Viewpoint of Strengthening Industry Competitiveness

Increasing Productivity is Essential

Encourage manufacturing to come back to Japan
Regulatory reform and technological innovation are key


  • Hard to resolve insufficient demand problem with only monetary easing and weak yen
  • Many shortcomings with government-led growth strategies
  • Japanese manufacturers have kept their competitiveness by reducing wages

By Kyoji Fukao, Professor at Hitotsubashi University

The Japanese government held the initial meeting of its Industrial Competitiveness Council in late January, and will draft growth strategies by June. While there has been further deterioration in fundamental conditions for economic growth, such as the accumulation of sovereign debt and baby boomer retirement, it appears that the next several years will be the final opportunity for Japan to break away from its long-term stagnation which has continued for over 20 years. In this article, I would like to look at growth strategies from the point of view of how to resolve the structural causes of this long-term stagnation.

Breaking away from deflation is important in both regaining the effectiveness of financial and foreign exchange policies and in stimulating investment via reduction of real interest rates. Abe's policy mix, in which the government fully mobilizes economic policies in order to get out of deflation, is in right direction. However, since there is a high correlation between inflation and aggregate demand, it will be difficult to achieve the inflation target of 2% unless there is a full resolution of the problem of inadequate aggregate demand. According to estimates by the Cabinet Office, since there is currently a 3% “GDP gap” (the ratio of [potential GDP minus actual GDP] to [potential GDP]). Therefore, it is necessary to expand annual aggregate demand by 15 trillion yen or more.

Monetary easing and yen devaluation are not sufficient to offset this magnitude of insufficient demand. In the short-term, it is necessary to generate demand by radically expanding government expenditures and stimulating investment through the reduction of taxes on companies. However, given that the government's financial condition is seriously in the red, it is not feasible to continue an expansive fiscal policy over the long term. It is critical to quickly shift to autonomous expansion of private sector demand.

Also, some say that if Japan breaks out of deflation, real interest rates will fall, and the problem of insufficient demand can be resolved by stimulating capital investment and by expanding net exports through yen depreciation. However, this is not correct.

In Japan, investment opportunities have dried up because of the decreasing population, stagnating productivity, and relocation of manufacturing factories to overseas locations. Given this situation, in order to resolve the problem of insufficient demand only using monetary policy, it will be necessary to continue having real interest rates at zero or negative over the long-term. However, there is a high risk that such policies might re-ignite the bubble economy. It is also difficult to maintain policies for expanding net exports of goods and services at a scale which may resolve the issue of insufficient demand by significantly reducing the value of the yen, because of currency war and trade dispute risks.

Due to the above restrictions, it is necessary to aim to resolve the issue of insufficient demand by, over the medium term, expanding private capital formation through increasing returns on investment via productivity improvement, encouraging “re-shoring”, and increasing private consumption through creation of jobs and wage income. Because of Japan's serious fiscal condition, there is no room for continuing large-scale fiscal expenditures in order to keep demand. It is necessary to allocate a large proportion of government expenditures on policies for increasing the return on investment and generating sustainable employment.

There are many shortcomings with current processes for establishing growth strategies and already-announced policies. Growth strategies are scheduled to be specifically looked into at the Industry Competitiveness Council. However, the majority of participants from the private sector are extremely busy company managers, and it is highly likely that certain ministries and agencies will be responsible for setting up these growth strategies. If this happens, there will be no difference from past growth strategies, which achieved little.

For example, industrial targeting policies may be used for the purpose of obtaining budgets for ministries and agencies, and this may result in poorly-considered budget allocation, based on the idea that policies will be accepted as long as they are related to relevant industries. Although it is necessary to focus on regulatory reform in four fields, including health, agriculture, forestry, fisheries, most ministries and agencies are not proactive in reforms. Since there are no proposals on policies which span different ministries and agencies, and there is little criticism by ministries of policies put in place by other ministries, it is doubtful whether there will be progress with fundamental and rational regulatory reform. The government funds which are currently being considered, as well as the uniform support for small and medium-sized enterprises, have a high risk of preventing Japan from growing because they will cause distortions in asset allocation and will keep alive zombie companies for which there is no prospect of restructuring.

One of the important goals which the Liberal Democrat Party could not achieve while they were the opposition was to establish an organisation which could function in place of Kasumigaseki, and which would have high research and policy-setting capabilities. I hope, although it may be a little late, that private research institutes and universities work together in setting up policies which are independent from ministries and agencies, as well as on the evaluation of policies after they are implemented.

What does Japan need to maintain a real growth rate of approximately 2% while the country has a decreasing working-age population and while there is stagnating return on investment? It is essential to improve productivity through innovation (technological improvement) and by increasing efficiency of resource allocation, as well as by increasing workforce participation and broadening the range of human resources that are employed, such as women and senior citizens who wish to work.

When looking at changes in total factor productivity (TFP), which shows the degree of improvement in production technology and efficiency, it can be seen that since 1991, when the long-term stagnation began, productivity growth fell dramatically in the manufacturing sector. As shown in the diagram, if productivity had continued to grow in the same way as it had grown up until 1991, real added value in the manufacturing sector would be greater by 50% than that it is at present.

TFP in manufacturing and non-manufacturing sectors

Additionally, the productivity growth rate in the non-manufacturing sector has been stagnant for a long time. While the productivity growth rate in the US non-manufacturing sector significantly increased from 1995 due to the introduction of IT (information technology), there was no such IT revolution in Japan.

What is necessary to accelerate productivity growth? When looking at data on a company level, large manufacturing companies have in fact been relatively steadily increasing productivity since 1991, against a background of active research and development (R&D). The main cause of stagnant productivity growth in the overall manufacturing sector is stagnation in small and medium companies, which have lagged in R&D and globalisation, and the fact that large companies with high productivity did not expand production within Japan due to reasons such as relocation overseas. Therefore, it is important to have policies for R&D and globalisation at small and medium sized enterprises; to sign the Trans-Pacific Partnership (TPP), and to have policies which encourage large companies to come back to Japan, such as reducing corporate taxes.

In relation to this, the significant delay in IT investment relative to other developed countries, and stagnant investment in intangible assets, such as organisational transformation and education and training spending, can be pointed to as causes of stagnant productivity in the non-manufacturing sector. It is desirable that government policies are considered for to stimulate and expand these kinds of investment.

The reduction in corporate education and training is closely linked to the increase in term-contract employment. Those working on term contracts tend to change jobs frequently, leading to insufficient accumulation of human capital, and term-contract employment is highly likely to cause significant losses for the whole of Japan. Labour market deregulation is an urgent task, - for example, increasing mobility of labour and reducing the unfair gaps between regular staff and term-contract employees, while at the same time improving the safety net.

An increase in TFP will reduce average production costs by the same proportion. Conversely, stagnant productivity reduces the international competitiveness of the manufacturing sector. The relative competitiveness of the manufacturing sectors in Japan and the US, as measured using average production costs, is mostly determined by trends in relative TFP in Japan and the US, the yen/dollar exchange rate, and trends in Japanese and US wage rates. Japan was rapidly catching up with the US in terms of TFP until 1991; however, Japan remained stagnant thereafter. Therefore, Japanese manufacturing TFP relative to that in the US at the end of the 2000s was approximately 10% lower than that in 1991.

While wage rates in the US rose significantly, they have been stagnant in Japan for the past 20 years. When measuring with the currencies of each country, labour compensation per hour in the Japanese manufacturing sector relative to that in the US has recently fallen to 60% of the 1991 level. During this time, the value of the US dollar fell to 70% of the 1991 level ($1 = 135 JPY -> $1 = 90 JPY). Accordingly, wage rates converted to the same currency are now 10% lower in Japan compared to 1991. In other words, when looking at the real foreign exchange rate, based on wage rates, it can be said it has decreased by approximately 10% in Japan since 1991.

In summary, it can be said that the Japanese manufacturing sector has almost recovered its competitiveness to the level at the time prior to the long-term stagnation by making up for the deceleration in productivity growth through a reduction in wages which more than offset the strong yen. It can be seen that it is essential to accelerate increases in productivity in order to raise both global competitiveness and wages.

As has been mentioned, the key to growth is having policies which improve the environment for workers and companies. It is essential to accelerate regulatory reform, encourage innovation, implement measures for the return of manufacturing sector to Japan, utilise women and senior citizens who want to work, improve the safety net, deregulate the labour market, and strengthen corporate governance to accelerate resource allocation and industrial reorganization.

This article originally appeared in the Keizai Kyoshitsu column published in the February 7, 2013 issue of the Nihon Keizai Shimbun.

Kyoji Fukao was born in 1956, and graduated from the Faculty of Economics, The University of Tokyo. He specialises in international and macroeconomics.

Translation kindly provided by the American Chamber of Commerce, Growth Strategy Task Force.