Remarks by Yutaka Yamaguchi, Deputy Governor of the Bank of Japan, at the Edinburgh Finance & Investment Seminar, on June 22, 2001
June 22, 2001
Bank of Japan
- I was wondering a few days ago who in Scotland first wrote at all on Japan, and when. My colleagues found me the answer. That towering figure in social science wrote in 1776 in his monumental An Inquiry into the Nature and Causes of the Wealth of Nations, "The price of copper in Japan must have some influence upon its price at the copper mines in Europe." Adam Smith was talking about the supply-side effects on price level at the dawn of industrial capitalism. Could he imagine that two and a quarter centuries later a visitor from Japan would discuss the same theme, struggling to find the answer to the issue he raised?
- Today I will spend some time on Japan, partly because we in Japan are facing some basic questions in economics and monetary policy which we don't have to think about in normal times. But let me begin with the U.S. economy, because the abrupt slow down of the U.S. growth in the last few quarters has no doubt been the epicenter of the changing global economic landscape and chances of its recovery are the focal point for the outlook of the world economy. The adjustment of the "new economy" that began with the stock market correction last year has now shifted from inventory liquidation to lower capital spending. This was to be expected as profit continues to fall. Employment is also weakening. In contrast, the "old economy", from housing construction to auto sales, is holding up remarkably well, no doubt helped by the Federal Reserve interest rate cuts. The net result so far has been small positive growth. It is still difficult to predict how this balance between the "two economies" will swing later this year and beyond.
- To throw some light to this question, brief comparison between the U.S. and Japan, on how they are positioned when or just after a major financial bubble burst, might be useful. I warn you in advance that the following comparison will not make the outlook much clearer. It has only limited value for short-term forecasting. Nonetheless such comparison is important from my perspective to gain some insight into the underlying development.
- First, euphoria during a bubble inevitably produces investment boom, which is reflected for instance in the rising share of capital spending in GDP. Such ratio (ie. nonresidential fixed investment in GDP) in real term rose 4.4 percentage point in the U.S. from 1995 to 2000. The corresponding ratio in Japan also rose 4.4 percentage point in the "bubble years" from 1985 to 1990. This is not to say that unproductive and inefficient investment was carried out in the U.S. in the same magnitude as in Japan. Much of the U.S. investment was directed to information technology, making it less likely that a huge excess capacity has been built. One can also take some comfort by looking at the GDP in current dollars, which shows that the investment share in nominal term rose more moderately from 11.1% in 1995 to 13.7% in 2000, up by 2.6 percentage point. Falling trend in the price of capital goods must have been a major stimulant of capital spending. Thus, while one can hardly avoid an impression that the rate of capital spending was unsustainable and some excess is now left, the "work out" process may not be as prolonged as in Japan.
- Second, in contrast to the sharp deterioration that emerged in the Japanese banks' balance sheet in the 1990s, the U.S. banking system appears to be well positioned in terms of capital. To be sure, problem loans are rising; profit from capital market activities is plummeting; and we should be prepared for more unpleasant news to come if the recovery is delayed. But, since the U.S. expansion in recent years was not accompanied by a major real estate bubble, the banking system will likely avoid a major capital erosion associated with sunk cost in the property market. If this is the case, the U.S. economy will not have to suffer from persistent head wind generated by a weakened banking system, which has characterized Japan's economy in the aftermath of the bubble.
- Third, a major uncertainty lies with the effects of the stock market decline on U.S. consumers. The stock portfolio, excluding investment via mutual funds, in the household financial assets in the U.S. is 34% and much larger than in Japan's 6%. The flow of funds data indicates that the value of U.S. household stock holding expanded by 5 trillion dollars from the Q4 1995 to the Q4 1999; it shrank by 3.3 trillion dollars since. Should we emphasize that the stock value at household is still about 40% larger than in 1995? Or should we rather expect them to return to a positive saving ratio now that over 60% of the capital gain since mid 1990s has been wiped out, particularly if, as seems likely, the consumers are overextended by taking on greater debt on the other side of the balance sheet? We didn't have this sort of problem in Japan: the risks were heavily concentrated in the banks and their business borrowers. The risks are more dispersed in the U.S. and it remains to be seen how the financial assets allocation there can absorb the impact of the market decline.
- Turning to Asia, the economies in the Asian region have been hit hard by the U.S. slow down. They will continue to be strongly affected by the U.S. economic performance. This might sound odd because there has developed increased intra-regional trade flows, which appeared to provide significant sources of economic growth. Japan's changing trade pattern is illustrative: real imports from the region grew at an annual rate of 10% in the last 3 years surpassing 5% increase in real exports; and the IT related capital goods and components have been the fastest growth items. Needless to say, FDI to the Asian emerging markets has provided the background, with increasing share going to China. Why then is the U.S. just as, if not even more, important for Asian economic growth? One aspect is undoubtedly the recent above-potential U.S. expansion which resulted in a sharply higher imports and current account deficit; last year's imports in total GDP stood at 15% compared to 10% in 1990. Another key is to understand the tech boom as a truly global phenomenon. A global division of labor and closer integration has been developed, with a number of Asian economies providing important manufacturing base of high technology. It is ironic that, because of this closer integration in "TMT" area, countries better equipped with high-tech capacity have been particularly hard hit. Such inter-dependent structure can be easily confirmed by observing that the U.S. "new economy" reduces the inventory level at the expense of unsold inventories piling up in some Asian economies.
- Finally, it should be noted that, after the " Asian crisis", the spontaneous strength of recovery has never been robust in most economies in the region. One should not jump to a hasty generalization why this has been the case. It seems to me, however, that in many countries where capital market is shallow or seriously underdeveloped, the woes in the banking system has constrained a healthy economic development. Large injection of public funds in Japan, Korea, and Thailand not withstanding, the magnitude of capital loss, traditional governance structure and complex societal context have delayed simple market-oriented solutions. Thus, while an U.S. recovery is eagerly being awaited, much remains to be accomplished by serious structural reform.
- I now turn to the Japanese situation. We have seen over the course of last 18 months ebb and flow of expectations. At mid-year in 2000, the recovery appeared to accelerate toward real GDP growth rate of around 2%, which if materialized would have been broadly in line with the estimated current short-run capacity growth of 1.5-2% a year. The U.S. deceleration worked as a major external shock and growth momentum fast receded. Since around the turn of the year, exports have been falling sharply; inventories suddenly accumulating; industrial production declining; and the Q1 GDP fell at an annual rate of 0.8%. Moderate deflation is going on, with the CPI softening by a half percent over a year. Bank of Japan decided last year to publish biannually a brief summary paper titled "Risk Assessment of the Economy and Prices" which contain Board member's own forecasts of GDP and prices. In their April forecasts for the fiscal year 2001, the majority of the Board members saw 3-8/10th of one percent growth for real GDP, and minus 6-9/10th of one percent change for CPI. The forecasts recognized the significant effects of external developments and assumed as the standard scenario that the world economy, the U.S. in particular, begins to recover in the second half of this year.
- An interesting feature of the ongoing adjustment is that it has been largely confined so far to the high-tech, IT related industries. There we observe a strong synchronization with the global environment. We saw there in 1999 and 2000 a surge in profit and capital spending but with little spillover on other segments of the economy. Does symmetry hold and the collapse of the tech fever stop short of hitting the "old economy"? At this juncture, there has emerged little sign for businesses to begin a large scale payroll reduction. Obviously outlook of profit is a key element here. If businesses happen to conclude that profit deterioration may not be short-lived, they may resort to cuts in wages and/or payrolls, which will eventually induce more cautious consumer sentiment. You probably notice here that I am talking about macro-economic implication of profit-employment dynamics in a different logic than that for the U.S. economy. In the American economy, falling profit is followed swiftly by layoffs, which tends to weaken consumer confidence and spending. But lower labor cost makes profit recovery easier. The rest of the sequence depends on the strength of aggregate demand under lower employment. In contrast, while Japanese firms are endeavoring to gain more flexibility to adjust the labor cost in hard times, most of them still don't appear to give a serious thought to outright layoffs.
- Important as the shift of adverse external environment has been, it is the lack of solid foundation for domestic-demand-led recovery that has made the Japanese economy vulnerable to such shocks. In retrospect, Japan's economic growth in the 1990s was 1.7% a year, far lower than 2.6% for the OECD area. Given massive mobilization of fiscal and monetary policies during the decade, it is reasonable to assume that structural forces were exerting strong constraints on growth. That said, it is not easy to identify exactly what are the relevant structural elements. Indeed various aspects of the system have constantly been changing even while debates on structural reform are going on. It is therefore at the risk of some arbitrariness that I emphasize the importance of banking reform.
- It would be too harsh for banks to say that they have helped abort economic recoveries by creating credit crunch. To be sure, when their capital position was squeezed at the height of the Asian crisis, a genuine credit crunch developed. Since then, however, a large safety net was built and employed, including capital injection to major banks in March 1999. Today they are not directly constrained by capital to extend loans. They are not suffering from shortage of liquidity either. While outstanding bank lending (adjusted for write-offs and sales of assets) is now about 1.5% lower than 12 months ago, this is more a result of extremely weak demand for borrowing. Nonetheless problem loans outstanding has not decreased even after years of huge write-offs. Their capacity to take on and absorb risks is constrained. Their credit rating has sharply dropped and stayed low. Every time some shocks arrive, particularly when the shock induces the stock market to fall, financial market visibly becomes nervous. The banking system is hardly providing energy for sound economic development. In an economy where the overwhelming share of financial intermediation is born by banks, their woes have to be regarded as a drag on activity even when the problem does not surface as acutely as in 1997-98.
The Japanese Government also places high priority on resolving the banking problem. It has focused on accelerating the write-offs of the worst classified non-performing loans. I prefer to see a more rigorous reassessment of broader scope of problem loans as well. In fact one money center bank seems to have done just that with respect to its Fiscal 2000 statement, resulting in substantial increase in NPLs. It remains to be seen if other major banks follow suit.
- On other aspects of structural policy, there was released yesterday an important document, declaration if you will, by the Government of Mr. Junichiro Koizumi. The Prime Minister proposes to pursue wide ranging reform agenda. From our macro-economic perspective, we are paying close attention, among others, to options for fiscal consolidation. It is now established to restrain new debt issuance for Fiscal 2002 within 30 trillion yen. This compares with 34.5 and 28.3 trillion yen for the last and current Fiscal years respectively. The proposed plan pursues further consolidation in the following years paying due attention to macro-economic development. Expectation is high that the Prime Minister reshuffles Government outlays, redirecting the money from some pork barrels to more productive projects. This promises to be a formidable task indeed. Already stories abound with possible "pains" caused, for example, by reallocation of public spending. Reshuffling has nevertheless gained wide public support as it is regarded a "must" to accomplish meaningful structural reforms. It is not possible to estimate macro-economic "pains" before more details are determined. They will be in due course, particularly when the basic structure of the Fiscal 2002 budget emerges in late August. On the other hand, the positive side of the coin has to be properly taken into account in order to arrive at a more balanced view. For example, if the market gives a high mark to the beginning of serious structural reform, financial stimulus associated with such market response will partly mitigate the "pains".
- In this situation, declining trend of prices, or deflation, has attracted enhanced attention. Argument goes that deflation, regardless of its cause, is a deadly disease and, since it is a monetary phenomenon just like inflation, the central bank with money creation power should arrest the deflationary forces by expanding money supply. Let me offer some observations and then present the issue as one relevant to other countries as well.
- First, year-to-year decline of Japan's CPI, excluding perishables, has been 5-6/10th of one percent. The rate of decline certainly doesn't sound disastrous and might in more normal times be regarded as falling within a margin of error of price stability. But for the positive inflation targeters, be the exact number 2.5% for the Bank of England, or "less than 2%" which is the definition of price stability at the European Central Bank, a negative rate, however small, might be unacceptable. Obviously we have to go beyond the numbers and analyze the dynamics between economic activity and price development to arrive at an evaluation of inflation or deflation. Second, decomposition of the price basket shows that prices of imports, and of domestic goods that directly compete with imports, are declining much faster (at about 2% a year) than others. As a result goods price as a whole is about 1% down over a year. It should be noted here that, thanks to the enhanced capacity of emerging economies to manufacture and export quality consumer goods at lower prices, goods price has tended to stabilize in many developed economies. In the U.K., as you know well, goods inflation is now virtually zero while service inflation is still around 3%. The same can be said of the U.S. Third, and this is a unique feature of Japan's price performance, service prices are quite stable. Traditional service prices can be roughly regarded as a function of wages. Nominal wages dropped 2.5% cumulatively in 1998 and 1999, and rose only marginally by 4/10th of one percent in 2000. In other developed economies, tight labor market conditions have pushed up wages, and therefore service prices, by 3-4% a year. In addition, as deregulation is under way in Japan, some administered service prices are being cut; telephone and electric utility rates are the most notable examples. Fourth, the combined forces of deregulation, technology and globalization are effectively rationalizing the distribution system and offering our consumers for the first time "cheap chics" and other attractive merchandise, including imports, at very reasonable prices.
- These observations appear to indicate that in Japan today positive " supply shock" is at work to exert strong downward pressure on prices. The general background for such supply side improvements is the trend for enhanced integration of the world economy and the pressure it is generating for Japan's economy to grow more efficient. Regrettably it is not possible to quantify such " supply shock" effects due to limited information from the CPI. When the Bank of Japan deliberated on price stability last year, the Policy Board recognized such supply side effects on prices and decided not to define price stability in numerical terms. The Board left open the option to do so in the future, when structural adjustment hopefully slows down.
- I have so far discussed how structural changes are affecting Japan's price performance. Their importance notwithstanding, they are but one aspect of our moderate deflation. You might then ask if there isn't any downside, as is generally associated with deflation, and, if there is, how monetary policy can address it. Above all, you might ask, why monetary expansion can't keep the general price level stable, leaving the relative change in prices. The latter parts of the question can be better treated in the context of monetary policy options a few minutes later. I will first discuss how we at the Bank of Japan have evaluated the deflationary trend. Put simply, deflation is a problem when it exerts pressure on demand and output. When output gap widens, it tends to aggravate deflation and so the process could feed on itself. In the light of this, we have been focusing on the possibility of such theoretical chain reaction. Through mid-last year, profit was surging, wages were stabilizing, and GDP growth appeared to gain some speed. Thus a moderate deflation then was thought to be a product of supply side shock as well as of relatively moderate growth of demand, and not to hinder mild economic growth. The picture changed significantly toward the year-end. We gradually shifted emphasis to weaker aggregate demand and its downward pressure on prices. This change in our assessment of the background of deflation, from supply side to demand, led us to a series of policy easing since early this year, culminating in the March 19 decision that we would maintain de facto zero-short-term-interest-rate-regime so long as CPI deflation continues. Therefore we clearly recognize the negative effects of deflation under certain macro-economic environment and have mobilized our conventional weapon, the short-term rate, to the maximum degree.
- I have now arrived at the final topic for today ... monetary policy. The question left is whether monetary policy can still do something meaningful after hitting the zero interest rate bound, presumably by mobilizing " unconventional" instruments. This is the point raised here last month by my central bank colleague, Governor Laurence Meyer of the Federal Reserve Board. Critics of Bank of Japan usually proposes aggressive "monetization" after short-term rates have dropped to zero. Generally speaking, the "monetization school" assumes that the central bank can expand money supply by injecting more reserve to the banking system. This would be done by purchasing, or "monetizing", Government debt. I think this argument doesn't always hold in the real world.
- Let me start with some plain numbers in Japan. In the last 5 years, the monetary base (which the central bank directly supplys) has increased at 8% a year. Broad money (which private depository institutions provide through activities in the market) grew at much slower 3.3 % a year. And this 3% growth is entirely due to financial institutions' acquisition of Government debt; loans have contracted by -0.4% a year.
- There are two issues here. One is well known: malfunctioning of banks' intermediary role. It is the consequence of balance sheet problem at creditors and debtors. Improvement here is an important item in the structural reform agenda of the Government. The other is less well known and less well understood, but nonetheless a fundamental question: can central bank inject reserve as it wishes when there is no demand? That short-term interest rates are effectively zero means that liquidity is abundant and market players can raise liquidity any time. In this environment, financial institutions don't seem to have incentives to hold excess reserve beyond certain level even at zero cost. Such a lack of appetite for holding excess reserve has already surfaced in the form of " undersubscription" for Bank of Japan's offer to purchase short term bills. Purchasing long-term bonds or "monetization" wouldn't solve the problem, as it does not change the total demand for reserve. Supplying reserve at the long-end would simply replace the reserve injection at the short-end. It is an alternative channel to supply water to a reservoir with the water level unchanged: a "monetization" of Government debt without increasing the monetary base.
- I am also skeptical of the monetization's effects to lower long-term interest rates. According to the expectation theory, long-term rates are determined by the expected series of short-term rates in the future plus a term premium. "Monetization" might be interpreted by the market as the central bank's will to keep low short-term rates and might affect the expectation. But the central bank can show such determination by more explicit commitment and that is what the BOJ did in March. Some of you may recall that the Bank of Japan expanded the reserve so as to induce short-term rates to zero and promised to continue such operation until CPI deflation comes to an end.
- In this environment, structural policies are important though they may in the short-run prove to generate deflationary pressures. But they are the ones to improve the system more flexible and productive. Expectations for future growth may well be enhanced as structural adjustments take hold. Although our monetary policy options are essentially used up, we at the central bank shall nevertheless continue to explore if there is still an avenue left that would help generate new positive expectations for the future without leaving behind serious adverse effects.