What Model for Japans Future?

Overcoming the Hollowing-Out Syndrome

Presentation at the Brookings Institution Conference on The Hollowing-Out of Japans Economy: Myths, Facts, Countermeasures. February 20, 2013 Jun Saito Senior Research Fellow, Japan Center for Economic Research, and Project Professor, Keio University

Structure of the Presentation

Introduction
Hollowing-out is a problem because it leads to low per capita GDP growth in the longer-term.

Alternative Scenarios
For the scenarios to sustain, Japanese economic systems have to be reconstructed.

Additional Remarks
Scenarios imply that Japan is going to stay as immature creditor-lender.
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Introduction

Hollowing-Out Syndrome in Retrospect

Hollowing-out can be defined as a decline in domestic manufacturing production due to deterioration of the competitiveness of tradables. In that sense, Japan has experienced similar situations in the past when Asian economies started to show rapid developments as a result of inflow of capital and technology. In those days, Japan was able to had over laborintensive industries to Asian developing economies and expand capital- and technology- intensive industries instead.
i.e. Flying-Geese type of economic development in Asia.
4

Recent Experience of Hollowing-Out

Since mid-1980s, Japanese firms in the manufacturing sector have been increasing FDI and shifted production sites abroad, mainly to Asia, to make the most of low labor cost and export products from the host country. More recently, Japanese manufacturing firms are increasing FDI to capture the expanding domestic market of the host country (particularly China). Non-manufacturing firms are also increasing FDI to do business in the host country with large population.
5

Modest Impact on Production

While exports from the subsidiaries partly substituted exports from Japan and increased imports of final goods back to Japan, they also stimulated exports of intermediary goods from Japan to the host country.
As a result, total manufacturing production managed to show a modest increase since 1990.
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Adverse Impact on Employment

On the other hand, employment in the manufacturing sector declined (meaning increase in labor productivity). Released labor force was absorbed by the growth in the services sector. Moreover, the rapid appreciation of the yen exerted a significant adverse impact on the economy that exceeded the speed of market adjustment and policy response. It has provided upward pressure on unemployment.
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Longer-Term Implications
Over the longer-term, especially when the rapid appreciation of the yen is alleviated, the adjustments can be expected to take place so that more balanced macroeconomic condition is restored. However, because of the aging and decline in population, the growth in Japanese total GDP is expected fall in the longer-term. Moreover, if Japanese competitiveness remains low, larger share of production is going to take place in the services sector where labor productivity is lower than the manufacturing sector (Figures 1&2*). As a consequence per capita GDP growth rate is also going to stay low. This is a great concern for the welfare of the Japanese people.
* Projections are taken from Japan Center for Economic Research, Medium-Term Forecasts for FY2012-2025, December 2012. They do not include impacts of the policies suggested below.
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Figure 1. Projection of Changes in Labor Productivity

2.5 2.0 1.5
Annual average rate of increase,

1.0
0.5 0.0 -0.5 -1.0 -1.5 -2.0 96-00
Changes in industrial composition Increase in value-added ratio in individual industry Increase in output per worker in individual industry

01-05

06-10

11-15

16-20

21-25
9

(Source) Japan Center for Economic Research, Medium-Term Forecast for FY2012-2025, December 2012.

Figure 2. Contributions to the Changes in Labor Productivity (2016-2020)

*Others *Personal services *Other business services Advertisement, Research, and *Medical service, nursing care, etc. Other pubilc service Pubilc administration Communication and Broadcasting *Transportation Real Estate Finance and Insurance *Retail Wholesale Water supply and waste disposal Gas and heat supply Electricity *Construction *Other manufacturing Precision instruments Other transportation equipment Automobiles Electronic components Computer and communication Consumer electrical machinery *Indstrial electrical machinery General Machinery *Metal products Non-ferrous metals Iron and steel Ceramic, stone, and clay products Petroleum and coal products Chemical products *Pulp, paper, and wooden *Textile products Beverages and foods Coal, Crude Oil, and Natural Gas Mining *Agriculture, forestry, and fishery
-0.3
-0.1 -0.2 -0.4 -0.5 0.5 0.4 0.3 0.2 0.1 0.0

(Note) Industries with * indicate that their labor productivity is less than the macro-average labor productivity. (Source) Japan Center for Economic Research, Medium-Term Forecast for FY2012-2025, December 2012.

Annual average rate of increase,

Increase in output in individual industry Increase in value-added ratio in individual industry Change in industrial composition

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Alternative Scenarios

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Alternative Scenarios
A: Alleviation of hollowing-out pressures by depreciation of the yen B: Increase in exports by improvement in competitiveness of goods C: Increase in exports by improvement in competitiveness of services D: Increase in factor income by growing receipts from abroad E: Increase in output capacity of high-value added sectors by receiving more foreign workers
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Scenario A
Depreciation of the yen could take place as a result of the overshooting of appreciation in the recent past. (It has already taken place since last December.) However, there are factors that provide upward pressure on yen:
Deflation Current account surplus

Moreover, newly industrialized economies will continue to improve their competitiveness. This scenario may offer only a short breathing space.
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Scenario B
Improvement in the competitiveness of the manufacturing sector could be provided by product innovation (allowing to compete by quality and uniqueness) rather than by process innovation (beneficial for price competition). Past record shows that exports have shifted to higher value-added goods (Figure 3). However, Japans national innovation system (once regarded as the best practice) cannot meet the current needs.
Rapid increase in R&D investment in Korea and China (Figure 4) Widening technology gap in biotechnology (Figure 5)

New national innovation system require;

Shift from in-house R&D based on initiatives from production lines to investment in out-of-the-firm R&D ventures. Requires changes in the systems of employment (e.g. more flexible labor market) , education (e.g. more resources for basic science), and financial (more supply of risk money ).
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Figure 3. Export Quality Improvement

15.0%

10.0%
5.0% 0.0% -5.0% -10.0% -15.0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
15

Change in composition of goods Higher value-added goods Export quality improvement

(Note) Export quality is measured by the ratio of unit-value of index exports (Paasche index supplied by the trade statistics), and export price index (Laspeyres index supplied by the Bank of Japan).

Figure 4. R&D Expenditures (Ratio to GDP)

4 3.5 3 2.5 2 1.5 1 0.5 0 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
(Source) National Institute of Science and Technology Policy, Japanese Science and Technology Indicators 2012, August 2012. 16

Japan USA Germany China Korea

Figure 5. Registered Patent at U.S. Patent and Trademark Office

(Share by country, average of 2008-2010)
Total
80 60 40

Nano-technology

20 0

Bio-technology

ICT Japan USA Germay

RenewableEnergy China Korea

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(Source) National Institute of Science and Technology Policy, Japanese Science and Technology Indicators 2012, August 2012.

Scenario C
Improvement in competitiveness could also take place in services as a result of product innovation. However, Japans national innovation system does not meet the needs in this area as well.
Product innovation is not so successful in services (Figure 6).

Export of technology service is one promising area (Figures 7&8). However, overhauling of national innovation system is necessary to maintain the lead in technology (as mentioned earlier).
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Figure 6. Realization of Innovation

Difference by amount of R&D expenditures and innovation types
100 90 80

70
60 50 40 30 20 10 0 None Less than 100 100-500 500-1000 More than 1 million dollars million dollars million dollars billion dollars Product Innovation (Services) Total Firms

Product Innovation (Goods)

Process Innovation

(Source) National Institute of Science and Technology Policy, Japanese Science and Technology Indicators 2012, August 2012. 19

Figure 7. Services Account Balance

10000 0 -10000

-20000
-30000 -40000 -50000 -60000 -70000 Other services Travel Transportation Total Services

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

(Source) Ministry of Finance and Bank of Japan, Balance of Payments Statistics.

2012
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Figure 8. Royalties and License Fees

30000
Debit 20000 10000 0 -10000 Credit

Net Balance

-20000
-30000

2012

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

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Scenario D
Factor income receipts recorded in BOP statistics include reinvested earnings. Repatriation is only a part of the total receipts (amounting to about 50 percent).
Care is needed when GNI is made a target (Figures 9&10).

Even if repatriated earnings increase, the impact may not be large when firms are cashrich.
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Figure 9. Income Account Balance

300000 250000 200000 Investment Income/Debit Investment Income/Credit Compensation of Employees/ Debit Compensation of Employees/ Credit Net Balance

150000
100000 50000 0 -50000 -100000 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
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(Note) Compensation of employees is negligible in magnitude. (Source) Ministry of Finance and Bank of Japan, Balance of Payments Statistics.

Figure 10. Direct Investment Income (Income on equity)

60000
50000 40000 30000 20000

60.0%
50.0% 40.0% 30.0% 20.0%

10000
0 -10000 -20000 -30000

10.0%
0.0% -10.0% -20.0% -30.0%

1998

2002

1996

1997

1999

2000

2001

2003

2004

2005

2006

2007

2008

2009

2010

2011

Repatriated Earnings/ Debit Reinvested Earnings/ Debit Reinvestment Ratio (Right Scale)

Repatriated Earnings/ Credit Reinvested Earnings/Credit

(Source) Ministry of Finance and Bank of Japan, Balance of Payments Statistics. 24

2012

Scenario D (continued)
More important may be the potential benefits to households (via dividend and interest payments, and capital gains) if they hold shares directly or indirectly (mutual funds) (Figure 11). However, Japanese households only a limited portion of their financial assets in shares.
Majority is held in bank deposits (Figure 12). In turn, the banks are increasingly investing in government bonds rather than lending to firms (Figure 13). Consequently, limited availability of risk money is going to venture firms.

Flow of funds need to change.

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Figure 11. Holders of Shares by Investors

35 30 25 20 15 10 5 0

1995

1986

1987

1988

1989

1990

1991

1992

1993

1994

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Central and Local Governments Trust Banks Securities Companies Foreigners

City and Regional Banks Other Financial Institutions Business Corporations Individuals

(Source) Tokyo Stock Exchange, Shareholding at Market Value by Investor Category.

2011
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Figure 12. Households Financial Assets

9000000 8000000 7000000 6000000 5000000 4000000 3000000 2000000 1000000 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 (Source) Bank of Japan, Flow of Funds. 27 Cash & Deposits Securities other than Shares

Shares and other equities

Insurance & Pension Reserves Others

Figure 13. Commercial Banks Assets

9000000 8000000 7000000

6000000
5000000 4000000 3000000

Cash & Deposits Fiscal Loan Fund Loans Securities other than shares Shares and other equities Others

2000000
1000000 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
(Source) Bank of Japan, Flow of Funds. 28

Scenario E
Aging of the population would increase demand for health and medical services. Since they cannot be imported, large portion of labor force has to engage in supplying such services. This leaves only a limited amount of labor force for high-productivity manufacturing sector. Consequently, macro labor productivity growth would fall.
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Scenario E (continued)
The constraint could be alleviated if;
productivity in the services sector is raised by e.g. information technology, and/or labor force is Increased by reversing the fertility rate trend (in the long-term) and accepting more foreign workers (in the short-term).

In order to accept more foreign worker, Japan need to be an attractive destination. Japanese has to be more acceptable, and has to establish necessary infrastructure. Japan may miss the opportunity if late in taking action.
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Additional Remarks

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Prospects of the Japanese Current Account Balance

Aging and decline of population in Japan is expected to lead to current account deficit in the medium-term.
cf. JCER Medium-Term Forecast (2012) (Figure 14)

From broader perspective, Japan can be considered to be following a typical development stages of the balance of payments.
From immature creditor-lender to mature creditorlender, and eventually to creditor-borrower (cf. Crowther (1957))
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Figure 14. Projection of the Current Account Balance

40 30 20 10 0 -10 -20 -30 -40 2000 Current transfers Trade and services balance 05 10 Income balance Current account balance 15 20
(Fiscal Year) Forecast (trillion yen)

25

(Source) Japan Center for Economic Research, Medium-Term Forecast for FY2012-2025, December 2012.
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Implications of the Scenarios for the future of Current Account

A&B: Stronger goods exports
Recover surplus in trade account, and maintain current account surplus?

C: Stronger services exports

Recover surplus in trade and services account, and maintain current account surplus?

D: Stronger factor income receipts

Achieve larger surplus in incomes account, and maintain current account surplus?

E: More foreign workers

Recover surplus in trade and services account, and maintain current account surplus?

Whichever the case may be, it means that there is going to be a reversal of development stage in BOP (revert back to the stage of immature creditorlender).
How is domestic investment and savings going to change? (Figure 15)

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Figure 15. Projection of Net lending/borrowing by sector

15 10 5 0 -5 -10 -15 1980

Ratio to GDP, Forecast

85

90 Social security

95

2000

05

10

15

Business corporation

National, local governments Household sector

20 25 Fiscal Year

(Source) Japan Center for Economic Research, Medium-Term Forecast for FY2012-2025, December 2012.

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Thank you for your attention!

Jun Saito Japan Center for Economic Research and Keio University