------------- ---- - - - - - - - - - - - - - - - - - - - • DEPARTMENT OF THE TREASURY 95-146946 WASHINGTON D C OE R SEC RETARY June 9 1995 MEMORAJ 1DUM FOR SECRETARY RUBIN FROM Lawrence Summer Under Secretary I nternational Affairs SUBJECT Japanese Recession and the Global Economy The attached note explains in some detail our growing concern abou t macroeconomic developments in Japan With strong economic performance in the United States and hopeful signs of a recovery in Japan macroeconomic issues have fallen out of the spotlight while we have vigorously pursued our structural agenda with Japan There have been some successes notably the correction in the Japanese current account Now with the emergence of signs of a protracted slowdown in Japan it would appear to be a good time for a tactical step-up in our attention to the macroeconomic dialogue I would reco mm end the following steps in that connection That you meet with Finance Minister Takemura in Halifax and reinforce your concerns about tl1e macroeconomic situation more explicitly than you have in past meetings A slot has been reserved for a 30 minute bilateral on Thursday afternoon after the Presiden t's meeting with Prime Min ister Murayama That you send Jeff Shafer or myself to Tokyo later this summer to meet our counterparts some of whom have just assumed their position and reinforce your message AL That you look for an appropriate public forum for expressi ng the view that il i s in Japan's in terest as well as that of its major trading partners to put in place the policies sufficient to support a strong recovery One final caveat any public sta tements wil l need to be handled delicately to avoid simply ringer pointing because Of trade disputes or 10 denec attention evidence of a slowdown in the Unite d States r he charge that we are from Clas sified by Robert B Kahn I Robert B Kahn June 9 1995 Japanese Recession and the Global Economy rhe major uncertainty affecting our generally JX Si6ve outlook for sustained expansion in the major industrial countr es is the prospect for recovery in J a Mo t private and forecasts now show weak growth in 1995-96 and there is some concern of a 1930s While not the most likely outcome a downward spiral or black hole scenario would have serious consequences for Japan and the United States A shag recession in Japan -- or of no growth -- could weaken the world econo · Japanese firms might be forced ffii e d o llar And we would We identify three vicious cycles undermining activity in Japan i an interest rateslowdown cycle whereby falling prices and high real interest rates contribute to a growth slowdown which feeds another round of downward price pressure ii an unemploymentconfidence cycle whereby rising unemployment reduces consumer confidence leading to a further fall in spending and further layoffs and iii a deflation-exchange rate cycle whereby deflation has effects through the exchange rate channel leading to downward pressure on the yen price of imports and exports further contributing to deflationary pressure In addition the outlook is made aH the more difficult by the ongoing troubles of banking system Banks are burdened by rising levels of bad loans shrinking collateral and diminished levels of hidden profits available to cover losses Overall we are concerned by the possibility of a collapse of the real economy and the financial economy Monetary and fiscal JX licies can and should be used to provide support for aggregate demand and as a precaution against the downside risks The case is strongest for an immediate further cut in interest rates which could provide some additional stimulus and which has no cost in terms of inflation risks Fiscal policy should also contribute although we need to recognize that it has already moved a good amount In light of these considerations the Treasury should seek both in private and public statements to raise the profile of our macroeconomic dialogue with Japan and indicate the importance we place on the Japanese authorities putting in place the policies necessary to assure a strong and sustained recovery 1 lI -2 - I Japanese Recession and the Global Economy Overview This memo will address four issues First it will suggest that there are a number of forces simultaneously working to depress activity in Japan Second it will discuss concerns that Japan may be trapped in a number of vicious cycles where high·real interest rates deflation rising unemployment and yen appreciation reinforce one another and cause further declines in activity Third we argue that while not the most likely outcome a downward spiral or black hole scenario would have serious consequences for Japan and the United States Fourth monetary and fiscal policies can and should be used to provide support for aggregate demand and as a precaution against the downside risks For these reasons the Treasury should seek both in private and public statements to raise the profile of our macroeconomic dialogue with Japan and indicate the importance we place on the Japanese authorities putting in place the policies necessary to assure a strong and sustained recovery Cont ractionary forces A great deal of gloom surrounds the Japanese economy these days Th ere is growing concern that the economy will experience a triple dip with output falling or at least failing to recover strongly for a number of years A number of factors are seen as contributing to the weakening outlook Deflation With prices falling at all levels of production interest rates -- while low in nominal terms -- are high for this stage of the cycle Further continued declines in and and asset prices weaken balance sheets and consumption o The consumer price level has fallen 3 4% since the end of 1994 Given likely mismeasurement of the indices prices are probably falling in the neighborhood of 1 % or more Consequently the real short-term interest rate is 2 to 3% and real long rates are 4-5% Exchange rate woes The rise of the yen on a trade-weighted basis -- 11 % this year o and 27% since the end of J992 -- has contributed to deflation reduced consumer confidence and weakened export and growth prospects o No sign of reco11ery The economy has not grown over the last 10 quarters net with private domestic demand falling at a l 1 4% annual rate Consumer confidence is low retail sales weak and industrial production is below its level of 5 years ago Unemployment reached a post-war high of 3 2 % in April and is expected to rise further over the next year Classified by Robert B Kahn -3o Sw11ey numbers weak Industrial investment plans are restrained by the we k economy and appreciated yen many firms are looking to move production offshore MIT projects a 3 percent decline in industrial production between April and June based on its survey of manufacturers' intentions o lnvestmmt hango11er The economy is still working through a stock adjustment on the investment side left over from the easy money period of the late 1980s Business fixed investment stabilized late last year after three years of declines The strong yen discourages exports and reduces corporate profitability which could delay an upswing in plant and equipment investment o Banks continue to struggle Weak balance sheets of Japanese financial institutions potentially affect credit allocation and limit the capacity of banks to finance growth o A few blight notes The dramatic dec1ine in long-term interest rates with 10-year bond yields dropping 185 basis points since the beginning of the year is a plus for the recovery And the May Tankan Survey showed a slight improvement in shortterm business sentiment although the index was below earlier expectations and no further improvement is expected over the next three months Near-term outlook Most forecasters expect that under current monetary and fiscal policies Japan will have relatively little growth this year and next The May consensus forecast has growth of 1 3% in 1995 and 2% in 1996 down from 1 9% and 3 3% three months ago And we expect further downward revisions in the months ahead Our own forecast is for growth of 0 9% in 1995 and 2% in 1996 Growth in the 2% range is not likely to reduce the large output gap in Japan over the next two years A weak recovery in Japan threatens to spill over to its major trading partners depressing world wide growth prospects The most widely accepted scenario is one of a very moderate upturn strengthening a bit in 1996 But the recovery is sufficiently fragile that a profound downturn lasting several quarters should not be ruled out Most of the risks are on the downside Further the factors noted above are being propagated by three viciou cycles The interest rate-slowdown cycle Falling prices and high real interest rates for this stage of the cycle are contriburing to a growth slowdown depressing investment and raising credit risk Reduced aggregate demand ieads to lower income and consumption growth and lower firm profitability which feeds another round of downward price pressure Classified by Robert B Kahn -4 - The unemployment-confidmce cycle There is rising concern about unemployment and the breakdown of Japan's lifetime employment system Greater job insecurity is contributing to reduced consumer confidence This curtails household spending the primary engine of recovery to date as consumer increase their precautionary saving This leads to a further fall in demapd and further layoffs The defla tion-e cchange rate cycle Deflation also has effects through the exchange rate channel to the extent that higher real interest rates lead to an increase in the relative attractiveness of yen assets The appreciation of the yen leads to downward pressure on the yen price of imports and exports further contributing to deflationary pressure In addition to these three cycles the outlook is made all the more difficult by the ongoing troubles of the banking system Banks are burdened by rising levels of bad loans shrinking collateral and diminished levels of hidden profits available to cover losses Most knowledgeable opinion agrees on the following conclusions o The Government's estimates of the bad loan problem remain unrealistically low On June 6 the Government announced that non-performing assets of all Japanese financial institutions are about '40 trillion about $475 billion equal to about 6% of outstanding loans and 9% of GDP This estimate includes all the banks but excludes insurers which are also major lenders Conservative non-Government estimates place the bad-loan problem of the banks in the range of ¥60-70 trillion and some estimates are far larger o While reported capital levels are above Tier 1 Il guidelines the above figures suggest that Japanese banks are relatively poorly capitalized Continued weakness in the stock market would further erode the health of the financial system o Despite all this most regulatory e g FRB and Tokyo-based independent bank analysts do not believe that there is a substantial threat to the viability of the core of financial institutions Thus while further bank failures cannot be ruled out a systemic run on the banks is not expected There are a number of specialized financial institutions e g credit unions facing serious difficulties but their assets are a small share of the financial system o Banks are poorly positioned to finance a pick-up in demand making a normal recovery with a sharp bounceback and several quarters of above potential growth less likely Already there is generai agreement that banks have become more cautious in new lending and are seeking to shrink their overall balance sheets -5Overall we are concerned by the possibility of two serious and related risks The first is the prospect of a collapse of the real economy The second risk is the collapse of thejinallcial economy The Government provides a substantial amount of structural support to the financial sector through the direction of captured funds mainly deposits in postal savings system towards the purchase of domestic equity And there is some room for additional discretion on the part of the Government to assist weak and undercapitalized institutions Consequences for the United States The above scenarios would have important consequences for the United States o First a sharp recession in Japan -- or several years of no growth -- would further disappoint the aspirations of Japanese consumers and would have political consequences in Japan Already we are seeing something of a political revolt in the recent elections of anti-establishment figures as mayors of Tokyo and Osaka Japan is the world's second largest economy accounting for 8% of world GDP The economic and political fallout of a failure to achieve a strong recovery would have important spillovers to the rest of the world o Second U S trade interests could be harmed A Japanese economy more insistent on demand and job preservation will be a more forceful adversary on trade issues and there would be the prospect of slower progress on important structural reforms The necessary adjustment of external imbalances would be delayed Japan is our second largest export market after Canada with U S exports of $52 billion last year o Third a collapse poses financial risks for Japanese firms U S assets are relatively liquid and co1 td be liquidated defensively in order to buttress balance sheets and compensate for losses at home creating additional pressures in the exchange and bond markets The investment numbers tell a story of global inter-connectedness Japan is the argest foreign country holder of U S ·Tre asury securities with total holdings as of March 1995 of $196 billion 6% of total privately held U S Treasury securities and 27% of total foreign holdings 1 Of this amount Japanese official holdings were $89 b llion fn contrast U S investment in Japanese securities totals over $60 billion 'This excludes substantial Japanese holdings of Federal agency securities -6- The stock of direct investment by the Japanese in the United States at end-93 reached nearly $100 billion the largest of any single country and 22% of the total stock of foreign direct investment in the United States By way of comparison U S direct investment in Japan totalled $31 billion 6% of total U S outward DFI U S bank exposure to Japanese borrowers totalled $45 billion 14% of total U S b nk overseas exposure Japanese bank exposure to U S borrowers totals $67 billion Further yen appreciation also causes additional losses for japanese investors in yen terms on dollar denominated assets which one analyst places at $350 billion since the mid 1980s due to the appreciation of the yen alone In this connection market commentary has highlighted the recent reticence of some Japanese institutional investors to hold additional dollar investments Consequently we would disagree with those who would prefer that the United States sit on the sidelines arguing that there is little that the U S can or should say or do to support constructive solutions to what are essentially home grown Japanese problems What can Japan do Our view is that Japan can and should use monetary and fiscal policy more aggressively to reduce the risk of a free fall of the economy The case is strongest for immediate further monetary pol icy moves But there is also a strong case that fiscal policy could contribute effectively to the recovery in part because the monetary policy moves under consideration are likely to be small o Possible be zejits A further reduction in short-term interest rates in Japan could spur additional investment although it difficult to argue that the effect of a small cut would be significant and stimulate aggregate demand through a lower exchange value of the yen and stronger exports It would also encourage more consumption and investment in Japan which would tend co increase imports It is our presumption that the net effect wo uld be a reduction in the external surplus but in principle the effect of a monetary easing on the current account is ambi uous We wouid also expect a modest strengthening of bank profit margin which would assist in resolving the bad loan problem Classified by Robert B Kahn -7o Little at risk With deflation a strong yen and weak activity it is difficult to see any serious costs associated with an easing of policy at this time The market is now discounting a roughly 25 basis point reduction in official interest rates The Official Discount Rate is 1 % and the three-month CD interest rate is 1 3 % In the iwelve months through April Ml grew by 5 9% and M2 CDs grew by 3 1 % These growth rates are partly inflated by the increased willingness to hold cash balances when interest rates are as low as they are now in Japan Thus they tend to overstate the growth of money demand connected to economic activity Further options markets may well be assigning some probability to interest rates even going negative in effective terms A slightly negative interest rate would not be unprecedented and in fact may be preferable for lenders to keeping the money under the mattress The Bank of Japan argues that money supply growth is adequate and that further attempts to ease would represent pushing on a string given the weak state of demand o 4 more aggressive approach We would also note the possibility of more aggressive approach in which the government stands ready to provide sufficient liquidity to target a particular exchange rate perhaps ¥ 100 $ or alternatively the entire yield curve While we recognize that attempts to fix rates in this manner is often fraught with difficulty there is no danger in this case that the Bank of Japan will run out of yen o It is important at the start to recognize that they have already moved by a significant amount in recent years According to the OECD the general government deficit shifted from a surplus of 2 5% of GDP in l989 to a deficit of 3 4% of GDP in 1994 with 3 4 of the deterioration structural i e the result of policy actions Consequentiy despite a relatively low net debt GDP level Ministry of Finance MOF officials are hesitant to do more at this time They question the efficacy of further fiscal measures to assist in the recovery given the lags involved and the limited effectiveness of the usual mechanisms e g advancing public works spending and note the demands of an aging -8- popuiation on longer-term fiscal requirements Nonetheless the government does recognize that fiscal policy may be one of the few tools available to arrest the contraction of the economy and that some fu -ther deviation from the medium-term objectives of policy would appear warranted We share the MOF view that shifting public works spending is a relatively ineffective method of easing fiscal policy and would look towards additional temporary tax cuts as an alternative approach to spur consumer spending quickly o There is no question that the government will introduce a second supplemental in the fall to fill the hole created by the May supplemental's commitment to accelerate this year's public works spending and we will have to be involved and have a view when debate starts later this summer Consideration also could be given to additional tax cuts including deregulation are the usual prescription for stimulating demand and reducing external balances and has been the centerpiece of our efforts under the Framework talks in recent years The problem that we must confront squarely is that while it is generally well understood what needs to be done there is presently no political capacity for moving ahead with the tough measures Should the government attempt serious deregulation or other measures public opposition to painful adjustment would mount quickly Reform is inevitable over the longer term but there is no quick solution and structural measures are not a panacea for current macroeconomic difficulties R