Conclusion

Japan was hit hard by the global financial crisis even though its relatively resilient financial system initially limited the direct impact. The severe collapse of industrial production that followed was no doubt attributable to a confluence of factors, including the stock price declines that eroded the capital base of commercial banks and thus limited their willingness to lend as well as the lagged impact of the sharp rise in oil and other commodity prices in the summer of 2008. As a primary cause of the severe recession, however, this paper has highlighted the impact that came from the contractionary effect of global deleveraging on the real economy. In this environment, Japan was particularly vulnerable because of the structural changes that had taken place over the past decade in its trade and industrial structures. VAR analysis has confirmed that, as a result of these structural changes, Japanese output became much more responsive to output shocks in the advanced markets of the US and Western Europe.

Japan's structural changes had two components. First, over 90% of Japan's exports consisted of highly income-elastic industrial supplies, capital goods, and consumer durables. Though emerging Asia is Japan's largest export market, the region's imports from Japan largely consist of industrial supplies and capital goods that are necessary at least in part for the production of final consumer goods destined for the advanced markets of the US and Western Europe. Asia's intra-regional trade had expanded rapidly until the outbreak of the global financial crisis, with Japan as the most important supplier of foreign direct investment and technology intensive products, but much of it had been in the trade of parts, components, and capital equipment. With final demand coming from the developed markets outside the region, the demand contraction in these developed economies due to global deleveraging had direct and secondary impacts on Japan—and other similar emerging economies like Korea, Singapore and Taipei,China.

Second, Japan's trade dependence had increased since the early 2000s, as evidenced by a rising export to GDP ratio and a declining share of the non-tradable sector. This was induced by the return of the real effective exchange rate of the yen to a level more in line with the long-run average, allowing the Japanese economy to finally come out of a decade-long stagnation. Fundamentally, increasing trade openness can be thought of as a natural part of the process of economic globalization and regional integration that has been advancing throughout the world and especially in Asia. But the manner in which this process played out made Japan particularly vulnerable to a large output shock coming from outside.

In looking to the future, one must make a distinction between the outcome of the natural process of economic globalization and integration, of which Japan has been a part, and the need to manage that process. As Japan continues to integrate with the regional and global economies, as it should, a rise in the ratio of exports to GDP is likely to continue; a share of emerging Asia in Japan's total exports may well continue to increase, especially as the region's income levels rise. What matters is the geographical and product diversification of the likely increases in exports. To make Japan more resilient to external shocks, policymakers could create enabling environments to stimulate the export of finished goods to emerging Asia, for example, through the establishment of a region-wide free trade arrangement. In this context, it is instructive to note the experience of Germany during the current crisis. Although Japan and Germany share similar industrial structures, German industrial production did not decline as much despite the fact that its export dependence was even greater than that of Japan.⁸

Domestically, there is no rational ground where one can advocate a policy of reducing trade openness just to minimize vulnerability to external shocks. Japan, as a relatively large economy, however, cannot rely on external demand alone to sustain its economic growth over the medium-term. To the extent that there are impediments that may inhibit the vigorous expansion of domestic demand or the non-tradable goods sector, policy needs to address them. To promote domestic demand, the social sector protection system (for education, health, unemployment, and pensions) needs to be substantially reformed so as to reduce households' uncertainty for the future. To promote a better allocation of resources between the more regulated non-tradable goods sector (such as medical, health, and young- and old-age caretaking) and the less regulated tradable goods sector, further deregulatory measures are called for. A substantial lifting of restrictions in agriculture, especially the corporatization of agricultural production, would be especially helpful. More liberal immigration policy should help invigorate private investment in an aging society. With little available fiscal space, these and other measures will help create a climate in which private investment can flourish, driven by final domestic demand.

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