Japan: Another economic recovery, new political terrain

This paper reviews Japan's recent economic performance through the first half of 2005, as well as the economic implications of Koizumi's snap election. After a disappointing final 3 quarters in 2004, first quarter growth in 2005 was a strong 5.8 percent annual rate, followed by a reassuring second quarter at 3.3 percent annual rate. Slow gradual improvements across the economy can be expected to continue, but achieving sustained full employment economic growth depends on whether growth rates over the next five years are closer to 3 percent or 1 percent. The most significant improvement over the past year has been in the labor market. Unemployment dropped to 4.4 percent in July, from its 5.5 percent January 2003 peak, while total employment and employee compensation figures are on the rise. The systemic problem of bank excessive nonperforming loans has been solved. Corporate restructuring proceeds, albeit in the light of new worries over hostile takeover bids. Despite improvement in virtually all Japan's economic indicators, most of the major concerns fundamentally persist. Aggregate demand remains inadequate; both deflation and labor market slack continue; household income growth is modest; capital is misallocated; and business borrowing continues to decrease. Koizumi's potent political victory will ensure the necessary postal privatization, although the details of implementation remain unclear. He has yet to define how he will use his public mandate to make other economic reforms, but general optimism prevails. The most difficult fiscal challenge will be to successfully navigate tax increases without inhibiting economic growth. The Bank of Japan faces two challenges: reducing the quantitative target, and proceeding to exit the current ZIRP monetary policy. Internationally, Japan must forge productive political relationships with its regional economic partners, specifically China, and continue to work towards greater East Asian economic corporation