Home > About the Bank > Speeches and Statements > Speeches 1996–2010 > Speeches 1998 > Summary of the speech given by Masaru Hayami Governor, the Bank of Japan to the Kisaragi-kai meeting in Tokyo on December 22, 1998 (Recent Economic Conditions in Japan)

Recent Economic Conditions in Japan
---The role of a central bank and its balance sheet---

A summary of the speech given by Masaru Hayami Governor, the Bank of Japan to the Kisaragi-kai meeting in Tokyo on December 22, 1998

December 22, 1998
Bank of Japan

I. Economic Conditions and Monetary Policy Management

Looking at the economy, we have recently seen some bright signs such as an increase in public investment and exports, a deceleration in the decline of production, and, on the financial front some easing of uncertainty with respect to corporate fund-raising over the year-end period.

It is still uncertain at this stage whether such bright signs suggest a recovery from the current vicious circle or just a pause before further hardship. The December "Tankan" suggests that the majority view is still one of caution.

While the economy is supported by the public sector, the key to recovery is whether the private sector can regain confidence. However, prospects are not necessarily bright. The environment surrounding business fixed investment and private consumption is not favorable. Prices continue to fall against a widening supply-and-demand gap, and market participants continue to take a cautious view of credit risk and liquidity risk which is reflected in the relatively high interest rates over the financial year-end (the end of March next year).

Under such circumstances, the Bank of Japan is prepared to do its best to support economic activity and financial stability while maintaining the current easy monetary policy.

Since the failure of some financial institutions in the fall of 1997, increasing uncertainty regarding the financial system has had a dampening influence on economic activity. In response, the Bank of Japan has provided ample liquidity to the market including a policy change on September 9 to lower the target call rate.

As a result of strenuous efforts by the Bank of Japan in the face of shrinking economic activity and also rising concern with respect to the financial system, its balance sheet has changed substantially over the year.

For example, the Bank of Japan has provided ample longer-term funds to ease pressure on interest rates over both the calendar year-end and financial year-end. As a result, the balance sheet of the Bank of Japan has expanded by about 40 percent over the previous year.

With a view to facilitating corporate financing, the Bank of Japan expanded its commercial paper repo operation, and in November also introduced new money market operation measures including a temporary lending facility to support corporate financing. As a result, we now observe a higher proportion of private sector debt in the Bank of Japan's balance sheet.

Lastly, in order to maintain financial stability, special lending has increased since last year, which was recently replaced by an increase in loans extended to the Deposit Insurance Corporation.

II. Role of a Central Bank and its Balance Sheet

The questions and criticisms we often receive focus on whether the balance sheet change I just mentioned might impair the financial soundness of the Bank of Japan.

It goes without saying that the fundamental mission of a central bank is to maintain the stability of both prices and the financial system so as to contribute to sound and sustainable growth.

This mission is implemented through banking activities just like commercial banks. For example, what we call money market operations are a combination of the sale and purchase of financial assets. By easing monetary policy, the balance sheet of a central bank increases as it provides funds to the market by purchasing financial assets. Such activities are reflected in changes in the Bank of Japan's balance sheet.

The balance sheet of a central bank is sometimes the focal point of confidence in it. And the kind of balance sheet assets held against liabilities, of which a large proportion is in the form of banknotes, is closely monitored. For example, assets should be liquid enough so that they can be utilized flexibly. They should be sound. There should be enough capital to support any emergency measures.

Some observers have expressed concern over the expansion of the Bank of Japan's balance sheet as a sign of deterioration in its assets. However, the truth is that much of the increase in the balance sheet is due to the aggressive provision of liquidity.

But, we should not take such concern lightly since the perception of a deterioration in our balance sheet may undermine confidence in the Bank of Japan and the Japanese economy. Hence, we have to be very vigilant regarding the expansion of our balance sheet and also its composition.

Having described the importance of the balance sheet of a central bank, I would like to point out three key principles in our portfolio selection.

The first principle is to maintain the soundness of assets. This is achieved by various measures such as securing the Bank of Japan's credit by the creditworthiness of plural entities. For example, our loans are secured by not only the creditworthiness of financial institutions to which we extend loans but also the creditworthiness of the public sector and non-bank private sector that are debtors of the financial institutions. Needless to say, we conduct a strict internal rating of the corporate financial debt we accept. Also, we pay particular attention to avoid the over concentration of risks.

The second principle is to maintain neutrality with respect to resource allocation. If the Bank of Japan holds certain assets excessively, it may not be possible for price making in the market to be conducted normally. Hence, the Bank of Japan must choose assets prudently so that there is no distortion of the resource allocation process in the economy nor any adverse consequences for the financial market.

The third principle is to maintain liquid assets. The Bank of Japan must always be ready to respond to any sudden policy decisions. The assets we hold, therefore, must be such that they can be liquidated at reasonable cost at any time.

Bearing in mind these three principles, we have given our best efforts to implement various measures to accommodate the current policy agenda. For example, the new measures announced on November 13 are intended to "contribute to facilitating corporate financing activities, both in the lending market and the capital market, while maintaining the soundness of the Bank of Japan's balance sheet."

III. Some Related Issues

I would like to address some of the often asked questions relating to the balance sheet.

The first question is whether a central bank should primarily hold such safe assets as government obligations. In fact, the Bank of Japan holds a substantial amount of government securities (about 57 trillion yen at the end of November 1998), which comprise two-thirds of our total assets. However, such a high proportion of government obligations in the balance sheet is not necessarily universal. The proportion is higher in the US, but lower in European countries.

Historically speaking, a central bank provides funds by rediscounting bills, which are discounted by commercial banks. Before a huge increase in government bond issuance in Japan, the Bank of Japan resorted to the active use of corporate sector debt, such as bills, when providing funds. When dealing with corporate sector debt, we have to control the risks involved. But, at the same time, we should not forget that actively using corporate sector debt is a traditional monetary operation for a central bank. What is important in our portfolio selection is not whether the assets are government or private sector debt, but to make sure that the assets we acquire should not distort resource allocation in the respective financial markets.

The second question is whether a central bank should deal only with the banking sector. This question focuses on the counterparty of a central bank in its monetary operations. The question seems to arise from the fact that the Bank of Japan actively uses private sector debt, such as commercial paper, which gives the impression of excessive involvement in corporate fund-raising. However, it should be noted that we purchase commercial paper not directly from companies, but from financial institutions. Hence our counterparty has not changed.

However, it is an important issue as to whether we should limit our counterparty only to the banking sector. The European Central Bank appears to deal only with the banking sector, whereas the Fed in the US utilizes a primary dealer system. The counterparty question is related to whether we put emphasis on interbank transactions or open market transactions. If a central bank primarily uses interbank transactions, then the banking sector is a natural counterparty. However, it seems to us that the global trend is toward a preference for open market transactions. In the case of the Bank of Japan, we deal not only with the banking sector but also securities companies and "tanshi" companies which have accounts with us and are eligible for money market operations.

The counterparty issue boils down to achieving the effective transmission of monetary policy. I do not think we should restrict our counterparty only to the banking sector, but choose from a wider range of entities to achieve a swift, certain, and maximum policy effect. In this regard, it is important that the short-term financial market, where transactions by a central bank are conducted, should be improved in terms of both quality and quantity. The introduction of a public auction system for the financing bills would be a welcome step in this direction.

The third question is whether we should purchase corporate debt and equity because the Japanese economy is in a critical situation. First of all, I would like to emphasize that a central bank can create liquidity but not capital. There is intrinsically a very strict limit as to the extent to which a central bank can take on private sector risk. By shouldering such risk and seeing a subsequent deterioration in our assets, we might lose the confidence placed in us to fulfill our fundamental mission. Hence, the new Bank of Japan Law (effective April 1998) prohibits the Bank from purchasing equities bearing large credit and price risks. We thus do not think it appropriate to purchase corporate debt and equity.

A related question concerns the acquisition of a large amount of government-guaranteed assets, which raises the question of the acquired assets being fixed for the long term on our balance sheet. For example, loans extended to the Deposit Insurance Corporation are increasing rapidly, but we could not justify extending them longer than necessary simply because they are government-guaranteed. Such loans becoming a fixture on our balance sheet should be avoided because such a situation would become an obstacle to the flexible management of monetary policy, and eventually undermine market confidence through concern over balance sheet deterioration. We, as a lender of last resort, will provide whatever liquidity necessary to the Deposit Insurance Corporation from the viewpoint of securing immediate financial stability. But, at the same time, I would like to emphasize that the Deposit Insurance Corporation should make efforts to replace the loans from the Bank of Japan by issuing government-guaranteed bonds and/or borrowing from commercial banks.

IV. Concluding Remarks

The policy agenda for next year is to rebuild the Japanese economy and financial system. Our role as a central bank is to maintain the current aggressive easy monetary policy and to provide enough liquidity to maintain financial stability.

The underlying problem that the Japanese economy faces is not a shortage of liquidity, but a shortage of capital and a reluctance to take the necessary risks that would help the economy expand. The cure for this is, first of all, to strengthen the capital position of financial institutions so as to revive their function as financial intermediaries. The second is to provide an environment that is more attractive to investors and allows taking risks in the capital market. And the third, the most important factor, is to restore private sector confidence.

January will see the debut of the "euro," resulting in the de facto formation of three currency areas, the dollar, the euro, and the yen. Rebuilding the Japanese economy and financial system in a global context will lay a foundation for the yen to become a more easily usable and more reliable currency.