BMI's Executive Summary

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From Q108 we will be calculating the Commercial Banking Business Environment Rating (CBBER) for each of the countries surveyed by BMI. This will permit a more systematic and comprehensive comparison of the conditions within the banking industries of the various countries than was possible in the past. For each country, it will also facilitate a comparison of the conditions within the banking sector and conditions prevailing in other sectors.

Japan's overall CBBER at 75.0 is high, the third highest of the countries in the Asia-Pacific region that are surveyed by BMI. This score is underpinned by high scores in all the major components of the rating. Japan's score is particularly underpinned by the high score of 76.3 on the heavily weighted banking market elements of the limits to potential returns element. This, in turn, reflects both the large scale and high degree of sophistication of the Japanese banking system.

In particular, the banking market structure element of the limits to potential returns have a higher although roughly comparable score to the country element (i.e. 76.3 versus 70.6). On the other hand, the banking market elements of the risks to the realisation of potential returns is considerably lower than the country risk rating (i.e. 66.7 versus 84.7). That is, although the banking sector is well positioned within what is admittedly a weak economy, it, rather than the economy more generally, is also the primary locus of risks to its own further development. This is because the banking system remains fragmented and is losing market share to its competitors in a very low domestic interest rate environment.

Japan's economy faces a number of headwinds in 2008 that have prompted us to cut our growth forecast to 2.0% from 2.5% previously. Factors constraining the economy include political uncertainty, a weaker external environment, subdued consumption, and the prospect of higher sales taxes to rein in Japan's massive fiscal deficit and debt burden amid an ageing population.

Japan's economy will begin 2008 on a weaker note than 2007, owing to a number of external and domestic factors. Japan's relatively robust growth in recent years has been boosted by exports, which have benefited from a weak yen. However, we envisage slower growth in the US, China and the Eurozone in 2008, which will have the effect of sapping demand for Japanese exports. In addition, we also forecast the yen appreciating to JPY108.00/US$ at the end of 2008 – with the possibility of stronger gains in the meantime – from JPY112.00/US$ at present, which could reduce the competitiveness of Japanese goods. Going forward, we caution against the notion that Japan can 'decouple' from US growth. Although China is poised to overtake the US as Japan's biggest export market in 2007 for the first time in modern history, the truth is that many Japanese items sent to China are machine components assembled into finished products at local factories for re-export to the US.

Japan's economy is also experiencing weak domestic demand (personal consumption generates 55% of GDP). Strong Japanese corporate profits have generally failed to translate into higher wages because over the past decade or so, Japanese companies have been shedding staff and replacing them with 'temporary' workers, who are paid less than their full-salary predecessors, constraining personal consumption. Going forward, domestic demand may well suffer another blow if the government proceeds with raising the consumption tax rate to finance increasing social security costs. Certainly, the government needs the extra revenues. Japan has run nominal fiscal deficits in excess of 6.0% of GDP in recent years, as a legacy of the 'lost decade' of the 1990s, when massive government spending was used to prop up the economy. Consequently, its national debt burden, at JPY834trn (US$7.4trn), now exceeds 160% of GDP – virtually the highest debt-to-GDP ratio in the world. In addition, Japan's population is simultaneously ageing rapidly and shrinking, meaning that more money will have to be spent on looking after the elderly over the coming decades. As such, Japan needs to find all the revenues it can muster. At 5.0%, Japan's sales tax is still lower than many developed states, meaning that the government has leeway to raise it. Overall, the above factors mean that Japan can no longer rely on fiscal 'pump priming' (i.e. public works projects) measures to bolster the economy. The Bank of Japan's long-running quest to normalise monetary policy by raising interest rates will also run into difficulties in 2008, owing to several global and domestic factors. As regards the former, weaker economic growth in the US and Eurozone is likely to reduce demand for Japan's exports, thus putting its economy under pressure. Domestically, for all the BoJ's talk of the need to pre-empt inflationary pressures, Japan is barely out of deflation. Core CPI was 0.1% y-o-y in October 2007, marking the first positive reading in 10 months. The fact that Japanese inflation has remained so low even amid record oil prices underscores the strength of deflationary forces at work. Although we see Japanese core CPI picking up to 0.5% in 2008, this hardly merits aggressive rate hikes.