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Asked by reporters how the IMF could downgrade expectation for Japanese
growth despite announcements of new fiscal stimulus said to equal 4% of
GDP, IMF chief economist Michael Mussa said:

"I think the way to look at the revisions for Japan is that if we had
not had the recent policy announcements, we probably would by now have
revised down the forecast even more....The Tankan business survey was
more negative than expected. And we have, of course, also had to revise
the forecast to take into account the very sharp appreciation of the yen
that occurred in September."


This prediction by the "experts" was made just 2 years before Japan's GDP experienced an "unexpected" 7.6% increase in 2000 and an equally "unexpected" 9.2% increase in 2001.

What is it about hese "experts" that they are incapable of even being in the ball park on economic projections?



Date: Tue, 22 Dec 1998 14:15:11 -0800
From: Richard Katz <[email protected]>
Reply-To: [email protected]
X-Mailer: Mozilla 3.0C-NC320  (Win16; U)
MIME-Version: 1.0
To: [email protected]
Subject: The Bond Crisis and Japanese Growth
The Obuchi Administration's "muddling through" strategy is based on two
premises: 1) the Opposition is too divided, coopted and pathetic to pose
a threat; and 2) the economy will bottom out in fiscal 1998, recover to
0.5% in 1999 and then grow as much as 2% in 2000. Let's leave the first
premise for another occasion. Meanwhile, two new developments create
plenty of doubt about the second premise.
The first is that, despite the gigantic stimulus packages announced by
Tokyo, the IMF says Japan's recovery prospects are worse than it thought
only two months ago. In October, the IMF projected that Japan would GROW
0.5% in CALENDAR 1999, rebounding from a 2.8% decline in 1998. In its
new, December 21 "World Outlook," the IMF says that GDP will DECLINE
0.5%. (Most private estimates for FISCAL 1999 range from minus 0.5% to
minus 1.5%) That's a 1% downward change in only two months. This
accompanies recent downward revisions by other sources. The reasons for
the spate of revisions shed light on some of the obstacles to recovery.
Second, is a huge upward spike in the interest rate on Japanese
government bonds in response to the mammoth borrowing needs caused by
the fiscal stimulus program. Ten-year bonds, now at 1.9%, are almost
triple the rate of only a couple months back. They're at the highest
rate since September 1997. This hike in interest rates causes more
financial difficulties for the banks and insurance companies, will deter
new investment and home purchases, and offsets the benefits of fiscal
stimulus. Should the interest rate hikes continue, the goverment mayhave
reached the point where the positive benefits of fiscal stimulusare
overcome by its financially depressing consequences. That wouldleave the
goverment with no weapons to fight the recession. Things haveprobably
not gotten that far, but clearly fiscal stimulus is hitting diminishing
Asked by reporters how the IMF could downgrade expectation for Japanese
growth despite announcements of new fiscal stimulus said to equal 4% of
GDP, IMF chief economist Michael Mussa said:
"I think the way to look at the revisions for Japan is that if we had
not had the recent policy announcements, we probably would by now have
revised down the forecast even more....The Tankan business survey was
more negative than expected. And we have, of course, also had to revise
the forecast to take into account the very sharp appreciation of the yen
that occurred in September."
The best measure of the size of fiscal stimulus is the change in the
so-called "structural budget balance" or "full employment budget
balance." This measures what the budget surplus or deficit would be if
the economy were at full employment. Since tax revenues automatically
fall in a recession due to rising employment, an increase in the deficit
from that alone does not add new stimulus. Moreover, no deficit, no
matter how high, adds stimulus. It is only the increase in the deficit
that adds to purchasing power. 
By this measure, Japan has actually done quite a lot in recent years to
counter the recession. In 1991, the structural balance was in surplus to
the tune of 2% of GDP. By 1993, it was a deficit of 1.2% of GDP. That's
a big swing of 3.2% of GDP. And by 1996, the structural deficit had
grown to 4.2%, in other words there was an additional stimulus equal to
3% of GDP during 1993-96. This helped promote the illusory recovery in
Then in the second half of 1996, miscalculating that the economy was
strong again, the MOF began retrenching. The structural deficit fell to
3.2% in 1997, and the economy crumpled. All the stimulus in 1998 just
managed to bring the deficit back to the 1996 level of 4.2%. However, by
next year, based on the latest packages, the IMF says the structural
deficit will be a 5.8%. In other words, a rise of 1.6% from 1998 and
2.6% from 1997. That makes the increase 0.5% bigger than the IMF had
assumed in its October outlook. It's quite a hefty dose of stimulus. Had
it not been used, things would have been even worse, as Mussa pointed
A few conclusions emerge from this: 1) the notion offered by some that
Japan didn't start using fiscal stimulus until 1995 is dead wrong; 2)
fiscal stimulus helps when it is used and hurts when it is withdrawn;
and 3) had this been a normal recession, Japan would have recovered by
All this stimulus is fighting the headwinds of continuing declines in
the private economy. By some estimates the supply-demand gap (the gap
between what the economy could produce at full employment and current
demand) is now as high as 6-8% of GDP (30 to 40 trillion yen). That
means two things: 1) Even all this fiscal stimulus is still not enough
to close the gap; and 2) the continuing large gap depresses investment,
which, in turn, means that the fiscal stimulus fails to be "multiplied"
in the private economy. 
Even the government's own "optimistic" forecast of 0.5% growth in fiscal
1999 presumes that the private economy will decline by 0.2% of GDP, the
trade balance will decline by 0.1% of GDP and that fiscal stimulus will
overcome these by adding 0.8% to GDP. 
The big difference between the government and private economists is that
private economists see a much bigger drop in private demand. For
example, The government sees housing demand rising while Nikkei says it
suffer another fall.
Most important of all, Nikkei sees capital investment falling another
15% in fiscal 1999 after a 15% fall in 1998. If so, then by 1999,
private investment will have fallen back to its lowest level since 1987.
Relative to GDP, investment would be at about 13%, down from 18% in
1997. That would be its lowest rate since the early 1980s, before the
bubble raised it 20%. Nikkei now joins the Japan Center for Economic
Research in seeing a gigantic fall in capital investment. (Note: in the
October issue of TOE, we projected a long-term fall in investment rates
by several percentage points of GDP. Investment and cumulative capital
stock was simply too high to be sustainable given Japan's long-term
potential rate of growth of only 2% of GDP. Declining investment is not
simply an artifact of the recession, but a long-term downward shift. In
fact, cause and effect go in large part the other way: it is not just
the recession that is causing a decline in investment, but a long-term
downshifting of investment that is causing the long recession.)
To make matters worse, the rise in the yen and in interest rate is
countering the fiscal stimulus. According to the IMF, the monetary
tightening indicated by the rise of the yen and interest rates so far is
enough to reduce GDP by another 1% over a 1-2 year period, compared to
what GDP would otherwise have been. And that's before the big spike of
the last few days.
The bond crisis shows why all medium-term forecasts must be taken with
large lumps of sale. Financial developments are too unstable. On
Tuesday, rates rose and bond prices fell their daily limit, the stock
market fell in response, particularly financial stocks. 
Tokyo is attempting to spend its way out of recession. It is spending
more on public works, cutting taxes, lending more money to private
firms, buying up bad assets, giving money to banks. The budget deficit
this fiscal year is heading toward 10% of GDP, as is the need to issue
new government bonds and the government's debt load.
That is fine, as long as financial markets allow the government to get
away with this much deficit spending. If, however, the bond market
revolts, as it did in the U.S., that puts a constraint on the
government's ability to stimulate the economy. A rise in fiscal
stimulus, under those circumstances, could lead to a rise in long-term
interest rates, which depresses spending. (Remember the Bank of Japan
can only directly control short-term rates, not long-term ones). If the
rise in interest rates is high enough, it can outweigh the fiscal
Recent events raise concerns that this could be happening in Japan. When
the government builds up debt so much that the debt:GDP ratio rises
rapidly, there are only two ways it can pay the debt service on those
bonds: 1) raise taxes and or cut spending in the future, which will
depress the economy; and 2) inflate the debt away by having the Bank of
Japan create money to buy up news bonds to repay the old. The economy is
too depressed for inflation to show up now, but under the second
scenario it would show up once the economy recovers.
Already, the ratio of gross government debt to GDP is higher than in any
other major industrialized country. The net debt ratio is the smallest
but that assumes that the assets held by the government are far more
solid than those held by banks. We should make the opposite assumption.
In anticipation of potential inflation years down the road, investors
have turned away from long government bonds, like 10-year and 30-year
ones, to shorter term bonds. Moreover, rates have risen sharply. The
10-year bond is now at 1.9% compared to an all-time low of 0.64% in
September. High rates make it tougher for businesses to invest or
consumers to buy new homes or cars. The IMF estimates that a 1% hike in
rates has the same depressing effect on the economy as a 10% hike in the
Higher rates also hurt the finances of banks and borrowers. The
borrowers have lower sales (due to the depressing effect of higher rates
on the economy) but higher debt service costs. This double whammy makes
it even tougher for them to pay their debts. Formerly, serviceable loans
now become dubious. That's one way the banks are hurt.
The banks, in turn, are also hurt by a big decline in bond prices. When
interest rates go up, prices on existing bonds go down. (If a $1,000
bond yields $50 a year on issue, the interest rate is 5%. If rates
double to 10%, the bond price must fall to $500 to make a $50 a year
coupon equal to 10% of the bond.) This year, as rates were falling and
thus bond prices rising, banks lowered lending to business customers and
instead bought government bonds very heavily. By some estimates, 25% of
bank profits in recent months came from bond trading. Now, the banks are
getting hit by plunging bond prices. Nikkei reports:
"Japan's 18 major banks had about 600 billion yen [more than $5
billion--rk] in latent profit on bond holdings as of the end of
September. If long-term rates rise to 1.8-1.9%, that profit could
evaporate, calculates Merrill Lynch Japan Inc. With their unrealized
profit on stockholdings already declining, some banks and life insurers
are finding it difficult to write off bad loans. This could erode
earnings for the year through March. Japanese companies will redeem
about 3 trillion yen in bonds during the January-March period of next
year. Those that plan to finance redemptions through new bond issuance
will be forced to pay higher costs to raise funds."
While rates have been rising for a few weeks, they spiked upward on
Tuesday after Finance Minister Kiichi Miyazawa announced that, as of
January, the MOF's Trust Fund Bureau (TFB) would stop buying government
bonds. The exact reason for Miyazawa's announcement is unclear right
now. One factor being suggested is that the postal savings system may no
longer be automatically sent over to the TFB. Also the TFB is spending
more money on direct support, e.g. loans to semipublic and private
Some reports speculate that the MOF wants higher long-term rates. The
reasoning is this: once long-term rates reach a high and stabilize, then
it would be of advantage to banks to take in deposits at very low
short-term rates and invest in higher long-term rates. This combination
of low short-term rates and high long-term rates is known as  a steep
positive yield curve. The only question is whether the eventual cash
flow benefits to the banks of a steep yield curve are offset by the
capital losses in the process of getting there, not to mention the
depressive effects on the economy and borrowers. If that was truly the
MOF's reasoning, the markets didn't agree. They felt the losses
outweighed the benefits. Stocks in general fell with bank stocks falling
Moreover, if this was the MOF's reasoning, it means the MOF has decided
to sacrifice borrowers for the sake of the banks, the opposite of what
some LDP construction and real estate zoku would like.
Whatever Miyazawa's motivation, his announcement put added pressure on
private investors to absorb the bonds. In 1997, private investors didn't
actually have to buy any new bonds (not counting rollovers). IN 1999,
they will have to buy about 17 trillion (almost 4% of GDP) according to
Deutsche Bank.
If, as the Bank of Japan and some private analysts believe, this is just
a temporary spike and rates will settle down, then the fiscal program
can go on as scheduled with the expected ameliorating effects on the
downturn. If, however, the interest rates stay high or get even higher,
it's back to the drawing board. 
Richard Katz
Senior Editor, "The Oriental Economist Report"
Author: "Japan: The System That Soured"


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