No. 9 — March 8, 1996

Weekly Review

--- by Douglas Ostrom

The results of the Bank of Japan's latest survey of business sentiment (tankan), released March 1, have been reported widely as "confirmation of a gradual recovery" of the long-struggling economy. That single phrase would appear intended to debunk two other notions still prevalent among analysts, even after the Economic Planning Agency announced in February that an economic upturn was underway (see JEI Report No. 6B, February 16, 1996). Given past false economic starts, some analysts remain skeptical that the economy really has turned the corner. Another group has become surprisingly optimistic, expecting Japan's economy to outperform that of the United States this year for the first time in five years.

Hence, the emphasis in the summary statement can be read as confirmation either of "gradual recovery" or "gradual recovery." In fact, the tankan contains ample evidence for both points of view. For example, confidence among large manufacturing companies, determined by subtracting negative responses from positive ones, rose to the highest level since 1992 but remained relatively bearish at -12 percentage points, although that was an improvement from the -14 points in the survey conducted three months earlier. Similarly, confidence among large nonmanufacturers rose to -18 from -22. The improvement across both types of industries generally was below expectations, but at least the slow upward trend, which began in 1994, continued in both series. Small businesses overall remained less confident about the future than their larger counterparts but demonstrated an increase in optimism across a broad front; that contrasted with the previous survey, which had shown an improved outlook only among small nonmanufacturers. Confidence among small manufacturing firms rose to -25 from -30 and among nonmanufacturers to -13 from -17.

Other tankan results suggest details as to the economy's likely trajectory over the next few months. For example, both small and large manufacturers continued to feel they had too many workers, as did large nonmanufacturers; by a narrow 1-point margin, however, small nonmanufacturers actually felt they faced a shortage. On balance the results reinforce the impression that weak labor markets have made consumers wary, thereby rendering a robust recovery more difficult.

Although firms of all types anticipate higher profits in the fiscal year beginning April 1, they do not necessarily plan a proportionate increase in domestic capital spending. While large businesses project a small 0.6 percent increase in plant and equipment expenditures in FY 1996, small firms expect to scale back spending 20.4 percent from estimated FY 1995 levels. Taken together, the tankan data suggest that a boost to aggregate demand from capital spending is far from assured. Private-sector researchers, who typically concentrate their efforts on large firms, have reported similar assessments. For example, Industrial Bank of Japan, Ltd. expects a 1.3 percent drop in FY 1996 capital spending and Nippon Credit Bank, Ltd. just a 0.4 percent increase.

Other tankan data hint that one factor holding down domestic corporate investment is the growth of Japanese direct investment overseas. Among large manufacturing firms with significant overseas operations — the only segment BOJ surveyed — foreign capital spending is expected to rise 1.8 percent in FY 1996 on top of an estimated 28.1 percent increase in FY 1995. In terms of the share of the investment yen going overseas among these firms the ratio is expected to rise to 28.4 percent from a projected 27.8 percent in the current fiscal year. By contrast, large manufacturing firms overall are expected to reduce domestic capital expenditures 2 percent in FY 1996 after increasing it 10 percent or so in the year through March.

The expectations and the inferences regarding overseas investments and the foreign share of capital spending should be interpreted with caution. Only those enterprises with a 10 percent or greater interest in an offshore affiliate are covered, for example. For this reason the reported share is not inclusive of all large manufacturing companies, only those having significant production operations. Hence, the reported figure is likely to overstate overseas investment as a share of overall investment by manufacturing firms inasmuch as companies not covered are likely to have much lower foreign investment shares. In addition, the reported figures are in yen; dollar-denominated statistics regarding rates of change in overseas investment might not necessarily show the same trend.

Even in light of these disclaimers, the figures hint at a growing importance for foreign investment vis-a-vis that aimed at the domestic market. Among those manufacturers investing in plant and equipment abroad the data suggest that, if the increase in foreign investment had been directed toward the home market in FY 1995, the domestic rate of expansion would have doubled. The data also suggest a leveling off of direct investment abroad, the conventional Japanese wisdom notwithstanding. If, as is likely, the yen depreciates on average against the dollar in FY 1996, some or all of the expected 1.8 percent increase in foreign direct investment would be absorbed in currency changes.

In sum, the tankan results suggest an economy finally shaking off the effects of a surging currency between 1993 and early 1995 as well as an on-again, off-again recession that has spanned nearly five years. The rise in foreign direct investment, in part a consequence of the strong yen, may have depressed an important component of domestic demand, thereby rendering the recovery weaker than it otherwise would have been in FY 1995. That adjustment to changed currency values now may be almost complete, but the prospect of continued weakness in plant and equipment spending as well as the likelihood of weak consumer expenditures understandably are keeping Japan's business community wary.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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