WORLD TRADE ORGANIZATION

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1 WORLD TRADE ORGANIZATION RESTRICTED 17 December 2004 ( ) Trade Policy Review Body TRADE POLICY REVIEW JAPAN Report by the Secretariat This report, prepared for the seventh Trade Policy Review of Japan, has been drawn up by the WTO Secretariat on its own responsibility. The Secretariat has, as required by the Agreement establishing the Trade Policy Review Mechanism (Annex 3 of the Marrakesh Agreement Establishing the World Trade Organization), sought clarification from Japan on its trade policies and practices. Any technical questions arising from this report may be addressed to Mr. Masahiro Hayafuji (tel: ), Mrs. Zheng Wang (tel.: ), Mr. Nirat Supthaweethum (tel.: ) and Mr. Michael Daly (tel: ). Document WT/TPR/G/142 contains the policy statement submitted by Japan. Note: This report is subject to restricted circulation and press embargo until the end of the first session of the meeting of the Trade Policy Review Body on Japan.

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3 Japan Page iii CONTENTS Page SUMMARY OBSERVATIONS (1) ECONOMIC ENVIRONMENT vii (2) TRADE POLICY REGIME: FRAMEWORK AND OBJECTIVES vii (3) TRADE POLICIES AND PRACTICES BY MEASURE viii (4) TRADE POLICIES BY SECTOR ix (5) OUTLOOK x I. ECONOMIC ENVIRONMENT 1 (1) MAIN ECONOMIC DEVELOPMENTS 1 (2) MACROECONOMIC POLICIES 4 (i) Monetary and exchange rate policy 4 (ii) Fiscal policy 5 (3) STRUCTURAL POLICIES 6 (i) Financial system and corporate reform 6 (ii) Pension reform 8 (iii) Regulatory reform 8 (4) DEVELOPMENTS IN TRADE AND FOREIGN DIRECT INVESTMENT 9 (i) Composition of merchandise trade 9 (ii) Direction of merchandise trade 9 (iii) Composition of trade in services 9 (iv) Foreign direct investment (FDI) 12 (5) PROSPECTS 12 II. TRADE POLICY REGIME: FRAMEWORK AND OBJECTIVES 13 (1) TRADE POLICY OBJECTIVES 13 (2) TRADE POLICY FORMULATION AND EVALUATION 13 (i) Trade policy formulation and implementation 13 (ii) Trade policy evaluation 16 (3) TRADE AGREEMENT AND ARRANGEMENTS 17 (i) WTO 17 (ii) Regional Agreements 17 (iii) Bilateral agreements 19 (iv) Preferential treatment 22 III. TRADE POLICIES AND PRACTICES BY MEASURE 24 (1) INTRODUCTION 24 (2) MEASURES DIRECTLY AFFECTING IMPORTS 25 (i) Procedures and valuation 25 (ii) Tariffs 26 (iii) Non-tariff border measures 32 (iv) Contingency measures 33 (v) Government procurement 34 vii

4 Page iv Trade Policy Review Page (vi) State trading 36 vii) Standards, and sanitary and phytosanitary measures 37 (3) IMPORT AND INWARD INVESTMENT PROMOTION MEASURES 40 (i) Import promotion 40 (ii) Investment regulation and promotion measures 41 (iii) Foreign access zones (FAZs) 43 (4) MEASURES DIRECTLY AFFECTING EXPORTS 44 (i) Export taxes, charges, and levies 44 (ii) Export prohibitions, restrictions, and licensing 44 (iii) Export promotion schemes 45 (5) MEASURES AFFECTING PRODUCTION AND TRADE 45 (i) Taxation and tax-related assistance 45 (ii) Subsidies and other financial assistance 47 (iii) State-owned enterprises, corporatization, and privatization 47 (iv) Trade-related intellectual property rights 47 (v) Regulatory reform 50 (vi) Competition policy 51 (vii) Corporate governance 56 IV. TRADE POLICIES BY SECTOR 58 (1) INTRODUCTION 58 (2) AGRICULTURE 59 (i) Overview 59 (ii) Policy developments 59 (3) MANUFACTURING 64 (4) ENERGY AND UTILITIES 65 (5) SERVICES 66 (i) Overview 66 (ii) Financial services 66 (iii) Telecommunications 71 (iv) Transport 73 (v) Professional services 75 (vi) Construction 76 (vii) Education services 76 REFERENCES 77 APPENDIX TABLES 81

5 Japan Page v CHARTS Page I. ECONOMIC ENVIRONMENT I.1 Product composition of merchandise trade, 2001 and I.2 Direction of merchandise trade, 2001 and II. TRADE POLICY REGIME: FRAMEWORK AND OBJECTIVES II.1 Policy evaluation system in Japan 16 III. TRADE POLICIES AND PRACTICES BY MEASURE III.1 Share of non-ad valorem duties, by HS section, FY III.2 Simple average applied MFN tariff rates, by HS section, FY 2002 and I. ECONOMIC ENVIRONMENT TABLES I.1 Selected macroeconomic indicators, I.2 Shares of GDP and employment by sector, II. TRADE POLICY REGIME: FRAMEWORK AND OBJECTIVES II.1 Japan's major trade-related laws and regulations 14 II.2 GSP shares for the ten largest beneficiaries 23 III. TRADE POLICIES AND PRACTICES BY MEASURE III.1 Structure of MFN tariff in Japan, III.2 Preferential tariff rates, FY III.3 Procurement composition by product and by origin, III.4 Major standards and technical regulations in Japan, III.5 Total budget for Japan's import promotion programmes 41 III.6 Measures to promote foreign direct investment into Japan, FY III.7 National government tax revenue, FY III.8 Stockholding by the Government of Japan, as at October III.9 Legislation regarding protection of intellectual property rights in Japan 48 III.10 Suspension of imports likely to infringe intellectual property rights, III.11 Exemptions from the Anti-monopoly Act, III.12 Enforcement of competition policy, IV. TRADE POLICIES BY SECTOR IV.1 Applied MFN tariff protection in agriculture, FY IV.2 Special safeguard (SSG) actions in agriculture, FY IV.3 Procurement prices for all major crops subject to pricing and/or marketing arrangements/price controls, IV.4 Financial institutions in Japan,

6 Page vi Trade Policy Review APPENDIX TABLES Page I. ECONOMIC ENVIRONMENT AI.1 Composition of trade in services, AI.2 Inward and outward FDI flows by source and destination, FY AI.3 Inward and outward FDI flows by activity, FY II. TRADE POLICY REGIME: FRAMEWORK AND OBJECTIVES AII.1 Status of notifications to the WTO, September AII.2 Disputes to which Japan has been a party, 2002 to April III. TRADE POLICIES AND PRACTICES BY MEASURE AIII.1 Applied tariff escalation and tariff ranges, FY 2002 and FY IV. TRADE POLICIES BY SECTOR AIV.1 Tariff quota quantity and in-quota imports, FY

7 Japan Page vii SUMMARY OBSERVATIONS (1) ECONOMIC ENVIRONMENT 1. Since its previous Trade Policy Review, Japan's economic situation has improved, particularly compared with the previous decade of slow growth. After recording negative growth in 2002, Japan's economy grew by 2.4% in real terms in 2003, and continued to achieve similar rates of growth in the first three quarters of Both domestic demand, notably private nonresidential investment and private consumption, and external demand contributed to this growth. Unemployment has been falling and deflationary pressure on prices appears to be easing. Growth has helped Japan with its structural problems, including non-performing loans (NPLs). However, it would appear that growth may have slowed in the fourth quarter of 2004; thus the sustainability of the recovery remains to be seen. 2. During the period under review ( ), the Bank of Japan continued to relax its monetary policy; the official discount rate and the short-term call rates have been kept at nearly zero, and the monetary base has been increased. However, with negative rates of inflation, real interest rates have tended to be higher than nominal interest rates. This, together with remaining problems in the banking system, may be an impediment to corporate borrowing and investment. The fiscal deficit and public debt are expected to have been in the order of 7% and 163% of GDP in 2004, respectively; the Government aims to achieve a surplus at its primary balance by the early 2010s (compared with a deficit of 5.3% in 2004). 3. Trade has played an important role in the economy. Although the shares of exports and imports are each around 10% of GDP, external demand has contributed substantially to Japan's economic growth since 2002, due in part to the openness of the multilateral trading system. Japan's trade surplus has increased, reflecting an increase in the merchandise trade surplus and a decrease in the services deficit. Japan's current account surplus, capital and financial account surplus and its foreign exchange reserves have all increased. 4. A sustained recovery would appear to hinge on continued structural reforms, which the Government continues to emphasize. Progress has been made in particular in the financial and corporate sectors (notably the disposal of NPLs, corporatization of stateowned enterprises, deregulation in network industries and some professional services, and establishment of Special Structural Reform Zones). (2) TRADE POLICY REGIME: FRAMEWORK AND OBJECTIVES 5. Japan's trade policy has remained largely unchanged since its previous Review; the overall aim continues to be to ensure longterm prosperity and growth by promoting business activities in Japan and at the international level. In this regard, Japan has placed high emphasis on supporting the multilateral trading system, and has been participating actively in the Doha Development Agenda. Japan grants at least MFN treatment to all WTO Members. 6. Concurrently, Japan has been intensifying its pursuit of bilateral/regional FTAs with some of its trading partners, including in areas like trade facilitation, investment, competition policy, and improvement of business environment. Japan considers that regional and bilateral trade arrangements complement the multilateral system, and are useful tools for market liberalization and structural reform. Japan has signed bilateral free-trade agreements with Singapore and Mexico, and is currently negotiating agreements with the Republic of Korea, Thailand, the Philippines, and Malaysia, as well as consulting with ASEAN as a whole. Japan also supports the "open regionalism" approach of the Asia-Pacific Economic Cooperation (APEC) forum, and

8 Page viii Trade Policy Review participates in various other regional trade fora, such as the Asia-Europe meeting (ASEM) and ASEAN During the period under review, Japan granted preferential treatment to products from certain developing and least developed countries under the Generalized System of Preference (GSP) scheme. The main beneficiaries of Japan's GSP include China, Thailand, Indonesia, Malaysia, and the Philippines. (3) TRADE POLICIES AND PRACTICES BY MEASURE 8. Since its previous Review, Japan has introduced various measures aimed at further liberalizing its trade and investment regimes. Progress has been made in improving the competitive environment, including in telecommunications and financial services; however, the use of contingency measures is somewhat more evident than before, and potentially important distortions to competition remain in some sectors, particularly agriculture. The authorities attach priority to regulatory reform and sound competition policy, which could, inter alia, help create more opportunities for domestic and foreign businesses, including those entailing inward FDI. 9. The tariff is Japan's main trade policy instrument; most imports enter Japan duty free or are subject to low tariff rates. In the fiscal year 2004, the simple average applied MFN tariff was 6.3%. Nearly 99% of tariff lines are bound and most applied rates coincide with bound rates, thereby imparting a high degree of predictability to Japan's tariff. At the same time, non-ad valorem duties are an important feature of the tariff, particularly in agriculture. Such duties, which account for 6.6% of all lines, are indicated clearly in Japan's tariff schedule; they tend to involve high ad valorem equivalents (AVEs). Moreover, bound tariff rates that exceed applied rates pertain mainly to non-ad valorem duties. The simple average of all specific rates for which AVEs were available was approximately ten times the simple average of purely ad valorem tariff rates. 10. Japan has few non-tariff border measures. Those currently applied involve some import prohibitions and quantitative import restrictions, for example, on certain fish and silk items. Imports of certain goods are subject to licensing requirement in order to ensure national security, safeguard consumer health and well-being, or preserve domestic plant and animal life and the environment. Certain aspects of the import quota system can be intricate. 11. During the period under review, Japan used one anti-dumping measure. Recently, Japan began investigating the case for countervailing measures against imports of dynamic random access memory chips from the Republic of Korea. Japan has not imposed any safeguard measures since its previous Review. 12. Certain export controls are maintained on the grounds of national security and public safety, and to ensure adequate domestic supplies of certain agricultural and other primary products. Japan has not notified any export subsidies to the WTO, thereby indicating the absence of such subsidies as defined in the WTO Agreements. Finance, insurance, guarantees, and drawback schemes are available for exports. 13. Various forms of assistance are provided by central and local governments, particularly for agriculture. The total value of assistance to agriculture exceeds the sector's contribution to GDP; most of the assistance seems to consist of measures that distort production and trade. 14. No preferences are granted to domestic suppliers with regard to government procurement covered by the Agreement on Government Procurement. The share of foreign suppliers in the total value of

9 Japan Page ix government procurement was 4.2% in 2002 (down from 6.9% in 2000). 15. About 92% of Japan Industrial Standards (JIS) were aligned to their international counterparts as of March Japan has also taken further steps to ensure acceptance of foreign test data and conformity assessment. 16. Japan has continued to participate in multinational and regional discussions on agreements to promote international harmonization of regimes protecting intellectual property rights (IPRs). 17. A growing awareness that ineffective corporate governance has contributed to the misallocation and perhaps excessive use of capital and labour in the corporate sector has prompted the Government to implement a number of policy measures, such as an amendment to the Commercial Code and the revision of the Certified Public Accountants Law. 18. In March 2004, Japan adopted the new Three-Year Program for Promoting Regulatory Reform (TPPRR), which listed 762 measures envisaged to contribute to creating new opportunities for domestic and foreign businesses. The Council for the Promotion of Regulatory Reform (CPRR) was established in April 2004, to replace the Council for Regulatory Reform (CRR), whose mandate expired on 31 March In April 2003, a scheme of special zones for structural reform was adopted; exceptions to particular regulations are granted within approved special zones according to the zones' specific circumstances. Moreover, the growing importance of deregulation and competition in the Japanese economy has increased the status and size of the Japan Fair Trade Commission (JFTC), which has hitherto been somewhat weak. To achieve a higher degree of independence for the JFTC, it was transferred from the then Ministry of Public Management, Home Affairs, Posts and Telecommunications to the Cabinet Office in April (4) TRADE POLICIES BY SECTOR 19. Since Japan's previous Review, the Government has continued to promote structural reforms, pertaining especially to the energy and services sectors. 20. During the period under review, the Basic Law on Food, Agriculture and Rural Areas and the Basic Plan that implements the policy stipulated in the law continued to provide the framework and policy direction for agriculture; one of the main objectives of the Basic Law is to secure a stable food supply. The Government is also promoting the consolidation of scattered farmland with a view to raising productivity. The Law on Special Zones for Structural Reform allowed general corporations to lease farmland under certain conditions. The average applied MFN tariff for agriculture (WTO definition) decreased from 20.0% in FY 2002 to 17.7% in FY Total transfers to agriculture exceed the sector's small contribution to GDP. Japan's food self-sufficiency ratio has remained stable at around 40% since the previous Review, despite efforts to raise it to 45%; it continues to be the world's largest net importer of food. 21. Japanese manufacturing is more exposed to international competition than agriculture and certain services. Tariffs on industrial products are usually low; non-tariff barriers are few and the sector receives relatively little financial or other support from the Government. In 2003 an Industrial Revitalization Law was amended to strengthen Japan's industrial competitiveness, and the Industrial Revitalization Corporation of Japan was established to revitalize Japanese companies with "excessive" debt. Manufacturing's contribution to GDP declined from 20.8% of in 2001, to 20.5% in 2002; the sector employed 17.7% of Japan's total labour force in 2002, down from 18.4% in 2001.

10 Page x Trade Policy Review 22. Japan's energy self-sufficiency ratio was about 20% in 2000; achieving a stable supply of energy is one of its major policy objectives. Prices of electricity and gas are relatively high by international standards; however, entry into the electricity and gas market has been partially liberalized. 23. The share of services in Japan's GDP has been growing steadily; services accounted for 71.1% of GDP in 2002, up from 70.6% in In recognition of the growing importance of services, not just to consumers, but to all kinds of businesses for which services are essential inputs and therefore a significant determinant of their international competitiveness, the Government's attention has been focused increasingly on regulatory reform combined with the strengthening of competition laws and their enforcement. Reforms have continued, especially in financial and telecommunications services. 24. Reforms in Japan's financial system are especially important because of the system's key role in channelling savings into the most profitable investments across various sectors of the economy. Reforms in Japan's financial services sector have focused mainly on the disposal of NPLs, which have been a hindrance to the efficient re-allocation of resources and thus to improved productivity and economic growth. The ratio of NPLs to the total lending of all banks decreased from 8.4% in March 2002 to 5.8% in March In telecommunications, the Basic Telecommunications Law was revised in July 2003 to abolish approval requirements for basic telecommunication business entry and exit, and to eliminate classification of Type-I and Type-II categories and regulations on prices for certain services. 26. As a result of corporatization of the Postal Services, Postal Savings and Postal Life Insurance, Japan Post was established on 1 April A Basic Policy on the Privatization of Japan Post, which was adopted by the Government in September 2004, stipulated that privatization would start from 2007 and would be completed by (5) OUTLOOK 27. The Government's official forecast predicted further economic recovery in FY 2004, with improved labour market conditions and an easing of downward pressure on prices. The latest quarterly estimates indicate that real GDP grew by 3.9% year on year in the third quarter of 2004, driven largely by domestic demand. But growth may recently have slowed and thus the strength of the recovery remains to be seen, particularly given persistent deflation and seemingly fragile business and consumer confidence. The sustainability of the recovery also depends on external factors such as the pace of economic growth in the world economy, including China, and prices of crude oil. Medium and long-term downside risks include its rapidly aging population and a declining labour force. Structural reforms, including the disposal of NPLs, financial and corporate sector reform, pension reform, strengthening of competition policy, and trade liberalization, particularly in agriculture, are of great importance. If implemented, these reforms would help restore business and consumer confidence, contributing to the sustainability of Japan's economic recovery.

11 Japan Page 1 I. ECONOMIC ENVIRONMENT (1) MAIN ECONOMIC DEVELOPMENTS 1. After recording negative growth in 2002, Japan's economy grew 2.4% in real terms in 2003 (Table I.1), and continued to grow in the first three quarters of 2004, suggesting that Japan may be extricating itself from a protracted period of slow growth and from the recent economic downturn. 1 However, the sustainability of the seeming recovery remains to be seen as the strength of growth has apparently been diminishing since the first quarter of 2004 owing to a sharp drop in net exports, hitherto one of the main engines of growth. The growth in 2003 was led by domestic demand, notably private non-residential investment and private consumption, and external demand, notably a substantial growth in exports to China 2 ; the growth has helped Japan to solve its structural problems, including non-performing loans. Since February 2003, seasonally adjusted unemployment in Japan has fallen, reaching 4.6% in September Downward pressure on prices also appears to be easing, with the year-on-year decline in the core CPI (excluding fresh food) becoming smaller. 4 Table I.1 Selected macroeconomic indicators, ( trillion and per cent) National accounts (% change, unless otherwise indicated) Real GDP d Real domestic demand d Private consumption d Government consumption d Gross fixed investment d Real exports of goods and services d Real imports of goods and services d Exports of goods and services (% of GDP) Imports of goods and services (% of GDP) Employment e Unemployment rate (annual average) f Household disposable income (% change) Prices and interest rates Consumer prices (CPI) (% change) g GDP deflator (% change) Official discount rate (%) Table I.1 (cont'd) 1 For the first time since 2000, the Japanese economy was officially declared to be "recovering steadily" in January 2004 (Cabinet Office 2004). 2 In 2003, private non-residential investment grew by 9.3% and private consumption 0.8%; contribution of domestic demand to GDP was 1.7 percentage points, while that of net exports of goods and services was 0.7 percentage points. 3 The unemployment rate (seasonally adjusted) reached a record high of 5.5% in January It would appear that many regular workers are being replaced by part-timers and contract workers, who account for about one third of the total workforce. (Financial Times, 28 August 2004). 4 For example, while year-on-year changes of the monthly CPI (excluding fresh food) between January 2001 and February 2003 were below -0.7%, those from July 2003 onwards were between -0.3% and 0.1%.

12 Page 2 Trade Policy Review Money stock a (end of year, % change) M2 + CDs h Exchange rate ( per US$) i (per cent of GDP, unless otherwise indicated) Fiscal balance b Revenue Expenditure Balance Balance excluding social security Government debt c Saving and investment National saving (gross) Domestic investment (gross) ( trillion, unless otherwise indicated) Current account balance Current account j Current account (% of GDP) Goods balance j Services balance j Income balance j Net transfer balance j Capital and financial account balance j Financial account j Capital account j Changes in reserve assets j Statistical discrepancy j.. Not available. a Money stock here is measured by M2 + CDs, which include cash currency in circulation, deposit money (demand deposits), quasi-money (time deposits, etc.), and certificate of deposit accounts (CDs). b General Government basis. c Gross financial liabilities, including the debt of the Japan Railway Settlement Corporation and the National Forest Special Account from 1998 onwards. d 2 nd quarter 2004, % change from the same quarter previous year. e September 2004, % change from the same month previous year. f September 2004, seasonally adjusted figure. g September 2004, % change from same month previous year. h October 2004, % change from same month previous year. i September 2004, period average. j First half of Source: Information provided by the Japanese authorities. 2. The Bank of Japan has continued to relax its monetary policy; the monetary base has been increased, and the official discount rate and the short-term call rates have been kept to nearly zero. With continuing negative inflation, real interest rates have tended to be somewhat higher than nominal rates. This, together with remaining problems in the banking system, may be an impediment to corporate borrowing and investment. The fiscal deficit is expected to reach 7.1% of GDP in 2004, and public debt continues to increase, reaching 163.4% of GDP in 2004; the Government's

13 Japan Page 3 medium-term target for fiscal consolidation is to achieve a primary surplus (excluding social security) by the early 2010s The Government has continued to place emphasis on structural reforms. In this connection, progress has been made, inter alia, in the financial and corporate sectors (notably disposal of nonperforming loans (NPLs)), corporatization of state-owned enterprises (such as universities and postal services), and deregulation (particularly in telecommunications and some professional services); Special Structural Reform Zones have also been established, within which exceptions to particular regulations are granted. Against this backdrop, Japan's export competitiveness has apparently increased as shown in a continuing decline in unit labour costs. 6 It remains to be seen whether the current recovery is cyclical in nature or more long-term due to structural change. 4. As regards the external sector, Japan's current account surplus has increased; the growing surplus reflects an increasing gap between gross domestic saving and gross domestic investment. The current account surplus was about 15.8 trillion (or 3.2% of GDP) in 2003, reflecting an increase in the merchandise trade surplus and a decrease in the services deficit; the merchandise trade surplus amounted to 12.3 trillion, while the services account deficit was 3.9 trillion. By the end of March 2004, Japan's foreign exchange reserves had risen to about US$827 billion (compared with US$496 billion at the end of March 2003), reflecting Japan's substantial intervention in the foreign exchange market (e.g. purchasing of foreign currencies). After recorded a surplus of around 8.1 trillion in 2003, Japan's capital and financial account surplus was 7.7 trillion in the first half of 2004 (compared with a deficit in 2002), reflecting largely an increase in portfolio investment and other investment. 5. Trade plays an important role in the economy. Although the shares of exports and imports amount to around 10% of GDP each, external demand has contributed substantially to Japan's economic growth since The United States and the European Union have continued to be Japan's main trading partners, while China's share in Japan's exports and imports has been rising. Japan's inward and outward FDI flows both decreased in FY FDI into Japan remains considerably lower than its outward FDI, and, despite a rapid increase in inward FDI over the past decade, the level of inflows remains low compared with other developed economies. 6. The share of services in GDP has continued to grow since 2002, largely at the expense of manufacturing (Table I.2); much of the growth has occurred in financial services and real estate. Services' share of employment increased from 68.5% in 2001 to 69.4% in Agriculture accounts for a small share of GDP and employment; OECD estimates suggest that total government assistance was greater than the sector's value-added in 2002 (Chapter IV(2)(i)). 5 In 2004, the primary balance of the General Government was estimated to be in deficit of 5.3% of GDP. The General Government includes the central government, local governments, and social security. Data provided by the authorities indicate that the primary balance of central and local governments combined was estimated to be in deficit of 4.6% of GDP in The primary balance of the Central Government is national debt service less government bond issues. The primary balance for local governments is debt services + cost of repaying corporate debt included in money transfer to public enterprises - local bonds. 6 The unit labour cost declined by 3.1% in 2002 and 2.3% in 2003 (OECD, 2003b).

14 Page 4 Trade Policy Review Table I.2 Shares of GDP and employment by sector, Share of GDP (per cent) Agriculture, forestry and fishing Mining Manufacturing Services Construction Electricity, gas and water Wholesale and retail trade Financial services and insurance Real estate Transport and communications Other services Government Non-profit services for households Import tax and other Statistical discrepancy Total ( trillion) Share of employment (per cent) Agriculture, forestry and fishing Mining Manufacturing Services Construction Electricity, gas and water Wholesale and retail trade Financial services and insurance Real estate Transport and communications Other services Government Total (million) Not available. Note: Total and shares of employment data are based on SNA statistics on "Employed Persons". Available at: Source: Information provided by the Japanese authorities. (2) MACROECONOMIC POLICIES (i) Monetary and exchange rate policy 7. Monetary policy has been expansionary since Japan's previous Trade Policy Review. The official discount rate has remained unchanged at 0.10%, and the balance of current accounts of financial institutions held at the BOJ, its main target for money market operations since March 2001, has been raised to around trillion since January 2004 (compared with trillion

15 Japan Page 5 previously). 7 Against this backdrop, the call rates in the short-term money markets remain around zero. The BOJ maintains that the current procedures for money market operations are to be continued until the core CPI (excluding fresh food) registers a stable zero per cent or an increase year on year for at least a few months. In November 2002, the BOJ also started the purchase of stocks held by banks with a view to reducing market risk pertaining to the shareholdings of these institutions. The question arises as to whether these measures could have artificially raised share prices. 8 The BOJ also started the purchase of asset-backed securities in June 2003, with a view to developing a market for these securities and thereby strengthening the transmission mechanism of monetary policy. 9 The BOJ is of the view that the low cost of credit resulting from the current monetary policy has supported banks' disposal of NPLs and the restructuring and rehabilitation of debtor companies 10 ; nonetheless, this has permitted inefficient companies to postpone addressing their problems. 8. For the past two years, the nominal exchange rate of the yen has appreciated against the U.S. dollar (for example, from 119/US$ at the end of 2002 to around 106/US$ at the end of October 2004). According to the authorities, market intervention took place during 2003 and 2004 to smooth excessive short-term volatility in the yen. (ii) Fiscal policy 9. During the period under review, Japan maintained a deficit in its budget; the General Government's fiscal deficit as a percentage of GDP is estimated to be 7.1% in 2004 (compared with 8.0% in 2003). 11 Japan's public debt to GDP ratio is expected to increase to 163.4% in 2004 (compared with 157.3% in 2003). Nonetheless, these figures exclude the debts of some public enterprises (outside General Government), whose financial situation tends to be opaque, as well as a variety of contingent liabilities in the pension, state-owned banking, and credit guarantee systems. 12 The Government's medium-term fiscal consolidation programme requires it to maintain its expenditure at or below its FY 2002 level until FY 2006, and to achieve a primary surplus by the early 2010s (the actual amount of surplus is unspecified). The FY 2004 budget amounts to 82.1 trillion, of which expenditure on public works accounts for 9.5% ( 7.8 trillion), down 3.3% from the FY 2003 budget, while the national debt service amounts to 17.6 trillion (21.4% of the budget), up 4.6% from 7 The BOJ is to conduct money market operations targeting the maintenance of the announced range of current account balances, which may, without such operations, fluctuate according to the demand for money. The BOJ is to provide more liquidity irrespective of the target if it recognizes a risk of financial market instability, such as a surge in liquidity demand. The BOJ has raised the target several times since March 2001, when it was initially set at 5 trillion; it was increased to 6 trillion in August 2001, trillion in December 2001, trillion in October 2002, and trillion in May The purchasing of stocks by the Bank of Japan ended on 30 September Between November 2002 and September 2004, it purchased stocks worth 2 trillion. 9 The year-on-year growth rate of the monetary base (i.e. cash in circulation and current accounts of financial institutions held at the BOJ) was 16.4% in 2003, while that of money supply (i.e. the sum of cash currency in circulation, demand deposits, quasi-money (such as time deposits) and negotiable time certificate of deposit) was 1.7% in 2003, suggesting that the increase of the monetary base induced only a small increase in money supply. This may be attributed to weakness in the monetary policy transmission mechanism, against a backdrop of persisting fragility of the financial system (as reflected in NPLs) and weaknesses in corporate balance sheets, and thus lack of investment demand. 10 See, for example, a speech made by a BOJ Policy Board member, 25 March Available (in Japanese) at: 11 OECD (2004a). Japan's public debt to GDP ratio includes the debt of the Japan Railway Settlement Corporation and the National Forest Special Account. 12 Research Institute of Economy, Trade and Industry, Policy debate. Available at: [5 November 2004].

16 Page 6 Trade Policy Review the FY 2003 budget. 13 With a view to increasing fiscal transparency, a study group in the Ministry of Finance began to create a balance sheet of the Japanese Government in 2000; the authorities indicate that each ministry and agency is currently preparing financial statements Japan's FY 2004 tax reform measures include: extension of tax cuts for residential mortgages, reduction of taxes on capital gains from land and housing and non-listed stocks, extension of the period for loss carried-forward from five years to seven years for corporations, and reform of taxation on pensions, including the abolition of a tax exemption for elderly and the reduction of the tax deduction in respect of pension income for those aged 65 and over. 15 Other changes in the taxation measures since the previous Review include tax cuts for IT or R&D-related investments. 11. The Government has also been considering reforms of the fiscal relationship between the central and local governments. To this end, the Government has decided to transfer about 3 trillion from personal income tax revenues to local inhabitants tax accounts by FY As an intermediate measure, about 3% ( 425 billion) of the expected personal income tax revenue ( 13.8 trillion) in FY 2004 is to be transferred to local governments in proportion to their population. (3) STRUCTURAL POLICIES 12. Since the previous Review, the Government has continued to emphasize structural reform. The Government's main policy direction for structural reform is described in the "Basic Policies for Economic and Fiscal Management and Structural Reform" formulated annually by the Council on Economic and Fiscal Policy. The 2003 Basic Policies stipulated, inter alia, that Japan would reduce impediments to business activities by eliminating various regulations and government interventions, creating Special Structural Reform Zones (see below) and reforming financial and corporate sectors. In the 2004 Basic Policies, issued in June 2004, the authorities emphasized, as a policy objective for FY 2005 and FY 2006, the construction of a socio-economic system led by the private sector (including privatization of Japan Post); reform in both the public and private sectors, particularly in the financial system; labour market reform; and pension and other areas of social security reform. The Government's concrete measures for regulatory reform are stipulated in the new three-year programme on regulatory reform, adopted in March (i) Financial system and corporate reform 13. Non-performing loans (NPLs) and overhanging debts have adversely affected the Japanese economy over the past decade. The Government's main policy agenda has thus included the reform of the financial sector, including disposal of NPLs, in order to improve the efficiency of the capital market. An efficient capital market, through which savings are channelled into profitable investment, is an essential factor in raising the productivity of the corporate sector. Government-led reform of 13 For details of the budget formulating process, see WTO (2003), Chapter I(2)(ii). 14 According to the Government Balance Sheet for FY 2002, the Government's assets totalled 765 trillion. According to Kurtzman et. al. (2004), out of 50 countries surveyed, Japan was ranked the 16 th "least opaque" country, as measured by their "opacity indices", which aim to indicate the degree to which countries lack "clear, accurate, easily discernible and widely accepted practices governing the relationships among businesses, investors, and governments, which form the basis of most small scale, high frequency risks." Japan's opacity index in 2004 was 28 (100 = complete opacity), while that for Finland was 13, the United States 21, Canada 23, and Germany 25. Opacity indices are available at: 15 The share of persons aged 65 or above in Japan's total population is estimated to reach 22.5% in 2010, 27.8% in 2020, and 29.6% in 2030.

17 Japan Page 7 Japan's financial system included in particular further disposal of NPLs, introduction of limits to the protection of deposits, and corporatizing/privatizing the Postal Savings and Insurance. 14. In October 2002, the Financial Services Agency (FSA) formulated a Program for Financial Revival (PFR), with the aim of, inter alia, halving by end-fy 2004 the ratio of NPLs to total credits held by major banks at the end of March To this end, the PFR stipulated support measures in case a financial institution falls into distress or faces a capital shortage; these measures include injection of public funds based on the Deposit Insurance Law, provision of liquidity through special loans by the Bank of Japan, and enhanced monitoring of financial institutions to which public support is provided. The disposal of NPLs has apparently progressed; the ratio of NPLs to the total lending of all banks decreased to 5.8% ( 26.6 trillion) in March 2004 (from 8.4% in March 2002). 16 Moreover, according to the results of FSA's special inspections of major banks' lending in April 2004, the ratio of loans classified as "in danger of bankruptcy", or below, to total lending declined. 17 In accordance with the PFR, the Government has made decisions to inject public funds into some distressed institutions Since 1 April 2002, full protection of bank deposits bearing interest has been limited to 10 million (and interest therefrom) per depositor per financial institution; previously, the Government had fully protected all deposits. Current deposits, ordinary deposits, and other miscellaneous liquid deposits continue to be fully protected until 31 March 2005; from April 2005, only deposits for payment and settlement purposes bearing no interest and redeemable on demand are to be fully protected. 16. The previous Postal Saving System, the largest financial institution in Japan, was reorganized into a part of a new state-run public corporation, Japan Post, in April It has been argued that the large share of Japan Post in savings and insurance, together with certain privileges it enjoys, may deter competition from the private sector. 20 Moreover, the large amount of money supplied by postal savings and insurance to finance public projects may distort the allocation of savings among various investments. 21 On 10 September 2004, the Government adopted a Basic Policy on the Privatization of the Japan Post, which stipulates privatization of Japan Post in The Basic Policy also envisages establishment of four joint-stock corporations, to deal with postal services, postal savings, postal life insurance, and the maintenance of the post office network, with one holding company controlling the 16 The ratio of NPLs to the total lending of major banks decreased to 5.2% ( 13.6 trillion) in March In accordance with the Financial Reconstruction Law, the FSA announces the status of NPLs held by all banks every six months. 17 The result of the April 2004 inspection shows that out of total lending of 10.5 trillion by 11 major banks to 133 companies, loans of 1.8 trillion (17.1% of the total) to 22 companies were classified as "in danger of bankruptcy" or below (i.e. "in de facto bankruptcy" or "in legal bankruptcy"); in the April 2002 inspection, the ratio of loans classified as "in danger of bankruptcy" or below accounted for 28.7% of total lending. These inspections have been carried out since October In May 2003, public funds were injected into Resona Holdings. In December 2003, the Deposit Insurance Corporation acquired all shares of the Ashikaga Bank, thus bringing it under government control. 19 At the end of June 2004, deposits in Japan Post's postal savings amounted to 226 trillion, which is about 16% of Japan's total households financial assets. In addition to the postal savings, deposits with Japan Post's insurance system, Kampo, were 119 trillion at end-march The Law Concerning Correspondence Delivery by Private-Sector Operators, which entered into force in April 2003, also allowed private-sector operators to engage in correspondence delivery business, which was once monopolized by the Government. 20 Japan Post also faces constraints such as universal service obligation, insurance and deposit ceiling regulations, limitations on the scope of products and services, and restrictions on asset management. 21 See MOF 2003, p. 6. Since FY 2001, the compulsory deposit of postal savings funds to the Trust Fund Bureau to finance public projects through the FILP has been abolished.

18 Page 8 Trade Policy Review four companies. The Government is to retain more than one third of the holding company's shares issued A growing awareness that ineffective corporate governance has contributed to the inefficient use of capital and labour in the corporate sector has prompted the Government to implement a number of policy measures since the previous Trade Policy Review of Japan. These include: an amendment to the Commercial Code, which involved the introduction of a new corporate governance structure and the relaxation of restrictions on issuance of stock options; and the revision of the Certified Public Accountants Law, which introduced a revised structure for overseeing auditors and provisions to enhance the independence of auditors from private companies under audit (Chapter III(5)(vii)). Other relevant regulatory changes include the amendment in 2003 to the Law on Special Measures for the Revitalization of Industrial Dynamism (Industrial Revitalization Law), which introduced additional tax measures related to mergers and acquisitions approved under the law; these measures are to expire before the end of March (ii) Pension reform 18. Responding to the rapid aging of the population, a law concerning Japan's public pension reform was approved by the Diet in June Reforms under the new law include annual increases in the contribution rates until 2017, gradual reduction of the benefit and increase in the government contribution, together with tax reform measures, until Questions have been raised on possible effects of pension reform on the Japanese economy, including whether the planned raise in contribution rates and the consequent increase in companies' expenditures may affect companies' employment strategies and increase unemployment, and whether the planned raise in contribution rates may reduce households' disposable income and thus reduce consumption. 24 The authorities are of the view that pension reform will help improve the financial soundness of the pension system. (iii) Regulatory reform 19. Sustained efforts have been made to gradually reduce regulatory intervention in various sectors, including energy, financial services, telecommunications, legal, and education services (Chapter IV(5)). In March 2004, the Council for the Promotion of Regulatory Reform issued a "Three-Year Program for Promoting Regulatory Reform (TPPRR)", which includes some 760 concrete measures (Chapter III(5)(v)). 25 Moreover, under the Special Zone for Structural Reform Act, which entered into force in April 2003, over 320 special zones were established during the first fiscal year of implementation (FY 2003). Within a particular zone, the Act allows relaxation or elimination of specific regulations; these included extending the period foreign researchers are allowed to stay in Japan from three years to five years, round-the-clock opening of the Customs, and permission for joint-stock corporations to engage in agriculture and lease farmland. The question arises as to whether such measures should be applied nationwide in the first place. The Government 22 Privatization of other public enterprises is under consideration. On 2 June 2004 a law to privatize Japan's four public highway corporations was approved by the Diet. According to the law, Japan's expressway public corporations are to be privatized by the end of March Japan's public pension system has a two-tier structure: the first tier is the national pension plan, which basically covers all Japanese citizens; in the second tier, based on salaries of participants, are employees' pension plans covering workers of private companies, and mutual aid pension plans covering civil servants. 24 See, for example, "Japanese Pension Reform, Don't Grow Old", The Economist, 18 December 2003; and Takayama (2004). 25 After the Council for Regulatory Reform expired at end-march 2004, a Council for the Promotion of Regulatory Reform and Headquarters for the Promotion of Regulatory Reform were established in 2004, with a view to, inter alia, overseeing the progress of the TPPRR.

19 Japan Page 9 is of the view that special zones are pragmatic solutions to the promotion of regulatory reform, which has often been resisted by local authorities and the private sector (presumably domestic firms), who apparently are in favour of existing regulations. The Headquarters for the Promotion of Special Zones, headed by the Prime Minister, has been discussing which deregulation measures applied to special zones would be beneficial for nationwide application. (4) DEVELOPMENTS IN TRADE AND FOREIGN DIRECT INVESTMENT 20. In 2003, the share of exports of goods and services in GDP was around 11.8% (11.2% in 2002) and the share of imports around 10.2% (9.9% in 2002). In 2003, Japan was the world's third largest exporter (counting the EU as one) and importer of goods. (i) Composition of merchandise trade 21. Manufactures accounted for about 93% of Japan's exports in 2003, up slightly from 92.8% in 2001 (Chart I.1). During the period , machinery and transport equipment remained Japan's most important merchandise export, accounting for 66.8% of total exports of goods in 2003; the increase of merchandise exports was mainly attributed to the increase in exports of machinery and transport equipment. 22. The share of primary imports increased in 2003, and that of manufactured imports declined slightly. Machinery and transport equipment continue to be Japan's most important merchandise imports, with a share of 27.6% in 2003, down slightly from (ii) Direction of merchandise trade 23. The United States remains the main destination for Japanese exports, attracting 24.9% of total Japanese exports in 2003, although the share declined by 5.5 percentage points compared with 2001 (Chart I.2). The share of Asia increased to 49.2% in 2003 (up from 43% in 2001); in particular, the share of China has continued to grow since During , the share of the European Union (15 members) in Japan's exports decreased to 15.3% and APEC's share decreased to 75.7%. 24. Since 2002, China has replaced the United States as Japan's main supplier of imports. China's share in Japan's total imports increased to 19.7% in 2003, while the United States' share declined to 15.6%. The share of East Asia as a source of imports continued to increase in 2003; APEC's share declined to 68.2% in (iii) Composition of trade in services 25. In 2003, Japanese cross-border sales (exports) of services increased, while its purchases (imports) declined (Table AI.1). The services deficit was reduced from 5.3 trillion in 2002 to 3.9 trillion in Deficits in both transportation and travel decreased in 2003.