What will happen if there is a Recurrence of Financial Instability in the EU? In this report we examine the following: (1) Brexit, (2) The Secular Stagnation Theory, and (3) The Gini Coefficient and Economic Inequality(No.190)

◆Downside risk remains for the Japanese economy due to global economic factors:In light of the 1st preliminary Apr-Jun 2016 GDP release (Cabinet Office) we have revised our economic growth outlook. We now forecast real GDP growth of +0.9% in comparison with the previous year for FY16 (+0.7% in the previous forecast), and +0.9% in comparison with the previous year for FY17 (+0.7% in the previous forecast). Japan’s economy remains in a lull, but we expect it to recover gradually due to the following domestic factors: (1) growth in real wages, (2) low price of crude oil and improvement in terms of trade, and (3) domestic factors including the development and implementation of an economic stimulus package. However, caution is needed regarding downside risk in the global economy, especially that of China. In this outlook we consider the following issues.

◆What will happen if there is a Recurrence of Financial Instability in the EU Due to Brexit?:In Chapter 2 we present the results of DIR’s quantitative analysis of risks which could occur via the global financial and banking system as a result of the Brexit decision in the UK. The most immediate risk is a possible collapse in real estate prices in the UK. The effects of this occurring would most likely be limited as far as both UK banks and the UK economy are concerned, with limited effect on the world economy as well. Similarly, the problem of the disposal of nonperforming loans in Italy would be a situation with a fairly strong impact on the Italian economy, but without much serious impact on the world economy. However, if both of these events were to occur simultaneously, the compound effects could push the entire European financial system into a state of crisis, possibly bringing world GDP down by 2.7% and Japan’s GDP by as much as 1.9%. The European financial system will likely be watched closely for some time to come.

◆Evaluating economic stimulus packages for Japan in light of secular stagnation theory:We expect that the advanced nations will actively pursue proactive means of avoiding secular stagnation in the world economy in the future, such as the practice of wise spending. The Japanese government made the decision in August to put together a large-scale supplementary budget. However, with its huge fiscal deficit, Japan is not in the position to engage in excessive spending on economic stimulus. It is therefore essential to push through structural reforms for the purpose of encouraging future growth and to continue promoting growth strategy while the economy is on the up side due to increased public spending. According to our estimates, potential GDP can be increased by around 24 trillion yen by encouraging growth in the labor participation rate through labor market reforms and by extending the work hours of part-time workers.

◆The Gini Coefficient and economic inequality in Japan ? economic policy challenges: In Chapter 4 we take a new look at the problem of income inequality in Japan through an international comparison, and consider future policy issues related to this problem. Looked at from an international perspective, Japan’s income gap expanded between the years 1985 and 2000. However, between the years 2000 and 2009 it does not appear to have expanded further. The problem that Japan needs to solve in the future is not income inequality, but decline in income. In order to shake off the problem of income decline, there are three problems which Japan must come to grips with. These are: 1. Resolve the income gap between regular employees and non-regular employees, 2. Handle the problems of the low-income population ? in the short-term a policy to provide income support may be quite valid, but from the mid to long-term view, raising the value of human capital is more desirable, and 3. Raise the minimum wage in order to increase the level of overall wages.

◆Risk factors facing Japan’s economy:Risk factors for the Japanese economy are: (1) The downward swing of China’s economy, (2) Tumult in the economies of emerging nations in response to the US exit strategy, (3) A strong yen / weak stock market situation brought on by risk-off behavior of investors due to geopolitical risk, and (4) The UK’s withdrawal from the EU (Brexit), and deleveraging at EU financial institutions. Our outlook for China’s economy is optimistic in the short-term and pessimistic in the mid to long-term. Looking at China’s economic situation in a somewhat reductive way, the fact is that China’s government holds treasury funds totaling between 600 to 800 tril yen with which it is standing up to under 1,000 tril yen in excessive lending and over 550 tril yen in excess capital stock. China is expected to be able to avoid the bottom falling out of its economy for a little while, but in the mid to long-term, there is risk of a massive capital stock adjustment.

◆BOJ’s monetary policy:We expect additional monetary easing measures by the BOJ to be initiated after September this year. The Bank of Japan has been in a long-term battle with the problem of deflation, and one of its biggest challenges is to restructure its monetary policy in a way that it can become more sustainable.

Our assumptions
◆Public works spending is expected to increase by +7.4% in FY16, and then decrease by -2.9% in FY17.
◆Average exchange rate of Y103.2/$ in FY16, and Y101.5/$ in FY17.
◆US real GDP growth of +1.5% in CY16, and +2.2% in CY17.