organised grass-roots organisation. The Economist Intelligence Unit forecasts that real GDP will grow by 2% in 2003 and by 1.6% in 2004. Growth will be supported by a recovery in domestic demand. Consumer prices will fall by an average of 0.3% in 2003 and 0.5% in 2004. Large current- account surpluses will be recorded in both years.

Key changes from last month Political outlook • Mr Koizumi indicated in mid-August that he would be prepared to include some of his opponents within the LDP in the cabinet at the next reshuffle, provided they are willing to commit to his reform programme. This was most likely an attempt to divide his opponents ahead of the September 20th party leadership election. Economic policy outlook • The government approved the guidelines of the budget for fiscal year 2004/05 (April-March) in late July. Overall spending is slated to rise by 5% to ¥85.7trn (US$726bn), but discretionary spending is likely to remain flat. Economic forecast • Following the release of GDP data for the second quarter of 2003, we have made extensive revisions to growth forecasts for 2003-04. This largely reflects revised assumptions about prospects for domestic demand. • The all-industry business activity index compiled by the Ministry of Economy, Trade and Industry rose by 0.9% in June month on month. This was the fastest rise since January this year. The tertiary industry sub-index rose by 1.3% month on month in June. Both results suggest a deepening and broadening of the economic recovery.

September 2003

The Economist Intelligence Unit 15 Regent St, London SW1Y 4LR United Kingdom The Economist Intelligence Unit The Economist Intelligence Unit is a specialist publisher serving companies establishing and managing operations across national borders. For over 50 years it has been a source of information on business developments, economic and political trends, government regulations and corporate practice worldwide. The Economist Intelligence Unit delivers its information in four ways: through its digital portfolio, where the latest analysis is updated daily; through printed subscription products ranging from newsletters to annual reference works; through research reports; and by organising seminars and presentations. The firm is a member of The Economist Group.

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Contents

3 Summary

4 Political structure

5 Economic structure 5 Annual indicators 6 Quarterly indicators

7 Outlook for 2003-04 7 Political outlook 8 Economic policy outlook 9 Economic forecast

13 The political scene

17 Economic policy

20 The domestic economy 29 Employment, wages and prices 32 Financial indicators

35 Foreign trade and payments

List of tables 9 International assumptions summary 10 Gross domestic product by expenditure 12 Forecast summary 14 LDP faction strengths 17 Budget guidelines for 2004/05 18 National government debt 21 Expenditure on gross domestic product, quarter on quarter 21 Expenditure on gross domestic product, year on year 23 Contributions to real GDP growth 24 Tankan survey results 24 Retail sector indicators 27 Vehicle production and registrations 27 Industrial production, shipments and inventories 28 Machinery orders 29 Construction industry 29 Employment statistics 31 Wages and costs 31 Inflation indicators 32 Money supply 33 Bank lending 34 Financial market indicators 35 Trade values, volumes and prices 36 Bilateral merchandise trade flows

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36 Exports of selected commodities 37 Imports of selected commodities 38 Balance of payments, IMF basis

List of figures

12 Gross domestic product 12 Consumer price inflation 23 Business sentiment among small and medium-sized firms 26 All-industry activity index 35 Exchange rate

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Summary September 2003

Outlook for 2003-04 The prime minister, Junichiro Koizumi, should win the September Liberal Democratic Party (LDP) leadership election, although a small margin of victory may reduce his political authority within the party. The LDP is likely to win the next lower house election, reflecting both Mr Koizumi!s popularity and the party!s well-organised grass-roots organisation. Real GDP will grow by 2% in 2003 and by 1.6% in 2004. Growth in the period will be supported by a recovery in domestic demand. Consumer prices will fall by an average of 0.3% in 2003 and 0.5% in 2004. Large current-account surpluses will be recorded in both years.

The political scene The largest opposition party, the Democratic Party of Japan, and the much smaller Liberal Party agreed in July to merge by end-September. Parliament passed legislation in July enabling the Self-Defence Forces (SDF, the de facto military) to be sent to Iraq to assist in post-war reconstruction, but concern about the region’s instability is likely to delay dispatch until early 2004.

Economic policy At end-July the government approved the basic budget guidelines for fiscal year 2004/05 (April-March). Total spending will rise by nearly 5%, to ¥85.7trn (US$726bn), partly reflecting an assumed 6% year-on-year increase in debt- servicing costs. The Industrial Revitalisation Corporation has had difficulty in finding companies to rehabilitate. Its first candidate is a regional bus company, Kyushu Industrial Transportation. In July parliament passed legislation enabling life insurance companies to cut pay-outs on guaranteed policies.

The domestic economy Real GDP grew by a faster than expected 0.6% in the second quarter of 2003 in quarter-on-quarter terms. The outbreak of Severe Acute Respiratory Syndrome (SARS) in the region had a positive impact on growth in Japan. Outward tourism fell, boosting private consumption and suppressing services imports. Employment and wages grew modestly in the first half of 2003, supporting a small recovery in consumer sentiment in the forecast period. Consumer price deflation has eased, mainly as a result of volatile oil prices and increases in prices for fresh food. Large-scale Japanese intervention on the currency markets helped to keep the yen in a narrow band of ¥118-120:US$1 in January-August.

Foreign trade and payments The merchandise trade surplus (fob-cif) narrowed by 10% year on year in the first six months of 2003 to ¥4.4trn. The rapid growth of the cost of imports, as global oil prices remained relatively high, was largely responsible for the deterioration. Demand from China remained robust. In August Japan raised tariffs on beef imports. The current-account surplus narrowed in January-June by ¥626bn (US$5.3bn) to ¥5.4trn.

Editors: Robert Ward (editor); Graham Richardson (consulting editor) Editorial closing date: August 26th 2003 All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule

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Political structure

Official name Japan

Form of government Representative democracy

The executive The prime minister is chosen by a ballot of the Diet (parliament) and appoints a cabinet, a majority of whose members must also be members of the Diet

Head of state Emperor Akihito

National legislature Bicameral Diet, comprising the 480-member House of Representatives (the lower house), elected every four years, and the 247-member House of Councillors (the upper house), elected for six-year terms, with half of its number elected every three years. There are 300 single-seat constituencies and 180 seats filled by proportional representation in the House of Representatives. The number of seats in the upper house will be reduced by five at the chamber’s next election

Legal system A US-style Supreme Court, appointed by the cabinet, presides over a legal system of lesser courts divided into four arms: the High Court, District Courts, Family Courts and Summary Courts

National elections The last election was in July 2001 (House of Councillors); the next election for the House of Representatives is due by June 2004. The next election for the House of Councillors is due three years from the last upper house election, which was held in July 2001; the exact date has, however, not yet been fixed

National government On August 26th 2003 the ruling Liberal Democratic Party (LDP) held 244 seats in the House of Representatives. The LDP’s coalition partners, the New Conservative Party (NCP) and New Komeito, held 10 seats and 31 seats respectively. The largest opposition party, the Democratic Party of Japan (DPJ), held 115 seats

Main political organisations Government"coalition of three parties: the LDP, the NCP and New Komeito Opposition"DPJ; Japan Communist Party; Liberal Party; Social Democratic Party

Main members of the cabinet Prime minister Junichiro Koizumi (LDP) Chief cabinet secretary Ya s u o Fu kud a ( LDP )

Agriculture, forestry & fisheries Yoshiyuki Kamei (LDP) Defence Shigeru Ishiba (LDP) Economy, trade & industry Take o Hi ranuma ( LDP ) Education, culture, sports, science & technology Atsuko Toyama (not in the Diet) Finance Masajuro Shiokawa (LDP) Foreign affairs Yoriko Kawaguchi (not in the Diet) Health, labour & welfare Chikara Sakaguchi (New Komeito) Justice Mayumi Moriyama (LDP) Land, infrastructure & transport Chikage Ogi (NCP) Public management, home affairs, posts & telecommunications Toran osu ke Katayama (LDP )

State ministers Financial affairs/economic & fiscal policy Heizo Takenaka (not in the Diet) Administrative reform Nobuteru Ishihara (LDP)

Central bank governor Toshihiko Fukui

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Economic structure

Annual indicators 1998a 1999a 2000a 2001a 2002a GDP at market prices (¥ trn) 516.4 509.6 510.3 506.3 499.8 GDP (US$ bn) 3,944.5 4,473.6 4,734.8 4,165.9 3,986.3 Real GDP growth (%) -1.2 0.2 2.1 0.8 0.4 Consumer price inflation (av; %) 0.7 -0.3 -0.7 -0.7 -0.9 Population (m; Oct 1st) 126.1 126.3 126.5 126.8 126.9b Exports of goods fob (US$ bn) 374.0 403.7 459.5 383.6 395.6 Imports of goods fob (US$ bn) 251.7 280.4 342.8 313.4 301.8 Current-account balance (US$ bn) 118.7 114.6 119.7 87.8 112.5 Foreign-exchange reserves excl gold (US$ bn) 215.5 286.9 354.9 395.2 461.2 Exchange rate (av; ¥:US$) 130.9 113.9 107.8 121.5 125.4 a Actual. b Economist Intelligence Unit estimates.

Main origins of gross domestic product 2001 % of total Components of gross domestic product 2002 % of total Agriculture, forestry & fishing 1.4 Private consumption 57.2 Manufacturing 20.5 Government consumption 17.9 Construction 7.0 Private housing investment 3.6 Electricity, gas & water 2.9 Private plant & equipment investment 14.3 Wholesale & retail trade 13.9 Government investment 6.3 Banks, insurance & real estate 19.9 Change in inventories -0.4 Other services industries 20.6 Exports of goods & services 11.2 Government services 9.3 Imports of goods & services 9.9

Main exports 2002 US$ bn Main imports 2002 US$ bn Transport equipment 104.0 Machinery & equipment 107.3 Electrical machinery 95.4 Mineral fuels 66.9 Non-electrical machinery 84.8 Food 42.2 Chemicals 33.4 Chemicals 25.9 Metals 25.8 Raw materials 20.1

Main destinations of exports 2002 % of total Main origins of imports 2002 % of total US 28.5 China 18.3 China 9.6 US 17.1 South Korea 6.9 South Korea 4.6 Taiwan 6.3 Indonesia 4.2 Hong Kong 6.1 Australia 4.1

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Quarterly indicators 2001 2002 2003 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr Outputa GDP at 1995 prices (annual rate; ¥ ‘000 bn) 532.5 529.7 530.0 536.7 540.5 543.0 544.8 547.9 Industrial production index (2000=100) 91.5 89.3 89.6 92.1 93.8 97.3 94.7 94.1 Industrial production index (% change, year on year) -8.9 -12.1 -9.1 -3.6 2.5 5.6 5.7 2.2 Employment, wages & prices Employed (m) 64.30 63.99 62.71 63.54 63.66 63.31 62.21 63.59 Unemployed (‘000) 3,410 3,463 3,597 3,727 3,593 3,437 3,633 3,737 Unemployment rate (%)b 5.1 5.1 5.4 5.6 5.3 5.2 5.5 5.6 Real gross earnings (2000=100)ac 101.0 101.1 101.3 101.7 99.8 101.9 103.5 103.8 Consumer prices, Tokyo (2000=100) 98.8 98.3 97.6 98.0 98.0 97.9 97.4 97.7 Consumer prices, Tokyo (% change, year on year) -1.1 -1.3 -1.5 -1.1 -0.9 -0.5 -0.3 -0.3 Corporate goods prices (2000=100) 98.8 97.6 98.2 97.6 96.4 96.7 96.6 96.3 Financial indicators Exchange rate ¥:US$ (av) 121.7 123.7 132.5 127.1 119.2 122.9 118.8 118.4 Exchange rate ¥:US$ (end-period) 119.3 131.8 133.2 119.5 121.6 119.9 120.2 119.9 M1 (end-period; ¥ trn) 263.1 281.8 330.8 340.6 329.7 348.0 349.7 354.4 M1 (% change, year on year) 10.5 13.7 30.6 29.8 25.3 23.5 5.7 4.1 M2+CDs (end-period; ¥ trn) 656.8 671.3 673.9 679.0 670.6 683.6 682.0 689.0 M2+CDs (% change, year on year) 2.9 3.3 3.3 3.2 2.1 1.8 1.2 1.5 Discount rate (end-period; %) 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 Call money rate (end-period; %) 0.01 0.00 0.00 0.00 0.01 0.00 0.00 0.00 Three-month CDs rate (av; %) 0.04 0.04 0.12 0.04 0.04 0.04 0.04 0.04 TOPIX (end-period; April 1st 1968=100) 1,023 1,032 1,060 1,025 921 843 788 903 Sectoral trendsa Mining & manufacturing production (2000=100) 90.8 88.4 88.7 91.6 93.6 93.5 93.7 94.0 Investment goods production (2000=100) 89.8 86.5 85.1 84.3 86.7 85.1 84.4 83.1 Consumer goods production (2000=100) 97.8 94.8 94.1 94.5 95.8 96.3 96.4 95.4 Producer goods production (2000=100) 88.2 86.1 88.3 93.2 95.7 96.3 97.9 97.3 Machinery orders, net new, incl ships (¥ bn)d 5,980 5,633 5,363 5,635 5,451 5,643 6,118 6,606 Total construction starts (m sq metres) 46.5 45.4 43.3 44.1 41.6 43.5 41.8 44.1 Residential construction starts (m sq metres) 28.0 27.3 26.9 26.7 25.6 25.8 25.2 27.0 Retail sales (2000=100) 97.2 95.3 95.5 94.6 93.7 92.7 94.2 92.1 Foreign trade (¥ bn) Exports fob 12,030 11,925 12,354 12,983 12,914 13,857 12,978 13,342 Imports cif -10,260 -10,312 -10,149 -10,318 -10,479 -11,281 -10,977 -10,965 Trade balance 1,770 1,613 2,205 2,665 2,435 2,576 2,001 2,377 Foreign payments (US$ bn) Merchandise trade balance 18.35 16.88 20.06 24.35 24.26 25.16 n/a n/a Services balance -11.82 -9.18 -7.85 -10.38 -11.63 -12.36 n/a n/a Income balance 17.62 16.33 19.39 15.79 17.95 12.64 n/a n/a Net transfer payments -1.97 -1.88 0.80 -1.59 -2.17 -1.96 n/a n/a Current-account balance 22.18 22.15 32.40 28.17 28.41 23.48 n/a n/a Reserves excl gold (end-period) 389.81 395.16 394.10 438.36 452.76 461.19 487.94 n/a a Seasonally adjusted. b Percentage of the labour force. c Manufacturing. d 280 firms. Sources: OECD, Main Economic Indicators; Statistics Bureau, Government of Japan, Monthly Statistics of Japan; IMF, International Financial Statistics; Bloomberg.

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Outlook for 2003-04

Political outlook

Domestic politics The next most important event on Japan’s political calendar is the election for the leadership of the ruling Liberal Democratic Party (LDP), which will be held on September 20th. The Economist Intelligence Unit believes that the current leader, the prime minister, Junichiro Koizumi, stands a good chance of winning re-election in September. Although Mr Koizumi remains unpopular with large swathes of the parliamentary party, no credible alternative candidate has emerged from the ranks of his opponents to challenge him. He also remains by far the most popular of Japan’s mainstream politicians, with public approval rates touching 50%. Mr Koizumi will, however, need to win by a convincing majority if he is to maintain his political authority within the party and retain control over personnel changes in the likely post-election cabinet reshuffle. The recent changes in the party’s election rules favour the members of parliament, among whom Mr Koizumi has many enemies, suggesting that this may be difficult. If he wins the party election, Mr Koizumi is likely to call the next election for the lower house, which is due by June 2004, in either October or November 2003. Bringing the election forward will allow him to capitalise on the momentum generated by his likely party leadership win and to avoid the budget season which begins in earnest in December and lasts until the end of March. Although he could delay the election until the June deadline"possibly to coincide with the next upper house election, which must be held in mid- 2003"this would leave him vulnerable to negative developments in the economy and give his opponents more time to prepare. Irrespective of when the election is held, the LDP should fare well enough to remain the largest party in parliament and thus retain power, albeit still in coalition with New Komeito and the New Conservative Party (NCP). This will reflect Mr Koizumi’s personal popularity as well as the strength of the LDP’s grass-roots organisation. The looming union of the largest opposition party, the Democratic Party of Japan (DPJ), with the smaller Liberal Party will help the opposition gain proportional representation seats, but this is unlikely to be enough to offset the “Koizumi factor”, particularly if Mr Koizumi can continue to appeal to Japan’s legions of non-affiliated voters. Mr Koizumi will, however, be less assured of victory in the next upper house election. Partly reflecting its inferior legislative status, voters that would normally choose the LDP in lower house elections frequently use upper house elections to punish the party for policy mistakes and scandals. The LDP’s trouncing in the mid-1998 upper house election as a result of voter ire at the 1997 increase in the consumption tax was a good example of this. A poor or mixed result for the LDP in the election is likely to be seized upon by Mr Koizumi’s enemies as a sign of his political mortality. This could trigger the start of a concerted campaign to remove him, or at least to hobble his policy agenda. With no more national elections due until late in the decade, his opponents would have little to lose electorally from taking this route.

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Conversely, should Mr Koizumi succeed in restoring the LDP’s majority in the upper house, his position as party leader would probably be secure for the forseeable future.

International relations North Korea continues to cast a long shadow over Japanese foreign policy. North Korea still refuses to allow the families of the five surviving Japanese nationals it abducted in the 1970s and 1980s"and who have since returned to Japan"to leave North Korea. Meanwhile, concerns about North Korea’s budding nuclear programme have risen further after US intelligence suggested in mid- July that North Korea might be producing plutonium for use in nuclear bombs at a second underground site. Although Japan participated in the end-August multilateral talks in Beijing on resolving the North Korean nuclear crisis, differences on the abductees issue suggests that this in itself is unlikely to lead to a rapid improvement in relations. Heightened Japanese security concerns will fuel pressure for Japan to take a tough line on North Korea, but this will militate against an early resolution of the abductees issue. There are signs that Japan’s stance on North Korea is hardening: in July the Japanese government proposed suspending a project under the auspices of the international consortium, the Korean Peninsula Energy Development Organisation (KEDO), to build two light-water nuclear reactors in the North. In addition, the LDP’s policy council approved a bill authorising Japan to impose sanctions on North Korea without a UN resolution.

Economic policy outlook

Policy trends Given the more rapid than expected second-quarter GDP growth, and the fact that two national elections are approaching, economic policy over the forecast period will be directed at maintaining the status quo rather than implementing change. The radical policy agenda that brought Mr Koizumi to power in April 2001 has in effect been abandoned, reflecting opposition to his policies within the LDP and the overambitious nature of many of his promises. Although Mr Koizumi has reiterated his commitment to the privatisation of postal services and the privatisation of road construction corporations, pledging to make these party policy if he wins the looming leadership election, substantial progress is unlikely on either issue in the short term. Opposition to the former will be particularly intense, as the so-called tokutei post offices in rural areas have long functioned as pro-LDP support groups at elections.

Fiscal policy Japan’s fiscal position will continue to deteriorate in the forecast period, with the budget deficit touching 8% of GDP in 2003 and 2004, and the gross public debt stock nearing 170% of GDP by end-2004. In June Mr Koizumi repeated his pledge to rule out a consumption tax increase during his term as prime minister. (This promise came as the Ministry of Finance’s Tax Commission called for an increase in the consumption tax to 10% or higher, from the present rate of 5%.) Income and corporate taxes are therefore unlikely to rise over the short term. As a consequence, revenue will not rise significantly above 30% of GDP in either 2003 or 2004. Meanwhile, expenditure will rise to nearly 40% of GDP in the forecast period as the cost of providing for the ageing population

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and the large number of unemployed places increasing pressure on the public purse. We expect net new issuance of Japan government bonds to remain at around ¥40trn (US$339bn) in each year of the forecast period.

Monetary policy The presentation of monetary policy has improved sharply under the new governor of the Bank of Japan (BOJ, the central bank), Toshihiko Fukui, compared with that under his octogenarian predecessor, Masaru Hayami. Mr Fukui won plaudits for the BOJ’s swift reaction to avert the risk of a systemic crisis following the bankruptcy in May of Resona Holdings, Japan’s fifth largest banking group. This was achieved by increasing the target for current-account balances held by private banks at the BOJ to ¥27trn-30trn, from ¥22trn-27trn. Mr Fukui has also been praised for the BOJ’s decision in June to start buying around ¥1trn of (even low-rated) asset-backed securities to ease financing for smaller companies. Despite the radical nature of this move, the focus of Mr Fukui’s policy remains unchanged from that of his predecessor, namely to maintain sufficient liquidity in the system to safeguard the stability of the financial sector and to ensure that long-term interest rates remain low and stable. We do not expect this to change during the forecast period. This suggests that large-scale, radical measures, such as monetisation of the government’s deficit in order to generate inflation, are unlikely.

Economic forecast

International assumptions International assumptions summary (% unless otherwise indicated) 2001 2002 2003 2004 Real GDP growth World 2.2 2.9 3.2 3.9 US 0.3 2.4 2.4 3.3 EU 1.5 1.0 0.7 1.9 Exchange rates US$ effective (1995=100) 129.1 127.7 114.1 110.8 US$:€ 0.896 0.945 1.123 1.183 SDR:US$ 0.785 0.772 0.718 0.702 Financial indicators US$ 3-month commercial paper rate 3.61 1.70 1.01 1.33 € 3-month interbank rate 4.26 3.33 2.27 2.25 Commodity prices Oil (Brent; US$/b) 24.5 25.0 26.8 18.9 Gold (US$/troy oz) 271.1 310.3 343.3 317.5 Food, feedstuffs & beverages (% change in US$ terms) -1.9 12.7 2.1 1.8 Industrial raw materials (% change in US$ terms) -9.7 2.2 9.1 3.9 Note. Regional GDP growth rates weighted using purchasing power parity exchange rates. Global growth prospects over the short term are mixed, owing to the slow rate of economic recovery in the US. Although US economic activity has started to pick up on the back of recent tax cuts, a sustained recovery requires an improvement in investment and employment, which so far remains elusive. The euro zone will also underperform in the short term, mainly owing to the uncertainty over Germany’s prospects. Although the deepening US recovery in

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2004 will help to drive a faster recovery in world trade growth, at 3.9%, growth will fall short of the blistering rate of nearly 13% recorded in 2000. Crude oil prices remained relatively high in mid-2003, as the expected return of Iraqi oil to the world markets failed to materialise. Nevertheless, we forecast that prices will come under strong downward pressure towards end-2003, owing to oversupply. As a result, the average Brent blend prices for the year will rise only by a modest 7.3% for the year as a whole. Although demand for oil will pick up in 2004 on the back of more rapid world economic growth, the world oil glut will persist, ensuring an average fall in oil prices of nearly 30% over the year.

Economic growth Gross domestic product by expenditure (¥ trn at constant 1995 prices; % change year on year in brackets unless otherwise indicated) 2001a 2002a 2003b 2004b Private consumption 293.9 298.2 301.1 304.2 (2.2) (1.5) (1.0) (1.0) Public consumption 88.8 90.9 91.4 92.3 (2.8) (2.3) (0.6) (1.0) Gross fixed investment 143.5 137.0 139.6 143.5 (-1.2) (-4.6) (2.0) (2.8) Final domestic demand 526.2 526.0 532.2 540.0 (1.3) (0.0) (1.2) (1.5) Stockbuilding -0.8 -2.0 0.3 0.4 (0.2)c (-0.2)c (0.4)c (0.0)c Total domestic demand 525.4 524.0 532.5 540.4 (1.5) (-0.3) (1.6) (1.5) Exports of goods & services 56.1 60.7 64.9 68.0 (-6.1) (8.2) (7.1) (4.6) Imports of goods & services -46.2 -47.1 -49.1 -51.5 (0.1) (2.0) (4.3) (4.9) Foreign balance 9.9 13.6 15.9 16.5 (-0.7)c (0.7)c (0.4)c (0.1)c GDP 535.3 537.5 548.4 556.9 (0.8) (0.4) (2.0) (1.6) a Actual. b Economist Intelligence Unit forecasts. c Contribution to real GDP growth. We have made extensive revisions to our Japanese growth forecasts following the recent release of stronger than expected GDP data for the second quarter of 2003; we now expect real GDP to rise by 2% in 2003 (compared with 0.6% previously) and by 1.6% in 2004 (0.6% previously). These revisions reflect an upgrading of prospects for domestic demand. In particular, the outlook for business investment has improved sharply since our last forecast. This reflects both increased profitability on the back of recent restructuring and the gradual improvement in corporate sentiment, particularly among large manufacturers, as a result of firming external demand. Assuming that our central forecast of a slow recovery in the US market continues, we expect corporate sentiment to improve further in the coming months. The improvement on the corporate side is supporting a gradual turnaround in consumer sentiment through increased employment and a rise in real and nominal wages. Although a number of one-off factors, including inclement weather and calmer international conditions, suggest that private consumption

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growth is likely to slow sharply in the third quarter of the year, we expect growth to pick up again in the fourth quarter and to remain steady in 2004 against a background of deepening world economic recovery. The outlook for Japan’s exporters over the next 18 months or so is broadly positive, largely reflecting firming demand in the US and continued demand from the rapidly growing Chinese market. Our expectations for a broadly stable yen:US dollar rate and continued deflation in Japan also suggest that Japanese goods will remain competitive in price terms on third markets, which will also support export volume growth. We expect import volume growth to recover in the third quarter of this year as domestic demand continues to firm. The second-quarter contraction reflected a one-off fall-off in outbound tourism, partly owing to the outbreak of Severe Acute Respiratory Syndrome (SARS) in the region. The foreign balance will make positive contributions to overall growth in both years of the forecast period.

Inflation We have made a modest revision to our consumer price forecast for 2003 in light of the recent easing of deflationary pressures as a result of one-off factors, such as the inclement weather which boosted fresh food prices, and the rise in global oil prices. We now expect consumer prices to fall by an average of 0.3% in 2003 and by 0.5% in 2004. The forecast for 2004, however, masks a gradual easing of deflationary pressures over the year in quarter-on-quarter terms, as the recent relatively rapid economic growth helps to narrow the output gap. Nevertheless, downward pressure on prices will remain throughout the forecast period, reflecting continued price-cutting by firms in order to maintain market share; changes in relative price levels as a result of supply-side deregulation in retail and distribution; technology-driven productivity gains and the influx of cheap goods made abroad, particularly in China. Falling global oil prices and the relative strength of the yen against the US dollar will also contribute.

Exchange rates The yen:US-dollar exchange rate has fluctuated between ¥118:US$1 and ¥120:US$1 since the beginning of 2003. Upward pressure on the yen has largely reflected US-dollar weakness on the back of the increasingly large US current- account deficit, and policy pronouncements from the US that favour a weak dollar. We expect these upward pressures on the yen to persist in 2003-04, particularly if the recent improvement in Japan’s economic prospects continues, forcing the BOJ to continue its intervention on the foreign-exchange markets to stop the yen from strengthening beyond the apparent “red line” for Japanese policymakers, which is ¥115:US$1. We expect the yen to average ¥118:US$1 in 2003 and ¥117:US$1 in 2004.

External sector Large current-account surpluses of around 2.5% of GDP will be recorded in 2003-04. The merchandise trade surplus (fob-fob) will remain broadly steady in 2004 at US$91bn compared with US$94bn in 2002, as the spike in oil prices in the early part of the year inflates the full-year import bill. The expected fall in oil prices in 2004 owing to oversupply in the market should, however, help to compress the import bill and widen the trade surplus to around US$107bn in 2004. The services deficit will remain broadly steady in 2003 at US$45bn, reflecting the SARS-induced fall-off in outward tourism in the early part of the

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year. The deficit should, however, widen in 2004 to US$52bn, as outward tourism continues to recover. The income surplus will reach US$68bn in 2003 as inflows of interest, profits and dividends from Japan’s stock of overseas assets keep income credits buoyant. Income outflows will rise rapidly in 2004 owing to Japan’s deepening economic recovery, reducing the income surplus to US$59bn that year.

Forecast summary (% unless otherwise indicated) 2001a 2002a 2003b 2004b Real GDP growthc 0.8 0.4 2.0 1.6 Industrial production growth -6.5 -1.5 1.9 0.2 Gross fixed investment growthc -1.2 -4.6 2.0 2.8 Unemployment rate (av) 5.0 5.4 5.4 5.3 Consumer price inflation (av) -0.7 -0.9 -0.3 -0.5 Consumer price inflation (year-end) -1.2 -0.3 -0.3 -0.6 Short-term interbank rate 1.4 1.4 1.4 1.4 Government balance (% of GDP) -6.1 -7.1 d -7.9 -7.9 Exports of goods fob (US$ bn) 383.6 395.6 442.5 459.6 Imports of goods fob (US$ bn) 313.4 301.8 351.7 352.9 Current-account balance (US$ bn) 87.8 112.5 108.5 108.6 Current-account balance (% of GDP)e 2.1 2.8 2.5 2.5 Exchange rate ¥:US$ (av) 121.5 125.4 118.1 116.8 Exchange rate ¥:€ (av) 108.8 118.5 132.6 138.1 Exchange rate ¥:US$ (year-end) 131.8 119.9 117.0 116.0 Exchange rate ¥:€ (year-end) 116.2 125.7 137.5 134.6 a Actual. b Economist Intelligence Unit forecasts. c Break in series from 1994. d Economist Intelligence Unit estimates. e Break in GDP series from 1994.

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The political scene

TheThe government political calendar enacts fora new the The coming year promises much political drama. The excitement is due to start nextsecurity year policy is full on September 20th when the ruling Liberal Democratic Party (LDP) holds its next presidential election. This poll is important because, by tradition, the party’s leader also becomes prime minister when the party is in power. The current prime minister and party leader, Junichiro Koizumi, will be hoping to take the prestige of a party leadership victory into the next important event in the political calendar, the election for the lower house, which is due by June 2004, but which will probably be held in late 2003. Ideally, a triumph in an early general election would leave Mr Koizumi with plenty of time in which to prepare for the less powerful upper house election in mid-2004. The system for electing an LDP president

After the April 2001 party leadership contest, in which the strong support for the prime minister, Junichiro Koizumi, from the party’s regional representatives overwhelmed lukewarm support from the party’s members of parliament (MPs), the rules for such elections were changed to redress the balance in favour of the MPs. The most important change will be the introduction of a proportional representation system at the grass-roots level, in which the 47 prefectures’ allocated votes may go to multiple candidates; in 2001 the winning candidate received all the prefecture’s votes. MPs will also no longer be expected to vote in line with the wishes of the rank and file in the prefectures where they have their seats. A total of 655 votes will be cast. The 355 Liberal Democratic Party (LDP) MPs will each cast one vote and the LDP’s regional organisations in the prefectures will cast 300 votes. The latter will consist of three “base” votes for each prefecture, making a total of 141 votes; the remaining 159 votes will be allocated across the prefectures in proportion to the number of members in each prefecture. If no candidate wins more than 50% of the total vote, a second round of voting will be held by MPs only. The new party leader will serve a three-year term; previously party leaders served two- year terms. The prime minister remains Mr Koizumi has never commanded much respect with the LDP’s old guard, vulnerable to intrigue many of whom view his reform policies as anathema and would like to see him defeated in September. As an incumbent prime minister, Mr Koizumi should have a distinct advantage in the election. He controls the schedule and the party administration and he has ubiquitous exposure in the media. There is, however, still cause for concern as Mr Koizumi’s public approval ratings are not as high as they were when he first took office. This makes him vulnerable to backroom intrigue. It is possible, for example, that an alternative candidate might succeed in uniting the party’s two largest conservative factions"the Hashimoto and the Eto-Kamei factions"behind a single candidate. With the two factions accounting for around one-half of the LDP’s members of parliament (MPs) and around one-quarter of all votes cast, such a scenario would certainly reduce Mr Koizumi’s chances of re-election, particularly in view of the possible complexities arising from the newly introduced proportional representation system at the grass-roots level.

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LDP faction strengthsa No. of members No. of cabinet posts Hashimoto faction 101 2 Mori faction 59 3 Eto-Kamei faction 59 1 Horiuchi faction 51 1 Yamasaki faction 27 1 Komura faction 15 1 Former Kato factionb 14 1 Kono group 11 0 Unaffiliated 18 3 Total 355 13 a Late July 2003. Includes LDP members from the upper and lower houses. b The faction's leader, Koichi Kato, resigned from the Diet in April 2002. Sources: Asahi Shimbun, July 23rd 2003; Economist Intelligence Unit.

The “forces of resistance” are Although the new election rules have tilted the balance away from the rank weaker than they look and file in favour of the MPs, the “forces of resistance”, as Mr Koizumi disparagingly refers to his opponents in the party, will need considerable luck as well as political skill if they are to defeat him. The leader of the arch- conservative Eto-Kamei faction, Shizuka Kamei, has declared his intention to run for the leadership, but he is too thuggish and old to have much voter appeal, and too hardline in his views to have much appeal beyond his own faction. Many in the party will also remember his dismal performance in the 2001 leadership contest; with no hope of winning, he withdrew early from the election in order to support Mr Koizumi’s bid.

Mr Koizumi outmanoeuvres By contrast, the Hashimoto faction, as the largest faction, has the numerical the Hashimoto faction strength to organise a serious campaign. However, by late August the faction had yet to find a suitable challenger to the prime minister. In May Mr Koizumi moved to neutralise the threat from the Hashimoto faction by arranging a series of meetings with the secretary-general of the party’s upper house MPs and a senior member of the faction, Mikio Aoki. In these meetings the two struck a deal whereby Mr Aoki would endorse Mr Koizumi as LDP president in exchange for a promise to reshuffle the cabinet within a few weeks of the September election. The reason why Mr Aoki agreed, apparently, was his belief that he could parachute his allies into cabinet positions after the election, thereby increasing his clout in the Hashimoto faction.

The Hashimoto faction’s In obtaining Mr Aoki’s agreement, Mr Koizumi was also exploiting the loyalties are divided Hashimoto faction’s already uncertain unity by increasing the rift between Mr Aoki and the faction’s éminence grise, Hiromu Nonaka. Mr Nonaka has recently become more outspoken in his criticism of Mr Koizumi’s leadership of the LDP, and now openly advocates his replacement. Still smarting from the defeat in 2001 of its candidate and leader, the former prime minister, Ryutaro Hashimoto, the faction appears at a loss as to how to approach the next contest. The senior faction leaders’ unspoken fear is that the faction’s unity may not survive if it backs another losing candidate. As a result, the Hashimoto faction may not issue instructions to its members on whom to vote for on the

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day. Many of the faction’s members, keen to see their own preferment, may therefore choose Mr Aoki’s route and back Mr Koizumi.

The Liberal Party and the DPJ Perhaps the most important factor in the LDP’s long control of parliament has agree to merge been the incompetence of the opposition. This is partly a cultural problem" Japan’s political parties have tended to be unstable congeries of factions in a perpetual state of realignment"but it also reflects the failure of opposition leaders to combine internal party discipline with policies that appeal to voters. The LDP is in this sense exceptional: its factions have managed to hold together well enough for the party to survive as a coherent entity since its founding nearly five decades ago. In this context, the decision in mid-July by the Liberal Party and the largest opposition party, the Democratic Party of Japan (DPJ), to merge into a single entity by end-September this year could mark a fundamental improvement in the organisation and political power of the opposition.

The Liberal Party’s leader is The possibility of a union between the Liberal Party and the DPJ has been in defanged the air for roughly a year. A disagreement over the issue almost fractured the DPJ after its leadership election in September 2002 (March 2003, pages 14-15), and was only resolved when the victor in that election, Yukio Hatoyama, resigned in December to make way for the more conciliatory Naoto Kan. The DPJ’s pro- and anti-merger groups appear to have reached a compromise since then, which entails the party’s right wing agreeing to the demand of its left wing that, as a key merger condition, the Liberal Party leader and arch conservative, Ichiro Ozawa, be defanged. Thus, after the merger"or more accurately, in view of the terms of the union, the acquisition"the new entity will keep the DPJ’s name, its leaders, its policies and importantly for the DPJ’s left wing, Mr Ozawa will have no formal role in leading the party.

The two parties agree on The prospects for the new party are mixed. Encouragingly, Mr Ozawa appears security policy to have put aside his famed ambition in the interest of political survival and has accepted the DPJ’s harsh merger terms. Moreover, Mr Ozawa and Mr Kan agree that the government has gone too far with its recent legislation enabling Japan’s Self-Defence Forces (SDF, the de facto military) to be sent to participate in Iraq’s post-war reconstruction; Mr Ozawa believes that Japan should only send its troops abroad when that dispatch is endorsed by a UN resolution. The consensus against Mr Koizumi’s policy means that the DPJ is united on at least one major issue and can use that unanimity on the campaign trail. An opinion poll conducted by the leading national daily, the Asahi Shimbun, in July showed that 55% of those questioned were opposed to the SDF being dispatched to Iraq and only 32% were in favour, so the issue could be a vote-winner.

There are clouds over the DPJ’s There are, however, reasons to doubt the viability of the new party in the future longer term. The DPJ has long been divided between the conservatives that defected from the LDP in the political upheavals of 1993 and groups of refugees from the various parties of the left, notably the previous incarnation of the current Social Democratic Party, the Japan Socialist Party. The addition of a few more hardline conservatives from the Liberal Party may well exacerbate the DPJ’s centrifugal tendencies. This is especially true given that Mr Ozawa has

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agreed to serve as a mere backbencher, a position that presumably will soon rankle. Since his departure from the LDP in 1993, Mr Ozawa has formed several different parties only to then behave in so domineering a fashion as to alienate many of his erstwhile allies and lose them to other parties. Mr Ozawa has never shown a desire to co-operate on equal terms with others, let alone to follow their instructions, and the odds favour an attempt by him eventually to assert control over the other members of the DPJ, or at least those on its right wing. Mr Ozawa’s announcement in late August that he would maintain his political study group, which meets on a regular basis to discuss policy issues, further added to fears on the DPJ’s left wing that he could become a rallying point for the party’s disgruntled conservatives.

North Korea overshadows The issuing of statements by the North Korean government over the last year Japan’s security that it is developing nuclear weapons, will continue to do so and may ultimately export them to other countries, poses an extreme threat to East Asia’s stability and Japan’s security. It also threatens to spark a regional arms race. If North Korea succeeds in assembling a large arsenal of ballistic missiles armed with nuclear warheads, Japan might respond by deploying missile defence systems or even by building countervailing nuclear forces. It is also possible that attempts by the North Korean government to sell advanced weaponry to countries or organisations in the Middle East will provoke the US or other countries to launch a military strike to destroy North Korea’s nuclear facilities in a manner which precipitates a larger regional conflict.

Mr Koizumi curries favour Japanese foreign policy strategists have concluded (reasonably) that the most with Mr Bush promising way to contain North Korea is to join the US in applying diplomatic and, implicitly, military pressure on the country. Indeed, Mr Koizumi seems to believe that US assistance is critical to Japan’s security and hence has gone out of his way to garner the goodwill of the US president, George W Bush. The most recent example of this was the legislation, passed by parliament in July, to enable Japanese troops to assist in the reconstruction of Iraq. In addition, Mr Koizumi tacitly supports both the Bush administration’s refusal to negotiate the nuclear problem bilaterally with North Korea, and its demand that talks must include other regional interlocutors: South Korea, Japan, China and Russia.

Dispatching the SDF to Iraq Not only does North Korea’s military strategy threaten Japan’s security, it also could damage Mr Koizumi complicates Mr Koizumi’s political calculus as he enters the campaign season. In order to win re-election as president of the LDP in September, and then to lead the party to victory in the general election, Mr Koizumi must ensure that his support for the US does not alienate voters. As noted above, a majority of voters in polls indicate that they oppose sending the SDF to what is still a combat zone despite the official cessation of hostilities. The bombing of the UN’s headquarters in Baghdad in late August, which highlighted the vulnerability of so-called soft targets in Iraq, has further complicated the government’s position. Recognition of the political damage that the death of even one Japanese soldier in Iraq could do to Mr Koizumi’s political authority explains why the Japanese government announced, just after the adoption of the new law, that it would not dispatch the SDF to Iraq until early 2004. Based on current trends, even this timeframe might prove optimistic.

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Japan keeps the abductees A desire to distinguish Japan’s position from that of the US in a manner issue alive consonant with Japanese public opinion likewise explains why in early August Mr Koizumi insisted that North Korea’s treatment of Japanese citizens kidnapped in the 1970s and 1980s must also be on the agenda in the impending six-nation talks. (In the event he did not get his way as Japan agreed in mid-August to conduct parallel negotiations on the issue outside the framework of the multilateral talks.) This demand was not welcome by the US, where it was seen as detracting attention from the nuclear discussions that are the Bush administration’s highest priority, but it helped Mr Koizumi establish a degree of independence from his main ally.

Economic policy

TheThe guidelines government’s for the economic 2004/05 At end-July the government approved the basic guidelines of the budget for recordbudget is not are impressive published fiscal year 2004/05 (April-March). This was the first stage in a tortuous process which in the coming months will entail wrangling among the ministries over securing funds within the framework of the guidelines, approval of a detailed initial draft by the cabinet in late December and approval by parliament in early 2004. Total expenditure is slated to rise by nearly 5% compared with the initial budget for 2003/04, mainly reflecting the higher debt-service costs. The government hopes, however, to keep “general expenditure” or discretionary spending broadly at the level of the previous initial budget. Although in real terms, in view of Japan’s price deflation, this translates into a small increase.

Public works are slated to fall, One of the most politically charged budget items, public works, is slated to fall but bond issuance will rise by 3% to ¥8.6trn (US$74bn at an exchange rate of ¥117:US$1). However, public works projects are unlikely to fall significantly in volume terms in the new fiscal year as the government intends to make its money go further by lowering the fees it pays to construction companies. Japan government bond (JGB) issues are set to rise by more than 10% to just over ¥40trn in the new fiscal year, partly reflecting the government’s conservative tax revenue estimates. This suggests that the prime minister, Junichiro Koizumi, has accepted that his earlier pledge to hold net new JGB issuance to ¥30trn per fiscal year is unrealistic.

Budget guidelines for 2004/05a ¥ trn % changeb Tax & stamp duty 41.8 0.0 Non tax revenue 3.5 -2.8 Total revenue 45.3 -0.2 General expenditure 48.1 1.1 Public works 8.6 -3.0 Debt service 17.8 6.0 Tax grants to local governments 19.8 13.8 Total expenditure 85.7 4.8 Deficit to be financed by government bond issues 40.4 11.0 a April-March. b % change over initial 2003/04 budget. Source: Ministry of Finance as cited in press reports.

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The IRC is established In October 2002 the financial services minister, Heizo Takenaka, proposed a series of new rules that would have revolutionised the way Japan’s banks function. The political reaction to that scheme was profoundly antagonistic, with the result that the final programme was predictably anodyne (December 2002, pages 18-21). The most important element to survive was the establishment of the Industrial Revitalisation Corporation (IRC), which was given a budget of ¥10trn and instructed to identify financially troubled firms which had salvageable core operations. The IRC would then purchase those firms’ debts from Japan’s commercial banks, restructure the companies and return them to the private sector.

National government debt, 2003 (¥ trn) Jan Feb Mar Apr May Jun National government debt 648.0 661.2 668.8 636.5 646.8 643.8 Domestic bonds 498.8 504.4 504.3 510.0 517.4 517.1

Source: Bank of Japan.

The first potential candidate For all its initial promise, the IRC has so far failed to make much headway since for rehabilitation withdraws its launch in May. Its first candidate, a struggling ferry company, East Japan Ferry, abandoned its bid for rehabilitation at end-June as a result of opposition from one of its creditors, the Corporation for Advanced Transport and Technology (CAT), a public-sector lending entity affiliated to the Ministry of Land, Infrastructure and Transport. The CAT objected to the firm’s rehabilitation by the IRC on the grounds that the restructuring could involve debt waivers, which it would be unable to accept because loans made using the government credit programme, the Fiscal Investment and Loans Programme (FILP), have in principle to be repaid in full. In view of the country’s dire fiscal position, many in government are reluctant to sanction what may be seen as a backdoor partial public bail-out for such firms.

The second candidate is a The second candidate, announced in July, is a bus company based in the regional bus company southern city of Kumamoto, Kyushu Industrial Transportation (KIT). Like hundreds of other companies, KIT expanded dramatically in the bubble years of the late 1980s into businesses unrelated to its original bus lines, and ultimately employed 4,000 workers, but was left with nearly ¥60bn (US$508m at an exchange rate of ¥118:US$1) of debt. When its management revealed that, at the end of 2002/03, KIT would report that its net worth was negative, its banks began calling in their loans to the firm. Several meetings of creditors were held, and in July representatives of Mizuho Bank, the world’s largest private bank and KIT’s chief lender, announced that the IRC would be assuming control of the debt rescheduling process.

KIT’s long-term viability is in That Mizuho and the other banks would agree to this process signifies that they doubt perceive little remaining value in KIT. Untangling KIT’s complex corporate structure will tax the IRC’s ingenuity even as the search for additional restructuring candidates exhausts its human resources. Although as a major local employer, the firm’s continuing existence is important to the region, there are doubts about its long-term profitability without large-scale lay-offs and deep

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cuts in unprofitable bus routes, both of which may be politically difficult. It is also unclear how another public-sector lender, the Organisation for Promoting Urban Development (OPUD), will react to the possibility of debt waivers. KIT owes the OPUD ¥7.5bn, which must be repaid by 2005/06.

The life insurers are in dire Like much of the country’s financial sector, the Japanese life insurance industry, straits the world’s second largest after the US, has been badly affected by the country’s economic weakness since the bursting of the asset price bubble in the early 1990s. A large part of the problem stems from so-called negative spread, in which returns on investments such as stocks and bonds fail to keep up with returns promised to policyholders. (The pay-outs on the policies have not been subject to recalibration as they have for property and casualty insurance companies.) In 2002/03, for example, investment income at Japan’s 42 lifers fell ¥1.3trn short of the sums they paid out to policyholders. In the current fiscal year it is likely that the gap will close, owing to the recovery in the stockmarket, but the industry is still thinly capitalised and vulnerable to widespread bankruptcies.

The government allows the There are two obvious ways in which such a crisis could be avoided: the lifers to cut pay-outs government must either recapitalise the entire industry or let the companies individually default on their contractually agreed pay-out ratios. In the event, the government has chosen a third option: in July parliament passed a law letting the insurers lower the guaranteed yields on policies. The conditions attached to the adjustment process are, however, so onerous as to make such cuts practically impossible. One such is the requirement that a company obtain approval from at least three-quarters of the policyholders who attend the general meeting at which the rate cut is proposed. Another is the ability of any 10% of policyholders, at the general meeting or not, to veto such a change. Since it is highly likely that one-tenth of any insurer’s clients will disagree with the notion that they should give up money to which they have a legal right, the probability that the new law will be widely used seems low.

The risk of the need for an Also problematic is the bill’s stipulation that if any firm is fortunate enough to industry bail-out remains obtain the required approval for a pay-out reduction, its managers must explain to policyholders how they intend to take personal responsibility for the company’s poor financial performance"in other words, how they will sacrifice their jobs, healthcare benefits and pensions. Rather than sacrifice their own interests in this fashion, insurance executives will presumably persist in doing business as they recently have, letting the losses mount until, at the last possible moment, the government is forced to choose between a spectacular bankruptcy and an industry bail-out. Mr Takenaka, seems to understand this logic: in late July he told reporters that at some point in the near future, “a financial revitalisation programme intended specifically for the life insurance business may [still] be needed.”

Japan’s pension systems are The Pension Fund Association (PFA), which manages accounts for people that severely underfunded switch jobs or whose employers go bankrupt, recently announced that in 2002/03 its unfunded obligations had increased by ¥1.9trn, owing to “negative spreads” of the sort that have caused so much trouble for the life insurance

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industry. The PFA has now seen its assets depreciate in value three years in a row and is consequently underfunded by at least one-third. Reports from Japanese companies suggest that private pension funds are in even worse condition. Unfortunately, the situation is only likely to get worse. Not only are stock and bond yields too low to generate the kind of returns necessary to redress the pension companies’ balance sheets, but the number of people with claims against those funds is about to explode. According to the UN, the proportion of the population over 65 years of age will rise from 28% in 2000 to an enormous 38% in 2020. How a shrinking workforce can pay enough taxes to support the ranks of Japan’s future retirees is a question that should be disturbing the sleep of many Japanese bureaucrats and politicians.

The government considers Until now the government has maintained a constant level of pension raising welfare taxes distributions by holding the level of benefits steady and raising the premiums that workers must contribute from their wages and salaries. Realising that this is not sustainable, the Ministry of Health, Labour and Welfare has published a series of reform proposals, some of which would apply to both public and private pension funds. One such suggestion is that welfare taxes should be raised yet again. Another is that in the medium term Japan should adopt a variant of the Swedish system whereby contributions are set at a permanent level, and benefits are set in relation to contributions. This proposition, makes sense in economic terms. Nonetheless, it is difficult to see how such a law could be enacted in a country in which elderly voters vastly outnumber younger ones.

Mr Shiokawa suggests Meanwhile, some in the Japanese government are considering more novel exporting the elderly approaches to the pension problem. In response to a recent suggestion by the Philippines president, Gloria Macapagal Arroyo, that the Japanese government should let more of her people immigrate to Japan, the finance minister, Masajuro Shiokawa, suggested that Japan should export its growing cohorts of old people to the Philippines. The benefits, he claimed, would be two-fold: first, it would solve the problem of a lack of carers for the elderly in Japan; second, it would help to reduce the high rate of unemployment in the Philippines. Mr Shiokawa, who is over 80 years old, did not comment on whether he would set an example by moving to the Philippines after his retirement from the Ministry of Finance.

The domestic economy

Second-quarter 2003 real GDP Real GDP growth in the second quarter of 2003 was surprisingly strong at 0.6% growth is surprisingly strong quarter on quarter. In a now well-established pattern, price deflation meant that the nominal performance in the second quarter was less impressive, with growth of just 0.1%. Nevertheless, this was the first expansion in nominal GDP since the third quarter of 2002. With three important elections due in less than a year, the government wasted little time in trumpeting the good news. Indeed, Heizo Takenaka, who holds the financial services, and economic and fiscal policy portfolios, was quick to claim in a newspaper interview that the data showed that Japan’s economy was returning to “normalcy”.

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Expenditure on gross domestic product, quarter on quarter (% change unless otherwise indicated; constant 1995 prices; seasonally adjusted) 2002 2003 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr Private consumption 0.5 0.3 0.7 0.0 0.3 0.3 Private plant & equipment investment -1.8 1.5 1.5 2.8 1.2 1.3 Private residential investment -2.4 -0.4 -0.1 -0.8 -1.0 -0.4 Government consumption 0.4 0.4 0.7 -0.1 0.3 -0.4 Government fixed investment 2.2 -3.1 -2.7 -2.3 -2.9 -0.9 Stockbuilding (all sectors)a -0.5 0.6 0.4 -0.2 0.1 0.1 Exports of goods & services 5.4 6.9 0.1 4.3 0.6 1.0 Imports of goods & services 1.0 3.4 2.6 1.5 0.7 -1.1 GDP 0.1 1.3 0.7 0.5 0.3 0.6 Implicit GDP deflator 0.2 -1.4 -0.4 -1.0 -0.5 -0.4 a Contribution to growth. Source: Cabinet Office.

Domestic demand is strong in Total domestic demand contributed to overall real growth in the second the quarter quarter. Private consumption held up relatively well in the period, notching up the seventh straight quarter of expansion. One factor behind the outturn was the recent growth in employment and real wages on the back of firming corporate sentiment. This has contributed to making consumers feel more positive about the future. The Cabinet Office’s consumer sentiment index for the second quarter rose (albeit modestly) to 37.3 points in April-June, from 36.1 points in January-March. Perversely, the outbreak of Severe Acute Respiratory Syndrome (SARS) in two of Japan’s most popular holiday destinations, China and Hong Kong, and the outbreak of war in Iraq, probably boosted private consumption in the second quarter by persuading many Japanese not to go abroad and to spend their money at home.

Expenditure on gross domestic product, year on year (% change unless otherwise indicated; constant 1995 prices; seasonally adjusted) 2002 2003 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr Private consumption 1.3 0.9 2.2 1.4 1.3 1.3 Private plant & equipment investment -9.3 -7.8 -4.5 4.1 7.1 7.0 Private residential investment -9.4 -3.0 -2.6 -3.6 -2.3 -2.3 Government consumption 2.8 2.4 2.8 1.4 1.3 0.4 Government fixed investment -4.1 -3.0 -4.9 -5.8 -10.6 -8.5 Stockbuilding (all sectors)a -1.1 -0.4 0.3 0.3 0.9 0.5 Exports of goods & services -2.9 7.7 11.0 17.7 12.3 6.1 Imports of goods & services -5.5 -0.2 5.3 8.8 8.5 3.8 GDP -1.9 -0.3 1.5 2.5 2.8 2.1 Implicit GDP deflator -0.7 -1.6 -1.8 -2.6 -3.3 -2.4 a Contribution to growth. Source: Cabinet Office.

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Business investment is strong Business investment also performed well in the second quarter, growing by 1.3% quarter on quarter"the sixth quarter of expansion in a row. The robust result largely reflected the above-noted improvement in business sentiment, which was also picked up in the second quarter Tankan survey of business confidence published by the Bank of Japan (BOJ, the central bank). Confidence appears to have rebounded particularly in large manufacturers, which have been able to reap the benefits of rapid growth in the Chinese market and which stand to benefit most from the expected recovery of US growth. Some businesses may also have implemented investment in the second quarter which had been held over from the first quarter of the year, owing to concerns about the situation in Iraq. Support to business investment may also have come in the wake of a general rise in profitability in corporate Japan owing to recent restructuring. According to a survey undertaken in August by Japan’s leading financial daily, the Nihon Keizai Shimbun, the country’s top 195 listed firms expect group pre-tax profit to rise by a year-on-year average of 23% in 2003/04.

Public and residential Public investment, meanwhile, fell for the fifth consecutive quarter in April- investment remain weak June, although, at 0.9% quarter on quarter, the rate of slippage was smaller than in recent periods. This may have reflected the impact of the supplementary budget of early 2003, which contained public works measures worth about ¥1.5trn (US$13bn at an exchange rate of ¥118:US$1). Residential investment also fell in the second quarter, although this was not unexpected in view of the continued weakness of land prices; in August the National Tax Administration (NTA) announced that in January 2003 the average price of land bordering major roads nationwide had fallen to ¥121,000 per sq metre, a fall of 6.2% year on year and the 11th straight year of contraction. (The NTA uses roadside land prices to calculate inheritance and gift taxes on property transfers.)

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Contributions to real GDP growtha (year on year; quarter on quarter in brackets; seasonally adjusted) 2002 2003 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr Private consumption 0.7 0.5 1.2 0.8 0.7 0.7 (0.3) (0.2) (0.4) (0.0) (0.2) (0.2) Private plant & equipment investment -1.6 -1.3 -0.8 0.6 1.1 1.1 (-0.3) (0.2) (0.2) (0.4) (0.2) (0.2) Private residential investment -0.4 -0.1 -0.1 -0.1 -0.1 -0.1 (-0.1) (0.0) (0.0) (0.0) (0.0) (0.0) Government consumption 0.5 0.4 0.5 0.2 0.2 0.1 (0.1) (0.1) (0.1) (0.0) (0.0) (-0.1) Government fixed investment -0.3 -0.2 -0.3 -0.4 -0.7 -0.5 (0.1) (-0.2) (-0.2) (-0.1) (-0.2) (-0.1) Final domestic demand -1.0 -0.7 0.5 1.2 1.2 1.3 (0.1) (0.2) (0.5) (0.3) (0.2) (0.3) Stockbuilding (all sectors) -1.1 -0.4 0.3 0.3 0.9 0.5 (-0.5) (0.6) (0.4) (-0.2) (0.1) (0.1) Total domestic demand -2.1 -1.2 0.8 1.4 2.2 1.7 (-0.4) (0.8) (0.9) (0.1) (0.3) (0.4) Exports of goods & services -0.3 0.8 1.1 1.8 1.3 0.7 (0.6) (0.7) (0.0) (0.5) (0.1) (0.1) Imports of goods & services 0.5 0.0 -0.5 -0.7 -0.7 -0.3 (-0.1) (-0.3) (-0.2) (-0.1) (-0.1) (0.1) Foreign balance 0.2 0.8 0.7 1.1 0.6 0.4 (0.5) (0.4) (-0.2) (0.4) (0.0) (0.2) GDP -1.9 -0.3 1.5 2.5 2.8 2.1 (0.1) (1.3) (0.7) (0.5) (0.3) (0.6) a Individual contributions sum to percentage change in GDP, subject to rounding. Source: Cabinet Office.

SARS depresses import The foreign balance also made a modest positive contribution to overall growth volumes in the second quarter. Exports of goods and services grew by 1% quarter on quarter. This modest performance was respectable in view of the tough external environment in the period and it will have, in part, reflected continued export growth to China. Continued price deflation and a relatively steady exchange rate will also have helped to support export volumes by improving the competitiveness of Japanese exporters. Imports of goods and services, meanwhile, contracted by 1.1% quarter on quarter, again largely owing to the impact of SARS on outbound travel.

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Tankan survey results (all industry unless otherwise indicated; actual conditions) 2002 2003 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr Business conditions, all industrya -41 -32 -30 -28 -26 -26 Manufacturing -47 -32 -28 -24 -22 -20 Non-manufacturing -36 -30 -31 -30 -30 -30 Demand/supply conditionsb -49 -45 -44 -44 -43 -42 Inventory level of finished goods & merchandisec 25 22 21 20 19 19 Wholesale inventory levelc 43 37 35 33 31 32 Production capacityc 18 16 14 14 13 13 Numbers of employeesc 20 18 15 14 13 15 Company financial positionsd -11 -10 -9 -9 -9 -6 Lending attitude of financial institutionse -5 -4 -6 -7 -6 -4 Interest rate on loansf 10 10 12 12 11 8 Output pricesf -38 -34 -34 -32 -30 -31 Input pricesf -8 -5 -5 -2 3 -3 a Net percentage of respondents who reported "favourable". b "Excess demand" minus "excess supply". c "Excessive" minus "insufficient". d "Easy" minus "tight". e "Accommodative" minus "severe". f "Rise" minus "fall". Source: Bank of Japan.

InclementConsumption weather data hits theare Despite the positive private consumption data in the second quarter, this is problematicretailers unlikely to have been sustained into the third quarter. All segments in the retail sector appear to have been adversely affected by the unusually cool start to the summer, which brought an unusually long rainy season, with sales of seasonal items such as summer clothing and air conditioners all down in year-on-year terms. August brought little cheer. Having decided, after the experience of the early part of the summer, to bring forward sales of autumn merchandise, retailers later found themselves in the middle of a heat wave. Worse, in early August Japan was hit by a particularly strong typhoon. This lasted until the peak o-bon holiday season in mid-month and kept many consumers at home and out of the shops.

Retail sector indicators, 2003 (¥ bn unless otherwise indicated; % change year on year in brackets) Jan Feb Mar Apr May Jun Total retail sales 10,285 9,869 11,743 10,536 10,427 10,429 (-2.6) (-0.3) (-0.9) (-3.1) (-2.4) (-2.2) Department store sales 778 620 813 708 712 730 (-1.7) (0.0) (-3.5) (-4.7) (-3.0) (-2.1) Supermarket sales 1,133 928 1,028 1,039 1,037 1,036 (-2.6) (-1.0) (-1.9) (-3.2) (-4.0) (-3.5) Chain store sales 1,258 1,042 1,175 1,190 1,187 1,185 (-2.4) (-1.4) (-2.0) (-2.6) (-4.2) (-2.9) Total wholesale sales 32,422 35,027 47,866 36,185 35,302 37,215 (0.3) (0.7) (0.2) (-0.4) (-0.1) (0.9)

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Retail sector indicators, 2003 (¥ bn unless otherwise indicated; % change year on year in brackets) Jan Feb Mar Apr May Jun Real household expenditure, all householdsa 97.8 98.9 96.9 98.3 96.1 n/a (-2.0) (-1.6) (-2.6) (-1.5) (-2.2) n/a Real household income, workers' householdsa 97.0 96.4 94.3 96.3 96.6 n/a (-4.9) (-4.4) (-7.5) (-2.8) (-2.4) n/a a 2000=100; seasonally adjusted. Sources: Japan Department Stores Association; Japan Chain Stores Association; Ministry of Economy, Trade & Industry; Ministry of Public Management, Home Affairs, Posts & Telecommunications.

Daiei continues to sell off non- Japan’s third largest general merchandiser by sales, Daiei, has made some core operations progress in the restructuring programme that it agreed with its creditors in early 2002. (Opinion on whether the restructuring plan will work is still divided; many analysts reckon that the firm’s debt level is higher than it can sustain and that another bail-out may be needed to stave off bankruptcy.) As part of this programme the company has begun to change the way it does business, for example, by divesting itself of subsidiaries in industries that have nothing to do with its core retail operations and in which it has little managerial expertise. In February 2003 Daiei sold four hotels to a US investment bank, Goldman Sachs. In addition, it has announced plans to dispose of Shinkobe Oriental Hotel, in Kobe, before end-2003. It also expects to dispose of a stadium, Fukuoka Dome, on the southern island of Kyushu, and a hotel nearby in early 2004.

Creditors pick over the bones The misery of another major retailer, Mycal, which went bankrupt in of Mycal spectacular fashion in September 2001, owing creditors more than ¥1trn (US$8.2bn at an exchange rate of ¥121.5:US$1), also continues. In June the firm filed a rehabilitation plan in Tokyo District Court in which it proposed to offer different treatment to the failed company’s large and small creditors. The notion informing this plan, presumably, was that whereas large lenders have the wherewithal to investigate the clients to whom they lend"and hence have more responsibility when those clients fail"small lenders, suppliers, and distributors lack those resources and accordingly deserve more legal protection.

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Thus the administrator wanted to give those “small” creditors with less than ¥20m (US$169,500 at an exchange rate of ¥118:US$1) in exposure refunds 30% of their original principal, while returning 5% or less of the original principal to “large” creditors. The “large” creditors, however, including a US private equity partnership, Lone Star, objected to this scheme and proffered an alternative scheme which would have allowed large creditors to recover 6.2% of their loans, leaving less than 30% for the smaller claimants to recover. In late July, however, the District Court rejected this alternative and endorsed the administrator’s initial plan. In total the firm has around 44,000 creditors.

Tesco moves into Japan Japan’s already crowded retail sector gained another new player in June-July 2003 when the UK’s largest (and the world’s eighth largest) general merchandiser, Tesco, took control of a second-tier Tokyo-based supermarket chain, C Two-Network. Tesco’s “friendly” takeover of the financially healthy firm is unusual for a foreign firm seeking to enter the Japanese market. Until now, firms have set up on their own, like the French general merchandiser, Carrefour, or the US wholesale warehouse operator, Costco. Alternatively, they went into partnership with an ailing local firm like the US general merchandiser, Wal-Mart, did with Seiyu. Tesco’s decision to start its Japanese operations by first acquiring a small player may be sensible, particularly in view of how difficult it has been for foreign firms to penetrate the Japanese general merchandise market. The firm’s pattern of operation in other countries outside the UK suggests that it will eventually start building its market presence by acquiring more smaller stores. It will, however, have to reckon with stiff competition from the two leading domestic players, Ito-Yokado and Aeon, both of which are highly profitable and aggressively seeking to boost their market share.

Emission standard changes Domestic vehicle production was generally muted in the first seven months of boost truck sales 2003. In part, this reflected a natural slowdown from the rapid rates of increase recorded in the early part of 2002 as producers ramped up production at home to meet export demand, which is now being met largely from factories overseas. New vehicle registrations were also generally lacklustre in the first seven months of the year. The one exception to this was in sales of smaller vehicles, which have been rising respectably, largely owing to the increased frugality of Japanese consumers. The sharp increase in vehicle registrations in July was largely owing to a rapid increase in truck registrations. This in turn reflected an impending change in government regulation: beginning in October 2003 all new trucks will have to meet higher emission standards, which means that prices for new trucks will rise. According to the Japan Automobile Dealers Association, a desire to avoid this de facto tax increase has caused consumers to accelerate their purchases.

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Vehicle production and registrations, 2003 ('000 units; % change year on year in brackets) Feb Mar Apr May Jun Jul Vehicle production 902.3 943.8 774.3 786.3 874.9 n/a (0.6) (-1.1) (-0.4) (-2.1) (3.9) n/a New vehicle registrations 526.0 823.1 378.7 419.2 496.8 588.6 (1.8) (6.7) (-6.0) (-0.3) (-0.9) (11.8) Passenger cars 414.1 644.4 289.7 323.4 371.8 426.0 (5.1) (10.2) (-7.0) (-0.8) (-3.4) (5.7) Trucks 110.1 174.8 87.6 94.6 123.6 160.7 (-9.3) (-4.8) (-2.8) (0.9) (7.1) (31.5) Buses 1.8 3.9 1.5 1.2 1.5 1.9 (23.3) (16.9) (16.7) (22.8) (37.2) (38.3)

Sources: Japan Automobile Dealers Association; Japan Mini-Vehicles Association.

IndustrialEmission production standard remainschanges The year-on-year figures for industrial production growth would seem to boostbasically truck sales flat indicate a gradual deterioration over the first half of 2003, from just over 8% in January to under 2% in June. This impression, however, is misleading. Output in early 2002 was unusually low, with year-on-year falls of more than 10% in January and February of that year. It is therefore only when measured against that unusually low baseline that the figures for early 2003 look so impressive. Conversely, the apparent decline in growth between March and June is more a reflection of the recovery in mid- and late-2002, and hence of a higher baseline for comparison. A truer picture of industrial conditions is the operating rate index, which shows that plants were functioning at a broadly constant level in the first five months of the year. However, the decline in inventories between January and May could mean that demand is firming and that companies will accelerate production in the coming months.

Industrial production, shipments and inventoriesa, 2003 (% change year on year unless otherwise indicated) Jan Feb Mar Apr May Jun Industrial production 8.1 4.8 4.1 3.4 1.6 1.5 Producers’ shipments 8.2 6.3 3.3 3.7 1.3 3.6 Producers’ inventories -5.6 -6.5 -5.5 -4.2 -3.2 -2.7 Inventory ratiob 100.0 96.9 99.9 98.1 96.9 97.7 Operating rate in manufacturingb 96.8 95.8 95.3 95.1 97.3 n/a a Mining and manufacturing; seasonally adjusted. b 1995=100; seasonally adjusted. Source: Ministry of Economy, Trade & Industry.

Machinery orders from abroad Underscoring the possibility that demand may soon improve are recent data on are robust machinery orders, which tend to presage corporate investment by six to nine months. Total orders rose by an average of 12.5% in the first quarter of 2003 and by 18.2% in the second quarter. These were the fastest rates of growth since 2000, when the information technology (IT) bubble was at its height. Orders from abroad led the field, growing by 18.8% year on year in the first quarter of 2003 and by a blistering 50.4% in the second. Much of this demand probably came from China, where, despite the outbreak of Severe Acute Respiratory Syndrome (SARS), economic growth appears to be accelerating.

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Private orders rebound, but Encouragingly, domestic orders from the private sector also seem to be public orders remain uncertain improving, averaging around 8% year on year in the first half of 2003, although the data are slightly distorted by the depth of the contractions recorded in the year-earlier period. As might be expected in view of the expected improvement in the external environment, orders from manufacturers grew considerably more rapidly than those from non-manufacturers in the first six months of 2003. Orders for semiconductor manufacturing equipment were particularly strong, supporting hopes for a turnaround in the IT sector. The apparent vigour in public-sector orders in the first half of the year was also mainly owing to a modest rebound from the lows of 2002; in June 2002, for example, public o rders fo r machi ner y fe ll by nearly 50% year o n year.

Machinery ordersa, 2003 (% change, year on year) Jan Feb Mar Apr May Jun Total 27.2 3.9 10.5 4.6 13.1 34.9 Private-sector domestic demand 17.6 1.0 14.9 2.2 1.2 10.3 Public-sector demand 16.2 -14.2 8.0 -20.5 18.0 9.3 Foreign demand 54.1 14.9 5.7 20.6 33.6 89.5 Private-sector domestic demand excl ships & electricity 18.8 1.4 11.7 4.3 12.2 12.1 a Value. Source: Cabinet Office.

The LDP attempts to boost the In July the ruling Liberal Democratic Party (LDP) approved a series of measures housing market which it hopes will revive the housing market and which will be implemented in fiscal year 2004/05 (April-March). Key measures include an increase in the amount of money that home-buyers may borrow from the government’s Housing Loan Corporation (HLC), a broadening of the range of housing for which such credit is available and an increase in tax incentives to those who take out mortgages. Although the economics of the move is sound in that a buoyant housing market will also boost private consumption as people buy new items for their homes, it also stands to benefit the party politically, particularly as the measures target those living in rural areas, where the LDP is strongest and where private banks are often reluctant to make mortgage loans. The government plans to close the HLC’s lending operations by 2006/07. But until that time, on current trends, the LDP is likely to exploit its political potential in full.

Many people have difficulty However, the difficulty of revitalising the housing market was underscored in servicing home loans July when the HLC announced that in 2002/03 a record 25,270 people rescheduled mortgage payments, either by reducing monthly repayments or by extending the length of their loans; this was about 10% of the total number that applied for rescheduling. This was an increase of 77% year on year. In the first quarter of 2003/04 4,796 people had difficulty servicing their mortgages, a level 66% higher than in the year-earlier period. The reasons for the rise include the now familiar litany of economic woes, such as an uncertain income environment and high unemployment. Private-sector banks are also reporting increases in delinquent home loans, auguring ill for their attempt to boost

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profitability by moving into the market ahead of the HLC’s looming restructure. At end-March 2003 the HLC had some ¥60trn of home loans on its books, compared with ¥80trn for private banks, and ¥15trn for credit co-operatives.

Construction industry, 2003 (¥ bn unless otherwise indicated; % change year on year in brackets) Jan Feb Mar Apr May Jun Construction ordersa 760.2 938.5 2,320.0 672.0 733.0 925.0 (-11.0) (-11.4) (-9.3) (16.5) (-4.2) (13.7) Private-sector orders 494.1 603.3 1,478.9 460.4 535.2 620.8 (-8.7) (-6.0) (-4.5) (15.7) (17.7) (18.5) Public-sector orders 201.9 266.1 662.4 120.6 121.2 225.1 (-20.1) (-20.8) (-13.2) (8.0) (-42.6) (26.6) Housing starts ('000 units) 82.8 83.4 87.3 100.3 98.0 115.1 (-1.7) (-2.8) (-1.9) (1.4) (-7.7) (13.4) a Received by the 50 largest construction companies. Source: Ministry of Land, Infrastructure & Transport.

Employment, wages and prices

The employment picture The unemployment rate was almost flat in the first half of 2003, averaging 5.4%. improves—modestly However, the number of those in employment generally increased over the period in month-on-month terms, with particularly rapid growth in sectors such as information and communications, and healthcare and welfare"and even a modest rise in manufacturing, where employment has been in decline for some years now. There was also a modest improvement over the year in one of the key indicators of future employment trends, the ratio of jobs offered to applications. Although at just 0.61 in May (meaning that there were 61 positions for every 100 applicants) conditions remain harsh. Female employment rose more quickly than male employment in the first half of 2003, presumably reflecting the continued boom in temporary job placements. Anecdotal evidence suggests difficulty for school and university leavers.

Employment statistics, 2003 (m unless otherwise indicated) Jan Feb Mar Apr May Jun Labour force 65.60 65.42 66.49 66.91 67.35 67.71 Employment 62.03 61.93 62.66 63.06 63.60 64.11 Manufacturing 11.85 11.87 11.73 11.54 11.71 11.82 Unemployment 3.57 3.49 3.84 3.85 3.75 3.61 Unemployment rate (%)a 5.5 5.2 5.4 5.4 5.4 5.3 Jobs offers to applicants ratioa 0.60 0.61 0.60 0.60 0.61 0.61 a Seasonally adjusted. Source: Ministry of Health, Labour & Welfare.

Long-term labour market To put current employment conditions in Japan into perspective, it is helpful to trends are discouraging consider long-term trends. The labour force, for example, is on a declining trend with numbers shrinking each year between 1999 and 2002. There are two reasons for this. The first is demography: the Japanese population is ageing quickly and the ranks of the retired are starting to swell. The second is the weakness of the overall economy in the late 1990s and early 2000s, which

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persuaded many people to abandon hope of finding jobs and leave the labour market altogether"indeed, the ratio of the labour force to the size of the population over 15 now stands at around 60%, the lowest point on record. The loss of so many people from the labour market spells bad news for the country in that it will constrain the speed at which the Japanese economy can grow. But those fortunate enough to keep their jobs are also increasingly unhappy. A recent survey by Mitsubishi Research Institute found that the percentage of people who are dissatisfied with their current employers has risen from 27% in 1997 to 42% in early 2003.

The government tries to The government is worried about these trends for many reasons, including the maintain payrolls quality of life in Japan, the social stresses entailed by greater unemployment, the impact of job losses on consumption and economic growth, and"perhaps most important"the likelihood that disgruntled workers will not support the ruling LDP at elections. Accordingly, the Ministry of Health, Labour and Welfare (MHLW) is contemplating a number of regulatory and legal changes that it hopes will give a fillip to the labour market. The ministry has decided, for example, to expand the scope of a programme in which ¥110bn (US$932m at an exchange rate of ¥118:US$1) was made available to help companies maintain their payrolls if they had been hurt by non-performing loan disposals at Japan’s big commercial banks. Henceforth this assistance will also be offered to corporations who are seeking rehabilitation under the auspices of the Industrial Revitalisation Corporation.

LocalA opposition gap is opening to shelters between for Anyone who has not visited in the last five or six years would be shocked to privatethe and homeless public pensions is strong see the extent to which homelessness has taken hold in Japan: there are now people sleeping over heat vents on the streets, tarpaulin shelters in parks, and cardboard shanties in city centres. Such phenomena were rarely visible as recently as the middle 1990s, but are now a common sight in urban centres. The government’s statistics do not reflect the magnitude of the problem because they are based on a restrictive definition of homelessness and because the MHLW does not conduct thorough surveys. Nevertheless, the official figures do give a sense of how rapidly the situation is worsening: from a base of 16,500 in 1998 the number of people without homes has reportedly risen to 25,300 in March 2003. The authorities contend that these unfortunate people come from all professional backgrounds"but in fact most of them used to work in the construction industry, which has lost an estimated 700,000 jobs over that period.

WagesThe start human rising cost again of Wages (all industries; companies with 30 or more employees) rose by an unemployment is high average of 1.8% year on year in the second quarter of 2003. This was the first rise in six quarters and the first time in ten quarters that wages rose by more than 1%. Existing workers at companies have benefited from the revival in domestic demand and the gradual improvement in external conditions. Instead of hiring new workers who would qualify for healthcare and pension benefits, companies are asking their existing employees to put in more overtime. Initially this appears not to have had a significant impact on overall remuneration; the MHLW’s index of overtime hours worked rose by 7.8% year on year in the first quarter, but overall remuneration fell by 0.4% year on year. As economic

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conditions have improved, however, companies appear to have started to pay higher base wages.

Wages and costsa, 2003 (% change year on year in brackets) Jan Feb Mar Apr May Jun Average monthly wages, all industries (¥) 326,455 308,772 331,511 314,778 311,999 592,426 (-0.3) (0.3) (-1.1) (-0.6) (1.0) (3.6) Average monthly wages, manufacturing (¥) 332,799 321,670 329,076 330,473 325,469 575,681 (1.1) (1.8) (2.6) (1.7) (2.4) (3.9) Average monthly overtime earnings, all industries (¥) 24,729 25,248 25,577 25,874 24,611 24,437 (5.8) (7.4) (5.8) (3.4) (4.9) (2.8) Average monthly overtime earnings, manufacturing (¥) 34,619 36,982 37,432 37,773 35,893 36,781 (15.3) (14.4) (11.8) (9.3) (8.5) (7.4) Unit labour costs (1995=100) 92.5 94.0 93.6 93.8 n/a n/a (-8.8) (-6.1) (-5.1) (-4.9) n/a n/a a Companies with more than 30 employees. Sources: Ministry of Health, Labour & Welfare; OECD.

Consumer price deflation National consumer price deflation eased in the first half of 2003, averaging just eases 0.3% year on year. This reflected a number of factors, including year-on-year rises in fresh food prices in the early part of the year, owing to inclement weather, and increases in each of the first six months in petroleum prices, reflecting volatility in global oil prices. The impact of the latter was in turn magnified by the success of the BOJ and the Ministry of Finance (MOF) in intervening in foreign-exchange markets to ensure that the yen remained steady against the US dollar at around ¥120:US$1. The increase from April in the cost of health insurance for salaried workers also helped ease deflationary pressures in the second quarter. Relatively high global oil prices and the steady yen have also eased downward pressure on corporate goods prices, which stopped falling in July for the first time since early 2001.

Inflation indicators, 2003 (% change, year on year) Feb Mar Apr May Jun Jul Consumer prices, national -0.2 -0.1 -0.1 -0.2 -0.4 n/a Consumer prices, Tokyo -0.2 -0.3 -0.2 -0.3 -0.3 -0.5 Corporate goods prices -1.6 -1.3 -1.5 -1.6 -0.9 0.0 Corporate services prices -0.7 -0.5 -0.7 -0.8 -0.9 n/a

Sources: Bank of Japan; Ministry of Public Management, Home Affairs, Posts & Telecommunications.

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Financial indicators

The Resona fiasco continues to The failure of Japan’s fifth largest financial group, Resona Holdings, in May reverberate (June 2003, pages 30-33) has raised a number of political questions. Perhaps the most striking feature of this bankruptcy was the fact that it was caused not by the financial sector watchdog, the Financial Services Agency (FSA), which had given the company a clean bill of health as recently as last September 2002, but rather by an outside auditing firm, Shin Nihon, that was no longer willing to sanction its deceptive accounting practices. What happened in this instance, therefore, was in effect the privatisation of the regulatory process. The Japanese government has long let banks engage in practices that would not be permitted in other developed country, and in accordance with that policy, it was willing to let Resona stay in business indefinitely. But by establishing a precedent whereby only a certain degree of financial legerdemain is acceptable, Shin Nihon has both embarrassed the FSA and raised the possibility that other accountancies might likewise “blow the whistle” on errant bankers.

Money supply, 2003 (¥ bn; end-period; % change year on year in brackets) Jan Feb Mar Apr May Jun M1 337,498 340,890 349,720 354,544 354,291 354,408 (22.8) (19.4) (5.7) (4.6) (6.7) (4.1) M2 plus CDsa 672,831 674,087 681,967 684,617 686,014 689,038 (2.1) (2.1) (1.2) (1.4) (2.5) (1.5) M3 plus CDsa 1,129,940 1,131,845 1,138,564 1,110,525 1,113,745 1,119,545 (0.8) (0.7) (0.7) (-1.8) (-0.9) (-1.5) a Certificates of deposit. Source: Bank of Japan.

Parliament investigates the There are grounds to believe that the FSA was concerned by Shin Nihon’s FSA’s conduct decision. Most obviously, the auditor’s decision to force Resona into bankruptcy belied the regulator’s assertion that the bank had been healthy. The implications of the episode, however, were even more problematic in as much as Shin Nihon had cast doubt on all of the FSA’s judgements about the banking system. So when a rumour surfaced that in early May officials in the agency had talked surreptitiously with Resona’s management and then attempted to dissuade auditors from condemning the troubled bank, there was considerable reason to take it seriously.

Mr Takenaka performs an At first, the financial services minister, Heizo Takenaka, denied these reports, about-turn but then in early June an MP from the opposition Democratic Party of Japan, Kohei Otsuka, who claimed to have received briefings and documents from an inside source, started asking pointed questions at a parliamentary committee meeting. At this juncture Mr Takenaka shifted position. He admitted that conversations between bank managers and FSA personnel had taken place in May, but continued to claim that no pressure had been exerted on Shin Nihon. Mr Takenaka and his aides also rejected, as forgeries, the documentary evidence that Mr Otsuka proffered.

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The market is complaisant Even more significant is the equanimity with which investors reacted to the about the bank’s collapse announcement of Resona’s collapse: the Tokyo stockmarket actually rose in the aftermath of that event. Although this appreciation probably stemmed from independent economic developments, the fact that prices did not plummet as they did when several major financial institutions failed in November 1997 is remarkable. Some of the credit for the relative quiescence this time round must be attributed to the safety net that the government established under the banks in 1998 and 1999"but more importantly, the BOJ injected large sums of liquidity into the financial system in the days after the Resona announcement.

The state virtually assumes the Yet there seems to have been still another reason why investors were not banks’ portfolio risk shocked by Resona’s failure: namely, their belief that the government has already nationalised the banks"or at least the risks inherent in their portfolios. In 1997 no one knew how many financial institutions would be dragged into bankruptcy or whether the government would step in to prevent a systemic crisis. Since then, however, the regulatory authorities have recapitalised many of the major lenders, extended indefinitely the period in which household deposits will be guaranteed by the state, formally agreed to let the banks use accounting standards that would not be acceptable in other countries, and issued frequent statements that the financial system is sound. Having done all this, the political costs of letting a major lender default on its debts, suddenly stop lending money to its clients, or shut its doors, would be enormous"fo r both the regulators and for the ruling party. Investors understood this, so they viewed Resona’s failure as a relatively minor development: what the FSA “nationalised” in May this year was only the bank’s management and not its risks, which the government has been underwriting for years.

Bank lendinga, 2003 (% change, year on year) Feb Mar Apr May Jun Jul Total domestic lending -4.8 -4.5 -4.6 -4.6 -4.6 -4.7 City banks, long-term credit banks & trust banks -7.5 -7.1 -7.4 -7.3 -7.2 -7.5 Regional banks (Tier I) -0.3 0.0 1.0 0.8 0.4 0.6 Regional banks (Tier II) -1.8 -3.0 -5.2 -5.1 -5.0 -4.7 Foreign banks’ yen lending -13.3 -20.3 -26.4 -29.7 -24.2 -19.1 a Unadjusted for write-offs and securitisation. Source: Bank of Japan.

TheOther authorities banks undermine intervene To prevent the derailment of what appeared to be a nascent economic recovery massivelyShinsei’s in exchange pricing markets power in early 2003, MOF, which determines intervention policy, decided to buy as many US dollars as necessary to stabilise the yen:US dollar exchange rate. The scale of these operations would prove immense. In the first quarter of 2003 balance-of-payments data show that the government spent nearly US$20bn on yen stabilisation, taking foreign-exchange reserves up to US$478bn by end- March. It bought another ¥4.2trn in foreign currencies, on 18 separate days of intervention in the second quarter, according to MOF. On May 19th alone it bought ¥1trn worth of dollars. The total for the first seven months of this year was ¥9.1trn, outstripping the previous annual record of ¥7.6trn spent in 1999.

Country Report September 2003 www.eiu.com © The Economist Intelligence Unit Limited 2003 34 Japan

The interventions are This massive effort yielded the desired results: whereas the euro appreciated successful against the US dollar by around 30% between the beginning of January and the end of August, the yen remained in a narrow band of ¥118-¥120:US$1, appreciating by only about 6% at its peak. A large UK-based bank, HSBC, reckons that in the absence of MOF’s intervention, the yen would have appreciated by another 10% to between ¥105:US$1 and ¥110:US$1, a level that might have detracted half a percentage point from Japan’s GDP. Given the robustness of economic growth in the second quarter of the year, MOF’s currency manipulation made a significant difference.

Financial market indicators, 2003 (end-period unless otherwise indicated) Feb Mar Apr May Jun Jul Nikkei 225 stock average (¥) 8,363 7,973 7,831 8,425 9,083 9,563 % change, year on year -21.0 -27.7 -31.9 -28.4 -14.5 -3.2 % change since end-1989 high -78.5 -79.5 -79.9 -78.4 -76.7 -75.4 Total market value of shares listed on the Tokyo Stock Exchange (¥ bn)a 240,901 232,440 235,268 247,665 267,154 277,912 % change since end-1989 high -60.6 -62.0 -61.5 -59.5 -56.3 -54.5 Uncollateralised overnight call rate (%) 0.001 0.021 0.002 0.002 0.001 0.002 Ten-year government bond yield (%) 0.780 0.700 0.605 0.530 0.835 0.935 a First & second sections. Source: Haver Analytics.

The US reacts with unexpected In the past, the US has condemned attempts by the Japanese government to equanimity control the yen:US dollar exchange rate because it viewed those efforts as designed to give Japanese exporters an unfair advantage in international markets. This time round, however, the US government’s reaction has been relatively sanguine. There are several reasons for this. First, when it buys US dollars the Japanese government usually invests most of it in US Treasury bills, which has helped to lower interest rates in the US and hence to stimulate US GDP growth. Second, the US is so concerned that Japan’s economic stagnation represents a threat to global stability that it appears willing to tolerate moderate yen devaluation. The US government’s need for Japanese assistance in

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Afghanistan and Iraq and in building a united front against North Korea may also have contributed to the recent American patience.

Foreign trade and payments

The merchandise trade surplus Japan’s external position deteriorated in the first half of 2003 as the shrinks merchandise trade surplus (fob-cif) contracted by 10% year on year to ¥4.4trn (US$37bn at an exchange rate of ¥118:US$1). The slippage mainly reflects the 7.2% increase in the import bill in the forecast period, to just under ¥22trn, itself mainly a result of the nearly 40% year-on-year increase in the cost of petroleum imports. Although global oil prices eased in the immediate run-up to the recent war in Iraq, problems with putting Iraqi oil on stream have kept oil prices high. By contrast, export revenue performance was muted, with growth of just 3.9% year on year to ¥26.3trn.

Trade values, volumes and prices, 2003 (goods; % change year on year; values and prices in yen terms) Jan Feb Mar Apr May Jun Exports Total cash value 8.0 7.7 0.7 4.7 3.6 0.0 Unit prices -2.3 -2.4 -5.1 -2.2 0.7 0.2 Volume 10.3 10.1 6.3 7.1 2.8 -0.2 Imports Total cash value 10.4 4.6 9.3 5.6 2.0 11.6 Unit prices 0.8 3.0 2.0 0.5 -1.2 -1.5 Volume 9.5 1.6 7.2 5.1 3.3 13.4

Source: Ministry of Finance.

Car exports to the US fall as One reason for the relatively subdued performance on the export side was a makers boost local production fall-off in exports to the US, which remains the largest single market for Japanese goods. Revenue from exports of goods to the US fell by nearly 10% year on year, to ¥6.7trn. By June exports to the US had been contracting in value terms for six consecutive months. Exports of motor vehicles to the US, one of the mainstays of bilateral trade, fell by 11% in value terms and by 7% in volume terms. A large part of this decline may, however, reflect increased production of Japanese cars at factories in the US; in the first half of 2003 production at Japanese factories abroad rose by 16.2% year on year to just under 8m vehicles. Indeed, US demand for vehicles made by Japan’s largest vehicle maker, Toyota Motor, has been so strong of late that the firm intends to raise its US production capacity to 1.5m vehicles from 1.3m vehicles by end-2003. Sales in the US now account for 20% of Toyota’s operating profits. Moreover, US sales account for 40% and 60% of the operating profits of the next two largest vehicle makers, Nissan Motor and Honda Motor, respectively. Around two-thirds of Japanese cars sold in the US are now produced locally.

Country Report September 2003 www.eiu.com © The Economist Intelligence Unit Limited 2003 36 Japan

Bilateral merchandise trade flows, 2003 (¥ bn) Jan Feb Mar Apr May Jun Asia Exports to Asia 1,635 1,949 2,200 2,088 1,971 2,039 Imports from Asia -1,661 -1,387 -1,635 -1,671 -1,583 -1,585 Trade balance -26 561 565 417 388 454 EU Exports to EU 635 703 769 734 664 670 Imports from EU -477 -421 -492 -461 -459 -454 Trade balance 158 282 277 273 205 217 US Exports to US 1,049 1,087 1,178 1,172 1,115 1,082 Imports from US -574 -521 -577 -605 -603 -600 Trade balance 476 567 602 567 512 482

Source: Ministry of Finance.

China continues to boost The trade surplus with Asia rose by 32% year on year, to ¥2.4trn. This was export revenue largely the result of continued demand for Japanese goods from China, which helped to push up export earnings by 12% to ¥11.9trn. Much of this total is accounted for by Japanese companies located in China importing parts for electronic goods from Japan, some of which will then be exported back to Japan, and also by the demand for Japanese motor vehicles. The former is evident in that audiovisual equipment, personal computers and other office equipment are among Japan’s top imports from China. In the first half of 2003 China accounted for 11.6% of Japan’s export revenue, up from 8.8% in the year- earlier period. The data for the year to date suggest that the outbreak of Severe Acute Respiratory Syndrome (SARS) in China earlier in the year has had almost no impact on bilateral trade.

Exports of selected commodities (¥ bn unless otherwise indicated; Jan-Jun) 2002 2003 % change Food, beverages & tobacco 133 123 -7.9 Textiles 441 433 -1.8 Chemicals 2,064 2,239 8.5 Metals 1,575 1,648 4.7 Iron & steel 934 1,000 7.1 Non-electric machinery 5,180 5,354 3.4 Office machinery 1,477 1,283 -13.1 Automatic data-processing machines 702 483 -31.1 Construction & mining machinery 244 301 23.4 Metalworking machinery 338 390 15.3 Electrical machinery 5,649 5,998 6.2 VCRs 215 236 9.9 TVs 467 545 16.7 TV cameras 38 38 2.6 Telecommunications apparatus 266 319 19.9 Semiconductors, etc 1,832 1,865 1.8 Electronic circuits 1,179 1,222 3.7 Transport equipment 6,380 6,617 3.7 Passenger cars 3,770 3,880 2.9 Motor vehicle parts 1,029 1,122 9.0

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Exports of selected commodities (¥ bn unless otherwise indicated; Jan-Jun) 2002 2003 % change Ships 606 602 -0.8 Precision instruments 981 986 0.5 Total incl others 25,338 26,320 3.9

Source: Ministry of Finance.

Tariffs on imported beef are Japan managed to incur US, Canadian and Australian wrath in August when it raised increased tariffs on imported beef from 38.5% to 50%. The higher tariff is set to remain until March 2004. According to the government, it is needed to curb the recent surge in beef imports. (The value of imports of beef from the US and Australia rose by 11% and 36% year on year, respectively in the first half of 2003. Imports of beef from Canada, meanwhile, fell by 7% year on year, reflecting the outbreak of mad cow disease earlier in the year.) The move is permitted under World Trade Organisation rules when year-on-year imports rise by 17% or more. This is a safeguard designed to protect local producers from sudden surges in imports. Foreign meat producers point out that the figures for 2003 are distorted by the fall-off in sales of beef in 2002, after the discovery of mad cow disease in Japan. The measure has also angered domestic players in the restaurant and retail sectors, who fear that they will have to absorb the higher cost of imported beef. The Ministry of Agriculture, Forestry and Fisheries estimates the move will boost beef prices by around 2.5%.

Imports of selected commodities (¥ bn unless otherwise indicated; Jan-Jun) 2002 2003 % change Food, beverages & tobacco 2,610 2,502 -4.1 Raw materials 1,230 1,342 9.1 Wood 265 294 10.8 Ore & concentrates 193 186 -3.3 Non-ferrous base metals 202 236 16.9 Mineral fuels 3,759 4,937 31.3 Coal 397 377 -5.1 Crude petroleum 2,055 2,833 37.8 Liquefied natural gas 701 860 22.7 Chemicals 1,564 1,708 9.2 Textiles 1,257 1,264 0.5 Metals 824 944 14.5 Iron & steel 144 186 29.1 Aluminium 238 277 16.5 Machinery & equipment 6,685 6,746 0.9 Office machines 1,451 1,341 -7.6 Audio & visual equipment 517 521 0.9 Telecommunications equipment 225 179 -20.2 Semiconductors, etc 929 943 1.4 Motor vehicles 376 367 -2.5 Aircraft 213 263 23.5 Total incl others 20,467 21,941 7.2

Source: Ministry of Finance.

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The current-account surplus Japan’s current-account surplus narrowed by ¥626bn (US$5.3bn at an exchange narrows rate of ¥118:US$1) in the first half of 2003, to ¥7.2trn. The merchandise trade surplus (fob-fob) and the services deficit both narrowed in the period. The former reflects the developments outlined above, and the latter was at least in part owing to the outbreak of SARS in China earlier in the year, and the uncertainties associated with the onset of hostilities in Iraq, which persuaded many Japanese to stay at home rather than travel abroad. The slump in services exports was particularly pronounced in the second quarter of the year, when debits on the travel account fell by 31% year on year. The income surplus also narrowed in the period, reflecting monthly contractions in year-on-year terms of inflows of direct investment on the back of sluggish global growth. Portfolio investment inflows, meanwhile, held up reasonably well in the first half of the year, posting a nearly 20% increase in June in line with the slow recovery in global equity markets.

Balance of payments, IMF basis (¥ bn; Jan-Jun) 2002 2003 Merchandise exports 24,050 25,053 Merchandise imports -18,299 -19,689 Trade balance 5,751 5,364 Services balance -2,360 -1,832 Income balance 4,575 4,175 Current transfers balance -97 -464 Current-account balance 7,869 7,243 Capital & financial account balance -4,365 2,146 Reservesa 446,198 545,618 a End-period; total of gold, foreign exchange, SDRs and IMF reserve position. Source: Ministry of Finance.

Country Report September 2003 www.eiu.com © The Economist Intelligence Unit Limited 2003