Chapter II The changing balance of payments structure and the Japanese economy

Chapter II The changing balance of payments structure and the Japanese economy Section 1 Trends in Japan s balance of payments Key points 1. Current account trends and characteristics in 21 In 21, while the income account surplus in fact grew significantly, the worldwide economic slowdown reduced exports and caused a major reduction in the trade surplus. As a result, the current account surplus fell 17.3 percent on the previous year to 1.6523 trillion yen. Reductions in the current account surplus to date have occurred when the domestic economy has been in expansion, with a boom in exports causing the trade balance surplus to shrink. This time, however, a recession in the domestic economy has slowed import growth, but the weaker world economy has also caused a significant drop in exports, resulting in a reduced trade surplus and current account surplus. 2. Current account trends by category and capital and financial account trends Due primarily to dwindling exports, the trade surplus began to shrink in 21, sparking concern that Japan s export competitiveness was waning. However, falling exports and a reduced trade surplus are not unique to Japan, but are also evident in the major East Asian economies, which have also suffered from the world economic slowdown. Weighed down by an enormous travel balance deficit, the service as balance has remained in deficit. The deficit on royalties and license fees is beginning to shrink in response to the recent increase in receipts of technology exports. The surplus on income has strengthened its expansionary trend since the 199s, backed by external assets accumulation, and is now on the same scale as the trade balance. Japan s capital and financial account continues to record a deficit (capital outflow. Both foreign direct investment in Japan and direct investment abroad have grown recently due to a boom in large-scale M&As, but foreign direct investment in Japan is still well below direct investment abroad and is low given Japan s economic scale. 6

1. Current account trends 1 and characteristics in 21 (1) Current account trends in 21 (Smaller trade surplus, larger income surplus, ongoing service deficit) The 21 current account surplus stood at 1.6523 trillion yen, (2.1 percent of GDP), which represented a 17.3 percent decline on the 12.8755 trillion yen (2.5 percent of GDP) in 2 (Fig. 2.1.1). A breakdown of this figure reveals that while the trade surplus slumped by a substantial 32.1 percent year-on-year to 8.527 trillion yen, the income surplus soared by 29.1 percent yearon-year to 8.47 trillion yen. The service deficit displayed little change at 5.315 trillion (3.5 percent expansion on the previous year s deficit), while the deficit for current transfers, which comprise only a small fraction of the current account balance, improved 9.4 percent on the previous year to 96.4 billion yen. The 21 reduction in the current account surplus despite the significant growth of the income surplus was due to a worldwide economic slowdown which reduced exports 2 and cut heavily into the trade surplus. Figure 2.1.1 Trends in Japan s current account 199 1996 1997 1998 1999 2 21 Current account 6.5 7.2 11.7 15.5 13.1 12.9 1.7 Compared to previous year(%) 25.7 31.1 64. 32.3 15.9 1.4 17.3 Balance on goods and services 3.9 2.3 5.8 9.5 7.9 7.4 3.2 Compared to previous year(%) 35.3 66.7 148.9 65.2 17.5 5.5 56.8 Trade balance 1.1 9.1 12.3 16. 14. 12.6 8.5 Compared to previous year(%) 9. 26.3 35.3 29.8 12.3 1.4 32.1 Exports 4.7 43.6 49.5 48.9 45.8 49.5 46.6 Compared to previous year(%) 8.8 8.2 13.7 1.3 6.3 8.1 5.9 Imports 3.6 34.5 37.2 32.9 31.8 37. 38. Compared to previous year(%) 16.2 23.5 7.9 11.6 3.4 16.3 3. Balance on services 6.2 6.8 6.5 6.5 6.2 5.1 5.3 Compared to previous year(%) 22.1 25.8 3.5 1.3 4.7 16.5 3.5 Balance on income 3.3 5.8 7. 7.1 6.6 6.5 8.4 Compared to previous year(%) 3.5 39.8 21.1 1.5 8. 1. 29.1 Current transfers.7 1. 1.1 1.1 1.4 1.1 1. Compared to previous year(%) 55.4 34.8 9.6 7. 21. 23.6 9.4 Source: Balance of Payments (Bank of Japan). (2) Characteristics (a) Economic slowdown cuts back current account and trade surpluses Why did the current account surplus decline? Fluctuations in current accounts to date have been heavily influenced by fluctuations in the trade surplus in particular, with import booms in 1 Due to a change in balance of payment calculation methods, figures up to 1996 were derived using the old method of calculation. 2 In this chapter, the terms exports and imports refer to export value and import value, unless 61

expansionary phases of the domestic economy shrinking the trade deficit and accordingly the current account deficit. However, in 21, the trade and current account surpluses shrank while the domestic economy was slowing down (Fig. 2.1.2). (%) Figure 2.1.2. Contribution of exports/imports to trade balance and business cycles 15 Import decrease Export increase 1 Expansion Contraction Expansion Contraction Expansion Contraction Trade balance against previous year Contribution of exports 5 5 Import increase Export decrease Contribution of imports 1 9 91 92 93 94 95 96 97 98 99 1 (Year) Sources: Trade Statistics (Ministry of Finance), National Accounts, Reference Date (Cabinet Office). Examining the relation between current accounts and economic growth, the tendency to date has been for expansion of the domestic economy to increase demand and push up imports, resulting in a smaller current account surplus, while contraction of the domestic economy conversely slowed imports and expanded the current account surplus. However, the recent decline of the current account surplus occurred during a domestic economic slowdown, distinguishing it from the current account surplus contraction phases of the past. What were the main factors behind the contraction? The slowdown of the domestic economy seems to have caused import growth to slow even as a world economic slowdown slashed back exports, resulting in the decline of both the trade and current account surpluses. (b) Changes in current account structure How is the structure of current accounts changing? A comparison of the last current account surplus contraction phase in 1986 with 21 current account trends suggests a number of differences. The 21 current account surplus topped the 1996 level, five years prior, by approximately specified otherwise. 62

3.5 trillion yen. However, a breakdown of the surplus reveals that compared to 1996, the trade surplus had declined, as had the service deficit, where the income surplus had soared by around 2.6 trillion yen. The income surplus has therefore grown to a scale rivaling the trade surplus, becoming a major component of the current account surplus (Fig. 2.1.3). 25 2 Figure 2.1.3 Trends in current account by category 15 1 5 5 Trade balance Services Income 1 Current transfers 85 86 87 88 89 9 91 92 93 94 95 96 97 98 99 1 (Year) Source: Balance of Payments (Bank of Japan). 2. Trends in current account surplus by area and capital account trends (1) Trade and service balance (a) Trade balance trends 3 in 21 (Trends in 21) In 21, exports slumped for the first time in two years, dropping 5.2 percent year-on-year to 48.9792 trillion yen. Imports, on the other hand, sustained a second year of increase, lifting 3.6 percent year-on-year to 42.4155 trillion. As a result, the trade balance 4 plummeted 38.7 percent year-on-year to 6.5637 trillion yen. This figure undercut even the 6.7379 trillion yen of 1996, the previous trade surplus contraction phase, reaching the lowest-ever level under the current statistical system. Comparing export-import volume indexes (seasonally adjusted) 5 year-on-year, where export volumes increased up until mid-1999, they maintained a slump between the third quarter of 2 through to the end of 21. Import volumes lagged slightly behind exports, beginning to slip as of 21 6. 3 The Ministry of Finance s Trade Statistics (customs clearance base) were used here to undertake a detailed analysis of trade trends by region and item. 4 Trade balance in Trade Statistics. 5 Calculated from Trade Statistics using the US Census Bureau (X-11) formula. 6 Both export and import volumes flattened out their downward slide as of around the fourth quarter 63

(Exports slip worldwide in 21) The drop in exports and imports has been suggested as evidence of Japan s declining international competitiveness. However, in 21, declining exports and imports and a smaller trade surplus (or larger deficit) were not unique to Japan, but in fact occurred in many East Asian nations, including South Korea, Hong Kong, Thailand, Malaysia and the Philippines. From this perspective, it would seem that the 21 export-import slump and dwindling trade surplus were heavily influenced by the post-2 slowdown in the world economy in particular, and provide an inadequate basis for determining a rapid decline in Japan s international competitiveness 7. (b) Expansion of trade relations with Asia 8 What about trends in exports and imports by region? Figure 2.1.4 confirms that Japan s trade relations with Asia have been deepening. Figure 2.1.4 Trends in import ratios by main (%) (%) 45 4 Asia 45 4 Asia 35 3 US 35 3 Other 25 25 US 2 2 EU 15 15 Other 1 88 89 9 91 92 93 94 95 96 97 98 99 1 1 Year 88 89 9 91 92 93 94 95 96 97 98 99 1 Year Source: Trade Statistics (Ministry of Finance) Source: Trade Statistics (Ministry of Finance) The share of Japan s total world exports absorbed by exports to Asia grew from 34 percent in 1991 to 4 percent in 21, while the ratios of exports to the United States and the EU both fell by around four percent over the same period. Asia s presence is also increasing in terms of imports. The ratio of Japan s imports from Asia stood at 42 percent in 21, up by more than 1 percent from the 31 percent level in 1991. The value of imports from China in particular topped imports from the United States for the first of 21, and began to increase as of 22. 7 The relation between international competitiveness and current accounts is explained in Section 2, between international competitiveness and exports in Section 3. 8 Asia here comprises North Korea, South Korea, China, Taiwan, Mongolia, Hong Kong, Vietnam, Thailand, Singapore, Malaysia, Brunei, the Philippines, Indonesia, Cambodia, Laos, Myanmar, India, Pakistan, Sri Lanka, the Maldives, Bangladesh, East Timor, Macao, Afghanistan, Nepal and Bhutan. 64

time in August 21. As a result, the value of imports from China reached seven trillion yen in 21, close to the 7.7 trillion yen in imports from the US. (c) Trends in exports and imports by item In terms of 21 trends in exports and imports by item, while automobiles did well, exports of IT-related materials fell due to the collapse of the IT bubble, as seen in the deterioration of semiconductor market conditions worldwide 9. Compared to the mid-199s, automobiles and scientific and optical instruments expanded their share of export value, while the share of semiconductors and other electronic parts and office appliances tumbled. Factors behind this trend include the growth in exports of scientific and optical instruments and other capital goods as manufacturers move their assembly processes to Asia, as well as the drop in exports of finished products from Japan which has accompanied the shift to local production. Import trends in 21 reveal a downturn in imports of semiconductors and other electronic parts and office appliances as a result of the slump in domestic IT demand. Textile products, chemical products and foods, however, all increased, leading to a second consecutive year of growth which represented a record high of 42.4155 trillion yen and a 3.6 percent rise in share of total import value. Compared to the mid-199s, imports from Asia in particular have meant a higher import share for office appliances and semiconductors and other electronic parts. The rising crude oil price 1 also pushed up the share of crude oil from 8.9 percent in 1995 to 11.1 percent in 21. (d) Service balance trends The 21 service deficit rose 3.5 percent year-on-year to 5.315 trillion yen, or 1.1 percent of GDP. The service balance comprises transport and other consumption and fares at the travel destination, as well as patents and other royalties. In recent years, as the content of world trade in services has diversified, receipts and payments have expanded to more than 2 percent of the scale of trade in goods. Figure 2.1.5 shows trends in Japan s service balance, which has remained consistently in 9 The locomotive force behind the export boom in 2 was provided by IT-related materials. 1 Calculating the crude oil price on a custom clearance basis using annual cumulative values and cumulative volumes reveals that the average price of US$18.1/barrel in 1995 lifted to 65

deficit. More than half of this comprises the travel balance, while transport and the other services category each account for around 2 percent. Factors behind Japan s service deficit include the heavy travel deficit resulting from the fewer number of visitors to Japan than Japanese traveling abroad, as well as the deficit run by air passenger transport, which is part of the transport balance. Looking at the service balance in 21, the September terrorist attack on the United States prompted a significant slump in the number of people traveling abroad, reducing the travel deficit by 8.3 percent year-on-year to 2.8168 trillion yen, and the transport account by.7 percent to 1.166 trillion yen. Figure 2.1.5 Trends in service balance by item 7 6 5 Total service balance Other services 4 3 Transport 2 Travel 1 91 92 93 94 95 96 97 98 99 1 Source: Balance of Payments (Bank of Japan) The other services category embraces a wide range of transactions, of which patents and other royalties in particular is considered to be an index of international technological competitiveness. The deficit for the latter is gradually declining, reaching 8 billion yen in 21. The patents and other royalties balance includes royalties on patent rights, trademark rights and other industrial property rights and copyrights. Japan has tended to run a surplus with Asia and a deficit against the United States and Europe in this area, but the rising value of receipts in recent years is diminishing the overall deficit (Fig. 2.1.6). US$25.1/barrel in 21. 66

1.5 Figure 2.1.6 Trends in balance on royalties and license fees Receipts 1..5..5 1. 1.5 Payments Balance 92 93 94 95 96 97 98 99 1 (Year) Source: Balance of Payments (Bank of Japan). According to the Ministry of Public Management s Survey on Science and Technology Research, there has been a marked increase in technology exports since the 199s. Where the value of technology exports for all industries stood at 339.4 billion yen in FY199, the same figure had more than tripled to 1.579 trillion yen by FY21. In particular, the auto industry grew to 6.5 times the FY199 level, communications, electronic and electrical instruments and the chemical industry 2.2 times, while pharmaceuticals expanded 3.5 times, all demonstrating steady growth (Fig. 2.1.7). Figure 2.1.7 Trends in technology exports by industry (1 million yen) (1 million yen) 6, 12, 5, All industries (right scale) 1, 4, 3, Communications, electronic and electric instruments Automobiles Electrical machinery 8, 6, 2, 4, 1, Chemicals 2, Pharmaceuticals 89 9 91 92 93 94 95 96 97 98 99 (Year) Source: Survey on Science and Technology Research (Ministry of Public Management). (2) Income balance (a) Income balance trends The income surplus rose 29.1 percent year-on-year in 21, reaching 8.47 trillion yen. As 67

noted above, the trade balance has fluctuated heavily, while the service balance has maintained a steady deficit. The income balance, on the other hand, has consistently sustained a stable surplus (Fig. 2.1.1). The income surplus has strengthened its expansionary trend since the 199s, almost reaching the level of the trade surplus. The growing surplus represents Japan s accumulation of foreign assets and the consequent gradual increase in income from the interest and dividends on foreign investment in particular. Backed by the mounting current account surplus, Japan s net foreign asset balance has grown steadily since the 198s, reaching 179 trillion yen at the end of 21 11 (Fig. 2.1.8). Figure 2.1.8 Trends in Japan s balance on income and external net assets 18 Against nominal GDP (%) 1.8 16 14 12 1 8 6 4 2 Balance on income (right scale) Exteral net assets (left scale) 1.6 1.4 1.2 1..8.6.4.2. 85 86 87 88 89 9 91 92 93 94 95 96 97 98 99 1 (Year) (b) Breakdown of income balance The income balance can be broadly divided into employee compensation and investment income. Of the 8.47 trillion yen income deficit recorded in 21, employee compensation accounted for minus 4.9 billion yen. Investment income reached 8.456 trillion yen, or 1.7 percent of GDP, revealing the bulk of the income surplus to be drawn from the investment income surplus. Investment income can be further divided into portfolio investment income, direct 11 The foreign asset balance dropped in 1999 due to yen appreciation, which pushed down foreign currency-denominated asset valuations, while active investment by foreign investors, as well as rising Japanese stock prices, boosted the valuation of non-resident stockholdings and the foreign 68

investment income and income from other investment. In 21, these stood at 6.2269 trillion yen, 1.5433 trillion yen, and 635.5 billion yen respectively, with the portfolio income surplus contributing the bulk of the investment surplus (Fig. 2.1.9). 1 Figure 2.1.9 Breakdown of investment income balance 8 Investment income 6 4 2 Portfolio investment income 2 91 92 93 94 95 96 97 98 99 1 Year Source: Balance of Payments (Bank of Japan) Portfolio investment income has remained on the rise since the mid-199s, reaching an historical high in 21 at more than 1.2 percent of GDP. This performance has been buoyed by the long-term factor of net foreign asset accumulation, and the short-term factor of yen appreciation since 2. Other investment income Direct investment income (3) Capital account trends (a) Capital account trends In 21, the capital account deficit shrank 34.5 percent year-on-year to record a 6.1726 trillion yen deficit (capital outflow). The capital account comprises receipts and payments for assets or debts between residents and non-residents, and can be broadly divided into investment and other capital. The investment which comprises the bulk of the capital account can be further divided into direct investment, portfolio investment, financial derivatives and other investment. A breakdown of the capital account deficit in 21 reveals that the investment balance shrank 3 percent year-on-year to a deficit of 5.8264 trillion yen, while other capital fell 65 percent over the same period to a deficit of 346.2 billion yen. Within the investment balance, direct investment ran a deficit of 3.9 trillion yen, portfolio investment a deficit of 5.6291 trillion yen, financial derivatives a surplus of 185.3 billion yen, and other investment a surplus of debt balance, reducing the net foreign asset balance (Ministry of Finance, 2). 69

3.5175 trillion yen. While Japan continues to experience a current account surplus, the capital account has therefore remained constantly in deficit (capital outflow) (Fig. 2.1.1). Figure 2.1.1 Trends in Japan s capital balance 1996 1997 1998 1999 2 21 Capital and financial account 3.3 15.1 17.1 6.3 9.4 6.2 Disparity from previous year 11.8 1.9 1.8 3.1 3.3 Financial account 3. 14.6 15.2 4.4 8.4 5.8 Disparity from previous year 11.7.5 1.8 4.1 2.6 Direct investment 2.5 2.8 2.7 1.1 2.5 3.9 Disparity from previous year.2. 1.6 1.4 1.4 Portfolio investment 3.7 4.1 5.8 3. 3.8 5.6 Disparity from previous year 7.8 9.9 2.8.8 1.8 Financial derivatives.8.7.1.3.5.2 Disparity from previous year.1.8.4.2.7 Other investment 4. 15.3 6.7.1 1.6 3.5 Disparity from previous year 19.4 8.6 6.8 1.7 5.1 Capital account.4.5 1.9 1.9 1..5 Disparity from previous year.1 1.4..9.5 Source: Balance of Payments (Bank of Japan). (b) Direct investment in Japan well down on foreign direct investment Japan s foreign direct investment in 21 stood at 4.6586 trillion yen, the highest level since the 7.3518 trillion yen level in 199. By comparison, direct investment in Japan from abroad in 21 was only 758.5 billion yen, falling for the second consecutive year. As a result, the capital account saw an outflow of 3.9 trillion yen, with capital outflow expanding. Direct investment includes stock acquisition, re-investment income, and capital leases. Direct investment in Japan has consistently fallen well below Japan s foreign direct investment (Fig. 2.1.11). Figure 2.1.11 Trends in direct investment 2 1 Foreign direct investment in Japan 1 2 Direct investment abroad 3 4 5 6 7 Balance 8 85 86 87 88 89 9 91 92 93 94 95 96 97 98 99 1 Source: Balance of Payments (Bank of Japan). 7

Looking at recent characteristics, large-scale M&As have been marked in terms of both foreign direct investment and direct investment in Japan, which is reflected in the expansion in direct investment in Japan in 1999 and other years. The GDP share of direct investment in Japan stands at.2 percent, small given the.9 percent level of foreign direct investment and Japan s economic scale, but the further advance of globalization should expand both direct investment in Japan and foreign direct investment. (c) Portfolio investment outflow tops five trillion yen Portfolio investment comprises stock and securities transactions for the purpose of acquiring dividends and interest. Japan s foreign portfolio investment in 21 stood at 13.675 trillion yen, and foreign portfolio investment in Japan at 7.4384 trillion yen, representing a capital outflow of 5.6291 trillion yen. Looking back over history, in 1986 following the Plaza Accord, portfolio investment reached 17.2 trillion yen, or five percent of GDP, but has since gradually declined. Portfolio investment since 199 has sustained a capital outflow of some trillions of yen with the exception of inflows in 199, 1991 and 1997 (Fig. 2.1.12). 2 15 Figure 2.1.12 Trends in portfolio investment balance 1 5 5 1 15 2 85 86 87 88 89 9 91 92 93 94 95 96 97 98 99 1 (Year) Source: Balance of Payments (Bank of Japan) Portfolio investment is broadly divided into stock investment and bond investment (medium- and long-term bond investment and short-term bond investment). In recent years, as medium- to long-term bond investment has become the core of foreign portfolio investment, 71

stock investment has become the central plank in portfolio investment in Japan (Fig. 2.1.13). Figure 2.1.13 Trends in inward and foreign portfolio investment balance Foreign portfolio investment Inward portfolio investment 18 16 14 12 Short-term bonds 14 12 1 Short-term bonds 1 8 8 6 4 2 Medium- and long-term bonds Stocks 96 97 98 99 1 Year 6 4 2 Medium- and long-term bonds Stocks 96 97 98 99 1 (Foreign portfolio investment) Foreign portfolio investment began to grow as of the late 198s, but slowed entering the 199s before subsequently expanding again. This corresponds with the trend for the foreign bond investment comprising the bulk of foreign portfolio investment, and particularly mediumto long-term bond investment, and reflects the behavior of institutional investors. Institutional investors (particularly life insurance companies) became active in foreign debt investment in the late 198s, but in the early 199s, the collapse of the bubble and ongoing yen appreciation caused them to restrain their risk assets. As of the late 199s, the foreign debt acquisition surplus has been expanding, particularly in the case of US and European debt, due to difficult fund management in Japan and the interest disparity between Japan and other countries. Foreign stock investment, on the other hand, grew from 1996 as a result of US stock appreciation, but since 2, the collapse of the IT bubble and the deceleration of the world economy have negatively affected stock market conditions, pushing down investment (Fig. 2.1.14). Figure 2.1.14 Breakdown of foreign portfolio investment Stocks 4 Medium- and long-term bonds 8 12 16 Foreign portfolio investment Short-term bonds 2 91 92 93 94 95 96 97 98 99 1 Year Source: Balance of Payments (Bank of Japan) 72

(Portfolio investment in Japan) Portfolio investment in Japan was concentrated in medium- to long-term bond investment in the late 198s, but since the 199s, attention has shifted to stock investment. Amid the yen appreciation of the late 198s, foreign investors moved actively to acquire Japanese government bonds, but turned away from these as of the 199s. Stock investment in Japan, on the other hand, has remained on the upturn, albeit with fluctuations, since the 199s. This represents more active investment by foreign investors in reflection of their expectations of Japanese companies, as well as the drop in Japanese stock prices (Fig. 2.1.15). Figure 2.1.15 Breakdown of inward portfolio investment 16 12 Inward portfolio investment 8 4 Stocks Medium- and long-term bonds 4 91 92 93 94 95 96 97 98 99 1 Year Source: Balance of Payments (Bank of Japan) 73