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Home > Announcements > Speeches and Statements > Speeches 1996 > Speech given by Yasuo Matsushita, Governor of the Bank of Japan, to the Yomiuri International Economic Society in Tokyo on October 11, 1996 (Financial Innovation, Financial Market Globalization, and Monetary Policy Management)
This article is excerpted and translated from a speech given by Yasuo Matsushita, Governor of the Bank of Japan, to the Yomiuri International Economic Society in Tokyo on October 11, 1996.
I greatly appreciate this opportunity to address the Yomiuri International Economic Society.
Today, I would like to first discuss recent monetary and economic conditions in Japan and the Bank of Japan's monetary policy management. I shall then review the financial innovations that are developing rapidly worldwide, the globalization of financialmarkets driven by these innovations, and monetary policy management in this newenvironment. I wish to convey to you the basic thinking behind the Bank's monetarypolicy management through today's talk.
First, with regard to the domestic economic situation, the Bank of Japan's judgment is that a moderate economic recovery continues.
In terms of domestic final demand, public and housing investments have maintained high levels to date. Business fixed investment in fiscal 1996 is expected to surpass the previous year's level for the first time in five years, according to the Bank of Japan's August TANKAN Report (Short-Term Economic Survey of Enterprises in Japan). Personal consumption continues to recover moderately in general, although some monthly fluctuations have been seen due to weather conditions and the effects of food poisoning.
This recovery in business fixed investment and personal consumption is underpinned by (1) the upward trend in corporate sales and profits in a wider range of industries and in smaller firms than previously observed; and (2) the favorable change in firms' stance toward fixed investment and employment reflecting the improvement in profits. Thus, it can be said that the mechanism of a self-sustained recovery, in which revitalized business activity leads to increased business fixed investment and personal consumption, is at work.
At the same time, however, the pace of production growth has remained slow on average. The Bank's August TANKAN Report indicated that the pace of recovery in business confidence had decelerated somewhat.
One of the factors behind such development is the continuing need for inventory adjustment in certain sectors. The semiconductor industry, in particular, has been burdened with excess inventories as the global supply and demand conditions deteriorated following the increase in production by chip manufacturers in East Asian countries since the latter half of 1995. Some raw materials industries, such as iron, steel, pulp, and paper, have also had to slash the high levels of inventories resulting from an overestimation of demand at the end of 1995.
Another factor that has maintained the pace of economic recovery moderate is the substantial decline in net exports (exports in excess of imports). As I shall explain in more detail later, one reason for this is that an increasing portion of certain domestically produced consumer and capital goods are being replaced by imports, with the expansion of the supply capacity of other East Asian economies.
However, it is highly likely that the downward pressures arising from these two factors will gradually attenuate. More recent developments indicate that production cutbacks in the iron and steel industry have led to significant progress in inventory adjustment, producing a recovery of the market conditions for certain product items in this industry. In addition, the depreciating trend of the yen since last year has started to have an effect on both exports and imports, gradually slowing the pace of decline in net exports.
In the meantime, public-sector investment, which has maintained a high level, is expected to decrease gradually in the latter half of this fiscal year.
On balance, the mechanism I mentioned a moment ago, namely, a virtuous cycle toward recovery originating from an upturn in business fixed investment and personal consumption, must gain further strength in order to place the economy firmly on a self-sustained recovery path.
In the management of monetary policy, therefore, the Bank of Japan will for the time being continue to monitor economic developments closely, placing an emphasis on further strengthening the foundation for an economic recovery.
Since the reduction of the official discount rate in July 1991, the Bank has consistently pursued a policy of monetary easing. In September 1995, the Bank lowered the official discount rate to 0.5 percent, the lowest level ever, and also encouraged further declines in money market rates. These measures were taken to counter the possibility that excessive price declines would adversely affect the overall economy, and to thereby encourage business confidence and put the economy back on the path of a self-sustained recovery. For more than a year since then, the Bank has maintained the low levels of money market rates, and a moderate economic recovery has restarted.
Nevertheless, we have met with criticisms and inquiries regarding the prolonged low interest rate levels. I shall, therefore, respond to these questions, especially to those regarding the effects of low interest rates on the household sector. But first, I would like to explain three channels through which monetary easing stimulates the economy, and how the measures to date have been able to make use of these channels to help bolster the economy.
The first channel via which monetary easing can positively influence the economy is the direct stimulation of firms' investment demand by the improvement of the profitability of investment. Specifically, business fixed investment is to a large extent determined by the projected profitability of investment, which is assessed by comparing the expected earnings from the investment with concomitant interest payments. It seems that the expected returns on investment have recently recovered to a level that sufficiently exceeds firms' interest payments, due to the notable decline in interest rates, and that this improvement has underpinned the recovery in business fixed investment.
The lowering of interest rates has also had direct effects on housing investment, lower housing loan interest rates having boosted purchases of housing. Recent figures for new housing starts have reached as high as 1.6 million annually, after hitting bottom in the summer of 1995 at 1.3 million.
The second channel through which the economy may be stimulated by monetary easing is the strengthening of corporate and household confidence underlying their investment and consumption, by the underpinning of asset prices. The prices of stock, land, and other assets are, in theory, equal to the present value, the total future earnings expected to be achieved through the utilization of the assets discounted by interest rates. Lower interest rates, therefore, in theory serve to increase the present value or the prices of assets.
Although this theory may not always hold in practice due to frequent changes in the earnings outlook, stock prices, for example, have risen by approximately 50 percent since bottoming out in July 1995. In contrast, land prices, especially commercial land prices, are still on a declining trend reflecting the ongoing adjustment following the bursting of the economic "bubble." However, signs of change have begun to appear recently in the environment surrounding land prices, such as a rise in the office occupancy rate and a slower pace of decline in rents. It can be considered that the support for asset prices through monetary easing has prevented confidence of the corporate and household sectors from waning further and has, as a result, encouraged investment and consumption by these sectors.
The third channel through which the effects of monetary easing may be transmitted is the boosting of corporate profits by the reduction of firms' interest payments. This in turn can strengthen the investment demand of firms and underpin the demand for labor. Recent developments in corporate profits indicate that large manufacturing firms expect an increase for the third consecutive year. Their profitability has reached the level which was achieved in past business cycles when the strength of the recovery had become fairly well established. Profits of large non-manufacturing firms and small and medium-sized firms, whose business conditions were previously slow to improve, are also expected to show a steady recovery this fiscal year.
While the rigorous restructuring efforts by firms have contributed greatly tothese improvements in profits, the reduction in interest payments brought about by the lower interest rates has also played a significant role. Reflecting the improvement in corporate profits and the gradual recovery of the overall economy, labor market conditions have also begun to improve recently.
Some argue that the third channel, via which monetary easing has helped to boost the economy through reduced interest payments of firms, has impaired the income of the household sector. It is certainly true that the net interest income of the household sector has decreased. However, the Bank currently places priority on realizing a self-sustained recovery through the permeation of the effects of monetary easing throughout the economy, so that every economic sector in the nation can benefit from the recovery. Specifically, if monetary policy boosts economic activity as a whole by revitalizing business activity, it will thereby benefit the household sector by increasing the number of people employed and employment income.
Looking at developments in the income of the household sector, interest income and interest payments have both declined during the five years since the beginning of monetary easing, and this has led to an approximately 8-trillion decrease in net interest income. Meanwhile, employment income of the household sector has increased by approximately 40 trillion Yen. For the household sector as a whole, therefore, there has been a reasonable increase in income during the five-year period I realize, however, that it is impossible to generalize from this data that every household is better off, since various types of households exist in terms of income sources. It pains me to think of the difficult situation faced by those households which depend largely on interest income.
Having said that, the effects of monetary easing are undoubtedly steadily penetrating the overall household sector through increased employment income. The recent gradual improvement in personal consumption is a reflection of this growth in household income. I would very much hope that you will understand that, through this mechanism, monetary easing underpins economic recovery and benefits the entire nation, including the household sector.
The Bank believes that monetary policy should be managed according to the prevailing condition of the economy as a whole. The Japanese economy today is at a crucial phase in its transition to a firm, self-sustained recovery. The Bank of Japan, therefore, is managing monetary policy with an emphasis on further strengthening the foundation for an economic recovery.
I would now like to move on to the main themes of today's speech; financial innovations, financial market globalization, and monetary policy management. Today, technological innovation and globalization are interacting and proceeding in both the real economy and the financial sector. Let me start with the developments in the real economy.
One of the features of the world economy in recent years is the further acceleration of economic globalization, particularly the strengthening of the relationship between the emerging economies and the industrialized countries. As an integral part of this globalization, the Japanese economy is strengthening its ties with the rapidly developing East Asian economies in terms of both trade and direct investment.
Another feature is the progress of a horizontal division of labor among various economies in the world, which is occurring with the intensified competition. Reflecting clearly this new international division of labor, a significant development in Japan's trade with other East Asian economies in recent years has been that exports of capital-intensive goods, such as electronic parts and office machinery, have been expanding rapidly, while imports of labor-intensive goods, such as household electric appliances and clothing, have been increasing significantly.
Another significant development reflecting this new international division of labor is the specialization by individual countries in one area of a specific industry, perhaps in one specific intermediate good or in one specific manufacturing process. A typical example is the computer-related industry. In this sector, there is currently a global production system in which East Asian countries other than Japan produce panels, keyboards, and semiconductors; Japan focuses on semiconductors and liquid crystal display parts; and the United States manufactures software and central processing units. The recent trade structure of Japan in which electronic equipment and electronic parts account for a large portion of both exports and imports reflects this international division of labor.
Certainly, this rapid economic globalization is largely attributable to the fast industrialization of the emerging economies, achieved through improved industrial infrastructures and transfers of technology from the industrialized countries. At the same time, the benefits of technological breakthroughs in information processing and communications industries cannot be overlooked. Such technological advances have enabled firms to allocate manufacturing processes or bases for inventory storage or sales in a number of countries, and to manage them optimally.
Economic globalization can therefore be defined as a process in which optimal allocation of resources is realized across borders reflecting technological innovations and increased international competition, thereby improving economic efficiency. Such economic globalization continues to proceed apace, contributing to further development of the world economy as a whole.
However, the trend of globalization has also placed adjustment pressures on Japan's industrial structure, spurring it to adapt to the new international division of labor.
For example, amid intense global competition, firms are searching throughout the world for the most favorable location for production in terms of cost, while working to preserve and improve product quality. An increasing number of Japanese manufacturers have been relocating their production bases outside Japan to other East Asian countries, where significant progress in industrialization has been seen, as part of their managerial efforts to survive competition.
Furthermore, a wider range of products and services have become exposed to severe international competition and, as a result, downward pressures have grown on domestic prices to narrow the existing price differentials between Japanese and overseas markets, inducing a "price revolution" in Japan. This trend has spread beyond the manufacturing sector to the non-manufacturing sector, whose prices had more or less been protected by regulations and various domestic business practices.
It is undeniable that such structural adjustment pressures have hampered the current economic recovery. However, the adjustment is indispensable for the Japanese economy to adapt to the changes in the world, and the resulting transformation of the industrial structure in Japan can be expected to produce further efficiency and renewed growth in the economy. It is of great importance, therefore, that the structural adjustment continue to be promoted to realize a more advanced industrial structure. Further, in order for the structural adjustment to proceed smoothly, it is necessary that a stable macroeconomic environment be maintained through the appropriate management of monetary and fiscal policies, and that the potential strength of the private sector be fully drawn out through drastic deregulation.
The recent rapid expansion of the mobile telecommunications market and increases in the business fixed investment of retailers in Japan followed deregulation in the telecommunications and retail sectors. As evidenced by these examples, I would like to emphasize once again that amid this economic globalization, effective deregulation has become increasingly important for the Japanese economy.
Propelled by such changes in the real economy, the financial markets are also undergoing globalization, and at an even faster pace. Here again, the major driving force has been the rapid progress in information processing and telecommunications technology.
An important aspect of financial business is exchanging transfer instructions for funds and securities and processing the trades on books. Another important aspect is gathering and analyzing information regarding the risks and returns associated with financial transactions (those arising from changes in the creditworthiness of the debtors or in the prices of assets) and also intermediating and underwriting such risks and returns. It can thus be said that financial business basically requires advanced techniques of data processing, and accordingly, benefits greatly from the progress in computer and network technology.
For example, in large-value funds settlement, electronic means have been widely used. Some new computerized methods are now being tested for small-value payments. One typical example is the recent trials of electronic money. These new developments in the area of payment and settlement could not have taken place had it not been for advances in telecommunication networks and computer technology.
Furthermore, new types of financial instruments such as derivatives and securitized products have grown rapidly in financial markets in recent years. These new instruments have been developed owing to progress in computer technology, which has facilitated statistical analysis and management of risks.
I would like to explain this development in a little more detail. Derivatives such as futures and options differ from bank loans, bonds, stocks, and other conventional financial instruments, in that certain elements, namely, credit risk, interest rate risk, and price risk, are separated from the underlying instruments, developed into individual financial products, and given a market life of their own. These elements can also be combined in various ways to meet the diverse needs of customers. For example, interest rate futures are a tool for transacting only the interest rate risk, detached from the credit risk of the original debtor. Conversely, credit derivatives carry only the risk of changes in the creditworthiness of the debtor, separated from the interest rate risks.
In general, these new financial instruments are perceived as extremely complex and difficult to deal in. However, as explained above, they are designed to carry one specific financial function, or a combination of functions based on different needs, making it much easier for investors and firms to select instruments that best suit their objectives, such as taking or hedging risks. In addition, derivatives can be easily standardized and can therefore be traded in a market with diverse participants. As a result, contracts such as currency futures and options as well as interest rate swaps are now traded 24 hours a day throughout the world, across borders.
The expansion of these new financial instruments has contributed to improving the efficiency of the financial markets as a whole, by heightening market liquidity through an increase in market participants and by facilitating arbitrage between different financial products. Such developments have also been strengthening the linkage between financial markets around the world, accelerating the global market integration.
According to a recent survey by the Bank for International Settlements (BIS), the notional amount of global over-the-counter (OTC) derivatives outstanding has reached approximately $48 trillion. The Japanese market today accounts for one sixth of the global transactions, a reflection of its integration into the global linkage. The fact that it has only been a decade since the emergence of derivatives was clearly recognized shows how fast the use of these new instruments has grown.
The progress of financial innovation thus promotes market efficiency. Therefore, it is essential that an environment in which the designing and trading of such innovative instruments are unrestricted be established for the further development of financial markets. Derivatives tend to remind people of notorious incidents in which massive losses were incurred. These, however, were strictly a problem of individual risk management. It should be remembered that, fundamentally, derivatives have provided diverse market participants with flexible and efficient means of hedging risks. The essential point is that each market participant must engage in transactions under appropriate risk management and that the development and trading of new financial products should not be impeded.
In the Japanese financial market, as I mentioned earlier, the turnover of derivatives contracts has already expanded to a substantial amount. However, the type of contracts lacks diversity, with the growth in OTC transactions being mainly in interest rate- and currency-related contracts. Transactions of securitized instruments have only just started to grow in Japan, and various institutional improvements are necessary for further development of these instruments.
In addition, these new types of financial instruments have the distinct feature of identifying and separating functions and risks involved in various financial transactions, unlike conventional financial instruments, such as bank deposits and loans, stocks, bonds, and insurance products, which are provided in each traditional segment of the industry. It will therefore also be necessary in the future to study the most appropriate institutional framework, including a review of the traditional segmentation of financial markets and businesses, to enhance the efficiency and stability of the Japanese financial market through the development of these new types of financial instruments.
What are the implications of these financial innovations and the resulting progress in financial market globalization for monetary policy management? Before discussing these implications, let me first explain the Bank's views on the questions that are frequently raised, regarding the objectives and the effectiveness of monetary policy amid globalization.
One of those questions is whether central banks should strengthen international coordination of interest rate policy for the purpose of stabilizing foreign exchange rates, as interest rates now have a greater and more immediate influence on them.
As I have stated on various occasions before, the Bank holds the view that, while exchange rate fluctuations have significant impact on the domestic economy including prices, monetary policy should be managed appropriately with the aim of stabilizing prices based on an assessment of the overall condition of the domestic economy, which includes the effects of exchange rate fluctuations.
Placing too much emphasis on exchange rate stability in managing monetary policy is likely to undermine the foundations of domestic price stability and destabilize the economy, as proved by experiences since the shift to the floating exchange rate system. The instability of one nation's economy may in turn adversely affect the world economy as a whole. The larger the economy becomes, as in the case of Japan, the stronger the global effects of its instability grows. Therefore, monetary policy should essentially be focused on maintaining price stability in the country, and on thereby achieving sustainable economic growth. When economies are stabilized through price stability, exchange rates will also stabilize reflecting the economic fundamentals of the countries concerned. This reasoning has become commonly accepted by the G-7 and other industrialized countries.
Another question that we are often asked in relation to financial market globalization is whether it has become more difficult for central banks to conduct monetary policy autonomously, and whether domestic interest rates can be disrupted by shifts in the interest rates of other countries, as the effects of interest rate fluctuations in one country are easily transmitted to other countries through globalized financial markets.
The Bank believes that a central bank is able to guide money market rates in the country without being unduly affected by the interest rate developments occurring in other countries, and that the shorter the term of the market rate, the less the influence. This is because money market rates are influenced mainly by a central bank's stance toward money market operations rather than by expectations of short-term fluctuations in foreign exchange rates. The differentials between domestic and overseas short-term interest rates will vary according to movements in money market rates, but such changes will be absorbed essentially by the spread between the spot and forward foreign exchange rates. That being the case, there is no cause for concern regarding the central bank's autonomy in its monetary policy.
With regard to long-term interest rates, the real interest rates of various countries tend to converge over a long period, as arbitrage transactions between financial markets become more active. However, this requires that the exchange rates be determined based on the inflation differentials between those countries. As this precondition is satisfied only in the long run, such convergence of real long-term interest rates will only be seen in the long run.
Foreign exchange rates fluctuate in the short term, however, due to various factors such as the prevailing economic and interest rate conditions in individual countries. Long-term interest rates of a country in the short run will thus also shift almost independently of rates in other countries. Such short-run movements in long-term interest rates of a country will basically reflect the recent and prospective developments in the economy and in the interest rate reflecting the Bank's policy. It can be seen therefore that the extent to which short-term fluctuations in long-term interest rates in one country affect the rates of other countries is rather limited.
Thus, even with the ongoing financial market globalization, the autonomy of a country's monetary policy will not be restricted, and the degree to which movements in the long-term interest rates of other countries affect its domestic rates will not be significant.
From the Bank's views that I have just explained, you may have gained an impression that nothing has changed regarding monetary policy management as a result of financial market globalization. It is true that the objective of monetary policy remains unchanged, and there is little concern that the autonomy and the effectiveness of monetary policy will be diminished by the international linkages of interest rates. However, with the globalization of financial markets, the range of market participants in a country's financial markets has expanded beyond its borders and, as a result, the markets have grown extremely large and their efficiency has been improved. In the light of these changes, the elements that the central banks must take into consideration in order to ensure rapid permeation of the effects of monetary policy while ensuring market stability are definitely changing and expanding.
This is due to the greater role the expectations of market participants have come to play in the formation of interest rates and prices. Accordingly, an incident occurring in one corner of the world can now trigger immediate price adjustments across markets, as market participants throughout the world will instantly react based on the changes in their expectations. Especially with the growth of derivatives, there is now a greater tendency in the financial markets to react to various economic events by "reading one step ahead." In the context of economic policy management, this means that when there is a change in economic policy, the market will react by predicting not only the immediate effects but also subsequent policy developments.
In this new environment there is the advantage that policy effects can be transmitted instantaneously throughout the markets, so long as the markets have confidence in policy management. Conversely, if the markets do not have such confidence, even appropriate conduct of policy may not be able to convince markets to react in the direction intended by the policy authorities, due to the markets' anticipation that policy may once again be guided in the wrong direction in the future. Such a situation can be called "the market's revolt."
The economic policy of a country is under constant scrutiny by market participants throughout the world and, accordingly, monetary policy needs to be managed with full awareness of such market evaluation. What is most important in reinforcing the effectiveness of monetary policy under these circumstances is to retain market confidence in the central bank's ability to achieve price stability, the objective of monetary policy.
The Bank of Japan is making continuous efforts to retain market confidence in its policies in this regard.
The obvious precondition for retaining market confidence is to manage monetary policy appropriately at all times with the aim of stabilizing prices based on accurate judgment of the economic circumstances.
Let me further elaborate on this point. Prices in the industrialized countries have remained relatively stable since the beginning of the 1990s. It has been pointed out that this can be attributed to the increased imports of low-priced goods from the developing countries of Asia, Latin America, and former socialist economies. Some have even suggested that the malady of inflation has vanished in the industrialized economies due to this structural change in the world economy.
The inflow of such low-priced goods from abroad is indeed most likely having the effect of pushing down prices in the industrialized countries. However, it does not necessarily guarantee the stability of prices as a whole, since it is only the prices of relevant goods and services that decline. For example, if the economy of a country overheats and the domestic supply and demand conditions tighten as a result, inflow of low-priced goods will not be enough to counter the upward pressures on overall domestic prices.
Prices are ultimately determined over a somewhat longer term by macroeconomic conditions, such as the supply and demand in the economy as a whole, inflationary expectations, and the amount of money supply, and monetary policy plays an important role in controlling these conditions.
For example, in the United States, imports of low-priced intermediate goods from the emerging economies increased in the latter half of the 1980s. However, prices in general have been stable since then fundamentally because of the series of preemptive policy responses by the Federal Reserve rather than the increase in low-priced imports: the Federal Reserve succeeded in suppressing inflationary expectations by taking measures aimed at curbing potential pressures for a rise in prices induced by domestic economic expansion. Also in Europe, it has been the stringent monetary policy stance against inflation along with the efforts for fiscal consolidation, both implemented with a view to satisfying the Maastricht criteria, that have made the most significant contribution to stabilizing prices.
The Bank of Japan, too, intends to manage monetary policy appropriately with the aim of maintaining price stability, preventing inflation or deflation of domestic prices.
Another effort that is necessary in retaining market confidence is to improve the Bank's accountability in policy management by providing adequate and appropriate explanation of the Bank's economic outlook and its views behind its policy management. The Bank has provided detailed explanation in this regard at press conferences, in speeches, and at other similar opportunities. In addition, in 1995, the Bank began to announce publicly all significant changes in its policy stance on market operations and to clarify the views behind the changes. This year, the Bank made improvements in the monthly and annual reports of the Policy Board to offer more details on the Board's decisions and the thinking behind them. Furthermore, the Bank has started to release immediately information on daily monetary operations through commercial information vendors and also to publish press releases concerning policy changes, TANKAN Reports, and other data via computer networks and other means, to facilitate access by the public in general.
The Bank is by no means complacent and will continue to contemplate ways to further improve accountability by enhancing the transparency of policy decisions.
In addition to such efforts by the Bank, it is important that both the process of and the responsibilities for monetary policy decisions remain clear in the eyes of domestic and overseas market participants, in order for market confidence to be retained. When they assimilate information regarding monetary policy in Japan, domestic and overseas financial markets may react in a way totally unintended by the Bank, or may misunderstand the Bank's real intentions. The Bank believes that independence of the central bank regarding monetary policy management should be clearly established, so that the central bank will be able to respond flexibly to developments in the market and market confidence in policy management will be improved. This in turn will reduce the risk of the Bank's being misunderstood by the markets and will further accelerate the permeation of policy effects.
I would like to emphasize that this is what the Bank considers the true significance of central bank independence in the current financial and economic framework, when a review of the Bank of Japan Law is being deliberated by the Central Bank Study Group, an advisory panel to the Prime Minister.
I have discussed today the background to the ongoing financial market globalization and monetary policy management amid such globalization. To summarize what I have said today, (1) even with the ongoing financial market globalization, the objective of monetary policy will continue to be domestic price stability; (2) however, market confidence in the central bank is becoming increasingly important to ensure rapid permeation of policy effects while maintaining market stability; (3) while the Bank itself will continue with its efforts in that direction, it is desirable that independence of the central bank concerning monetary policy be established; and (4) financial markets should be further improved to accommodate to the recent changes in the financial environment.
In addition to the above, central banks today face a fundamental need to strengthen cooperation with the monetary authorities of other countries to maintain the stability of the globalized financial systems. Today, I will only mention the need for such cooperation, as I have no time to go into details.
The Bank of Japan will continue to work on the various issues that I have discussed, and I would most appreciate your kind understanding and cooperation.
I am most grateful for your kind attention.