The recent acceleration of growth has raised hopes that Japan’s economic fundamentals are changing for the better following a disappointing decade, during which economic growth averaged only 1 per cent a year. Indeed, Japan has made progress in addressing some structural problems, notably the weakness of the banking sector, while restructuring in the corporate sector has advanced. However, despite these positive signs, there is still considerable uncertainty regarding Japan’s economic outlook. Achieving a robust, sustained expansion will depend on overcoming serious structural problems, which still limit Japan’s growth potential and weaken demand. Resolving such problems requires greater resolve in pursuing a broad-based policy that features structural reforms to improve resource allocation, revitalise business sector activity and restore the soundness of the banking sector. The latter would improve the effectiveness of monetary policy, which, while very expansionary, has proven incapable of bringing an end to the deflation that has persisted since the mid-1990s. Monetary policy must remain expansionary until the recovery is secure and deflation has definitely ended. Extensive use of fiscal stimulus has increased public debt to more than 150 per cent of GDP just as Japan enters a phase of marked population ageing. The challenge for fiscal policy is to pursue sustained fiscal consolidation over an extended period...

The economic upturn that began in early 2002 faltered during the course of the year but gained a second wind in the spring of 2003. With six consecutive quarters of positive growth, this upturn has already matched the length of the previous expansion, which started at the end of 1999 (Figure 1). However, the pace of output growth, at an annualised rate of nearly 3 per cent since the beginning of 2002, has not been strong enough to reduce the unemployment rate markedly from its record high of 5½ per cent, while deflation, as measured by the GDP deflator, was running at an annual pace of 3 per cent in the first half of 2003. Consequently, nominal GDP has now fallen about 4 per cent from its 1997 peak. The key question is whether this upturn will prove more durable, ending the pattern of mild expansions following shallow downturns that have resulted in average growth of only 1 per cent a year over the past decade. Japan’s poor performance, despite expansionary macroeconomic policies, reflects the impact of the collapse of the asset price bubble, failure to adequately address banking-sector problems, weak competition and outdated regulations in many sectors that limit business-sector dynamism...

Faced with the zero constraint on nominal interest rates, the Bank of Japan has substantially increased the quantity of base money through its quantitative easing policy. In addition, the scope of this policy has been expanded by broadening the range of assets purchased by providing credits directly to small and medium-sized enterprises. At the same time, intervention in the foreign exchange market has limited the appreciation of the yen, effectively supporting the recovery of exports. These monetary policy measures have been successful in maintaining financial-market stability and accommodating the current economic recovery. Nonetheless, the central bank has failed to achieve the objective of sustained growth in nominal income as deflation, as measured by the GDP deflator, remained persistent at an annual rate of 3 per cent in the first half of 2003. Moreover, the current policy has serious negative side effects that will complicate the exit from the current situation. Given the corrosive impact of deflation on economic prospects and the risk of a deflationary spiral, achieving a positive rate of inflation is a key priority. This chapter begins by outlining recent developments in monetary policy and the reasons why it has failed thus far to fully achieve the desired impact. It then outlines policy changes that will help bring deflation to an end. One necessary condition is to resolve the problems in the banking sector, which have closed the credit transmission mechanism. The chapter analyses the factors responsible for the fragile banking industry and suggests measures to help restore it to financial health, before offering an overall conclusion...

The deterioration of the fiscal situation has continued, with the general government deficit rising to a projected 7¾ per cent of GDP in 2003 and public debt soaring to more than 150 per cent. The large budget deficit mainly reflects weak economic conditions, which outweigh the authorities' consolidation efforts to date. The government is trying to reduce the deficit by keeping the level of expenditures constant as a share of GDP but, with deflation eroding the tax base, shortfalls in revenue have prevented progress thus far. One positive development is the fiscal reform initiatives launched during the past several years, which have improved the allocation of spending, thus boosting the efficiency of public expenditures...

The OECD Growth Study and other empirical work have shown that the strength of competition in product markets is likely to play an important role in the process of economic growth. In Japan, policies promoting product market competition have long been compromised by ministerial guidance and explicit exemptions from the competition law. Intense competition is thus lacking in many domestic sectors. As a result, these sectors are characterised by comparatively high prices, weak innovative activity and low levels and growth of productivity. The current allocation of resources thus seems inefficient, partly explaining why the Japanese economy has failed to come out of its quasi-stagnation of the past decade. From a positive perspective, however, this means that potential gains from more pro-competition policies are probably quite large. To realise such gains, the Japanese government has made the promotion of competitive markets one of the cornerstones of its policy to promote economic growth. For example, the resources of the Fair Trade Commission have been increased, and greater impetus has been given to regulatory reforms. However, the legacies of past policies appear difficult to dismantle and progress has been uneven...

As noted above, Japan’s poor growth performance during the past decade is symptomatic of the failure to adequately address structural problems. Preceding chapters have stressed the importance of reforms to improve the financial system (Chapter II) and to strengthen competition policy and improve competitive conditions in certain sectors, notably the network industries. This chapter takes up some other issues concerning Japan’s growth potential, beginning with the labour market. Indeed, success in restructuring the corporate and financial sectors is contingent on flexibility in the labour market. The following sections look at progress in regulatory reform and then the new strategy of creating special structural reform zones, which are intended to overcome obstacles to reform. The fourth section looks at policies to strengthen international competition by promoting trade and foreign direct investment. The chapter concludes with an analysis of issues important to ensure that growth is sustainable in the long run. Progress in structural reform since the 2002 Survey, as well as a summary of recommendations in this Survey, are presented in Table 24, while Annex II assesses the government’s structural reform programmes in detail...