I DEPARTMENT OF THE TREASURY -- ·v-- •-_ - WASHINGTON D C 20220 I - August 12 1997 BRIEFING MEMORAL DUM FOR DEPUTY SECRETARY SUMMERS Ifft-- FROM Timothy F Geithner Senior Deputy Assistant Secretary International Affairs SUBJECT Briefing for Your Lunch with Eisuke Sakakibara Vice Minister of Finance for International Affairs Ministry of Finance Japan Date Time Wednesday August 13 1997 at 12 00 - l 30 p m Location Your Office PARTICIPANTS Treasury Deputy Secretary Summers Senior Deputy Assistant Secretary Geithner Vice Minister Sakakibara DOB 27 March 1941 Minister Iwashita Embassy of Japan DOB I January 1948 BRIEFING Overview BACKGROUND Tab 1 Tab 2 Tab 3 Tab 4 cc David Lipton Japan's Economic Outlook Japan's Current Account Surplus U S Economic Policy Toward Japan for 1997-2000 Internal note draft August 5 1997 Exchange Rates charts OVERVIEW LUNCH WITH JAPANESE VICE MINISTER SAKAKIBARA August 13 1997 OVERVIE V Vice Minister Sakakibara specifically requested a meeting with you and asked that the meeting be kept as private as possible wire services have since morning of August 12 carried news of the meeting Sakakibara could raise the following • U S -Japan relations in light of economic data showing a rising current account surplus and weak domestic demand which conflicts with the GOJ's public commitment to the objective of promoting strong domestic-demand-led growth in Japan and avoiding a significant increase in the external surplus • Exchange rates The yen depreciated to nearly 120 ¥ $ last week after release of weak economic data for the second quarter It bounced back to 115 ¥ $ after comments by USTR Barshefsky and strong June current account data were released The yen could come under renewed pressure if Japanese gro Wih remains weak and South East Asian currencies remain fragile • Thailand and recent market developments following the IMF package in final stages of negotiation This is a prime opportunity to ask what the GOJ plans to do to achieve its objective of domestic demand-led growth We can use the pressure the Japanese must be feeling from adverse data releases to secure commitments on greater market access and comprehensive deregulation You may also want to broach the subject ofre-establishing a U S -Japan deputies-level group cochaired by Treasury State USTR and Japan's MOF MOFA MITI on economic issues as originally envisioned in the Framework agreement to address structural issues of concern to us MAIN ISSUES 1 Japan's Economic Prospects Data releases support our projections of weak domestic demand and a rising current account smplus • EPA staff have indicated that monthly data imply flat GDP for the first half of the year Q2 Q4 o A large decline in GDP expected for the second quarter will essentially offset first quarter growth artificially boosted by pre-consumption tax spending o The second quarter GDP data -- due for mid-September release -- are expected to show weak domestic demand led by a large decline in consumer spending more than offsetting robust export growth -2• Our internal forecast shows growth slowing to 1 9% for the year as a whole after a strong 3 5% in 1996 • The Government of Japan intends to reduce the central and local government deficit t0 below 3% of GDP by FY 2003 down from an estimated 6 7% of GDP in FY 1996 • • o Our embassy staff in Tokyo estimates that based on GOJ plans and as a percent of GDP the deficit will be reduced to 4 6% in FY97 and 3 3% in FY98 o The extreme front-loading of the fiscal plan threatens to derail Japan's fragile recovery by dampening domestic demand Vhile weak domestic demand may be suppressing import growth yen depreciation over the last couple of years is now fueling Japanese exports o We forecast Japan's current account surplus will reach roughly $93 billion this year after $66 billion in 1996 o The data support our forecast Japan's current account surplus for the first half of the year totals $86 billion at a seasonally adjusted annual rate and it is increasing o We project another increase next year to around $138 billion Others also project an increase albeit smaller than ours o Vice Minister Sakakibara told Senior DAS Geithner that internally MOF now expects a 1997 current account surplus in line with Treasury's forecast and a further increase in 1998 although not as large as we predict The Government of Japan has publicly committed itself to promoting strong domesticdemand-led growth and avoiding a significant increase in the external surplus However the GOJ has been slow to recognize that domestic demand has weakened since fiscal consolidation got underway and that the rising external surplus is not a temporary phenomenon o We need to press for slowing the rapid pace of fiscal consolidation and leave the details on how to do it to the Japanese o Our embassy staff in Tokyo estimates that based on GOJ plans and as a percent of GDP the deficit will be reduced from 6 7% in FY96 to 4 6% in FY97 and 3 3% in FY98 There is scope for the GOJ to slow the pace of consolidation and still meet the Prime Minister's publicly-stated targets i e below 3% by 2003 -3• We can use the current account domestic demand platform -- and GOJ's commitment to sweeping deregulation and structural reform -- to gain leverage on key deregulation and sectoral items on our agenda Key Points • Concerned about sharp increase in Japan's current account surplus • Appreciate goal of reducing the fiscal budget deficit by 2003 but the front-loaded fiscal consolidation planned for FY97 and FY98 seems inconsistent with GOJ commitment to promote strong domestic demand-led growth • In fact we think second quarter GDP data -- for release in mid-September -- will show a consumption-led contraction that leaves growth essentially t1at for the first half of the year • Would like to know how GOJ plans to achieve its objective of promoting strong domestic-demand-led growth in Japan and avoiding a significant increase in the external surplus • Important to reaffirm publicly Japan's commitment to promote strong domestic demandled growth and to moderate the rise in Japan's external surplus • Note that the OECD's WP-3 meeting in September will focus on current account issues and provides an ideal opportunity for further discussion • Note that sustained increases in Japan's external surplus likely to create political tensions between our two countries 2 Exchange Rates The yen has fluctuated between 110 ¥ $ and 120 ¥ $ in recent weeks alternately weakening with the release of data showing a weak domestic economy and strengthening on strong trade figures showing robust export growth The economic package for TI1ailand was welcomed and short-term pressures seem to have been defrayed However it wiH take sustained long-term performance before the Thai baht regains credibility and wins the confidence of international investors Other emerging market currencies have been affected by spillover pressures • The renewed rally in Japanese government bonds the decline of the Nikkei and the yields implied in forward rate agreements all reflect the view in the markets that the Japanese recovery has not reached a self-sustaining basis -4- • Early in the Japanese fiscal year you had maintained that the market was underestimating the pace of the recovery Now that further economic data have become available what is your view 3 Thailand Thai markets were relatively stable on August 11 with little in the way of a positive reaction to the completion of the financial assistance package in Tokyo and some remaining skepticism about the sufficiency of a $16 billion Fund program to help Thailand Overall the Thai stock market continues to droop on the realization that the party is over and growth will be meager at best On August 11 property developers and banks led the day's decline as the SET dropped 4 6 points 0 7% to 632 25 The baht was also down 0 3% to 31 39 $ in the onshore market Markets were closed in Thailand on August 12 for the Queen's Birthday but the baht dropped 1% in offshore markets to 31 48 $ from 31 18 $ Key Points • oky n£ renc Welcome the results of the IMF conference in Tokyo to discuss multilateral and bilateral financing for Thailand's economic recovery program • I as · Emphasize importance of making sure that commitments by the World Bank and Asian Development Bank are speedily translated into actual lending • Bridges Explore with Sakakibara the current Japanese position on a bridge loan through the BIS to either WB ADB loans or to a second tranche of the Fund program • Tran pa n y • Explain our position on the necessity of removing capital controls on a speedy basis based on a plan laid out in the Fund program Express U S desire to see strong transparency provisions in this program including the publication of the Bank of Thailand's balance sheet along with its forward obligations 4 Upcoming G-7 Meeting presumably September 8 ahead of the September 9 WP-3 meeting This will be Sakakibara's first Deputies meeting as Vice Minister The meeting will focus on surveillance in preparation for the Hong Kong G 7 ministerial IMF issues e g quotas capital account amendment and possibly other Denver follow-up such as the Africa Initiative • With respect to the Ho g K a - ii · t ia September 20 we understood informally from the Japanese embassy that we would start with a working lunch continue through late afternoon and finish the day with a social dinner That same evening the IIF is hosting a dinner in honor of EBRD President Jacques de la Rosi ere and has been trying through Gyohten to persuade MOF to forego the sociai dinner so that the G-7 Ministers and Governors could attend rhe IIF dinner instead We have not received anything in 'Miting from the Japanese and it might be useful to ask in a general way about 10F plans and arrangements -5- • as'-· At the July Deputies' meeting you indicated that no more than 35% increase was justified in view of the liquidity situation Japan has pushed for a larger increase not because of liquidity but because a larger overall increase would facilitate the share adjustment that is Japan's primary concern The Executive Board and G-7 Directors in particular will be addressing the issue further beginning next week G7 Deputies will need to resolve any remaining differences at the September 8 Deputies' meeting You could reiterate that we are prepared to close by Hong Kong if an acceptable deal is worked out and in that context to accommodate Japan's desire for a share increase as best we can • s I2 Rs We have some interest in delaying signaling support for an exact doubling -- to a new allocation of SDR 21 4 billion -- so that SDRs could be packaged with a quota deal particularly given that the NAB legislation may still be in Conference during late September However IMF staff seem to be already aware of the G- 7's tentative accord on the amount Key Points • Would be interested in your plans for arranging the Hong Kong Ministerial • Would appreciate your support for a 35% quota increase as merited by the liquidity situation Understand your concerns about share adjustment but think this is still achievable with the smaller 35% increase • Would like to package agreement on SDRs with one on the quota As you know we have certain sensitivities related to our legislative cycle -- NAB legislation may be in final stages Conference in late September UNCLASSIFIED - SENSITIVE IML C Carnes M Grewe August 11 1997 JAPAN ECONOMIC OUTLOOK • Growth Slowing We project real GDP grm vth will slow for 1997 as a whole down from 3 5% in 1996 as domestic demand slows while net exports rise We expect negative second quarter grovvth will follow an artificially strong first quarter buoyed by preconsumption-tax-hike spending • Fiscal Policy Under current plans the fiscal deficit will be reduced by more than 2% of GDP this year The Prime Minister is publicly committed to reducing the combined central and local government deficit excluding the social security surplus to below 3% by the year 2003 from over 7% in FYl 996 and his Cabinet has set specific spending cut targets to meet that goal • Monetary Policy Monetary policy remains accommodative with the overnight call rate averaging below 0 5% and ten-year bond rates around 2 1 % The markets still expect short-term interest rates to remain below 1% at least into the fall However market expectations for limited credit tightening appear to have shifted into early next year • Financial System Market concern about Japan's banks continues due to lower bank profits as bad loans are written off a slower growth outlook and the potential impact of financial reforms It will take a few more years of concentrated effort by the banks to complete write-offs and even longer for the collateral underlying bad loans to clear the market The system is still vulnerable to an economic downturn MOF still has to take further measures to strengthen banks and implement reforms aimed at improving supervision and bank disclosure • External Sector After falling 41 % to $66 billion 1 4% of GDP in 1996 Japan's current account surplus is projected to rise to over 2% of GDP in 1997 in Treasury and Fed forecasts The OECD IMF and Consensus have all forecast a smaller rise but have recently revised their forecasts upward GROWTH Japan's real GDP grew 3 5% in 1996 The May Treasury forecast predicts slower growth of 1 9% in 1997 Consensus forecasts predict 2 0% growth while IMF and OECD forecasts are a little higher 2 2-2 3% and the Fed forecast of 2 7% is at the high end • We expect real GDP to fall significantly in the second quarter virtually offsetting an artificially strong first quarter growth of 6 6% saar that was boosted by preconsumption tax spending UNCLASSIFIED - SENSITIVE lJNCLASSIFIED - SENSITIVE -2• The contribution to growth from domestic demand is expected to fall from 4 5% in 1996 to 1 0% in 1997 while the contribution from net exports is expected to rise from -0 9% to 1 0% Already in the last quarter of 1996 net exports accounted for 41 % of GDP growth RECENT STATISTICS Recent economic indicators have been mixed suggesting strong export growth but lackluster domestic demand in the wake of fiscal consolidation • • in June was 8 0% above its level a year ago However on a seasonally adjusted basis second quarter production was unchanged from the preceding quarter while inventories surged up 7 1 % from the first quarter rose to 78 5% in May up from 76 1 % in April and from 73 8% for 1996 as a whole • declined 4 0% year-on-year in June following an 3 3% decline in May while p Di s le also continued to decline post-consumption tax hike falling 11 4% y y in July 5 0% y y in June and 9 4% y y in May PRICES Inflation ticked up in April in response to the consumption tax hike but this is expected to be a temporary spike • in May rose 1 9% over a year earlier mostly due to the 2 percentage point hike in the consumption tax In June the Tokyo Consumer Price Index rose 0 4% month-on-month seasonally adjusted and 1 9% year-on-year Domestic prices rose 2 0% y y in June 1997 Export prices fell 0 9% y y while import prices rose 5 9% MONETARY POLICY The tight government budget weak domestic demand and banking sector problems weigh against an early tightening of monetary policy Over the past few weeks market expectations for a rate hike have shifted from the end of this year into early 1998 On the short end the overnight call rate continues to average below 0 5% where it has been since the government lowered the discount rate to 0 5% in September I 995 The interest rate on three-month government bills is 0 51 % • The markets are hedging against some edging up of interest rates at the end of this year or beginning of next The interest rate on the three-momh December 1997 future contract is 0 70% while the interest rate on the three-month March 1998 future is 0 79% UNCLASSIFIED - SENSITIVE lJNCLASSIFIED - SENSITIVE -3On the long end rates rose to the 2 6% level at the end of June after the· quarterly BOJ Tankan survey of business sentiment confirmed that large manufacturers are figuring the positive effects of recent export gro-wth into their investment decisions However the persistence of sluggish indicators for the economy is encouraging the view that -- at least for the time being -- GOJ will continue its accommodative monetary stance • The yield on the 10-year benchmark bond is now around 2 1 % significantly below last year's level of 3 3% end-July 1996 • After raising the long-term prime rate from 2 5% to 3 1 % in May banks -- finding the rate hike not sustainable -- lowered the rate to 2 9% June 11 and then 2 7% on July 10 Narrow measures of the money supply are growing rapidly but broader measures are growing more slowly • Ml grew at a 8 6% rate in May l 997 year-on-year and an annualized 12 0% in the last three months • The closely watched M2 CDs grew 2 8% in June y y slowing slightly from 3 1 % in May and 3 2% in April FISCAL POLICY We expect fiscal measures to reduce the budget deficit by more than 2% of GDP and slow growth by 0 4% of GDP in FY97 The main elements of fiscal consolidation are • Elimination of the ¥2 trillion income tax rebate at the end of 1996 and an increase in the consumption tax from 3% to 5% on April l • Spending declines as existing fiscal packages run their course Introduction of any new package this year is highly unlikely • The IMF estimates Japan's structural deficit will fall from 3 3 % of GDP in 1996 to I 7% of GDP in 1997 For next year FY98 the Prime Minister's fiscal reform council has announced spending cuts that include 7% reduction in public works spending l 0% reduction in foreign assistance decrease in defense spending below the FY I 997 level and constrained growth in social security EXCHANGE RA TE AND THE CURRENT ACCOUNT Appreciation of the yen between 1990 and 1995 stronger growth and structural changes have contributed to a decline in Japan's current account surplus • Japan's real trade weighted exchange rate appreciated 49% between April I 990 its lowest point since the Plaza Agreement and April l 995 The lagged effects of this appreciation helped to lower Japan's current account surplus from $132 bi Jion 3 1% of GDP in 1993 to $66 billion 1 4% of GDP in 1996 ' UNCLASSIFIED - SENSITIVE UNCLASSIFIED - SENSITIVE -4- • In 1996 in yen tem1s Japan's exports rose 8 2% in 1996 to ¥43 6 trillion while imports rose 23 5% to ¥34 5 trillion Export volumes rose only 0 7% while yen export prices rose 7 4% Import volumes rose 9 9% while yen import prices rose 12 4% We project that the depreciation of the yen since April 1995 and slower growth in Japan in 1997 will boost Japan's overall current account surplus to $93 billion 2 1% of GDP in 1997 and $139 billion 3 0% of GDP in 1998 The Fed projects nearly as big an increase The OECD IMF and Consensus Economics foresee a smaller but still significant rise to 2% of GDP in 1998 • Since its high in April 1995 the yen has depreciated 22% on a real trade-weighted basis reversing two-thirds of its appreciation since the April 1990 low • We estimate Japan's current account surplus for the first half of 1997 seasonally adjusted and annualized amounts to about $86 billion The bilateral surplus will likely rise more strongly than the forecasted rise in Japan's overall surplus • For the first half of the year Japan's customs basis bilateral trade surplus with the U S totaled $18 5 billion a 32% increase over the same period a year ago Not only are U S imports up by 5 3% but exports are also down 3 8% • The rise follows a year in which Japan's bilateral trade surplus with the U S narrowed from $59 1 billion in 1995 to $47 7 billion in 1996 In 1996 U S exports to Japan rose 5 0% to $67 5 billion U S imports from Japan fell 6 7% to $115 2 billion COMPARATIVE FORECASTS R al GDP Grnwth 0 Inflation CfI %chg 122 6 1997 12 2B 122 6 1997 122 R 3 5 I 9 2 5 IMF 2 2 2 9 OECD 2 9 Fed 2 3 L I 2 l Ll Consensus 2 0 i 9 1 5 Treasury - 0 1 L7 1 6 1 3 I 2 Current Account $bu 1996 66 Im 122 8 93 139 78 80 90 98 0 8 90 120 0 8 79 89 Source July I 997 forecasts except June for Treasury OECD and Fed and May for MF Treasury and Fed forecasts sensitive A BRIEF JAPAN CP UNCLASSIFIED - SENSITIVE lJNCLASSIFIED - SENSITIVE JAPAN'S CURRENT ACCOUNT SURPLUS Both Prime Minister Hashimoto and Finance Minister Mitsuzuka have reiterated support for the objective of strong domestic-demand-led growth and avoidance of a significant increase in the current account surplus However the bulk of the Prime Minister's political will is behind his fiscal structural reform program The Prime Minister has pledged to reduce the fiscal deficit excluding the social security system's surplus from 6 7% of GDP in FY 1996 to less than 3% of GDP by FY 2003 with most of the reduction in fiscal years 1997 and 1998 This is likely to dampen domestic demand and increase the current account surplus Recent Treasury-MOF discussions on forecasting Japan's current account surplus have raised some areas of disagreement We believe the key points are • Exchange rates matter most Changes in exchange rates affect trade flows with a lag of 12 years MOF has ignored the lagged effect Yen depreciation of 32% since April 1995 is stimulating Japanese exports • Structural change -- moving Japanese production offshore and deregulatory opening of Japanese markets to competition -- is a significant factor but is not occurring rapidly enough to offset the impact on trade of movements in the yen • Deficient domestic demand in Japan -- reflecting public expenditure cuts and the effect of tax increases on consumer spending -- is likely to contribute to external surpluses • Internal Treasury forecasts project a sharp increase iri Japan's current account surplus from $66 billion in 1996 to over $90 billion in 1997 and $140 billion or more in 1998 depending upon the extent of structural change Forecasts shown us by MOF show virtually no increase The outstanding issues between us include I the MOF's desire to focus on the goods and services balance instead of the current account different views about the role of real exchange rates and structural change and 3 different forecasts of the strength of domestic demand in Japan Of these the single most important issue is the role of the exchange rate CURRENT ACCOUNT VS GOODS AND SERVICES BALANCE MOF has sought to shift focus from the current account which includes a growing investment income component toward the goods and services balance While we have good reason to focus on the current account we are concerned about potentially large increases in both the current account surplus and the goods and services balance UNCLASSIFIED - SENSITIVE lJNCLASSIFIED - SENSITIVE -2The current account essentially consists of the goods and services balance a significant and growing income on net investments and a small negative flow of unilateral transfers With the latter two following a relatively steady trend swings in the current account surplus are dominated by swings in the more changeable goods and services balance Chart 1 Components of Japan's Current Account Surplus US$ billions 180 160 180 160 140 - 120 120 100 80 100 ·•········· __ · Goods ana'• _••·•' ••• 60 •• •• '• __ -····· '• 40 20 140 • - • • - · _ • Services 80 ··• -- -- - --- 60 40 20 ' · Nat Investment Income o · - · • - -- -- - - -- -- ----- ----_ i • ••••••• ••••••••••••• 0 Unilateral Transfers 20 ' ' - 20 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 There is good reason to focus on Japan's current account • It has public visibility and the attention of financial markets • The net investment income component captures the lasting impact of Japan's chronic trade surpluses which accumulate net external assets • The current account reflects the imbalance between saving and investment In the long run countries with a lot of net investment income are expected to run goods and services trade deficits reflecting the fact that they have more income to spend than domestic production Regardless of the focus -- current account or goods and services -- we project a sharp rise in Japan's external surplus BEST FITTING MODELS PREDICT SHARP GROWTH IN JAPAN'S EXTERNAL SURPLUS Statistical models that track history most accurately anticipate a iarge increase in Japan's current account UNCLASSIFrED - SENSITIVE UNCLASSIFIED - SENSITIVE -3• A simple statistical model that includes the lagged effects of exchange rates domestic and foreign demand and structural change tracks history well We use MOF data on the overseas production ratio to proxy structural change This model predicts a large increase in the goods and services balance • The Japanese forecasts showp us by the MOF underestimate exchange rate effects and depend heavily on structural change -- moving production overseas and opening Japanese markets to imports through deregulation -- to explain why the trade surplus will not increase significantly The models do not include the lagged effect of exchange rates • We have developed a simple statistical version of the MOF analysis that confirms the MOF prediction of no significant increase in the trade surplus However this model fits actual trade data poorly Chart 2 Japanese Net Exports of Goods and Services US$ billions 140 140 120 120 100 - 100 - 80 80 60 60 40 - 40 20 20 o 1981 1983 1985 1987 1989 1991 1993 1995 1997 o CRITICAL FACTOR IS REAL EXCHANGE RATE x h n e Ra The most critical factor in explaining movements in the current account is the real exchange rate • Large movements in the real value of the yen are followed by large movements in the trade balance after 1 or 2 years o As a quick rule of thumb a I 0% depreciation of the yen decreases the goods and services surplus $10 billion 02% of GDP the same year as the dollar price of Japanese exports falls has little net effect by the next year and increases the surplus by $20 billion 0 4% of GDP the second and subsequent years as the cheaper yen stimuiates purchases of more Japanese exports UNCLASSIFIED SENSITIVE $ UNCLASSIFIED - SENSITIVE -4- • o The real trade-weighted yen depreciated 17% in 1996 from the preceding year Despite the yen appreciation of recent weeks if the yen remains at its current level for the rest of the year that would imply an additional 11 % real yen depreciation on average this year relative to last year o The current real trade-weighted value of the yen is roughly equal to its value in 1991 which preceded a large increase in Japan's trade surplus see above chart MOF has ignored lags in trade flows and thus has underestimated the impact of the exchange rate Slow growth in Japan's domestic economy has suppressed demand for imports into Japan A stimulus to domestic demand that would return Japanese output to its full potential would reduce the trade surplus by $10-15 billion holding the exchange rate constant and even more if the stimulus led to an appreciation of the yen - MOF argues that structural change -- the shifting of Japanese production offshore and deregulatory opening of Japanese markets to foreign competition -- will prevent the current account surplus from rising significantly We have found that while the overseas production ratio is a significant factor structural change is not occurring rapidly enough to offset the shorter-term impact of exchange rates and projected economic growth rates • Foreign direct investment and overseas production by Japanese manufacturers have been growing for over a decade and are still far below the levels of U S and German firms • Incorporating these measures of structural change has little effect on forecast of Japan's external balances We find no connection between the stock of foreign direct investment and Japanese trade behavior and a positive relationship between the overseas production ratio and both exports and imports with a slightly larger effect on imports • MOF sees the rising share of manufactures in imports as evidence of structural change Our statistical model of Japanese trade separates fuel imports -- the primary class of nonmanufactured imports -- from other imports to improve predictability of each class of imports and factor in structural change • Nevertheless we are sympathetic to arguments that structural change wil1 have an increasing impact on future current account surpluses The Japanese haven't made a convincing case for it yet but we judgmentally adjust our forecast downward because we believe that our statistical measures understate the impact of structural change Structural change may explain the moderately large error in the statistical model's prediction of the 1996 goods and services balance see chart above lTNCLASSIFIED - SENSITIVE lJNCLASSIFIED - SENSITIVE -5ALTERNATIVE FORECASTS Outside forecasts also predict a rise in Japan's current account surplus although not as strongly as we do Table 1 Forecasts of Japan's Current Account Surplus 1996 1997 1998 actual forecast forecast 66 93 139 Federal Reserve 90 120 IMF 78 90 OECD 80 98 Consensus 73 78 Salomon Bros 94 143 MOP-provided BOJ-type MOP-provided EPA-type 68 76 86 Japan's Current Account Surplus US$ billions Treasury internal 89 Source June 1997 forecasts except May for IMF April for MOP-provided Treasury and Fed forecasts sensitive Converted at Y $ of 118 in 1997 and I 15 in 1998 NEXT STEPS We are still waiting for more information from MOF on the EPA and BOJ models shown us and on the assumptions underlying their predictions For our part we are providing MOF per their request the data series used in our statistical analysis Now is the time to press for concrete evidence for the role of structural change if MOF can provide it and to seek MOF acceptance of the importance of lagged exchange rate effects We may not be able to reach agreement on an appropriate model but the more evidence we can provide that bolsters the case for predicting a sharp increase in Japan's external surplus the more we may be able to stimulate MOF thinking about contingency planning should forthcoming data on trade and domestic demand bear our predictions out Trcas iMI C Carnes 2 July 1997 A IJAPAN CAB_MOF MOF_JUL MEM UNCLASSIFIED - SENSITIVE UNCLASSIFIED - SENSITIVE U S ECONOMIC POLICY TOWARD JAPAN 1997-2000 draft 8 5 97 This Administration faces two major risks vis-a-vis Japan • a rising current account surplus which may spark political tensions in the face of historically closed Japanese markets and • spillover to the international financial system should the legal regulatory and supervisory environment not be appropriately revised to deal with problem institutions and the competitive pressures arising from Big Bang market opening An appropriate U S economic strategy aside from protecting against these risks could yield substantial benefits • a strengthened global financial system • a more balanced bilateral trade relationship • new opportunities for U S firms • a more vibrant domestic economy in Japan and • greater choice for Japanese consumers This note outlines a U S economic strategy for Japan with greater emphasis on areas of Treasury influence for the remainder of this Administration through 2000 The first section will review the 1993-96 strategy and its performance The next section discusses considerations in selecting appropriate objectives The remaining sections outline our major strategic objectives for the 1997-2000 period 1993-96 U S ECONOMIC POLICY TOWARD JAPAN The 1993-96 U S economic policy toward Japan designed to integrate Japan more fully into the global economy and to ensure a more balanced division of the benefits of that integration established the following three objectives I Increasing the level of manufactured imports as a share of Japanese GDP and increasing the level of intra-industry trade II Reducing Japan's current account surplus over the medium term to a more sustainable level III Increasing the rate of growth of U S exports to the Japanese market especially in targeted strategic sectors To achieve these objectives we negotiated for fiscal stimulus market access to strategic sectors structural reforms competition policy financial liberalization and incentives for foreign direct investment and increased support for multilateral development assistance Under the I 993 UNCLASSIFIED - SENSITIVE lJNCLASSIFIED - SENSITIVE -2Framework agreement the Japanese agreed to reduce the current account surplus over the medium-term pursue sector-specific bilateral agreements and establish a bilateral Deregulation and Competition Policy Working Group on regulatory and stmctural barriers On balance the strategy worked well for the period By the end of 1996 Japan's current account surplus had been roughly halved imports comprised a larger share of Japanese GDP and U S exports to Japan had grown a art 1 Coqxments ofJai mi's Olrrent Account Smplm US$billiom • Japan's current account surplus peaked for the period in I 993 at $132 billion 3 1% of GDP and then decreased sharply over the last couple of years to $66 billion 1 5% of GDP in 1996 7 l lO j iro i 40 l 120 -I 100 i 00 11 • • - -I i 40 Both total imports and manufactured imports rose as a share of Japanese GDP Manufactured imports increased steadily as a share of goods imported from 43% in 1992 to 53% in 1996 J20 I U S exports to the Japanese market picked up from a stagnant pace at the beginning of the period to grow robustly by 12% in 1994 and 20% in 1995 and then grow more modestly by 5% in 1996 Table 1 TRADE PERFORMANCE OF JAPAN AND GNITED STATES 1992-1996 1992 Im l22i 1225 1996 6 3% 5 8% 5 9% 7 2% 8 1% 2 8% 43 5% 2 6% 44 9% 2 9% 48 1% 3 4% 52 2% 4 0% 52 7% $113 b 3 0% $132 b 3 2% $130 b 2 8% $111 b 2 4% $66b 1 5% Bilateral Trade U S Exports to Japan -- % annual growth U S Imports from Japan -- % annual growrh S48 b -0 6% $97 b 6_5% $48 b 0 2% $107 b 10 1% $53 b I 1 7% $119 b LI% $64 b 20 3% $123 b 3 6 o $68 b 5 0% $115 b -6 7% Imports Goods and Services -- %of U S GDP 9 2% 9 2% 9 9% 10 6% 10 8% Current Account Deficit -- % of U S GDP $62 b 1 0% $100 b 1 5% $148 b 2 1% $148 b 2 0% $166 b 2 2% Ji uum Irade Statistks US$ billions Imports Goods Services -- % of Japanese GDP Manufactured Imports -- % of Japanese GDP -- Share of Goods Imports s Sources International Financial Statistics l 1F Monthly Statistics of Japan Statistics Bureau 1anagement and Coordination Agency GOJ and U S Commerce Department UNCLASSIFIED - SENSITIVE UNCLASSIFIED - SENSITIVE -3Performance under the 24 bilateral trade agreements negotiated has been mixed Some agreements -- banking securities cellular telephones semi-conductors -- have been considered successful in opening up commercial opportunities while others -- insurance in 1994 paper telecommunications -- have been viewed as ineffective thwarted by anti-competitive practices and half-hearted implementation by the GOJ Aside from certain highly successful sector agreements mentioned above we have succeeded predominantly in areas of strong Treasury influence i e convincing the Japanese to undertake expansionary fiscal policy fiscal years 1995-96 support domestic demand-led grm v1h commit to financial sector reforms and initiate a broad deregulation agenda We have found progress difficult in more ambiguous wide-ranging areas that do not lend themselves to a discrete list of concrete actions Anti-competitive practices remain pervasive throughout the Japanese economy abetted by legislation such as the Premiums Law and the Large Retail Store Law We have also been blocked when the Japanese perceive little mutual advantage to changing as we propose suggesting we need to do more work on identifying and building constituency groups in Japan For example there has been a lack of concrete progress on structural change and facilitation efforts to attract more foreign investment to Japan aside from marginal improvements in the conditions for mergers and acquisitions Japan's ambitious Deregulation Action Plan launched in 1994 effectively shifted the agenda of the Deregulation Working Group from a bilateral process to a process dominated by Japan's domestic interests The guidelines laid out in the 1994 strategy paper remain valid We will be most effective if • we focus on concrete measurable actions within GOJ influence where there is some degree of mutuality between Japan and the U S • our approach is clear consistent and accompanied by concrete incentives to change and penalties for not changing CONSIDERATIONS AND CONSTRAINTS LOOKING AHEAD Looking ahead we see most scope for influence where the GOJ has publicly made a strong commitment to goals we share deregulation and structural reform to achieve a more efficient sound and vibrant domestic economy In pressing for less rapid fiscal consolidation political commitment in Japan for fiscal consolidation generally supported by the international community makes a traditional supplemental spending package unlikely However with some creativity we may be able to take a more innovative approach to fiscal stimulus that complements GOJ goals under deregulation and structural reform In Japan the foJlowing factors need to be considered in crafting a successful strategy Prime Minister Hashimoto· s commitment to sweeping deregulation -- and his agreement with President Clinton to engage in an enhanced deregulation dialogue -- provides an UNCLASSIFIED- SENSITIVE UNCLASSIFIED - SENSITIVE -4opportunity to influence the regulatory structure so as to promote opportunities for foreign firms improve transparency and disclosure and reduce systemic risk • In the past special interests and the desire to preserve Japanese culture have effectively fended off effective opening of domestic markets to foreign competition Protectionist pressures persist • • The Prime Ministers's strong political commitment to fiscal consolidation reduces prospects for a traditional fiscal spending package Concerns about future fiscal demands required by Japan's rapidly aging population and recent high fiscal deficits are widespread The current perception that spending on public works -- historically the typical type of supplemental expenditure -- has been wasteful inefficient and susceptible to corruption further limits receptivity to the spending side of the fiscal equation Senior GOJ officials have recently said that further spending packages are out of the question o We may be more successful in slowing fiscal consolidation from the tax side There are some Japanese constituencies in favor of tax cuts For example it appears MITI and Keidanren would support a corporate tax cut o On the other hand corporate tax cuts could be perceived in the U S as aiding and abetting our commercial adversaries The Prime Minister's commitment to sweeping deregulation may mean greater receptivity to stimulating domestic demand through investment incentives for foreign as well as domestic investors This could be particularly important if deregulation and competition policy succeed in opening market access to foreign competition o • There may be scope to offer tax credits on investment including on imported capital goods We have a precedent for discussing tax policies under SII and Deregulation Action Plan discussions Conventional wisdom holds that there is little scope for monetary policy stimulus The Bank of Japan has already taken an accommodative stance given the weakness in domestic demand Short-term interest rates are around 0 5% o There is nearly a 2 percentage point spread between short -term and long-term interest rates The Bank of Japan could increase monetary growth by purchasing long-term bonds potentially driving long-term rates lower and stimulating investment There is some debate about the ability of monetary authorities to have a sustained impact on long-term interest ra_tes - The downside risk to easing monetary policy further is that the lower rates could lead to yen depreciation increase orders for Japanese exports and contribute to further widening in Japan's external surplus UNCLASSIFIED - SENSTTIVE UNCLASSIFIED - SENSITIVE -5- In the United States our primary consideration will be trade-related tensions likely to surface as Japan's current account surplus rises • A rise in Japan's current account surplus above 2% of GDP roughly expected by many analysts this year could reactivate political pressures to take immediate corrective action • Market analysts project an even higher current account surplus for Japan in 1998 fodder for a potentially volatile political climate in an election year Exchange rates matter most for the current account Changes in exchange rates affect real trade flows with a lag of one to two years • As a quick rule of thumb a I 0% depreciation of the yen decreases the goods and services surplus $10 billion 0 2% of GDP the same year as the dollar price of Japanese exports falls has little net effect by the next year and increases the surplus by $20 billion 0 4% of GDP the second and subsequent years as the cheaper yen stimulates purchases of more Japanese exports • Since its peak in April 1995 the yen has depreciated 27% against the dollar and 22% on a trade-weighted basis Chart 2 Real Trade-Weighted Yen and Y $ Exchange Rates January 1980 - June 1997 1990 100 180 160 140 120 100 so LI ••••• I ••• 60 1- i ··•·4 • J 1980 198i 982 1983 1984 985 986 i987 1988 1989 990 99 1992 1993 1994 1995 i996 1997 Source JP Mori••· i« O rrade- W iahi f 'Hinlbiy •v•r11 gu ' 2 O ECD rnd 1J Ot1v tlopii1 t Cour1rnc1 •JO n 8 JOO_ c A rise in rhe inde tppreclationfd clme in comp titiveness A fail in the index d preciatio1 incrc-as e in - ompetitiven-ess Anecdotally Japanese exporters appear competitive at exchange rates over 100 ¥ $ but run into difficulty when the yen costs more i e less than I 00 ¥ $ CNCLASSIFIED - SENSITIVE lJNCLASSIFIED - SENSITIVE -6- The recent heavy devaluation of currencies in Southeast Asia Thailand Philippines Malaysia and Indonesia will tend to reduce overall grovvth in Japan's external surplus • Imports and exports for Thailand Philippines Malaysia and Indonesia collectively account for 12 2% of Japan's total trade by value • The cheaper Southeast Asian currencies encourage imports to Japan including reverse imports from overseas Japanese manufacturing bases and as the now more expensive yen dampens purchases of Japanese exports 1997-2000 U S ECONOMIC POLICY TOWARD JAPAN While our previous strategy coincided with yen appreciation and a virtual halving of Japan's current account surplus the yen has since depreciated from its April 1995 peak and we expect the current account surplus to rise substantially this year and next Domestic demand strong last year has faltered with rapid fiscal consolidation and imposition of the April I consumption tax increase We need to focus our policy vis-a-vis Japan on fostering sustainably strong domestic demand both for its direct benefits to the Japanese but also for helping redress the expected rise in Japan's external surplus by increasing imports into Japan We can use the GOJ's structural reform and deregulation agenda as a springboard to promote open transparent and competitive markets including financial services and strengthen the financial system against systemic risk and external shocks Success in deregulation and opening market access to U S and other foreign firms would contribute to a more balanced trade relationship over the longer term Finally high profile coverage of illegal payoffs to corporate gangsters gives us an opening to advance our agenda on anti-corruption and anti-money laundering and thereby improve the integrity of Japanese markets • • Stimulate domestic demand particularly if data shows weak growth in domestic demand o Moderate pace of fiscal consolidation -- put off spending cuts and or provide for targeted tax cuts to partly offset tax hikes earlier this year -- to stimulate domestic demand e g supplemental fiscal package investment incentives o Maintain accommodative monetary policy but don't ease further because of downside risk for yen depreciation Contain rise in Japan's external surplus More balanced growth requires promotion of domestic demand-led groVvth We don't need to tell the Japanese what difficult choices to make We just need to push them to make good their public commitment to strong domestic demand-led growth -- as well as avoiding a significant increase in the external surplus -- and let them decide how to achieve that objective UNCLASSIFIED - SENSITIVE UNCLASSIFIED - SENSITIVE -7• With limited scope for a more accommodative monetary policy and deregulation a longer-run positive factor more moderately-paced fiscal consolidation -- slowdown in spending cuts and or tax cuts -- is needed in the short run • Wbile political factors may preclude a supplemental spending package discussing the need to stimulate domestic demand may be a useful bargaining chip to advance the cause of tax cuts slowdown in spending cuts at the local government level and or other items on our agenda In addition to following up on the remaining issues arising from the 1995 Financial Services Agreement we have initiated a new dialogue with the Japanese on the Big Bang initiative involving our regulatory community and covering a three-part agenda • Free and Open Jfarkets Promote new opportunities for foreign financial services institutions e g fund management securities activities cross-border capital transactions • Fair and Transparent Markets Improve transparency and disclosure e g report market value of assets disclose losses and non-performing assets of effectivelycontrolled affiliates tighten non-performing loan definition disclose trading derivativesrelated activities and management of related risks report corporations' pension and benefit liabilities • Safe and Sound 1Vfarkets at International Standards Reduce systemic risk in financial markets e g improve banking supervision adopt daily settlement on securities trades require separation of customer and firm accounts in the securities market establish legal and regulatory provisions to facilitate liquidation of securities firms in default strengthen bank bankruptcy procedures and address moral hazard issues The recent high-profile coverage of financial crimes in the banking and securities sector provides the opportunity to add an additional topic to our financial sector agenda • Market Integrity Improve financial system integrity through anti-money laundering and anti-corruption measures strengthened anti-money laundering laws and enforcement improved reporting of suspicious transactions increased sanctioning authority for financial crimes tightened asset seizure laws and curbs on insider trading and differential access to information Part of Prime Minister Hashimoto's deregulation agenda is to undertake sweeping deregulation to make Japan·s financial market comparable with those of New York and London by 2001 Five government advisory councils have issued recommendations to carry out Big Bang financial reforms UNCLASSIFIED - SENSITIVE UNCLASSIFIED - SENSITIVE -8• The Foreign Exchange Reform Council's work is done A new Foreign Exchange Law goes into effect April I 1998 The law removes virtually all restrictions on cross-border capital transactions and international payments allows a much broader range of Japanese institutions to conduct foreign exchange business allows Japanese residents to exchange currency using establishments overseas facilitates more rapid approval of new forexrelated financial products and gives the government greater leeway in imposing economic sanctions This reform will push liberalization in other areas since failure to reform will accelerate the movement of transactions offshore • The other four advisory councils released reports in mid-June recommending measures to deregulate Japan's financial markets These reports -- while still imprecise on implementation details -- will be used to determine d craft necessary legislative changes for introduction in the Diet in Spring 1998 In many areas however the degree of change in the market vvill be determined by the wording of amendments to existing laws and implementing regulations that have yet to be developed and that will be shaped in large part by input from vested interests Significant potential remains for dilution and delay of the Big Bang objectives of free fair and global Japanese financial markets by 2001 Our primary interest in financial deregulation centers on promoting new opportunities for foreign firms improving transparency and disclosure and reducing systemic risk Trade agenda • Launch a competition policy initiative to reduce restrictive barriers and private practices that inhibit market access • Expand market access in key sectors by fully implementing aggressively monitoring and where necessary revisiting existing Framework agreements • Revitalize bilateral dialogue on deregulation results-oriented approach focussed on key sectors and key structural policies We do not need a new Japan trade strategy since the full potential of the Framework has not yet been realized • First we need to dispel the perception entrenched in Japan that government-business cooperation and market barriers -- not open competition -- benefits Japan's economy o The primary obstacle to changing public perception is concern that open competition might cause the disintegration of traditional Japanese culture and failure of inefficient single proprietor shops ' Recent developments -- the Prime Minister's commitment to sweeping deregulation and the penetration of a few U S firms into the Japanese retail market -- may cultivate a better appreciation for consumer choice We can also UNCLASSIFIED - SENSITIVE UNCLASSIFIED - SENSITIVE -9- use the cost-saving and gro½'th-promoting effects of deregulation to sell our market-opening agenda o We need to cultivate agencies in the Japanese government that are pro-reform For example the EPA has written that Japan's potential growth rate would fall by 50% if serious deregulation is not enacted • We can evaluate each Framework Agreement to determine whether our market access objectives have been met and what additional steps may be required Separately we can identify if any other strategic sectors particularly high-wage high technology industries where U S firms are typically competitive that would benefit by being added to the Framework • In tandem we need to pursue forward movement on structural issues such as competition policy distribution and transparency government practices tJJM WllWllrn __Q llJ Jillllim- The United States and Japan have agreed to create a limited number of sector-specific and structural working groups that would report to a high-level group The high-level group on deregulation would be chaired at the Deputy Secretary level by USTR and MOF A with participation at the Assistant Secretary level by other key agencies i e Treasury State and for Japan MOF MITI Sector groups have been established in housing telecommunications medical devices pharmaceuticals with two working groups on structural policy one for competition policy and distribution and the other for administrative reform and transparency issues under the aegis of the deregulation group The financial services group would continue to operate as it has in the past but would report to the high-level group Additional working groups could be established as agreed ACTION PLAN • · Establish a U S -Japan deputies-level group co-chaired by Treasury State USTR and Japan's MOF MOFA MITI on economic issues as originally envisioned in the Framework agreement nominally covering all economic issues including macroeconomic issues but really used as a vehicle for advancing the trade and deregulation agendas o • The group could meet annually or semiannually as necessary with meetings keyed to big events like Summits between the President and Prime Minister Press GOJ to stimulate domestic demand o In our dialogue with MOF we need to ask how they plan to achieve their objective of domestic demand-led growth in the face of recent weak data releases o Moderating the pace of fiscal consolidation is in order Instead of reducing the deficit as a share of GDP from 6 7% in FY96 to 4 6% in FY97 the GOJ could for UNCLASSIFIED - SENSITIVE UNCLASSIFIED- SENSITIVE - IO example slow the pace to 5 6% in FY97 and 4 6% in FY98 with future reductions of only 0 4% per year needed to achieve the GOJ goal of 3% by 2002 • o We should not push for specific tax and spending measures leaving specific policy choices to the GOJ to decide o We can agree with the Japanese on the need for medium- and long-term consolidation due to aging demographics while still pushing for a slower approach in the short run Monitor Japan's current account surplus and exchange rate for use in policy dialogue o The OECD's WP3 meeting in September will focus on current account issues and provides an ideal opportunity to discuss Japan's external surplus • Use domestic demand current account situation to push deregulation market access and financial sector reform • The next Treasury-MOF talks on financial services is later this fall We will continue to pursue market opening increased transparency and disclosure and enhanced systemic stability • We will also continue to encourage Japanese participation in multilateral fora such as IOSCO G-7 G-l O Deputies the OECD WTO and APEC to promote further liberalization in the financial sector and adherence to international agreements on regulatory cooperation and accounting standards A ·_ • n y unde · - We are working with the Japanese through the G-7 Financial Action Task Force on Money Laundering and the newly created Asia-Pacific Group on Money Laundering An FATF review of Japan which starts in December presents a particular opportunity to press the Japanese for key actions ahead of their review fJ il LtUI aOOlaL IYl W ill LiW illiS We are asking the Japanese to bind measures as agreed in our bilateral financial services agreements into the WTO Financial Services negotiations • First we need to ensure rhe effective launching of the revitalized deregulaiion initiative The high-level group is tentatively scheduled to meet for the first time in mid-October Most working groups will meet between now and the first high-level group meeting focussing on developing deregulation work plans for each group Particular attention should be focussed on the working groups dealing the structural and transparency issues UNCLASSIFIED - SENSITIVE UNCLASSIFIED - SENSITIVE - II - • Greater emphasis on competition policy would enhance our Japan trade strategy We are concerned that Japanese deregulation without strong competition policy enforcement may in practice evolve into a cover for reorganizing industry and legal structures in ways that promote industrial policy and inhibit foreign access to the Japanese market Competition policy objectives under deregulation talks as well as the bilateral Antitrust Cooperation Agreement proposed by Justice should be reviewed in this context • The U S Government should establish a systematic across-the-board mechanism for regularly assessing market access under the Framework agreements in particular the extent to which they have met their specific quantitative and qualitative criteria Where agreements have failed to meet their objectives determine the cause and develop concrete solutions which may require more aggressive implementation or even renegotiation of · substantive provisions 5 August 1997 Treas IMI Carol Carnes A JAPAN STRATEGY MEM UNCLASSIFIED - SENSITIVE