September 28, 2005
JS-2954

Testimony of
Deputy Assistant Secretary of the
Treasury David Loevinger
before the House Ways and Means Committee

Chairman Thomas, Ranking Member Rangel, and other Committee members, thank you for this opportunity to talk about developments in the Japanese economy and the Administration's engagement with Japan on macroeconomic and financial issues. This hearing is timely, as it is taking place at a time of growing optimism both about the possibility of sustained domestic demand-led growth in Japan and more rapid economic reforms following this month's elections.

My colleagues have testified on a number of sectoral trade issues. The Treasury Department works closely with USTR, Commerce, and other agencies on these issues through the Trade Policy Review Group.  Moreover, Treasury has focused particular attention on access to the Japanese market by U.S. financial services providers.

In addition to these sectoral issues, Treasury pays close attention to the overall growth of the Japanese economy.  Strong, sustained, and domestic demand-led growth in Japan – the world's second largest economy – would boost U.S. exports and jobs and would also contribute to more balanced global growth.   For the last decade Treasury has consulted closely with Japanese authorities on ways to achieve this.

Japan has struggled for the past decade and a half to overcome the effects of the collapse of the late-1980s asset price "bubble."  Falling property prices – with commercial land prices down more than 80 percent in Japan's major metropolitan areas between 1991 and 2004 – hit corporate and household balance sheets.  Banks were hit by the financial stress of their customers and by falling collateral values when they tried to foreclose. 

Firms that had built up capacity and staffing during the late-1980s boom reduced their investment spending.  They also held down hiring, cut back on overtime and bonuses, and replaced permanent employees with part-time workers.  The resulting drop in wages slowed household consumption.

The government responded to the economic downturn with a series of fiscal stimulus packages, mostly public works spending yielding low returns.  Regulatory forbearance allowed banks to remain technically solvent without dealing with their growing bad loans.  This led to the eventual failure of many banks, including some systemically large institutions, and large infusions of public funds since the late 1990s.

Japan's slowness in dealing with failing banks and delinquent corporate debtors kept it, until now, from achieving sustained domestic demand-led growth.  Evergreening loans to zombie borrowers locked resources up in non-productive activities, and heavy debt burdens limited investment in new activities.  Short-lived economic rebounds in 1993, 1995-96, and 1999-2000 faded quickly back into recession once the initial fiscal or export stimulus faded.  The protracted economic slowdown led to persistent deflation. 

Over the past decade U.S. engagement with Japan focused on resolving banking sector problems, overcoming deflation, and restoring sustained, domestic demand-led growth.  At times this discussion was acrimonious.  The Bush Administration established a quieter, more cooperative dialogue with Japan, focused on creating the fundamentals for sustained growth rather than encouraging fiscal stimulus to pump up growth over the next few quarters.

Japan's struggle to emerge from the deflation, sluggish growth, and banking sector problems may finally be coming to an end.  The Koizumi Administration made clear that restoring growth would require structural reforms such as increasing competition in domestic markets and improving the efficiency of financial intermediation, and could no longer rely on fiscal stimulus.  The Koizumi government also brought tougher banking regulation, which forced the banks to raise capital and deal with their problem borrowers.  Corporate restructuring has strengthened firms' finances and reduced excess debt and capacity. 

There are also growing signs that the labor market is finally strengthening: the number of full-time employees rose recently for the first time in seven years, and the number of part-time workers fell for the first time in a decade.  While exports, especially to China, helped fuel the early stages of Japan's current recovery, household consumption and investment have been the key growth engines in recent quarters.  So, at least for the Japanese economy, after several false dawns, a new day may have finally arrived.

But the Japanese economy still faces numerous headwinds.  Deflation, though diminished, still persists.  Many small banks and small firms still remain weak.  After years of stimuli, Japan now has the largest fiscal deficit and government debt, relative to GDP, of any G7 country.  A large fiscal retrenchment is inevitable.  Moreover, a rapidly aging population will necessitate increased public spending on health care and pensions, while a shrinking workforce will limit the growth of income and payroll tax receipts, making the fiscal retrenchment more difficult. By 2025, Japan is projected to have more than half as many elderly as working-age people, up from less than one-third today.  In the United States, in contrast, that ratio is projected to rise from about one-in-five today to about one-in-three by 2025.

Japan's long-term potential growth rate is estimated to be only about 1½ percent per year, vs. 3½ -4 percent in the United States.  We share Prime Minister Koizumi's view that, given these headwinds, far-reaching structural reforms are needed to boost productivity so that the Japanese economy can navigate the challenges of the 21st century and make a larger contribution to global growth.

Financial Sector Issues

The length of the post-bubble economic troubles and the high costs of cleaning up the banking sector owe much to the financial system that Japan maintained after the Second World War.  Bank-dominated, heavily segmented and regulated, and closed to outsiders, the Japanese financial system failed to innovate and develop the credit analysis and risk assessment tools that financial institutions in the United States introduced.

For the past two decades, starting with the Yen-Dollar talks in the 1980s, the Treasury has pressed Japanese financial regulators to reform and modernize Japan's financial system and open the sector up to foreign investment.  The U.S.-Japan Financial Services Agreement, negotiated in 1995, opened up a number of sectors for U.S. financial services firms, including the management of public pension funds.  The "Big Bang" financial liberalization decontrolled prices and fees, opened up financial markets to new entry and new products, and shifted regulation and supervision to a modern market- and risk-based system.  Regular discussions between Treasury, Japan's Ministry of Finance, and Japan's Financial Services Agency have continued to expand opportunities for U.S. firms – in managing the assets of Postal Savings system and offering 401(k) pension products, structured asset products, investment advisory and custodial services, and many others.

Ten years ago, foreign participation in Japan's domestic financial market was almost unthinkable. Today, market access and national-treatment are no longer prominent issues in our financial sector dialogue.  U.S. investors own two large Japanese banks and several small ones.  And the market share of U.S. and other foreign securities firms is growing, as it is for foreign pension and mutual fund managers.  Those developments are reflected in the rapid growth of U.S. direct financial services investment in Japan, which has grown from $6.5 billion in 1994 to more than $38 billion last year on a historical cost basis.  Income from those investments has grown even more rapidly, from around $400 million in 1994 to nearly $5 billion last year.

We still have a very active engagement with Japan on financial sector issues, but the issues have shifted from market access to market development. These have included restrictions on short sale transactions, the ability to conduct global risk management across financial entities, participation of global custodians in government bond settlement, and taxation of mutual funds. 

One recent example illustrates the importance of this engagement.  A revision of section 821 of Japan's proposed Corporation Law, submitted to the Diet this year, could have required many foreign financial and non-financial firms to reincorporate as Japanese subsidiaries, in many cases with substantial tax liability on realized capital gains.  Our financial attaché in Tokyo worked closely with U.S. firms and the Japanese Diet to craft a legislative history exempting foreign firms.  We continue to monitor this issue to determine if this will suffice or if corrective legislation is necessary.

The most important financial sector issue now is the privatization of Japan's postal financial institutions – Postal Savings and Postal Life.  These are huge institutions, by far the world's largest savings bank and life insurer, accounting for a third of Japan's deposits and 40 percent of its life insurance policies.  We believe Prime Minister Koizumi's postal privatization bills can help increase the efficiency of financial intermediation, and potentially reduce the need for such high precautionary savings, boosting growth and imports.  One key to success, as Secretary Snow and other Treasury officials have stressed to our Japanese counterparts, will be ensuring a level playing field so that the competitive advantages enjoyed by the privatized postal savings and postal life insurance firms are eliminated.  Another key will be strict regulation, especially to limit risk transfers or cross-subsidization among the privatized financial and non-financial corporations. 

But postal privatization will not be enough, as Prime Minister Koizumi recognized when he called for sweeping reforms including labor and product market deregulation and fundamental reforms of government lending institutions.  Japan also needs continued progress in capital market and corporate governance reforms to ensure that corporate managers are focused on shareholder value.  Our own experience shows that allowing the full range of foreign and domestic M&A activity helps develop the market for corporate control, which can contribute to better resource allocation, higher returns on investment, and faster growth and imports.

Exchange Rate Policy

Japan has intervened in the foreign exchange market in the past, sometimes in large amounts.  We have discussed foreign exchange market issues with Japanese officials, and they are fully aware of our views that the world economy works best with free trade, free flow of capital, and flexible exchange rates for large economies.  Japanese authorities have not intervened in the foreign exchange market since March 2004.  Japan has also supported the G7 position on exchange rates, expressed in a series of G7 Communiqués, calling for greater exchange rate flexibility.  And Japan has worked with us to bring about greater exchange rate flexibility in China and in other large economies in East Asia.  We will continue to strongly express our views that major economies should have flexible exchange rates, determined in the market with intervention kept to a minimum.

Thank you again for this opportunity to testify before you.  Ensuring vigorous, domestic demand-led growth, increased financial sector dynamism and opportunities for U.S. firms, and flexible, market-determined exchange rates in Japan and other large economies will continue to be priorities for the Treasury and the Administration.