The Impact of the Rise in Natural Resource Prices
How Should a "Distributed Disinflation" Phase be Interpreted?
Februaly 21, 2005
For the past few years, natural resource prices have been rising at an increasing rate. There are a number of reasons for this phenomenon, but one major factor has been the rapid economic growth of developing countries. It is estimated that if China's economy continues to achieve growth of around 9%, the prices of natural resource imports to Japan will be 50% higher in two years' time than they are today.
The general response among Japanese companies has been for raw materials divisions to pass approximately two-thirds of the rise in input costs downstream. However, in the wake of the fall in production prices, processing divisions, far from passing on their additional costs, are "sharing" with distribution divisions the burden of the downward pressure on profits due to the fall in final sales prices.
There are two reasons for the difference in response: (i) differences in the degree of progress made in condensing business operations and (ii) the "deflation trap" that has developed in Japan's consumer market. In other words, faced with a fall in consumer prices driven by the weakness of household demand together with a rise in the prices of natural resource driven by rapid economic growth among the developing countries, the manufacturing sector has basically found it necessary to absorb the impact of the rise in input costs. Under these conditions, besides contending with intensifying global competition, processing divisions, which have relatively more room to strengthen their management position and increase their control over prices through business restructuring, are being asked to bear a heavier burden.
On this basis, an estimate of the impact of the rapid growth of the Chinese economy on the profits of Japan's corporate sector, taking into account both the rise in the prices of natural resources and export growth, suggests that (i) the rise in natural resource prices (21.1%) has exerted a downward pressure of ¥1.0 trillion on raw materials divisions and ¥1.9 trillion on processing divisions. Meanwhile, (ii) export growth (10.8%) has benefited raw materials divisions to the order of ¥0.6 trillion, processing divisions to the order of ¥1.3 trillion and the non-manufacturing sector to the order of ¥1.1 trillion. The net impact of (i) and (ii) on the overall economy is virtually zero, but if the manufacturing sector is taken in isolation, it will be found that the ordinary profit of raw materials divisions has fallen by ¥0.4 trillion and that of processing divisions by ¥0.7 trillion, or around 5% each.
On the other hand, if the retail price of consumer goods continues to fall at the rate of 0.8%, as it did in 2004, the price effect alone on the overall economy will exert a downward pressure on profits of the order of ¥1.0 trillion. Given the "reverse transfer" from distribution divisions, approximately ¥0.4 trillion of this will be borne by processing divisions. At the end of the day, if the fall in consumer prices and the rise in natural resource prices continue, they could, together, depress the ordinary profits of processing divisions by ¥1.1 trillion (more than 8%).
Overall, thanks to the progress it has made in overcoming the "three excesses" and the rise in external demand generated by worldwide economic expansion, Japan's corporate sector is achieving the highest levels of ordinary profit on record. However, this achievement is largely supported by a "volume economy", and an examination of price structures reveals that the corporate sector is facing "distributed disinflation" in which input and output prices vary between industries and between individual companies. If the corporate sector is to achieve sustained growth, it is essential that individual companies (i) be rigorous in the "selection and concentration" of management resources and increase its non-price competitiveness in the global market, and (ii) review how they pass on the fruits of success to their employees and establish conditions under which a virtuous circle of profit growth and employee income growth can arise, so as to break the present trend of "distributed disinflation".
Furthermore, a fundamental solution to the distortion in the distribution of cost burdens that has arisen in conjunction with the rise in natural resource prices can only be found if a stable upward trend in consumer prices is established. In the absence of the clear upward trend in employee incomes on which this depends, policy makers must act cautiously. In particular, they must give careful consideration to the timing of the downsizing of the fixed-rate tax reduction and future increases in the consumption tax rate, which will have a direct bearing on disposable incomes.
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Makoto Ishikawa / Hisashi Yamada