Japan's Economic and Security Challenges

This report provides a snapshot of U.S.-Japan relations, current economic and security challenges facing Japan, and policies being adopted or considered to deal with them. The information was gathered primarily during a trip to Japan in February 2002 and augmented by subsequent research. Japan's economy is beginning to recover from its third recession over the past twelve years. This "lost decade of the 1990s" and slow growth means that Japanese gross domestic product is as much as $1.3 trillion dollars (equivalent to Brazil's GDP) below what it could have been if it had continued to grow at the 3.6% rate it did in the 1980s. Japan's economy faces three basic problems. The first is the legacy of the bursting of the economic bubble in 1989 that includes a large accumulation of nonperforming bank loans and deflation. The second is the current global recession, and the third is globalization. The largest immediate economic problem for Japan is the $417.7 billion in nonperforming loans held by its financial sector despite a decade of government programs (which critics call half-hearted) to strengthen Japanese banks and private efforts to clean up the financial mess. This is causing credit to contract, monetary policy to be less effective, and contributes to the ongoing recession. Economic policymakers realize that if they do not act aggressively, market forces may accomplish what policy will not. Japanese government bonds already are being downgraded; bankruptcies are rising; a major capital flight out of yen denominated assets could occur; a premium on borrowing by Japanese banks could return, or financial instability could begin in Japan that could spread to other countries. In a move that reflects near desperation, in September 2002, the Bank of Japan announced that it would consider directly purchasing stock shares held by more than a dozen Japanese banks. In October, Prime Minister Koizumi reshuffled his cabinet to enhance the authority of reformist leaders and promised aggressive action by month end. The Bush administration has become more vocal in articulating its desires for Japan to move forward to rehabilitate its economy and has advocated that Japan cut taxes and clean up the bad loan problem to spur investment and economic recovery. In the security area, Japan responded to the September 11 terrorist attacks on the United States by approving new laws that allowed its Self-Defense Forces to directly assist the U.S.-led war on terrorism. The Japanese navy was sent to the Indian Ocean to transport nonlethal supplies and provide fuel and other supplies to U.S. forces. This was the first time since World War II that Japan's navy had been allowed to operate outside of its home waters. Japan also is strengthening protection of its nuclear plants and taking other measures to counter the new terrorist threat. Japan is concerned over the rise of China and is seeking normalization of relations with North Korea. Japanese businesses are investing heavily in China -- often to the detriment of local manufacturing. Japan is concerned that it could be drawn into the China-Taiwan dispute.