1. This article is based on a speech given by Shin Nakahara, a member of the Policy Board of the Bank of Japan, to the Spanish Embassy in Tokyo on February 20, 2002.

March 5, 2002
Bank of Japan

Contents

1. 1. Introduction
2. 2. Monetary Policy Measures since March 2001 and Possible Policy Options in the Future
3. 3. Wild Card Play: Eradication of the Supply-Demand Gap and Government Bond Management Policy
4. 4. A Wild Card for Restoring Confidence in the Financial System
5. 5. Concluding Remarks

1. Introduction

Thank you very much Mr. Chairman. I am Shin Nakahara, a member of the Policy Board of the Bank of Japan. I would like to say first that it is an honor for me to attend this distinguished conference of EU financial counselors and to have this opportunity to talk to you today about Japan's economy and policy measures.

Recently, reports on Japan's economy have carried headlines such as "Terminally Ill," "No Hope," or even, "Bankrupt Japan." The tone of these articles, like their shocking headlines, is frankly astonishingly pessimistic. However, I have every faith in the Japan's economy's strong potential, because it remains a huge net external creditor, a large current-account surplus, a high savings rate, and vast accumulated household wealth. My own view of Japan's economy can be summarized as follows: it may harbor some substantial problems; however it is fully capable of reviving itself, as long as all economic players cooperate and direct their full energies at solving these problems.

First of all, let me spell out exactly what problems we are talking about. As I see it, the problems facing Japan's economy can be categorized into three sets. The first set consists of problems related to the widening gap between supply and demand. There is an excess of both capital and numbers of employees, with the flip side of the same coin being that the return on capital continues to be low; at the same time, labor's share of income remains at a relatively high level. There is, however, no compensating demand to match the increasing supply of capital and labor. It is likely that real GDP will be negative in fiscal 2001 and 2002. One of the factors behind this is business-cycle related: specifically the sharp deceleration of the global economy, and in particular of IT-related industry in the United States, since early 2001. Another factor is structural: Japan's economy, burdened with excess capital and high costs, is not well-suited to accommodate the rapid expansion of supply capacity in China and other emerging markets with low wage costs. Since neither the excess domestic capital stock nor high labor share have declined during this period, the gap between supply and demand is even wider now.

The second set of problems facing Japan's economy is fiscal in nature. The ratio of outstanding government debt to GDP has risen to 113.8 percent in 2001. The Council on Economic and Fiscal Policy forecasts that the primary balance will not be in the black until the beginning of fiscal 2010's. This huge fiscal deficit will become a burden on future generations. At the same time, government debt impairs the ability of the monetary authority to use its full discretion in the conduct of monetary policy. I will elaborate on this point later on.

The final, most immediate, and serious set of problems relates to non-performing loans (NPLs). According to the Financial Services Agency, although Japanese banks have disposed of 70 trillion yen of bad loans since 1992, NPLs have actually increased by 4 trillion yen. In addition, since 1992, a total 16 trillion yen of public money has been spent on cleaning up failed banks. In spite of this, concerns over Japan's financial system have not been dispelled at all. In fact, such worries are mounting, ahead of the start of limited deposit-insurance scheduled for April 2002.

I have just explained what I regard as the three sets of problems facing Japan's economy. Today, I would like to take this opportunity to discuss what must be done to resolve these problems, and what part the Bank of Japan can play in this process. But before I get into that, I want to start by explaining both the policy measures the Bank has taken in the past, and the possible measures that may be implemented in the future.

2. Monetary Policy Measures since March 2001 and Possible Policy Options in the Future

Led by IT-related industries, Japan's economy continued its recovery throughout the year 2000. However, following the sharp deceleration of the world economy which has been taking place since the end of 2000, Japan has once again entered an adjustment phase. To counter this, the Bank of Japan adopted some drastic policy measures in March 2001. First, the target for the Bank's money market operations was switched from the overnight interest rate to the outstanding balance of current accounts at the Bank, with the target amount set at 5 trillion yen, above the level of required reserves. Second, the Bank announced its intention of keeping these measures in place until the year-on-year increase in the consumer price index (CPI) stabilizes at zero percent or higher. When the economy continued to deteriorate after March 2001, the Bank compensated first by raising the target for current account balances from 5 trillion to 6 trillion yen, and then in August 2001 by increasing its outright purchases of long-term Japanese government bonds (JGBs). In September 2001, following the destabilization of financial and equity markets after the terrorist attacks in the United States, the Bank once again raised its target for current account balances, this time to "above" 6 trillion yen, supplying more ample funds to the money market, and lowering the official discount rate, which virtually sets a cap on short-term interest rates. At the end of last year, most members of the policy board shared the view that the economy was deteriorating further, and that the risk premium being demanded on assets with a lower credit rating was expanding. Given these conditions, the Bank recognized the need to raise the current account target again (this time to between 10 and 15 trillion yen), thus broadening the means at its disposal for providing liquidity to the markets.

I think that the quantitative policy measures the Bank of Japan has taken to date have had, as expected, at least three effects already.

First, needless to say, is the expansion of the monetary base brought about by the increase in the money stock. The monetary base as of the end of 2001 showed double-digit gains from its level in the previous year, due mainly to an increase in the balances of current accounts at the Bank. However, growth in the money stock (M2+CDs) has been limited. I think that this is largely attributable to two factors: the weak demand for money brought about by the existence of excess capital stock; and a decline in the effectiveness of the usual intermediary channels through which credit is multiplied, as a result of the existence of the NPLs.

Secondly, downward pressure has been maintained on interest rates, especially on instruments with a maturity of up to one year. In addition, there has been less volatility in medium- to long-term interest rates since 1997. In other words, interest rates have been essentially stable. However, the market has become very nervous recently, out of concern over the sustainability of the public finances and in fear that monetatization might push up the yield curve in the medium to longer ranges.

Lastly, ample liquidity provision by the Bank of Japan combined with the two effects discussed above has suppressed the credit uncertainty that stemmed from liquidity shortage. If we compare the yield gap of corporate bonds today (ranked according to their credit ratings) with the situation as it was in 1998 when corporate financing conditions tightened in general, we see that interest rate increase appears only in bonds with low ratings and that credit spreads are smaller this time.

On the other hand, policy measures taken by the Bank of Japan since March 2001 have not been effective in shaping economic expectations in corporate and household sectors that would increase their current levels of demand, nor have they been successful in encouraging financial institutions to hold riskier assets with higher returns. In other words, the policy measures since March 2001 have yet to succeed in pushing up the credit multiplier and exerting an effect on the economy. Technically speaking, the outstanding balance of current accounts at the Bank cannot be increased "without limit," since it cannot exceed the actual demand for funds by financial institutions. In recent days the total value of bids made in market operations has often fallen short of the amount being offered by the Bank, introducing the possibility that the Bank will be unable to maintain the higher targeted level. However, this type of quantitative easing policy is unprecedented. Opinion is split on its efficacy, even among academics. In practice, it was not until summer 2001 that the monetary base registered any substantial increase. Therefore, I think we need to maintain a high rate of expansion of the monetary base for a while, and wait and see the effect of this before we draw any conclusions.

If the current quantitative easing policy of targeting current account balances does not have the intended effect of increasing the credit multiplier and putting an end to deflation, then what other measures are to be considered?

One way to increase the money stock is by making use of instruments other than short-term interest rate targets and changes in the level of the monetary base. For instance, the central bank might target either the exchange rate or long-term interest rates; alternatively it might intervene in other private sector markets for loanable funds. However, each instrument has its difficulties. Foreign exchange cannot be used as an instrument of monetary policy under the Bank of Japan Law. Long-term interest rates are influenced by too many different factors to be reliably controllable. While the technologies for intervening in private sector markets such as those for stock, commercial paper, and corporate bonds, are not yet sufficiently developed. Not only are there issues here involving the soundness of the central bank's balance sheet, but it is also far from clear whether such unconventional measures can be implemented without overstepping the bounds of central bank discretion. The government and the Bank of Japan are of one accord about the pressing need to deal once and for all with deflation, however it cannot be denied that we are drawing close to the limit of what monetary policy alone is able to achieve. On the other hand, given the severity of the problems posed for the economy by spiraling deflationary pressure, I would not like to rule out a situation in which the Bank might choose to adopt a more unconventional monetary policy, closely coordinated with the appropriate actions by the fiscal authority.

There are some who say that the Bank of Japan should introduce inflation targeting as a way to stop deflation. Proponents of this idea say that inflation targeting leads to the creation of inflationary expectations; at the same time, they claim that nominal interest rates will rise by less than the full increase in inflationary expectations. The result is to push down real interest rates, which is the aim of inflation targeting.

Inflationary expectations are generated by many factors. Let us suppose for a moment that they do indeed depend upon the central bank's numerical target for inflation and that only a "numerical" target is meaningful. However, such a numerical target will not be achieved simply by expansion of the monetary base. Some people argue that the central bank should purchase NPLs or real estate properties in order to increase the money stock and to generate inflationary expectations. However, such policies go beyond the remit that the central bank is able independently to pursue. Moreover, the numerical target is only credible when there are suitable measures in place to realize it; and it will only succeed in generating inflation expectations if there is public confidence in these measures. Ultimately, the effectiveness of setting such a target is determined largely by the extent to which the target is credible to economic entities.

Assuming that the Bank is successful in generating inflationary expectations, what will happen to nominal interest rates? Nominal interest rates are determined by people's economic activities under inflation. Past data tell us that inflation and nominal interest rates typically move in tandem. In short, a surge of inflationary expectations unaccompanied by a rise in nominal interest rates is like a bed of roses: a pleasant fantasy, sadly far removed from our more brutal reality.

I believe that monetary policy is effective in stopping deflation in the long run because, under normal economic circumstances, price developments are monetary phenomena. The economy requires cash, which is highly liquid, as a common medium of exchange acceptable to all participants in economic activity, and it is the task of the monetary authority to provide necessary and sufficient money for this purpose. By providing this necessary and sufficient money, prices will stabilize. However, effective monetary policy requires that there is both a demand for money backed by economic activity and also a fully-functioning transmission mechanism. At present, there is scarcely any monetary demand coming from the cautious corporate and household sectors. In contrast, there is ample monetary demand coming from the public sector. Fiscal channels, therefore, are the only way to provide a large amount of money promptly. However, when we consider the issues surrounding the sustainability of the budget deficit, it is clear that this channel is not appropriate. Public anxiety about fiscal discipline is deeply-rooted and deserves serious attention.

As a final comment in connection with inflation targeting, I would like to add that setting a specific level of prices, as a framework of monetary policy in the long run and sharing the target with the government can be effective and enhance accountability. Needless to say, there needs to be a thorough examination of what kind of price indicators should be utilized and what level of price target should be set.

3. Wild Card Play: Eradication of the Supply-Demand Gap and Government Bond Management Policy

By this time, some of you may feel that there are no further monetary policy options available. But I do not believe this to be the case. For the time being, it is of paramount importance that the Bank supplies sufficient money to secure the stability of the financial system. This is because, with the start of limited deposit-insurance scheduled for April 2002, economic entities acting from precautionary motives may generate an unpredictable demand for money in the financial markets. Therefore, I am willing to study possible measures to supply further liquidity into the market, if this would be an effective means of dispelling credit anxiety. Moreover, it is necessary to examine the feasibility of increasing the number of channels available to the Bank for the expansion of the money stock.

At the same time, however, the Bank must restore the normal channels as well. This will be possible only when Japan's economy addresses its problems-the supply-demand gap, the fiscal deficit, and non-performing loans.

In a card game in which one must dispose of all the cards in one's hand in order to win, players must create an environment in which they can use up all their cards as soon as possible. At present, Japan's economic circumstances and the position of the Bank of Japan are not such that their cards can be played freely. Therefore, in order to create an environment in which it can play its other cards effectively, Japan must first deploy its wild cards. These wild cards are essential for Japan in the battle to stimulate its economy.

The first wild card consists of the structural reforms necessary to eradicate the supply-demand gap and to allow the efficient allocation of capital and labor resources to areas where there is demand. When we break down the GDP statistics by industry, we see that while construction, wholesale and retail are managing only low growth, the transport, communications, and service industries continue to maintain high growth rates. It is necessary to allocate capital and labor to these growing industries so that they can create goods and services that will generate new demand. I would also like to point out that there is a problem of income allocation among economic players in Japan. Since 1960, Japanese labor's share of income has grown sharply. This is in contrast to the stable share in the United States. During these years, the ratio of current profits to equipment for Japanese companies declined. What does this imply? First, if Japan's economy wants to achieve growth, then goods and services must target households. Second, if Japan wants to achieve recovery and growth in its corporate sector, it must lower labor's share of income. There may appear some small conflict between these two processes; nevertheless they must occur concurrently in the overall adjustment process of Japan's economy. During the allocation of capital and labor to growing industries, the share of capital will rise while that of labor will fall. Needless to say, further deregulation must take place as a precondition to this, so that corporate and household sectors can conduct economic activities freely.

The second wild card is fiscal consolidation. This will be achievable only when the government commits itself to sustainable management of the national debt. At the end of 2001, when the Bank of Japan decided to increase its outright purchases of JGBs as a way of supplying ample funds to the money market necessary to achieve the increased target for current account balances, long-term interest rates rose on the fear that it might undermine fiscal discipline. However, such operations represent one important tool with which the Bank of Japan can achieve its targeted level of current account balances. It is therefore vital to dispel fears for public finances, in order to allow the Bank a free rein to exercise its discretion in the pursuit of its quantitative easing policy. In a similar way, the bond market plunge at the end of 1998 was due to worries about a possible increase in JGB issues as a result of the fiscal expansionary policy at that time.

In the current severe circumstances, it is unrealistic to propose a Swedish style policy, which aims at balancing the budget in one business cycle. However, the government must strive to win back market confidence in solid government bond management, even though the Fiscal Structural Reform Law has been shelved, at least for the foreseeable future.

Reform of revenue and expenditure structure is also necessary to gain public confidence. In the area of expenditures, the efficiency of both central and local governments must improve, while administrative practice needs to become less rigid. On the revenue side, further discussion of the public burden is also indispensable. In Japan, the birth rate is declining while the population is aging. This points to an increase in the number of beneficiaries of public medical care and public pensions, while at the same time the size of the future generation who will pay taxes and shoulder the burden of public welfare is shrinking. Looking at the tax and social welfare burden as a proportion of national income, we see that the current ratio in Japan is relatively low compared with other countries. However, it is expected to surpass 50 percent over the medium to long term. Such an increase in this ratio will not be achieved without the assent of the future generation of taxpayers. In order to win this assent, the government needs to redress the ratio of direct and indirect taxes for individuals, because if it relies on income taxes to finance the aging society, the burden on the diminishing future generation will be heavy. A heavy burden reduces incentives to work, and thereby becomes a negative factor for the economy. At the same time, on the corporate side, the tax system must be remodeled in order to encourage companies both to make new investments and to form new businesses.

4. A Wild Card for Restoring Confidence in the Financial System

The final and the most important wild card is one for restoring confidence in the financial system by disposing of NPLs. More than 10 banks, and 140 shinkin banks and credit cooperatives have been liquidated or declared in a state of legal bankruptcy since the beginning of fiscal 1995. More than 16 trillion yen has been spent in disposing of these failed institutions. In addition, another 10 trillion yen of public funds have been used to provide capital injections. However, confidence in the financial sector has not yet been restored.

To begin with, it is essential that we have an accurate picture of the extent of NPLs held by banks. The government, financial institutions, politicians, and economists have their own yardstick for measuring bad loans. The scene is reminiscent of the Tower of Babel, with the lack of a common language causing anxiety about the state of Japan's financial system. According to the Financial Services Agency (FSA), aggregating the figures for 136 banks as of September 30, 2001, the total value of NPLs is 23.3 trillion yen--where, by NPLs, I mean specifically those classified as being made to borrowers belonging to the category "in danger of bankruptcy" or worse. Some people say that loans to borrowers "requiring attention" should be added to this figure for total NPLs, but I do not agree. Loans to borrowers requiring attention cannot be described as "non-performing." A comparison with the U.S. inspection criteria suggests that the category described as "loans made to borrowers requiring attention," according to the Japanese system of classification, would include all those loans classified as "substandard" and some of those classified as "special mention" according to the U.S. standard. Loan classification is an inherently difficult process, and one that is especially difficult in the case of small and medium-sized companies, because it requires lenders to engage in a qualitative evaluation of the loan in question: not merely taking into account obvious quantitative indicators and making judgments in accordance with standard benchmarks, but also bearing in mind a broad range of qualitative factors, such as long-term relationships with borrowers, the borrowers' management skills, and the long-term potential of the industry to which they belong. Improving the objectivity and the accuracy of such assessments is clearly vitally important, however it will inevitably take some time. According to FSA figures based on the numbers of loans made, 8.4 percent of loans to borrowers requiring attention as of March 2000 were downgraded into the category "in danger of bankruptcy" category or worse a year later, while 12.3 percent returned to the status of normal loans. In light of my experience at a private bank, these figures are entirely plausible. What the NPL category does include, however, is the portion of loans made to borrowers requiring attention that might deteriorate. Loans which fit this description are given as separate classification, and are lumped under the heading of loans "requiring special attention." Specifically, loans whose conditions are eased through interest reduction or postponement of principal payment will be categorized as loans requiring special attention. Broadly speaking, the total volume of NPLs should not only consist of those loans to borrowers in the category "in danger of bankruptcy" or worse, it should also include those loans deemed to "require special attention." As of the end of September 2001, the current best estimate of NPLs is 23.3 trillion yen plus the 13.5 trillion yen of loans which "require special attention," giving a total of 36.8 trillion yen. Admittedly the definition of loans "requiring special attention" is difficult and controversial. It might be possible that the actual figure for such loans is much bigger. It is certainly fair to say that the definition of loans "requiring special attention" should be both more detailed and more transparent. It was with this remit that the FSA set in motion its Special Inspection Task Force, and it is required that they will succeed in removing the cause of the misunderstanding as soon as possible.

Now, the question is this. Is the overall volume of NPLs too large to be resolved? During the 1980s and early 1990s, industrialized countries were plagued by NPL problems. When we compare the peak ratios of NPLs to total loans in these countries, we can see that the ratio in Japan is not exceptionally high by historic standards.

But this is not the view of the markets. Market participants do not trust the figures for NPLs publicized by the FSA. Although we do indeed need calm analysis and rational decision-making about both the scale of the NPLs and the best means of disposing of them, our first priority must be restoring public confidence in the financial system and regaining the trust of the markets. To this end, the relevant authorities' powers of inspection or examination should be substantially strengthened, thus enhancing the transparency of the financial sector. In addition, if banks which are insufficiently capitalized undermine public confidence in the financial system, the government should not hesitate to inject public funds into these banks. Needless to say, this is not to suggest that all banks should receive uniform and indiscriminate injections of public funds.

The question of why the markets don't trust the FSA's figures for NPLs deserves further attention. One answer to this, as I mentioned earlier, is the fact that the total volume of NPLs has not fallen at all for the past few years. This is the crux of the matter. In reality, because of the economic slump, the volume of newly-emerging NPLs has exceeded the volume which has been successfully disposed of. At the same time, as asset prices have declined so has the value of collateral, while the relative immaturity of the Japanese markets and of the legal framework to deal with loan disposals have hampered the process of writing off NPLs. A further problem affecting the disposal of NPLs has been Japanese banks' low levels of profitability. The banks need to develop new business models better suited to their relationships with corporations after the unwinding of cross shareholdings. However, it takes a long time for the banks' business model to transform itself from an old form based on obsolete relationships to a new shape based on the evaluation of credit risks and expected returns. Market confidence in Japan's financial system will not be restored unless financial institutions are able to reduce their NPLs.

Now, I want to focus on three detailed methods which will enable the NPL problem to be quickly and reliably resolved. First of all, banks should increase their provisions against NPLs including those which "require special attention" based on the results of the FSA inspectorate and by the Bank's examination. Even within this category of loans which "require special attention," banks should make efforts to differentiate between loans which have an especially high risk of subsequent downgrading and those where there is a better chance of a return to "normal" status. Clearly, the level of provision required for the former overwhelms that required for the latter. Banks must add provisions to close this gap.

Secondly, the functions of the Resolution and Collection Corporation (RCC) should be strengthened so that banks can completely remove bad loans from their balance sheets. The RCC should purchase large quantities of NPLs as soon as possible. It is even conceivable that the RCC be given the legal power of compulsory purchase at least of the loans of the borrowers "in danger of bankruptcy" or worse. The amendment to the law governing the RCC's activities made at the end of 2001 enabled it to purchase bad loans in the market. But this is not enough, because it does not yet give the RCC full powers to pursue corporate rehabilitation of troubled borrowers. For this reason, banks are unwilling to approach the RCC with their bad loans, while the borrowers themselves are understandably loath to see their debts being passed on to it. Human resources and know-how at the RCC must be fortified so that it can cooperate with the borrowers' main banks and contribute to the process of rehabilitation. For this purpose, the RCC should make use of the full range of banking resources available at the borrowers' main banks. At the same time, where main bank monitoring can be seen to be at fault, the RCC should make every effort to establish where responsibility for this lapse occurred in order to ensure full accountability in the future. Should the implementation of these necessary measures put excessive strain on any bank's capital position, then ,as I mentioned before, there would be adequate justification for the use of public funds to fortify the capital of such a bank. These procedures should be implemented as soon as possible, because the market is likely to be nervous until the end of March 2002, the end of fiscal 2001.

Lastly, in order for the banking sector to be more profitable, we must encourage further the reorganization of financial institutions, including public banks. Outstanding lending by public financial institutions amounts to 150 trillion yen today, which is 25 percent of total lending by private financial institutions. Public institutions have been able to expand their lending to this extent because they operate outside of the market mechanism. In order to stay in business, they require annual government subsidies equivalent to 0.4 percent of their total lending. Postal savings accounts, life insurance and postal annuity accounts deserve consideration, because to some extent they have distorted the underlying economic structure and interfered with the flow of funds. The number of Japanese banks is excessive, and in addition to this, the existence of public financial institutions squeezes the profits of private financial institutions even further. What are required are policies that promote competition and encourage reorganization of the banking sector. At the same time, the activities of public financial institutions should be kept strictly to a minimum, observing the fundamental economic principle that what can be done by the private sector is best left to the private sector.

5. Concluding remarks

In conclusion, I would like to share with you two thoughts about the fight to revitalize Japan's economy.

First of all, if Japan is serious about reviving its economy, this must be a battle fought on all fronts simultaneously. The Bank of Japan is not Horatio on the bridge. All economic players, including those in fiscal, financial, corporate and household sectors, must take part in this fight. To restore Japan's economy to strength, all economic players must cooperate in the strategic play of the 3 wild cards I have talked about to you today. They must act "all for one, and one for all," since it is only in this way that they will achieve victory.

Second, we must fully understand that this battle will take time. It will be a long time before Japan's economy overcomes pains caused by the structural reforms, starts growing again, and the credit creation mechanism once again starts to function normally. However, we have to make an unstinting effort in order to attain it. Third, we should take steps to ensure that the principles of market discipline are maintained, and that market mechanisms are allowed to function unimpeded. On this point, we have a lot to learn from the economic reforms carried out by you in the EU countries. Between the late 1970s and early 1980s, Europe was afflicted by the so-called "Euro pessimism." To combat this, EU countries made steady efforts to reduce fiscal deficits, to suppress inflation, and to enhance the efficiency of their industries, while at the same time encouraging individual economic entities to improve their management and take responsibility for the risks incurred during their own economic activities. As a result, 15 years later EU countries were able to launch their single currency with tremendous success, and their economies continue to enjoy relative prosperity today.

In closing, I would like to recall the statement with which I began this presentation: Japan's economy may harbor some substantial problems; however it is fully capable of reviving itself, as long as all economic players cooperate and direct their full energies at solving these problems. We have overcome many difficulties in the past, and we will do so again.

Thank you very much for your kind attention.