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Home > Announcements > Speeches and Statements > Speeches 1999 > Speech by Yutaka Yamaguchi, Deputy Governor of the Bank of Japan, at the Hong Kong Trade Development Council Financial Conference on Asia 99 in Hong Kong, on May 27, 1999 (Financial Instability from a Japanese Perspective)
Remarks by Yutaka Yamaguchi, Deputy Governor of the Bank of Japan, at the Hong Kong Trade Development Council Financial Conference on Asia 99 in Hong Kong, on May 27, 1999
May 27, 1999
Bank of Japan
Good afternoon, Ladies and Gentlemen.
I am honored to be invited to this conference and to be given the opportunity to speak to this panel of distinguished participants.
Japan is one country in the region that has been undergoing serious financial strains, although the nature of the problem can be distinguished from that of our neighbors. Most importantly, while the Japanese yen has been exposed to occasional pressures through the years of financial difficulties, yen's situation has been nowhere near a currency crisis that features the region's developments since the summer of 1997. Obviously, a currency crisis would have fundamentally changed the way macro-economic policies have been formulated in Japan.
The list can go on to cover other differences as well. Nonetheless, when a country unfortunately has to face a major systemic crisis, at least some of the basic ingredients to be contained in the policy prescription as well as the general background appear to be surprisingly common. It is also worth noting that the crisis unfolded in the common playground called globalized financial markets. The conditions there have to be taken into account as we jointly make efforts to revitalize the national and international financial systems. It is in this context that I start from Japan's recent history of financial difficulties.
One of the bitter lessons to be drawn from Japan's experience is the rather obvious: a problem cannot be resolved without correctly identifying it. It is now clear that the heart of the problem is the critical erosion of capital of the banking system. In a market where bank credit had been poured into property and other asset markets, large depletion of capital was an inevitable consequence when asset prices collapsed by two-thirds or more. When undercapitalization becomes system-wide, threatening the very survival of a nation's banking system, public assistance has to step in. Needless to say, such a public program has to be carefully designed so as not to leave behind the seeds of moral hazard.
The political process to arrive at public assistance for the banking system tends to be invariably painful. It is not apparent to the general public why the banking industry is entitled to receive what appears in their eyes a special treatment. Large funding requirements using taxpayers' money invites resentment. For these and other reasons, it took several years plus bouts of bank runs in my country before a political consensus was formed in October 1998 to substantially strengthen the safety net. The October package included a major bank recapitalization plan along with the legal underpinnings to deal with failing institutions and as such was recognized by the markets as a belated but serious attempt to address the magnitude of the problem. With the prospective recapitalization in sight, crisis sentiment in the markets subsided, but only after inflicting damage to economic activity.
In light of the prolonged process in Japan to address the problem, improvements to avoid repeating recent history are clearly called for in a number of areas, of which I would mention just a few. Proper assessment of systemic problems at an early stage is crucial. To this end, interactions between economic activity, financial markets, and international capital flows have to be more deeply explored. Also, prudential research at central banks and supervisory authorities needs to be strengthened. For example, we can now say, with the help of hindsight that a simple "stress test," incorporating a sharp fall in asset prices, would have told us a rough image of what could develop with respect to the banks' capital position.
Financial infrastructure too needs a thorough review. Inadequate accounting system, which failed to reveal the "true" balance sheet conditions, made it difficult even for bank management to promptly grasp the reality. Modernized accounting standards, coupled with enhanced disclosure, should work as a disciplinary force to facilitate initiation and progress towards recognizing and addressing the problems.
Finally, I would note that the unique structure of Japan's corporate governance may have contributed to the delay in responding to the evolving situation. Main features of such governance -- the cross holding of shares between companies, oversight by "main banks," and selection of directors from within, among others -- worked so well when growth was the norm; they appear to have failed to generate painful and yet necessary adjustment actions. Supervisory pressures, which should have supplemented the weak private governance mechanism, proved to be less than satisfactory due partly to the inadequate financial infrastructure cited above.
In this situation the banks were allowed to rest on "wait and see" attitude with an optimistic expectation that a recovery in the economy and asset markets would help them out of the problem. It has turned out that such forbearance merely aggravated the banks' problem and the economy.
What are the implications of these Japanese experiences to financial system reform more generally, as we enter the next millennium? Delivering the Ten Commandments to financial system stability is, as you imagine, beyond the scope of my presentation today. The financial world, unfortunately, changes too quickly for that. I will concentrate on a more specific aspect, the interactions between the authorities and market participants, including financial institutions, which had important influences over the developments in Japan.
The question that I am going to ask is: what changes should we envision in the division of labor between the authorities and market participants? I would like to offer my observations on what could and should change in that division of labor and what would not change.
Change would be most evident in the ability of the authorities to keep track, in a timely and accurate manner, of the risk profiles of individual market participants. Maybe as recently as a decade ago, supervisors and regulators were able to understand reasonably well the risk profiles of institutions under their jurisdiction by looking at the books of such institutions. With the advances in financial theory and information technology, now it has become possible to unbundle and repackage risks in a myriad of ways in a matter of hours if not minutes. This trend would probably accelerate. As a result, the checks and balances from market forces would become more important in the coming years. Strengthened corporate governance, from better decision making by management to more effective shareholder controls, is one element. Another would be discipline imposed by counterparties. Looking back, what prompted the changes in the behavior of Japanese financial institutions in the aftermath of the bubble were such uncompromising forces of the markets. Under these circumstances, there will likely be more and more instances where central banks and other authorities would defer to, and even encourage, the checks and balances imposed by the markets.
Let me turn to what would not change. Society needs someone to closely watch macro risk profiles, even when individual market participants carefully manage their own risks. This is the lesson we should all learn from recurrent bubbles since the Tulip Mania. The elements of the macro risk profile that need to be monitored would change over time. Sometimes, it could be the concurrent increase in real estate prices and bank credit. In a different place and time, it could be a flood of short-term capital inflows under pegged exchange rate regimes. Such incidents are rare indeed, but they repeatedly come back to haunt us and their repercussions are profound. Who is the most capable of fulfilling this monitoring role? There appears no better candidate than the central bank, which is often criticized for taking away the punch bowl at the party. Moreover, central banks have always been involved in maintaining overall financial stability. The form and nature of this important role would, of course, change as the global marketplace in financial services manifests itself. I will come back to the issue later in connection with the experiences of financial crises in the emerging markets.
The acute financial crisis that unfolded in Japan in late 1997 and continued through most of 1998 showed how a systemic problem could take a heavy toll on the economy. As the markets increasingly focused on banks' undercapitalized situation, liquidity of banks tended to dry up. The capital and liquidity shortage forced them to withdraw credit from their borrowers. Risk appetite sharply receded as undercapitalized banks lost the capacity to assume potential risks and as corporate borrowers were preoccupied with day-to-day liquidity. Without risk takers in the system, economic growth would be severely constrained. Such risk aversion in the aftermath of the burst of "bubbles" appears to have been one background to help explain the performance of Japan's economy in the 1990s. It is for this reason that a healthy financial system is a major condition for sound economic developments.
Financial markets in Japan have shown an impressive turnaround this year. Against the backdrop of major banks' recapitalization and the Bank of Japan's determination to hold down short-term interest rates to virtually zero, liquidity pressures have dissipated, the stock market has recovered some of the ground lost earlier, and interest rates have sharply dropped across the spectrum. These improvements are encouraging, and, contrary to last year, should work as a positive force to help make progress towards an eventual recovery.
Indeed, the downslide in overall activity has come to a halt. A modest upturn may emerge in the coming months. Inflation has also been stable at marginally negative rates. However, the recent stabilization is largely a product of policy mobilization in full dimension -- monetary ease, increased government outlays, tax cuts, and a financial safety net. Private spending shows little sign of responding to these stimuli yet.
It is important to point out in this context that Japan too has major "structural" problems. In terms of constraints on economic recovery, the following aspects appear to deserve special attention.
The first is the financial system, which needs to be substantially and boldly restructured. Experiences in Scandinavia and elsewhere suggest that it often takes a few years before recapitalized banks regain ability to function as healthy intermediaries. This may also hold for Japanese banks, as they would first have to clear up the balance sheets more thoroughly, cultivate more appropriate risk assessment methodologies, develop strategies to focus on where they believe competitive advantage lies, and grow far more efficient.
The second is the low productivity in the non-manufacturing sector relative to that in the manufacturing industry, although it is somewhat an oversimplification to lump together the wide spectrum of non-manufacturing industries. A better phrase to describe the industries in question may be segments of the economy which have not been fully exposed to global competition. Inefficiencies can partly be attributable to years of various regulations, which shielded the industries from competition. However, as globalization proceeds, the traditional distinction between tradable and non-tradable goods and services is becoming blurred every day. Some services, in particular financial and information services, are now tradable similar to cars, computers, VCRs, and what have you. As a result, the traditionally domestic non-manufacturing industries are now exposed to more and more competition, and have been forced to become more efficient. Based on such a recognition, Japan's deregulation focusing on non-manufacturing industries has made significant inroads since the early 90s. Of course, as the experiences of the U.S. and U.K. in the 70s and 80s show, it will take a considerable time before such efforts bear fruit.
The third is the growing imbalance between savings and investment from a relatively long-term perspective. Japan, like many other Asian countries, has enjoyed a high share of fixed investment to GDP, which is consistent with relatively high economic growth. However, with the aging population and decline of the labor growth rate to near zero, growth potential tends to become lower. Also, high investment in the past produced an unfavorable investment climate in which Japan's capital/labor ratio surpasses that of the U.S. and the rate of return on capital was extremely low. Cyclical development in the 90s augmented the downward adjustment of the capital spending ratio to GDP from 20% in 1991 to now about 13%.
On the other hand, contrary to what one might expect of an aging society, the savings rates has remained at a high level. It is always difficult to find plausible explanation for savings rates, but increased public anxiety over the future, including, in particular, the future of the pension system, is likely playing a role. Such savings-investment gap cannot be filled by macro-economic demand stimuli alone.
Against this background, we remain vigilant with the prospect of economic recovery on a sustained basis. Obviously, we are committed to make every effort to achieve sustainable growth and price stability -- neither inflation nor deflation. Now that macro-economic policies are fully mobilized, however, structural policies and adjustment should play a greater role to this end.
Important as Japan's resumption of growth is, the restoration of economic growth in Japan cannot necessarily be the magic bullet for East Asian economic recovery. When we look at the exports compositions of East Asian countries to Japan, the United States, the European Union, and other regions including intra trade and Latin American countries, the highest is intra trade excluding Japan, constituting 39% of the total trade during 1997. As for the rest, Japan constitutes about 12%, and the United States 20% of the total. In contrast, in the case of Mexico, its exports to the United States exceeded 80% of Mexico's total exports, which accounts for the "V shaped" exports-led recovery of Mexico after the currency crisis from the end of 1994 through 1995. Given this difference in trade relationship between Japan and East Asian countries vis-a-vis the United States and Mexico, Japan's recovery does not guarantee an automatic recovery of East Asian economies. Economic recovery in Asia is ultimately up to the efforts of individual countries in the region, including Japan.
In the last part of my presentation today, I would like to turn to the various efforts now underway in the international arena to address financial fragility, primarily the efforts I am involved in at the Committee on the Global Financial System, and how these discussions are relevant to economies and markets in Asia.
Whether we like it or not, financial crises grab the attention of everyone -- politicians, ministries and agencies, central bankers, market participants, and the public at large -- and raise their awareness of the importance of the smooth functioning of financial markets. As the initial shock waves recede and relative calm returns to the markets, discussions inevitably begin to draw lessons and to make the necessary improvements to the financial system. The Asian financial crisis was no exception. We have already seen a wealth of material from both the private and public sectors on its causes, the appropriateness of policy responses, and even proposals for an overhaul of the international monetary system. My task today, however, is not to give you an overview of these discussions. I will rather explain to you what the Committee on the Global Financial System and other international groupings have achieved so far and what we are aiming for in the near future.
The Committee on the Global Financial System, formerly known as the Euro-currency Standing Committee, is one of the Basle-based committees of the G10 central banks. We have invited representatives from emerging market economies, including those from the Hong Kong Monetary Authority, who have made valuable contributions. Its shorthand "CGFS" has not as yet gained wide recognition. The Committee is entrusted with the regular monitoring of international financial markets for the central bank community, with examining how financial markets work, and with developing appropriate recommendations designed to improve the functioning of markets. As this explanation of the role of the Committee clearly suggests, studies of the Asian financial crisis from the perspective of market functioning and discussions on desirable improvements to the international financial infrastructure have been at the center of the Committee's agenda.
The Asian financial crisis was partially a result of considerable excesses in the region's economies. I will not attempt to explain the root causes of such excesses, but would like to note that nobody forced the over-building, over-investment, or over-consumption that paved the road for the crisis. Unfortunately, excess is a fact of life in a market based economy and human beings. Excesses also contributed to the current problems of the Japanese economy, which I described earlier.
Just because excesses are ingrained into the system, however, it does not follow that we have to be at their mercy. Broadly speaking, there are two possible courses of action. One is to constrain directly the behavior of market participants through a system of prohibitions, regulations and controls. The other course is to improve the market's infrastructure so as to improve their functioning, thereby reinforcing the self-correcting forces of markets and lessening the likelihood of excess. Controls on short-term capital flows is an example of the former and enhancing market transparency is an example of the latter.
Generally speaking, central bankers are skeptical of the effectiveness of direct controls. While possibly effective as a short-term emergency measure to counter overshooting in times of stress, in the long run, direct controls are costly to administer and create distortions in the allocation of capital and risk-taking that are difficult to correct. This is why the Committee on the Global Financial System has stepped up its efforts to formulate recommendations for improving market functioning in the global context. The Committee has, in particular, concentrated on the issue of market transparency, because the availability of comprehensive, meaningful and accurate information is a necessary precondition for effective decision making and self-discipline by market participants.
One of the first results the Committee generated in this area involved enhancing the transparency of foreign exchange reserves and drains, as outlined in a report published in the autumn of last year. The recommendations, which were recently incorporated into the Special Data Dissemination Standards by the International Monetary Fund, reflected our thinking that more comprehensive, detailed and timely information on the foreign currency liquidity position of the public sector could improve the accountability of the authorities and the scope for markets to exercise financial discipline. This, in turn, could help induce an earlier correction of unsustainable policies and allow market participants to form a more accurate view of the condition of individual countries, thereby also possibly limiting contagion.
In that report, it was likewise noted that an effective market discipline mechanism could also require an appropriate framework for disclosure and reporting by private sector entities. Against this background, work is now underway from two angles: enhancing public disclosure by individual institutions, and identifying possible gaps in aggregate information available to market participants. As to disclosure, every market participant should provide sufficient information about its activities to the market so as to enable accurate and effective assessment of risks -- for example, market risk, credit risk, liquidity risk, etc. Meanwhile, the availability of sufficient aggregate information could contribute to the better evaluation of overall market conditions. While we have not published reports so far, I can assure you that considerable progress has been made and that the first results should become visible before long.
As a final point concerning the work of the Committee on the Global Financial System, I would also like to refer to its work aimed at furthering our understanding of the mechanics of modern international financial markets, especially market liquidity. This March, the Committee published a report describing the mechanics of repo markets and their growing importance in both private market participants and central banks. In addition, in April it released a report on the determinants of market liquidity and on possible steps that might be taken in order to establish liquid markets. This report is a significant first step -- it provides insight into market liquidity, which, while quite elusive, plays an important role in the unfolding of systemic financial crises.
These efforts by the Committee on the Global Financial System are, of course, not conducted in a vacuum. They are part of a broader set of initiatives by the international financial community to address financial fragility. An important development in this context has been the recent establishment of the Financial Stability Forum, composed for the time being of G7 central banks, ministries, and regulators, as well as key international groupings. This Forum should not be seen as becoming a super regulator. Rather, by assembling selected members of the public sector, it should contribute to enhancing cooperation among various bodies and ensuring a more effective allocation of human resources in the pursuit of financial stability. At its first meeting last month, the Forum decided to address issues pertaining to highly leveraged institutions, offshore centers, and short-term capital flows, all of which have obvious connections with our experiences during the Asian financial crisis. While it is too early to predict any outcome, the reality of modern international financial markets -- global integration, and continuing advances in financial and information technology -- would call for a heavy focus on efforts to structure incentives of market participants towards the goal of financial stability through enhanced transparency and better use of information.
Finally, I would like to offer a few thoughts on the implications of these international efforts for the economies and markets in Asia.
Just a few minutes ago, I have already noted the tendency of central banks to prefer market-based solutions. Having said this, I am, at the same time, not fully comfortable to concur with prominent hedge fund managers who maintain that hedge funds provide valuable services by correcting policy mistakes at an early stage. Meanwhile I cannot dismiss the view that international financial flows have become so large that they have the potential, because of their sheer size, to overwhelm smaller economies even without major policy mistakes. There might be a genuine problem if self-fulfilling expectations of market participants could dislocate an economy from a "good equilibrium" to a "bad equilibrium" in a multiple equilibria situation, if I may borrow some words from game theory.
Nevertheless, on balance, I would say I am optimistic as regards the role played by markets. In the case of Asia, it must be stressed that the remarkable growth before the crisis and relatively high level of per capita income widely observed today in the region were made possible by the entrepreneurship of the people and market-based policies adopted by the governments in the region. The market is like a pendulum. It oscillates from one side to another, and shocks can occasionally swing it widely off center. Eventually, however, it will return to the center, i.e., to the equilibrium reflecting collective wisdom of market forces.
Our strategy, therefore, should be to put the market first, but, at the same time, to carefully monitor developments and to take necessary steps to correct any market failures that may manifest themselves. This means that a long-term perspective on risks in the market and a thorough understanding of market participants' incentives are necessary. In this process, debate and interactions between the private and public sectors are desirable.
International fora should have a role in this context as monitoring vehicles and clearing houses for ideas and observations. For this purpose, the active involvement of emerging market economies, which the Committee on the Global Financial System and other Basle-based committees have sought in recent years, is very important.
Thank you for your kind attention.