For several years we have argued that Japanese economic revival will happen only when the nation's high-cost structure is rectified. We think this can be achieved by better utilization of corporate assets and human resources and by the adoption of policies to stimulate demand. We have also emphasized the importance of measures designed to step up decentralization and to deal with a declining birthrate and the aging of society, such as policies to promote greater work force participation by women. The current economic recovery is essentially cyclical in nature, and the pace of reforms has been gradual. Nonetheless, we see progress being made in the efficient utilization of human and physical resources. Companies have trimmed excess capital despite substantial increases in capex, and more efficient use of human resources—achieved through a transition to productivity-driven wage structures—has begun to spread from manufacturing to no-manufacturing sectors. Moreover, measures have been established to deal with an aging society, including the creation of more daycare facilities and the deregulation of temporary employment services.

The interaction of three factors—restraint in wage growth, growth in cheap imports, and effective utilization of migrant workers—enabled steady US economic growth during the 1990s. More recently, the US economy has shown signs of change, such as the sharp increase in the "twin deficits." Meanwhile, China, which now runs the world's largest trade surplus with the US, has allowed its currency to remain undervalued. We do not expect US pressure for a revaluation of the yuan to weaken going forward. But at the same time, we do not think the US trade deficit with China would disappear even if the yuan were to rise by 50%. If anything, a revaluation could remove one of the three pillars of recent US economic stability—cheap imports. Finally, Japan's industrial structure is not as advanced as that of the US, and its labor markets are not as flexible. While a major revaluation of the yuan might provide a short-term stimulus for Japan, it would only delay the development of the nation's industrial structure in the medium to longer term.

Provided that the US current-account deficit continues to widen, a sharp decline in the dollar triggered by the yuan remains a possibility. Even if dollar weakness did not lead to concerns about the US currency—essentially concerns about how the US current-account deficit is to be financed—we think it would have a large adverse impact on the global economy, and hence the US economy. A falling dollar would dampen US domestic demand through higher import prices. In view of the size of the US economy, lower imports would trigger a decline in global demand, which in turn would weigh on US exports. According to our medium-term model for the US economy, a 20% depreciation of the dollar would produce a 1% contraction in the global economy. In this simulation, the short-term interest rates is assumed to be fixed. Furthermore, if the interest rate becomes an endogenous index, a 20% appreciation of the dollar would inflict much more damage on the world economy. In this scenario, Japan would suffer the double blow of a stronger yen and weaker global demand, thereby exacerbating deflationary pressures.

The economic structure of the Pacific Rim is undergoing substantial changes triggered by the US twin deficits and the problem of the yuan. Efforts to revive the Japanese economy are urgently needed if Japan is to respond flexibly to these external changes. We have long argued that the promotion of bad-loan disposals, deregulation, and privatization are needed to rectify Japan's high-cost structure, and we think that measures to promote foreign direct investment in Japan would also be effective in this regard. In our view, it is critical to promote Japanese economic revival and not rely solely upon exchange rate adjustments.

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