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Briefing Report

The Outlook for the Japanese Economy in 2006

General Manager and Chief Economist, Investment Research Department, Mitsubishi UFJ Research and Consulting Co., Ltd.
Mr. Yuji Shimanaka

[Economy] January 13 , 2006

My forte is to make economic forecasts based on economic-cycle theories and leading economic indicators, and I believe that the outlook for the Japanese economy in 2006 is even brighter than it was for last year. Later on I intend to elaborate on my ideas concerning economic-cycle theories, but first of all I would like to take a look at the trends in leading economic indicators.

First of all, looking at the year-on-year growth rate of the leading economic indicator of the Organization for Economic Cooperation and Development [OECD], we can see that it continued to accelerate after June 2005, and in November of last year it climbed as far as 2.3 percent. Generally speaking, when the OECD leading indicator rises, after a time lag of about half a year, the economies of the major industrial countries that are members of the OECD begin to expand. Unfortunately, as you know, China is not yet a member of the OECD, so we have to discuss the Chinese economy separately. But anyway, in the world of the OECD, we can say that there is a good possibility that the economies of its member countries will continue a sustained expansion at least for about half a year from now.

Regarding the economies of the United States, Europe, and other Asian countries, I do not have either the ability or the time to talk about them here, but I would just like to say a word or two about the Chinese economy. Recently China’s economic statistics have been changed considerably. In particular, China’s real economic growth rates for 2003 and 2004 had been placed in the 9 percent range, but they have been revised upward to 10 percent and 10.1 percent, respectively. I think that the Chinese economy also registered growth of around 10 percent in 2005, and 10 percent growth is possible for 2006, too. That is to say, China also has a leading indicator of composite economic indexes, and this indicator tends to lead the growth rate of gross domestic product [GDP] by about a year. So if the trends of this leading indicator are automatically extended, then we can say that there is little likelihood of the Chinese economy slowing down in 2006.

Now let me turn to the Japanese economy. Regarding the economy, both the government and the Bank of Japan [BOJ] have stated in their Monthly Economic Report and Monthly Report of Recent Economic and Financial Developments, respectively, that “the Japanese economic is recovering moderately” or “the recovery is continuing.” Certainly it can be said that at present the Japanese economy is “recovering moderately,” or simply that “the recovery is continuing,” but I think that there has been a slightly more visible change at the foundations as well. That is to say, until the end of the July–September 2005 period, namely, until the end of the third quarter, the Japanese economy was in an inventory-adjustment phase. But this inventory adjustment came to an end during and after the October–December period, and the economy again shifted to a phase of acceleration. This trend is evident in what I call the shipment-inventory balance― hat is, the year-on-year growth rate of mining and industrial shipments announced by the Ministry of Economy, Trade and Industry minus the growth rate of product inventories. In other words, if the balance of shipment growth minus inventory growth is plus, then the supply-demand balance improves and mining and industrial production increases. If it is minus, there is an inventory surplus, which acts as a restraint on production.

In actual fact, the shipment-inventory balance registered a minus for three consecutive quarters―January–March, April–June, and July–September of last year―and the Japanese economy was in a phase of inventory adjustment. However, in the October–December quarter (the figures for December are not yet available, but taking the average for October and November) the shipment-inventory balance at last registered a plus of 0.1 percent. This means that in the October–December quarter the economy finally took off from what the government and the BOJ have been calling a “plateau.” And at the same time, it means that the economy broke out of the inventory-adjustment phase and entered a new phase of acceleration. Accordingly, regarding the current phase of economic expansion, after reaching a trough in January 2002, as of January of this year it has continued for 47 months. So we can say that the economy, which was a little stagnant in the inventory-adjustment phase, is once again revitalizing at its foundations.

I would like to draw your attention to the fact that similar phases occurred in 1989–90 and 1995–97. Both of these periods were phases of inventory adjustment, but in the case of 1989, this was the period when Japan introduced the consumption tax for the first time. Because it was also the bubble period, the adjustment was slight, and the economic expansion continued as it was, reaching a peak in February 1991 after the collapse of the bubble economy. In the case of 1995, three shocks occurred in that year― he Great Hanshin-Awaji Earthquake, the sarin attack on the Tokyo subway, and the super-appreciation of the yen, which at one point shot up to \79 to the dollar. Fortunately, though, the investment adjustment was slight, and the economy continued to expand until May 1997.

This time also the inventory adjustment was relatively limited, so it did not lead to an economic slowdown. Since the economy is expected to rejuvenate and reaccelerate from now on, it is likely that the experiences of the 1980s and the 1990s will be repeated―
amely, if the phase of inventory adjustment comes to an end and the economy reaccelerates, the economic expansion will continue for about a year. In other words, the economic expansion can be expected to continue until near the end of 2006. If that happens, then the current expansionary phase of the Japanese economy will surpass the so-called Izanagi boom, which came to an end in July 1970 after 57 consecutive months.

Just now I said that the inventory adjustment has ended. Well, it has ended overall, but inventory adjustment is still continuing for some products and some industries. For example, the shipment-inventory balance for information technology products and non-IT products shows that IT products have ended inventory adjustment and entered a phase of reacceleration, but inventory adjustment is still continuing for non-IT products. Similarly, the shipment-inventory balance for processing industries and material industries shows that while processing industries have ended inventory adjustment and entered a phase of reacceleration, material industries are still just below the surface. In this way, there are some products and industries that have ended inventory adjustment and some that have not, but overall we can say that inventory adjustment has ended. Accordingly, it is hoped that if inventory adjustment in material industries and non-IT industries ends, the reacceleration of the Japanese economy will become even stronger. Thus, in the short term, the Japanese economy is ending inventory adjustment and moving into a phase of reacceleration that could well become the longest period of expansion in postwar Japan.

Next, I would like to look at the Japanese economy in terms of a medium-term cycle of about 10 years― hat is, five years up and five years down. This is the Juglar cycle, named after the French economist Joseph Clement Juglar [1819–1905]. The Juglar cycle usually is shown as the ratio of capital investment to GDP. Looking at trends in the nominal value of this ratio of capital investment to GDP and investment profitability set just two years ahead (investment profitability is the ratio of net profit to capital before interest payments [to put it simply, the corporate earning ratio] minus the interest rate on interest-bearing debts [financial costs]), we can see that investment profitability moves ahead of the ratio of capital investment to GDP. The ratio of capital investment to GDP followed a downward trend until around 2002, but from now on the capital investment ratio itself is expected to switch to an upward direction.

The important thing here is that the level of this investment profitability is higher than at the time of the bubble in 1989. In the bubble period, the large improvement in investment profitability was the biggest reason for the capital investment boom. Of course, I am not saying that we will enter a bubble period from now on or that we have already entered a bubble. What I want to say is that the fact that the capital investment ratio is still at a low level despite the high level of investment profitability shows that companies have much margin for capital investment from now on. In the Japanese economy, the ratio of capital investment to GDP tends to hover from 15 percent to 20 percent, but a striking tendency can be seen for the real economic growth rate to increase if the capital investment ratio rises. And the reality, I think, is that this capital investment ratio at last is entering an upward phase.