Japan unveils pounds 118bn rescue plan

News Analysis: The markets are not convinced that tax cuts and free shopping coupons will halt the economic decline

THE JAPANESE government yesterday unveiled its biggest economic rescue package - worth pounds 118bn - in an attempt to drag its economy out of its deepest recession since the Second World War. It plans to slash taxes, pump up investment, and, in a highly unusual step, issue free shopping coupons to tens of millions of consumers in an attempt to get the economy back on track again.

But the markets are not convinced - most analysts believe the package will fail to halt the slump in the world's second largest economy. If pounds 118bn cannot solve Japan's problems, what can?

The scope of Japan's economic and financial difficulties is extraordinarily wide. The country is in the grip of a deep recession. The economy is expected to contract by 2.6 per cent this year, and, at best, will stagnate in 1999. Indeed, total demand is so far below potential supply - that is, the output gap is so large - that prices are falling.

Asset prices have collapsed and the levels of indebtedness are nothing short of staggering. Banks are refusing to lend to all but the most creditworthy, and many fear the financial system is close to collapse. With both unemployment and corporate bankruptcies at record highs - the latest figures show business failures up for the 17th consecutive month - it is no wonder that even the promise of "free money" may fail to tempt consumers back into the shops.

In most countries, the authorities respond to the threat of looming recession in three ways. First, they cut interest rates. Second, they loosen fiscal policy, by cutting tax and/or boosting spending. Finally, they may embark on so-called "structural" reforms which try and improve the way the economy works, although these are generally a longer-term solution.

In Japan's case, interest rates are virtually zero, and have been for many months. Rates cannot fall much further - only by 0.25 of a percentage point or so - and a cut of such a small size will make no difference to Japan's economic position. This means the authorities have to rely on a combination of fiscal measures and longer-term structural reforms to pull the economy out of the mire.

So, on the face of it, the Japanese authorities seem to be doing the right thing. They have announced a massive fiscal package and have approved plans aimed at restoring confidence in the debt-ridden financial system. So why are analysts so pessimistic?

The difficulties lie less with the general principles - cutting tax, boosting spending and sorting out the banks - and more with implementation.

Take the fiscal package first. Despite the large headline number, which, at pounds 118bn, is pounds 20bn higher than the markets were expecting after the ruling Liberal Democratic Party outlined the package last week, analysts have their doubts. Experts say the headline number is "exaggerated" and many say tax cuts will do little to boost consumption.

As Lehman Brothers put it in a research note issued last week, before the precise size of the package was known: "The package appears to contain the usual exaggerations, and given a flimsy private sector base and compositional shortcomings, we have little faith in its ability to do more than partially fill a cavernous output gap."

Economists say the proposed cuts in income tax, which will take the top rate of tax from 65 per cent to 50 per cent, will simply be saved not spent. The government also plans to cut other rates of income tax, although is unlikely to spell out details until the new year.

Reaction to the government's proposal to issue 35 million consumers - mostly the under-15s and the elderly - with gift vouchers worth pounds 100 each has been equally unenthusiastic.

Neil Parker, at the Royal Bank of Scotland, said the plan - first suggested by Japan's Buddhist party - would mean that customers would substitute one type of spending for another. The lucky recipients would simply switch from spending cash to spending vouchers and there would be no overall boost to consumption.

What the markets would like to see is a cut in so-called consumption tax - an indirect tax like VAT. The government's decision to hike consumption tax back in April 1997 is widely blamed for helping to tip the economy into recession. But the government is said to regard such a volte-face on tax as politically unpalatable.

Banking reform is the other area where the markets are keen to see action. There has been some progress here - the government has passed bills to allow the authorities to help banks in trouble, but only if the banks agree to come forward. But the markets feel the government has not done enough.

According to Stephen Lewis, chief economist at Monument Derivatives, the conditions attached to official assistance are so strict that few banks were willing to ask for help. Many in the markets advocate a mandatory scheme, where struggling banks are taken over by the government and are forced to either restructure or close.

So although the latest Japanese package looks impressive at first, many believe there is not enough meat on the bones. Key proposals - such as cutting consumption tax - are conspicuously absent. Banking reform is progressing painfully slowly, and politics is all too frequently put before economics. Despite the claims of the policy-makers, the Japanese economy is far from being back on course.