January 16, 2015

Atsushi NAKAJIMA, Chairman Research Institute of Economy, Trade and Industry (RIETI)

The Current Situation of the Japanese Economy and Abenomics

90

95

100

105

110

115

Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 2012 Q1 2013 Q1 2014

Japan U.S. Eurozone

85

90

95

100

105

110

115

-10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18 20 22

1991Q1

1997Q2

2000Q4

2008Q1

2012Q2

（Number of quarters）

Note: The peak of business cycle at 100. Each line shows a different business cycle and starts at the period mentioned below.

Source: Cabinet Office Note: 4Q of 2007=100 Sources: OECD, Cabinet Office, and each respective country's statistics

➣ The recovery of the Japanese economy has been significant since Shinzo Abe became Prime Minister. However, growth has been deteriorating since the consumption tax hike last April.

➣ The Japanese economy, since the collapse of Lehman Brothers, has experienced four periods of slowdown which were caused by: 1) the world economy’s recession, 2) the Great East Japan Earthquake and tsunami, 3) the strong yen, and 4) the hike of the consumption tax combined with bad weather.

➣ The hike in the consumption tax caused a big anticipation and a subsequent drop in consumption. Japan: Changes in Real GDP after Financial Crises Japan: Real Consumption Expenditure

1

1．The Japanese Economy’s Current Situation

-1.5

-1

-0.5

0

0.5

1

1.5

2

3

3.5

4

4.5

5

5.5

6

6.5

7

7.5

8

2010/1 2010/7 2011/1 2011/7 2012/1 2012/7 2013/1 2013/7 2014/1 2014/7

Trade Balance (right scale)

Exports (left scale)

Imports (left scale)

（trillion yen） （trillion yen）

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014

Private Consumption + Private Residential Investment Public DemandPrivate Non-Resi. Investment Change in Private InventoriesNet Exports GDP (constant price)

(Quarter to Quarter)

Note: q-to-q. Seasonally adjusted. Source: Cabinet Office

Note: FOB price for exports, CIF price for imports Source: Ministry of Finance “Trade Statistics”

➣ The Japanese economy’s GDP growth rate for Q3 2014 was -1.9% (q-to-q annualized), mainly due to the weak consumption and investment recovery after the consumption tax was raised.

➣ However, by additional fiscal and monetary stimulus, further yen’s depreciation, growth of disposable income and drop of energy prices, the economy will recover and might achieve 2.5% growth in FY2015 Although exports growth is low even with the weaker yen, net exports have been positive and exports are growing.

Japan: Real GDP Growth Japan: Exports/Imports and Trade Balance

2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

Heavy machinery ICSteel ManufacturingConstruction machinery Home appliances machineryMotor vehicle machinery Telecommunication equipment

➣ The loss of competitiveness and the hollowing out of some manufacturing industries together with the weak growth in the world economy have contributed to the weak recovery of exports. Telecommunications equipment has lost its competitiveness, as shown by the reduction in exports volume and increase in imports. The automobile sector, which has maintained its competitiveness, shifted production to the locations where their products are consumed.

➣ However, the yen’s depreciation has had and will have positive effects. The current depreciation of yen from 105 to 120 per US dollar will raise exports volume by 5% in 2015.

3

Japan: Weak Yen Effects on Exports Volume Growth

Note: Exports volume and World Economy's GDP are not seasonally adjusted. Forecast is calculated by 120 yen per US dollar

Source: Ministry of Finance, Bank of Japan, Oxford Economics

Exports Volume Index

Note: Jan 2008=1 Source: METI

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

2012/1 2012/5 2012/9 2013/1 2013/5 2013/9 2014/1 2014/5 2014/9

Household consumption expenditure

Disposable income

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 2012 Q1 2013 Q1 2014Disposable Income Nikkei 225 Home PriceFuel, Electricity and Water Others Consumption Expenditures

Japan: Consumption Expenditures and Disposable Income

Note: Workers household basis. Y-o-y, real and seasonally adjusted. Source: Statistics Bureau "Family Income and Expenditure Survey"

➣ Real consumption expenditures are falling in combination with a drop in real disposable income. The recent growth in consumption was generated mainly by the rising stock prices and marginally by the income growth. In order to have steady consumption growth to maintain economic growth in Japan, it is essential to have steady income growth.

➣ However, due to the growth of corporate profits and the recovery of the weather, both disposable income and household consumption tend to recover. The drop of energy prices is also serving as a big support for the consumption.

4

Note: Year-on-year change. Source: Ministry of Internal Affairs, Tokyo Stock Exchange, Thomson Reuters

Japan: Decomposition of Private Consumption Expenditures

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Equilibrium unemployment rate

Unemployment rate

（％）（％）Major Developed Countries: Unit Labour Costs

Note: Year-on-year basis. ULC is calculated by (compensation of employees)/Real GDP. Source: OECD

➣ Japanese companies have more room to hike employment and wages. The unit labour cost (ULC) has lowered for Japan among the major developed countries in recent years.

➣ The unemployment rate was 3.5% in November 2014 whereas the equilibrium unemployment rate (NAIRU) was 3.42%. The narrow difference of 0.08% surpasses the level of the business cycle just preceding the collapse of Lehman Brothers. Japan being in a nearly full employment situation also supports the wage to rise.

5

Note: Equilibrium unemployment rate is calculated by the relation between the unemployment rate (unemployed / (unemployed + employed) and the vacancy rate (Unfilled job openings/(job offers to job seekers +the number of employees) ) , showing the unemployment rate balancing labour supply and demand

Source: Ministry of Internal Affairs, Ministry of Health, Labour and Welfare

Unemployment Rate and Equilibrium Unemployment Rate (NAIRU)

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

Q1 2000 Q1 2002 Q1 2004 Q1 2006 Q1 2008 Q1 2010 Q1 2012 Q1 2014

Japan UK Germany OECD Total US France Euro Zone

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Estimation period: 2008/1Q~2014/3Q. Yen/dollar rate preceding 3Q, GDP output gap preceding 6Q. Assumption: CPI(energy)20%down from 3Q2014, Yen/dollar rate=120yen, GDP growth rate from ESP forecast survey Sources: Ministry of Finance, Cabinet Office, Bank of Japan

➣ The drop of energy prices also help household to enjoy a net positive disposable income growth ➣ However, even with to the depreciation of the yen/Us dollar rate to 120 offsetting CPI to be

negative, the CPI might be around 0%.

Factors of CPI Rise (after deduction of the consumption tax hike factor)

➣ Abenomics (Prime Minister Shinzo Abe’s policies) is composed of three major measures (“three arrows”)

1) Bold monetary policy The quantitative monetary easing policy announced by the Bank of Japan will double the

monetary base by the end of 2014. 2) Agile fiscal policy “The Emergency Economic Measures for the Revitalization of the Japanese Economy” (raising

GDP by around 2% and creating around 600,000 jobs) 3) Growth Strategy (“Japan Revitalization Strategy”) Revitalizing the corporate sector by using untapped potential (e.g., women workforce and

globalization) in the Japanese economy. Thus, the Growth Strategy is composed of various policies aimed to revitalize the economy and

the business activities, and not limited to some policies with big economic impact.

2. Abenomics

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（Japan） （United States） （Germany）

Note: Above 0 means an excess of savings, under 0 means an excess of investments. Both are on a GDP basis. Source: European Commission AMECO, OECD StatExtracts

➣ One of the reasons for the Japanese economy’s low growth and persistent deflation is the lack of vitality in its companies.

➣ The Japanese corporate sector has a relatively high investment-savings surplus, which provides companies with additional room to enhance investments and raise wages.

➣ The definite success of Abenomics will depend on how the Japanese corporate sector’s vitality is stimulated by the three arrows.

Japan-United States-Germany: Investment-Savings Balance

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Relation between Working-age Population ratio and GDP Note: OECD Economic Outlook, World Bank WDI

【Japan（1960-2013）】 【U.S.（1960-2013）】 【Germany（1991-2013）】

【France（1960-2013）】 【China（1992-2013）】 【Brazil（1996-2013）】

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➣ On the other hand, the productivity’s growth and the working population increase become more and more critical to Japan where the population is rapidly aging.

➣ Japan has to use more women and has to convert non-regular workers to regular ones in order to maintain the working population. The use of immigrants is also a big choice for Japan.

Source: RIETI Workshop “Studies on the Effects of Diversity and Work-Life Balance” (March 3, 2014)

➣ Japan’s potential growth rate will be decelerated by the aging population and the reduction of the labour force.

➣ The drop in the potential growth rate will be around 1% per year beyond 2020s. ➣ In order to maintain the potential growth rate for the medium and long term, it is indispensable for

elderly people and women to be more active in the labour market. However, as the total labour participation will be negative even with a higher labour participation of elderly people and women, improvement in TFP (by more deregulated and effective labour market etc.) is also necessary.

USA

1.5 1.9 1.4 1.4 1.4 1.4 1.4

1.9 1.3

0.4 0.7 0.5 0.7 0.8

3.4 3.2

1.8 2.1 2.0 2.1 2.2

-2

-1

0

1

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1980年代 1990年代 2000年代 2010年代 2020年代 2030年代 2040年代

就業者数変化率

生産性（就業者一人当たり実質GDP）成長率

実質GDP成長率

（平均変化率：％）(Average growth rate: %)

Labour force Productivity (real GDP per capita) Real GDP

1980s 1990s 2000s 2010s 2020s 2030s 2040s

1.7

-0.3 0.5 0.5 0.5 0.5 0.5

0.3 3.1

0.6

-0.2 -1.0 -0.8 -0.6

2.0 2.2

1.2 0.3

-0.4 -0.2 -0.1

-2

-1

0

1

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5

1980年代 1990年代 2000年代 2010年代 2020年代 2030年代 2040年代

就業者数変化率

生産性（就業者一人当たり実質GDP）成長率

実質GDP成長率

（平均変化率：％）

Germany

Labour force Productivity (real GDP per capita) Real GDP

1980s 1990s 2000s 2010s 2020s 2030s 2040s

(Average growth rate: %)

3.4

0.9 1.1 1.1 1.1 1.1 1.1

1.1

0.5

-0.2 -0.6 -0.8 -1.2 -1.4

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1.5 0.9 0.5 0.3 0.0 -0.2

-2

-1

0

1

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5

1980年代 1990年代 2000年代 2010年代 2020年代 2030年代 2040年代

就業者数変化率

生産性（就業者一人当たり実質GDP）成長率

実質GDP成長率

（平均変化率：％）

Japan

Labour force Productivity (real GDP per capita) Real GDP

1980s 1990s 2000s 2010s 2020s 2030s 2040s

(Average growth rate: %)

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➣ The IMF points out from the experiences of highly indebted major countries in the last century that: 1) high growth, 2) bold monetary easing, 3) strong export growth, and 4) a weak currency all contribute to fiscal consolidation. For Japan, these issues were all adverse winds until the arrival of Abenomics.

➣ Changing the structure of the Japanese economy from being in a vicious cycle into a virtuous one is needed not only to hike individual wealth but also to solve serious economic problems facing Japan.

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Lower consumption

Deflation & Low growth

Lower sales/profit

Lower wage

Higher consumption

Moderate inflation & growth

Higher sales/profit

Higher wage

Japanese Economy

Vicious Cycle (Lost Decade) Virtuous Cycle (Success of Abenomics)

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-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

Q11990

Q11992

Q11994

Q11996

Q11998

Q12000

Q12002

Q12004

Q12006

Q12008

Q12010

Q12012

Q12014

Wage

Labour productivity

Unit labour cost

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Labour Productivity and Wage Growth

Note: Year-on-year basis. Unit labour cost = compensation of employees/real GDP Source: US BEA, Bureau of Labour Statistics

（USA） （Japan）

➣ Indeed, it is clear that the steady productivity growth combined with the wage growth is not realized in Japan like in the United States.

➣ The success of Abenomics depends on the Japanese economy moving from a vicious cycle to a virtuous cycle, and the revitalization of the corporate sector is the key.

Note: Year-on-year basis. Unit labour cost = compensation of employees/real GDP Source: Cabinet Office, Ministry of Internal Affairs

Source: Cabinet Office “Revision of Japan Revitalization Strategy”

➣ The revised version of the Japan Revitalization Strategy puts importance on supply side reforms. ➣ The strategy aims to regain Japan’s earning power through corporate value growth, create

engines of growth through utilizing idle human resources, and nourish new drivers of growth through agricultural/healthcare reforms.

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Overview of the Revision of Japan Revitalization Strategy – 10 Key Reforms -

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➣ Unused potential in Japan is quite significant, especially in the human resources area.

➣ Japan is one of the least advanced countries within the OECD in terms of using female labour and realizing a diversified society.

➣ The hike in women’s labour participation and the narrowing of the gender wage gap will help the Japanese economy to grow further.

Japan: Average wages

Source: Ministry of Health, Labour and Welfare

OECD Countries: GEM ranking

Note: 2006. Gender Empowerment Measure (GEM) is a measure of inequalities between the opportunities of men and women in a country. GEM is composed of 1) political participation and decision making, 2) economic participation and decision making, and 3) power over economic resources. Source: OECD

➣ Increasing economic activities for women and enhancing work-life balance are mentioned in the Growth Strategy.

➣ Raising the women’s labour participation rate not only helps to enhance the insufficiently used human resources but also stimulates businesses related to working women.

➣ If the women’s labour participation rate curve becomes similar to that in France, Japan will have an additional three million workers and will achieve 2% GDP growth.

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Source: Ministry of Internal Affairs and Communications

Women’s Labour Participation Rate in Major Countries

➣ Even with the population aging and decreasing, the population will be stabilized at around 100 million if the female labour force participation rate increases by 5% and the birthrate recovers to 2.07 by 2030.

16

Note: Population aging rate is calculated as: (population elder than 65 years old) / (total population) Source: Cabinet Office

Japan: Estimation of the Population

Note: Data are from listed companies between 2003-2011 (about 1000). Female ratio is the ratio of female workers to regular workers in their 30s.

Source: RIETI Discussion Paper 14-J-016

Corporate Profit by Difference of Female Ratio in Each Company’s Regular Workers

among regular workers

Relations between Female Ratio and Profit Ratio

➣ Also, women playing a more active part in the economy serves to raise corporate performance. ➣ Not surpassing 40%, the higher the female ratio (especially for regular workers in their 30s), the

higher is the corporate profit ratio. This tendency is much more evident with companies which recruit workers in mid-career and promote enhanced work-life balance measures.

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-2%

0%

2%

4%

6%

2003年 2005年 2006年 2007年 2008年 2009年 2010年 2011年

正社員女性比率：中央値以上正社員女性比率：中央値未満

利益率(profit ratio)

Female ratio in regular workers: above median

Female ratio in regular workers: below median

-1%

0%

1%

2%

3%

正社員女性比率（30歳代）

利益率

<0.18> <0.43> <0.22> <0.09> <0.07>

(profit ratio)

Female ratio in regular workers (30’s)

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Income Increases Effect of the TPP

➣ The TPP will serve to globalize the Japanese economy as well as Japanese companies. ➣ The TPP’s economic effects are larger with tariff removals and non tariff measures reduction than

with only tariff removals. Multilateral FTAs are needed increasingly to support companies’ supply chains which are becoming more and more globalized.

➣ Japanese households are the biggest beneficiary of the TPP, ahead of export companies, and a 5%-10% cut in food expenses is possible.

Source: “The Relative Significance of EPAs in Asia-Pacific,” Kenichi Kawasaki (Consulting Fellow) （RIETI DP：14-E-009）

Major Countries: Engel’s Coefficient

Source: Ministry of Internal Affairs “Statistics of the World”, U.S. Department of Commerce, France INSEE