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Recent Trends in Business Fixed Investment and the Issues Attending a Full Recovery: Restoring Firms' Capacity to Generate Capital Investment*1

  • *1This article is a translation from the Japanese original published on June 26, 2003. For a key to the symbols and abbreviations used in this article, see page 60.

September 12, 2003
Bank of Japan
Research and Statistics Department

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SUMMARY

  1. A glance at recent trends in business fixed investment reveals that, after suffering substantial reductions in 2001, investment has stopped declining and seems to be bottoming out, on the back of increases in exports and corporate profits in 2001. Assuming that the recovery in overseas economies becomes more definite, we can now look forward to these increases in exports and production becoming gradually more firmly entrenched, bringing capital spending back on line for recovery. According to the Tankan, if we look at large businesses' fixed investment plans by fiscal year, we see that, although extensive reductions were the likely results in fiscal 2002, in fiscal 2003 manufacturers are planning to increase investment, albeit only slightly, while in nominal terms the overall amount of investment seems set at least to level out. Turning to individual sectors, there has been a halt in the decline in the electrical machinery sector, which gives an indication of trends in investment aimed at expansion of the capacity of liquid crystal and electronic devices, while in both the steel and chemical sectors there are plans to increase investment.
  2. However, although the improvement in corporate profits has been accompanied by an increase in firms' cash flow, in comparison to this the strength of the recovery in business fixed investment is only weak. In the background of this weakness lie the following facts: that the improvement in corporate profits has been, to a significant extent, built upon the effects of restructuring; and that there is still considerable uncertainty attending future demand. In addition to these, we should note that the weakness in capital spending relative to cash flow is not purely a recent phenomenon, but rather a characteristic that has become gradually more defined since the 1990s, and as such the influence of structural factors that have tended to suppress capital investment may well be considered important.
  3. The first of these structural factors has been the pressure to reshape the industrial structure. Since the 1990s, with the progress of globalization and the spread of IT, Japanese firms have increased investment abroad, particularly in East Asia, strengthening their production bases overseas. At least regarding manufacturing industry, this may be considered to have acted as a constraint upon domestic capital investment.
  4. The second factor is the rigidity that characterizes the Japanese corporate system. As is often pointed out, the traditional Japanese corporate system has several characteristic features: (1) low labor force mobility; (2) a lack of active participation by foreign-affiliated companies and new start-ups; and (3) weak corporate governance by shareholders. This corporate system may be deemed ill-equipped to encourage firms to reallocate resources beyond themselves in dynamic ways, thereby dealing with the rapid changes to the business environment that have been taking place since the 1990s.
  5. The third factor is the decline in asset prices. The asset price declines, which were triggered by the bursting of the bubble at the beginning of the 1990s, persisted until recently, partly reinforced by the Japanese economy's continuing failure to respond fully to structural adjustment pressures. Since the nominal value of liabilities is fixed, such falls in the value of firms' asset holdings cause their balance sheets to deteriorate. This problem is particularly severe in the nonmanufacturing sector, and especially among small and medium-sized nonmanufacturing firms, where asset accumulation during the bubble period was funded with debt, and there is an increasing incidence of cases where companies are simply unable to repay their debts. Even among firms that did not accumulate large debts, a fall in the value of their assets affects their balance sheets in adverse ways, such as by reducing the unrealized gains on their asset holdings, and this has acted to weaken the appetite for risk-taking among a wide range of firms including large manufacturers. By comparison with the evident problems posed by this asset price deflation, it is rather less clear whether or not the gentle decline observed in the general prices has acted to suppress business fixed investment in any way.
  6. The fourth factor has been the deterioration in financial institutions' performance of their function as financial intermediaries. The ill effects on firms' balance sheets of asset price deflation have spread to the balance sheets of financial institutions, by obliging the latter to dispose of a huge amount of nonperforming loans (NPLs). The result has been to shake confidence in the continuity of corporate financing and the stability of the financial system, and also therefore to make firms even more cautious about risk-taking. In particular, firms' experiences in 1997-98, when corporate financing took on a crisis aspect, may well have acted to reawaken their sense of the urgent need to restructure their finances. At the same time, it is worth pointing out an issue that is to some extent distinct from the NPL problem, namely the fact that financial institutions have not yet developed a fully functioning credit intermediation model with which to replace the old model of lending with real estate as collateral. The result is that these financial firms' ability to support the risk-taking of entrepreneurial firms has been compromised. On the other hand, with low growth becoming a chronic condition, share prices falling, and opportunities to extend performing loans growing scarcer, there have been extra burdens weighing down the balance sheets of financial institutions. Added to this has been the decline in the effectiveness of monetary policy, which, though aimed at dealing with this vicious circle within which the financial and real economies are locked, has been hampered by the zero nominal interest rate constraint.
  7. The fifth factor has been the decline in the expected growth rate. With both the real economy and the financial intermediary function in a weakened state, the actual growth rate has continued to be low, and this has driven firms' expectations of the growth rate into a declining trend since the 1990s. Since these low expectations suppress capital investment, thus weakening the real economy still further, we may also perceive certain aspects of a vicious circle at work here too.
  8. Finding a way out of this low-growth vicious circle must ultimately involve increasing the flexibility of the corporate system through structural reform and restoring fully functional financial intermediation. In fact, there has already been some progress made, and with a new liveliness characterizing areas such as M&A and corporate reorganization, at least in comparison with years gone by, there appear to be some signs of vigor in firms' efforts to think beyond their own boundaries when deciding how to reallocate resources. For example, in materials industries such as iron and steel there has been progress made in reorganization aimed at consolidating excess capital, and with growth in the East Asian economies providing the tail wind, capital investment is looking up. Also in the electrical appliances sector, under their enhanced concentration policy, firms are giving up on domestic production of commodity-type goods and concentrating their strategic efforts on high-value-added electronic devices for which worldwide demand is expected to expand. These strategic decisions entail their overall business consolidation and capital spending. Such developments, however, are taking place only in selected parts of the economy, and it will take quite some time before we can see an expansionary dynamism on the macroeconomic level that involves activity even at small and medium-sized firms.
  9. Looking forward, the industrial structure will be characterized by the following basic trends: (1) higher intensity of technology in the manufacturing industry and (2) a migration of labor from manufacturing and construction to tertiary industries. An example of high economic growth that concurred with a massive reallocation of resources was seen in the United States in the 1990s, where an increase in total factor productivity in manufacturing industry, significant employment gains in the service sectors, and active capital investment in IT-intensive nonmanufacturing sectors such as finance and telecommunications took place simultaneously. Of course, we should bear in mind that Japan will have its own unique optimal prescription in terms of industrial restructuring and the distribution of its resources. The precise make-up of that prescription, however, is something that should be left to market mechanisms, to be discovered as results of firms' own efforts to maximize their profits.
  10. The point, therefore, in promoting the optimal distribution of resources throughout the economy as a whole, is not only to improve the functioning of the markets for shares and corporate bonds, but also to create an environment in which market prices are readily available for real estate, loan claims, and as broad a range of assets and businesses as possible. Enhanced application of market principles will make it easier to identify nonviable businesses, and will spur management efforts to raise the value of assets. Of course, this is not to claim that markets are almighty, nor does it deny the need to use a variety of measures to supplement the areas where markets are incomplete. The Industrial Revitalization Corporation of Japan (IRCJ), which has recently begun to operate, may provide the breakthrough necessary to speed up structural reform, by promoting the corporate revitalization business in the private sector. Tasks such as building fully functional financial and capital markets, thereby breathing new life into Japan's industry, may seem to be part of a somewhat subterranean process that has no direct bearing on immediate economic expansion. Nevertheless, steady progress in these areas is vital.