by Masaru Hayami, Governor of the Bank of Japan, at the Federation of Economic Organizations on December 24, 1999

December 24, 1999
Bank of Japan

1. Introduction

I am honored to have an opportunity today to address such distinguished guests. Now that there is only a week remaining in the 1990s, it is perhaps appropriate that I say a few words about the last ten years which have sometimes been referred to as 'the lost decade.' Japan's economy has indeed trodden a very difficult path since the bursting of the bubble. But, in walking this very difficult path, it is also true that we have slowly but steadily nurtured the forces to prepare for a new age, as suggested by the term 'creative destruction.' Moreover, we have recently witnessed various developments that bring hope of a future. Today, by looking back at Japan's economy in the 1990s, I would like to discuss some of the issues which will be carried over to the forthcoming millennium from the perspective of the central bank.

2. The Japanese Economy in the 1990s

Under a prosperous world economy

Average annual growth of the Japanese economy was as high as 10.5 percent in the 1960s, started to slow down to 5.2 percent in the 1970s, and declined to 3.8 percent in the 1980s, tracing a gradual shift from high growth to stable growth. Then, growth further dropped to 1.7 percent in the 1990s. And, especially during the eight years from 1992, growth was only 1.0 percent, a figure we could have never anticipated in the 1980s when everybody was talking about the possibility of Japan trading places with the US and euphoric phrases such as 'Japan as Number One' were heard.

As a matter of fact, the 1990s has been a decade blessed with two new growth opportunities, namely the progress of information technology and the globalization of market economies. The US economy, though experiencing moderate growth in the early 1990s due to lingering effects of the credit crunch, has since been expanding steadily accompanied by the unprecedented combination of low unemployment and low inflation. In addition, the once seemingly withered European economies suffering from fiscal deficits and high unemployment have regained their vitality through efforts related to currency unification, a symbolic event for the beginning of a new era, and are now eagerly looking forward to the new millennium. And, turning to Asian economies, in the early 1990s they realized amazingly high growth often praised as 'a miracle.' Unfortunately, due to various distortions brought about by too rapid growth, they subsequently experienced difficult times triggered by the currency crises in 1997. But since the beginning of this year many Asian economies have been exhibiting a rather solid rebound. One general and significant feature of the 1990s is that, against the background of the increase in supply capacity due to the expansion in emerging economies as well as the appropriate management of macroeconomic policy in industrial countries, the foundation for price stability has become firmly embedded in economic structures worldwide.

Background to the stagnant 1990s in Japan

The question is why couldn't the Japanese economy take full advantage of such favorable global economic environment. Various factors can be cited, but today I would like to point out three: the mounting pressure of the non-performing asset problem, uncertainty about future prospects stemming from changes in demographic composition, and an inflexible economic structure.

The first and foremost factor behind low growth in the 1990s is presumably a decline in risk-taking ability due to the non-performing asset problem. A mutually reinforcing decline in both stock and land prices considerably eroded the capital position of firms and financial institutions. With impaired balance sheets firms naturally became cautious in taking on new risks in terms of business fixed investments, and with the looming non-performing asset problem in the background, the financial intermediation function of financial institutions was substantially weakened. In particular, the fact that indirect financing was central to corporate finance caused balance sheet problems at financial institutions to have a greater and more persisting impact on the real economy.

Potential growth opportunities found in the progress of information technology and globalization can only be seized when firms actively take risks and financial markets sufficiently support their fund-raising activities. Unfortunately, such risk-taking activities in Japan have been considerably weakened in the 1990s. In fact, a modest recovery of Japan's economy from 1994 through 1996 was vulnerable because the problem remained unsolved. Accordingly, when major financial institutions collapsed and the financial system was shaken in autumn 1997, Japan's economy again faced strong deflationary pressures. This only reaffirmed that the economy would never exhibit a solid recovery unless financial system stability was restored.

The second factor which occasioned low growth in the 1990s was the change in demographic composition, typically a problem of fewer children and an aging society. Although the future demographic composition had been somewhat accurately predicted in the 1980s, the illusion that 'the economy would always be on a rising trend,' in other words, overly optimistic presumptions about such factors as economic growth and return on assets, disguised the real problem. Hence, when the bubble burst, it became rapidly apparent that firms, households, and the public sector were not fully prepared for the emergence of an aging society. Many sensational headlines such as "Are your pension funds safe?" started to appear in the media, and uncertainty about the future has been casting a shadow over the consumption behavior of households. Suppressed private consumption, which comprises 60 percent of total demand, seems to have deprived firms of a bright future.

The third factor is that Japan's economic structure lacked flexibility to promptly adapt to big changes in the environment. Innovation in the area of information technology and globalization has completely altered the pricing system and necessitated considerable changes in the allocation and utilization of capital and labor. In other words, information technology and globalization provided opportunities for growth that could only be realized when accompanied by corresponding changes in industrial structure. But, for an economy that is not flexible, such changes in the environment do not always have positive effects in providing growth opportunities. Rather, they could burden the economy by lowering competitiveness and placing downward pressure on corporate profits.

The economic system and practices such as life-time employment, the crossholding of shares, various regulations that shielded industries from competition, and financing through main banks, had positive effects during the high economic growth period. But with the environment undergoing drastic changes, they have now become more of a constraint. The information revolution has had a substantial effect in expanding economies, especially in the US, and oft-cited reasons with respect to the US include a flexible labor market, prompt 'top-down' decision-making, and the effective use of risk capital. In Japan, a corporate culture that puts emphasis on stable employment and income as well as decision-making based on consensus has long prevailed. It has had some rationale and benefited Japanese firms under a certain pattern of economic growth. However, when an economy is faced with fundamental changes, such a corporate culture has tended to prevent firms from closing down non-profitable sections and reorganizing staff and management systems so as to seize new growth opportunities. Though small and medium-sized firms are inherently in a position to flexibly adapt to drastic changes, there were rather strict constraints with respect to funding. In the 1990s, financial system instability prevented both the expansion of small and medium-sized firms into new areas and also the emergence of innovative firms since they were unable to easily raise risk capital.

Current state of the economy

Now let me turn to recent economic developments.

With the improvement in corporate profits due to the increase in exports and production, the Japanese economy as a whole has recently started to improve. However, business fixed investments have not yet been activated by the improvement in profitability, and private consumption has not necessarily been on the rise reflecting the severe employment and income environment. Hence, clear signs of a self-sustainable recovery of private demand are yet to be seen. Bearing such a situation in mind, the Bank of Japan is maintaining its extraordinarily accommodative zero interest rate policy.

Nevertheless, the economic environment surrounding private demand is gradually improving. While such improvement has so far relied heavily on monetary and fiscal policy as well as the favorable situation with respect to overseas economies, we have begun to observe some positive changes in the factors behind the stagnant 1990s.

If such changes are real, the Japanese economy will be able to regain vitality over the medium to long term. There might be some justification for being optimistic because the yen's appreciation against the US dollar and the euro in the latter half of this year seems to be largely attributable to an increase in overseas investors betting on the resurgence of the Japanese economy, resulting in the increased inflow of capital into Japan. Of course, we need to be vigilant about the development of the yen rate since an excessive appreciation might nip the economic recovery in the bud. Having said this, it is an encouraging sign to see a movement to 'buy Japan' in markets both at home and abroad. A 40 to 50 percent increase in stock prices during the past year and the disappearance of the so-called Japan premium can also be interpreted in this context.

Then, what are the recent positive changes in the Japanese economy? Let me elaborate on them by referring to the aforementioned three factors which caused stagnation in the 1990s. With respect to the non-performing asset problem, since this spring financial system stability has been restored to a large extent against the background of the injection of public funds into major financial institutions. Various surveys indicate that the lending stance of banks is less strict compared with last year. And, while debt overhang still hampers the risk-taking activities of firms and the financial intermediation function of banks is still weak, we can say that the risk of the non-performing asset problem paralyzing the entire financial system and thereby aggravating anxiety on the part of firms and households has become quite small.

With respect to the second factor, demographic composition, firms have begun to look into new business opportunities regarding services for the elderly such as health and nursing. It is true that, with the birth rate declining, we cannot solve the pension problem without pain. This is a fact of life that we have to face. But we can equally say that the problem can be solved if each generation would agree to share such pain. Recent discussions on this issue seem to incorporate such a pragmatic viewpoint. Indeed, fewer people are obsessed with anxiety regarding the future of the pension system, and many are looking at diversified pension schemes such as defined contribution plans and asset formation as Japan's Big Bang advances, which can be regarded as a positive development.

And, with respect to the third factor, that is, adaptability of Japanese firms to changes in the environment, I strongly feel that there have recently been important changes which are worth noting. One such change is full-fledged restructuring among major firms which has been gaining momentum since early spring this year. Moves for full-scale alliances among major banks, something which could never have been imagined in the past, have been emerging. Some more time will be needed to see whether such moves end up as just restructuring, meaning withdrawal from non-profitable areas and the reduction of workers, or actually bear fruit as re-engineering which goes beyond the existing organization and business practices and aims at raising profitability through the concentrated allocation of resources to strategic areas. In this regard, developments such as the rise in stock prices since spring can be interpreted that investors both at home and overseas are expecting such changes to materialize.

In parallel with developments at large firms and financial institutions, one of the changes that I am encouraged to see is the rise of new enterprises as represented by the so-called 'bit valley' centering on the telecommunications sector. In the capital market, promising small and medium-sized firms are increasingly attracting attention. The Nikkei Stock Average has increased about 40 to 50 percent, the Second Section of the Tokyo Stock Exchange 2.5 times, and the OTC market 3.5 times. Also, new developments to facilitate fund raising by newly established firms are being seen, such as the MOTHERS project of the Tokyo Stock Exchange, reform of the OTC market by the Japan Securities Dealers Association, and a movement to establish NASDAQ Japan. There are high expectations that these developments will contribute to strengthening direct financing. It is true that the situation in Japan is still behind the US where new firms raise 70 percent of their funds from own capital and the remaining from venture capital and individual investors known as 'angels.' Nevertheless, it is a welcoming sign that a competitive framework in which promising and risk-taking firms are created and nurtured is beginning to emerge in Japan.

3. Toward a New Millennium

A flexible economic structure that accommodates changes

In the new millennium, there is little doubt that the two conspicuous changes seen in the 1990s, namely the information revolution and globalization, will progress even more. Though no one can predict precisely how fast these two megatrends will advance or what business opportunities they will offer, it is certain that the speed with which new technologies and ideas are transferred across borders will accelerate, wherever they are created. Whatever we do will entail considerable uncertainty and the environment in which corporate managers make decisions will likely change constantly.

Therefore, it will become all the more necessary for corporate management to be flexible enough to accommodate such changes and uncertainty. To support corporate activities, infrastructure related to accounting, tax, and legal systems as well as a deep and liquid capital market will hold greater importance. It will continue to be an important challenge for us to establish a flexible economic structure that can promptly adapt to unpredictable changes, which can be achieved through developing a highly transparent system and improving a framework that can efficiently manage various risks. In short, it is important to build an economy where the market mechanism functions effectively. In the 1990s, we were busy dealing with the aftermath of the bubble, and all we could do was support the economy through monetary and fiscal policy. In the coming millennium, with the progress of structural reform and enhanced awareness of the need to change on the part of both individuals and firms, I strongly hope that Japan's economy will take advantage of the progress of information technology and globalization, and that growth will be led by private demand.

Two hopes as a central banker

I would like to mention two hopes that I have in mind on entering the new millennium, both of which relate to the Japanese economy regaining dynamism.

One of the hopes is that we quickly overcome "deflationary concerns," to secure price stability, and build a dynamic economy propelled by innovation. Specifically, price stability is extremely important for economic expansion that accompanies a change in industrial structure. In an economy where people are confident of the maintenance of price stability over the medium to long term, they will not be excessively worried about changes in the macroeconomic environment and will be able to devote their efforts to appropriately assessing the risk of individual projects. This will intensify private sector energy in expanding economic frontiers. Hence, when price stability is clearly maintained, the change in relative prices of individual goods and services will be correctly recognized. In this way, the market mechanism, taking cognizance of price signals, will be fully functioning, thereby promoting the appropriate redistribution of labor and capital.

As such, it is recognized that price stability is indispensable for economic prosperity over the medium to long term. Such a recognition has been shared worldwide as the environment has changed during the 1990s. Despite this, there still exists in Japan the view that monetary policy should accommodate some inflation, which strongly suggests to me that Japan's economy is currently not in a normal situation. It is my sincere hope that Japan's economy will regain its inherent strength and promptly return to a normal economic situation where people can feel secure about the future, confident that the central bank is containing inflation.

The other hope is that the status of the yen as an international currency will rise as confidence in Japan's economy is restored. At present, the 15 EU countries account for a little less than 30 percent of world GDP, and European currencies are used for 20 to 30 percent of world trade and foreign exchange reserves. Their share of GDP almost corresponds to that of the use of their currencies. In the case of the US, its share of global GDP is almost the same as that of the EU, but the US dollar is used dominantly for 50 to 60 percent of world trade and foreign exchange reserves. In contrast, Japan has an approximate 15 percent share of GDP, but the use of the yen for trade and reserves is only 5 percent. Currently, yen-denominated exports are only 36 percent of total exports and the figure for yen-denominated imports is 22 percent of the total.

It is expected that, as globalization progresses, international capital flows through trade, direct investment, and securities investment will likely become more active. Thus, strengthening the infrastructure for international fund settlements and ensuring the stability of the international financial system is an important agenda throughout the world. The role of Asian economies will become increasingly significant in the development of global finance and the world economy. Bearing such a perspective in mind, it appears natural to think that the importance of the yen as an international currency is potentially quite large.

For the yen to be used internationally, it is necessary, first, for Japan to garner greater credibility including its economic policy, and, second, to make the yen more convenient to use. As for credibility regarding Japan's economy, we need to ensure non-inflationary sustainable growth. And, as for making the yen more convenient to use, we need to have efficient money and capital markets. In this regard, the issuance of financing bills through auction from this April and the subsequent substantial expansion of the financing and treasury bill markets was a welcome step. However, it is true that the reasons why the international use of the yen has not easily increased are rather complicated, involving some historical factors. It is my hope that a variety of suggestions and ideas will be put forward by business people leading to constructive discussions and whatever measures possible in this direction will be expeditiously implemented.

4. Concluding Remarks

To be Governor of the Bank of Japan when entering a new millennium is a stroke of fate. The Bank of Japan for its part will make the utmost efforts so that Japan's economy will successfully lay the foundation for a new era. I sincerely hope that those from the business world will move bravely forward so that various new innovative movements now being observed will lead to the full-fledged revitalization of Japan's economy.

In closing, may the 1990s be long remembered, not as 'the lost decade,' but as 'the decade that lay the foundation for the prosperity of coming generations.'

Thank you for your attention.