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Recent Economic and Financial Developments and Monetary Policy in Japan

Speech given by Teizo Taya, Member of the Policy Board of the Bank of Japan, at the Meeting on Economic and Financial Matters in Hakodate City, Hokkaido, on November 7, 2002

December 20, 2002
Bank of Japan



I am most grateful for this opportunity to speak at this meeting and exchange views with you who represent various sectors of industry in Hakodate and other parts of southern Hokkaido. I would first like to talk about recent economic and financial developments and monetary policy in Japan before listening to your views on the state of the local economy.

I. Recent Economic and Financial Developments in Japan

About this time last year, I had the opportunity to talk to the people of Shizuoka prefecture on a similar topic. At the time, less than a month after the terrorist attacks in the United States, the outlook for the global economy was extremely unclear. A year has passed, but the economic and financial future is no clearer today. In particular, the outlook for overseas economies, particularly that of the United States, is still uncertain, as are also the possible effects of the disposal of nonperforming loans (NPLs) held by financial institutions, if and when the process is accelerated. Before I go into these points in detail, I would like to touch on the Policy Board's most recent economic outlook released last week.

A. Outlook and Risk Assessment of the Economy and Prices as of October 2002

The economy as a whole has finally stopped deteriorating due to the better-than-expected performance of exports and production in the first half of the fiscal year, April-September 2002. The increase in exports and production, however, has recently slowed, and as a result, the economy is likely to move sideways for the rest of this year. Private consumption remains weak but is holding up despite the weakness in income. The downward trend in business fixed investment seems to be drawing to an end but is unlikely to bottom out immediately. Public investment continues to be on a declining trend, and housing investment remains weak. Looking ahead, the domestic economy is likely to start recovering from next year, probably in the first half of the fiscal year, as long as overseas economies, led by the U.S. economy, continue their gradual recovery. A continued increase in exports and production will lead to a rise in corporate profits, setting in train a mechanism for economic recovery. However, even with an increase in corporate profits, strong pressures for the reduction of excessive debt and redundant labor are likely to delay recovery in both business fixed investment and private consumption, and also slow its pace when it happens.

Against this background, the economic outlook of the majority of the Policy Board members was as follows: real GDP growth in fiscal 2002 ranged from 0.2 to 0.5 percent in their forecasts; the year-on-year change in the domestic CPI ranged from minus 0.9 percent to minus 0.7 percent; real GDP growth in fiscal 2003 ranged from 0.4 to 1.0 percent; and the year-on-year change in the domestic CPI in fiscal 2003 ranged from minus 0.6 to minus 0.4 percent. These forecasts indicate a continuation of gradual recovery but the board members add the caution that both upside and downside risks are more significant than in past recovery phases. They have in mind five risk factors as follows. The first risk factor stems from developments in overseas economies, especially the United States. The second is uncertainty regarding the strength of domestic private demand. The third is progress in dealing with NPLs and their effects. The fourth is the impact of fiscal developments, including fiscal reform, on the economy. And the fifth is financial market conditions. Today, I would like to talk about the first and third risk factors.

B. Overseas Economic and Financial Developments

I am afraid the ongoing recovery of Japan's economy will continue to depend greatly on external demand. This is because, at the moment, none of the domestic demand components seems to be able to achieve self-sustained growth and give a boost to the economy. The scope for possible policy measures is currently limited, and no component of domestic demand is sufficiently responsive to stimulus measures to lead the economy to a full-fledged recovery. Thus, developments in overseas economies are becoming increasingly important for the Japanese economy.

I would like to start with the U.S. economy. The U.S. economic outlook has gradually become cautious since around spring 2002. In the first half of October 2002, U.S. stock prices fell to the lowest level since the spring of 2000, but have been recovering since then. However, few see this as a sign of improvement in economic activity. The mainstream view is that the recent recovery of stock prices merely reflected the revision of extremely cautious views of corporate profits following the release of profits for the July-September quarter. Even considering the level of interest rates at that time, it is reasonable to think that stocks were under extremely strong selling pressure. Recently, however, concern about the economic outlook is on the increase.

Economic indicators suggesting a slowdown of the U.S. economy have been released one after another. Since around this summer, indexes of consumer confidence and business sentiment have declined sharply due partly to the fall in stock prices, but household spending continues to be firm. This is because, despite the fall in stock prices, interest rates have continued to decline and housing prices have remained strong. As a result, some parts of household spending that are sensitive to fluctuations in interest rates have underpinned the economy, for example, housing investment and automobile sales under sales promotion measures introduced late last year. The question now is when business fixed investment will recover, and whether household spending can maintain its strength until then.

The recent situation of the U.S. economy seems to be similar to what the Japanese economy experienced in the early 1990s in the aftermath of the bursting of the bubble in asset prices of not only stocks but also real estate. Developments in housing prices are considered to have a greater effect on household spending than stock prices, and their prospects will depend largely on interest rates. So far, housing prices are unlikely to fall as long as mortgage rates are either stable or declining. What about the effects of the fall in stock prices? The total market value of stocks listed on Nasdaq and the New York Stock Exchange plunged to 10 trillion U.S. dollars at the end of September 2002 from 18 trillion U.S. dollars at the end of March 2000, a decline of more than 40 percent. In the same period, the total market value of stocks listed on Nasdaq, where many high-tech companies are listed, fell sharply to 1.7 trillion from 6.3 trillion U.S. dollars. Again, this matches the size of the decline recorded on the Tokyo Stock Exchange since 1990.

In the case of the United States, the effects of stock price falls are not concentrated on financial institutions, which is a marked difference from the situation in Japan. U.S. banks do not hold stocks, and firms' dependence on bank loans is relatively low. Thus, losses from stock price falls are shared widely among market participants on a continuous basis. Even so, losses are still losses, and the negative effects from the fall in stock prices have surfaced recently with the passing of time. Those who have incurred losses are, for example, some private investors and also institutional investors, especially some pension funds, and their losses have recently become obvious. In the United States, approximately 40 percent of private pension funds are still defined benefit pension plans, and the shortfall in the reserves for pension benefits due to the decline in stock prices will have to be covered by firms themselves, as in Japan. The impact of the decline in stock prices will depend on how long it will take firms to cover the loss, but this will definitely place downward pressure on corporate profits. The decline in stock prices has also made investors more risk averse, and thus firms are experiencing greater difficulty in borrowing from the capital market. Furthermore, it has become increasingly difficult to issue initial public offerings of stocks. The issuing environment for corporate bonds and CP with low credit ratings is severe, and high interest rates are demanded of firms. And on top of this, firms are becoming more inclined to pay back debt. How these developments affect business fixed investment and household spending warrants closer attention than before.

The mid-term elections in the United States ended two days ago, and given the results, many people consider that the tension in the Middle East will increase further. Even before the elections, many Americans had felt that a heightening of tension would be unavoidable, and this placed downward pressure on stock prices and business sentiment. Depending on the way in which the Middle East situation is resolved, market participants may respond favorably to the outcome or, in the worst case, show extreme disappointment. The reaction of market participants could be either an upside or a downside risk to the outlook for the U.S. economy. Yesterday, the Federal Open Market Committee (FOMC) reduced the federal funds rate target by 50 basis points to 1.25 percent, and also the discount rate by 50 basis points to 0.75 percent. So far, market participants seem to be responding favorably to the decision, but further developments should be monitored carefully.

Another issue that should be kept in mind is the effect of the global deflationary trend. People talk a lot about "global deflation" these days, meaning a situation where there is downward pressure on prices resulting from expansion of the supply capacity of the world economy. The supply capacity of the world economy has, in fact, increased substantially. For example, China and the countries of the former U.S.S.R. have succeeded in becoming market economies, and their impact on the world economy has increased greatly. The IT bubble in stock markets has burst, but the positive effects of the IT revolution on economic activity have spread globally. This has also placed downward pressure on prices including services prices. Industrialized countries are caught up in intense competition unprecedented in history, and as a result, deflationary pressure is rising and there is an increasing possibility of a hollowing-out of industries. These are structural factors placing downward pressure on corporate profits, and in turn, domestic investment, employment, and wages may decline. This has become a problem not only in the United States but also more seriously in Japan and some European countries, especially Germany.

In the euro area, domestic demand has been weak overall, and as in Japan, the pace of increase in exports and production is slowing. The weakness in the German economy stands out in the area, and the situation displays many similarities with that in Japan. First, the total market value of stocks has fallen to 0.6 trillion U.S. dollars at the end of September 2002 from their recent peak of 1.55 trillion at the end of February 2000, that is, a fall of approximately 60 percent. Second, banks hold stocks, and along with insurance companies, their assets have been impaired due to the stock price fall. Third, it is becoming likely that there will be a shortfall in the reserves for pension benefits. Fourth, among the industrialized countries, Germany, like Japan, has a relatively high concentration of manufacturers. Fifth, the labor market is inflexible, and there seems to have been very little progress in deregulation. Other characteristics of the German economy are that, as a member of the European Union, there is very little room for Germany to take easy fiscal policy. Furthermore, the Bundesbank cannot take monetary easing measures independently because monetary policy decision-making is entrusted to the European Central Bank. Recently, the economy is being strongly influenced by the neighboring East and Central European countries whose economic reconstruction is in progress.

Lastly, I would like to comment on the situation of East Asian economies. The pace of increase in exports is declining in most of these economies. The decline has been especially conspicuous in Taiwan and Singapore where IT-related goods accounted for a large share of exports and production. In China, however, exports are growing rapidly by around 30 percent from the previous year. Domestic demand has been strong due to the increase in fiscal spending and the continued inflow of a high level of direct investment from abroad. The economy has grown by about 7-8 percent from the previous year. Meanwhile, it is interesting to note that consumer prices are showing a tendency to decline from the previous year not only in China but also in some neighboring economies, namely Hong Kong, Taiwan, and Singapore. Given that the renminbi is pegged to the U.S. dollar, the downtrend in consumer prices may be reflecting the influence of China's excessive supply capacity on other economies.

C. The Disposal of NPLs and Its Effects

Now I would like to turn your attention to the situation in Japan and consider the issue of the disposal of NPLs and its effects. About a month ago on October 11, the Bank released a paper titled "Japan's Nonperforming Loan Problem." I would like to briefly talk about this paper. It points out that the nature of the problem has changed. Some people are still of the view that the cause of the NPL problem lies essentially in the slow pace at which the negative legacy of the bubble era is being disposed of, and that the problem will be solved if bold steps are taken to eradicate that legacy. However, the facts do not support that view.

The cumulative amount of loan write-offs and loan-loss provisions by Japanese financial institutions since 1990 stands at about 90 trillion yen. This is equivalent to about 80 percent of the increase in loans during the bubble period of the second half of the 1980s. The ratio of loans outstanding to nominal GDP has already declined to the level observed before the bubble period. Nevertheless, large amounts of new NPLs continue to emerge and these continue to pose the greatest threat to the stability of the financial system.

Amid the intensified global competition and other changes in the business environment, the Japanese economy is under increasing pressure for structural adjustment, which forces nonviable firms to exit and allows new promising firms to emerge. As a result, more and more firms are seeing their business deteriorate due to reasons unrelated to the bursting of asset price bubbles, such as recession and falls in sales due to competitive import prices. In other words, while the NPL problem was previously characterized primarily as the negative legacy from the bursting of asset price bubbles, recently it has increasingly become more a question of dealing with NPLs newly generated through structural changes in industry and individual businesses.

Japanese banks now face a more severe challenge than ever in dealing with the NPL problem for the following reasons. First, a substantial amount of new NPLs is continuously being generated as structural changes progress. Second, the lending margins of banks remain low. And third, unrealized gains on bank stockholdings, which used to serve as a buffer to cover losses, have been exhausted. An appropriate evaluation of the economic value of NPLs and concomitant provisioning for the potential losses are prerequisites for the solution of the NPL problem. It is also essential to expand the secondary market for loan assets through such measures as active use of the Resolution and Collection Corporation (RCC), thereby providing an environment in which NPLs are priced on a market basis, and to urge banks to remove these loans from their balance sheets.

The Bank's paper concludes that "if faced with the risk of a financial crisis, we should respond to the situation in an appropriate and flexible manner with the government invoking Article 102 of the Deposit Insurance Law and the Bank of Japan acting as lender of last resort." It adds that, "while staving off a financial crisis, we need to prepare an environment which is conducive to the steadfast resolution of the NPL problem. In this regard, we should encourage banks to reduce their shareholdings. Furthermore, we should consider an option to inject public funds into banks at risk of becoming undercapitalized in the process of the quick disposal of NPLs. Injection should be conducted in such a way as not to undermine the incentives to improve competitiveness."

At the time the Bank was preparing the paper, no one expected the discussions on accelerating the process of NPL disposal to make so much progress in so short a time. The contents of this paper now seem commonplace. But, if that is so, it is because so much progress has been made over this period. Last week, the government announced the "Program for Financial Revival." While the Program and the Bank's paper have quite a lot in common, the Program's proposals are more specific.

Both, for example, take the same or a similar view with regard to conducting a more rigorous assessment of banks' assets by introducing discounted cash flow type methods in provisioning and by reviewing the criteria for the average remaining period of loans used to calculate the amount of provisioning. Furthermore, they both call for a swift injection, when required, of the necessary amount of public funds based on the Deposit Insurance Law.

Furthermore, the Program advises relevant ministries and government offices to: (1) introduce a new tax measure which enables provisioning to be recognized as a tax-deductible loss; (2) remove the freeze on the refund carry-back system; (3) extend the carry-over period for tax deficits; and (4) redefine deferred tax assets that are to be included in regulatory capital. With regard to any financial institution that accepts public funds and receives special support, the Program states that it should divide its account into a New Account and a Revival Account for the purpose of accounting management. It also states that the Financial Service Agency (FSA) will conduct another round of special inspections and disclose the gap between major banks' self-assessments and the results of the inspections. It also made clear its intention to convert in certain cases publicly held preferred stocks issued by banks into common stocks.

Establishment of an institution to assist the revitalization of industry was also announced by the government in its "Comprehensive Measures to Accelerate Reforms," which was released together with the above Program. This institution will exist alongside the RCC under the auspices of the Deposit Insurance Corporation. The role of this institution will be to purchase from banks other than the "main banks" of the firms the loans extended to firms which are classified such as borrowers needing "special attention" but have been judged by the institution to be capable of restructuring. These loans will be purchased at fair market prices on the assumption that these firms will be revitalized. In this way, together with the main banks of firms in difficulties, the institution will assist in their revitalization. I believe this institution will prove useful. There are, however, a number of points that are still unclear, such as the actual structure of the institution, the way in which the New Account and Revival Account are to be divided in financial institutions which received special support, and other points regarding tax effective accounting that are still under discussion.

Thus, there are matters that remain to be decided, as outlined above. However, with the help of stricter assessment of assets accompanied by adequate loan-loss provisioning, these new measures could produce significant impact. The exact size of that impact, however, depends very largely on how the measures as laid down in the Program are implemented, the volume of debts to be sold to the RCC and the new institution for industrial revival, and the span of time within which such sales are completed. Furthermore, the scale of future tax cuts, employment safety net measures, and steps to support small firms will also be important in assessing the impact of the implementation of the Program. Thus it is difficult, at this stage, to indicate the impact on the economy in quantitative terms. I shall have to pay close attention to further developments, staying on the lookout for any sign of anything that might impair the proper working of the financial system.

In order to facilitate resolution of the NPL problem, the Bank of Japan has announced that it will buy 2 trillion yen worth of banks' stockholdings at market prices, in principle by the end of September 2003. The decision was based on the view that, since market risk pertaining to stocks held by banks has become a significant destabilizing factor, it is essential to reduce such risk to ensure financial system stability as well as help lay the foundation for banks to deal with the NPL problem. Banks whose stockholdings exceed their Tier I capital are eligible for the scheme and the purchases will be made through a trust bank selected by public tender. Last week, The Master Trust Bank of Japan was awarded the rights as the buying agent. The Bank is likely to be able to start buying operations by the end of this year. Listed stocks with a rating of BBB- and above are eligible and the stocks to be purchased will be determined randomly under a fixed rule. In other words, there will be no room for the Bank's discretion. With regard to the exercise of voting rights, the Bank will present basic principles regarding these rights to the trust bank (the trustee), and the trustee will exercise them taking due account of fiduciary responsibility. The Bank will in principle hold the purchased stocks for five years and will thereafter complete disposal of the stocks over a period of ten years.

Banks generally have a tendency to refrain from selling stocks with unrealized losses to avoid recording losses on their financial statements. However, they are now required by law to sell stocks held in excess of their Tier I capital by the end of September 2004. Moreover, the recent volatility in the stock market has increased the risk involved in holding an excessive amount of stocks. The impact on market prices of purchases by the Bank is likely to be smaller than if the stocks are sold through the stock exchange, and some of the issuing companies might prefer their stocks to be in the stable hands of the Bank for a fixed period of time rather than have them sold to the market. As an option, I believe the Bank's stock purchasing plan is a meaningful one.

The scheme is not a so-called PKO, a "price keeping operation" to support the level of stock prices, nor is it part of the Bank's monetary policy. The Bank is not short of means for supplying credits in its pursuit of monetary policy. The scheme may incidentally have slightly alleviated concerns about the deterioration in the supply-demand balance in the stock market, but that is not the Bank's objective either. Some people have suggested that it would be better if the Bank increased the size of its planned purchases but this would be difficult. Banks have other means of sale and the Bank of Japan has its own financial soundness to maintain.

II. The Bank's Recent Conduct of Monetary Policy

I would now like to move on to recent monetary policy. Last week, the Bank decided to implement additional monetary easing measures. I would like to explain the background to the decision as well as the Bank's thinking on the measures from my point of view. Lastly, I will comment on the Bank's conduct of monetary policy in the future.

A. Recent Monetary Policy

At the Monetary Policy Meeting on October 30, the Bank decided to change the guideline for money market operations and take measures to strengthen its capacity to provide liquidity. First, the target for the outstanding balance of current accounts at the Bank was increased to "around 15 to 20 trillion yen" from "around 10 to 15 trillion yen." Second, the outright purchase of Japanese government bonds (JGBs) was raised to 1.2 trillion yen from 1 trillion yen per month. Third, the maximum length of maturity for bills purchased in outright bill purchasing operations was extended to one year from six months. It was also added in the statement released after the meeting that the Bank would explore possible measures to improve the environment for corporate financing.

The Bank's decision was based on the following reasons. The recovery of the economy is weak, and the pace of increase in production is likely to decelerate. The economy will continue recovering moderately in the standard scenario for 2003 and onwards, but risk factors warrant closer attention. Stock prices weakened due to concern that an acceleration in the process of NPL disposal would have a negative impact on the economy. There was a risk that this fall in stock prices could cause instability in the money market. Some types of interest rates started to rise slightly reflecting the shortage of funds in the market because some financial institutions became cautious about investing their funds there. However, this factor alone might not have necessitated the Bank increasing the amount of its funds provisioning. Meanwhile, there was also a view held by some members of the Policy Board that it was not appropriate to provide additional funds frequently in accordance with the contingency clause. Another option for the Bank could have been to wait until the overall picture of the Government's deflation countermeasures and measures to accelerate the process of NPL disposal, including measures to revitalize economic activity, became clearer. Nevertheless, the Bank's decision to purchase stocks held by banks and the release of "Japan's Nonperforming Loan Problem" have certainly advanced the process of the resolution of the NPL problem. Finally, given that the Government was going to release measures to counter deflation, the Bank considered it appropriate to implement a feasible monetary policy measure as soon as possible rather than to wait until some time later.

There are those who interpret the Bank's decision on further monetary easing as an act in cooperation or in coordination with the Government. However, the relationship between the Bank and the Government is clearly defined in the Bank of Japan Law of 1997. The Bank engages in frequent and full exchanges of views with the Government, as stipulated in the Bank of Japan Law, and decides on monetary policy at the Monetary Policy Meetings on the basis of economic and financial developments at the time. The Bank and the Government hold the same view of the current economic and financial developments and they share the same objective of overcoming deflation. And with this common basis, it turned out that the Bank's decision was in line with the Government's policy measures.

The Bank has again set a target range for the outstanding balance of current accounts held at the Bank. Up until the change, members had considered it appropriate to aim as high as possible within the target of "around 10 to 15 trillion yen," and the staff had been instructed to conduct money market operations to achieve this end. For the time being, the Bank will aim at the middle of the new target range, but at the same time the Bank will most likely discuss whether to aim at the higher end of the range on the basis of market conditions and other economic and financial factors. The Bank intends to increase the amount of outright purchase of JGBs, if that is deemed necessary in order to smoothly increase the outstanding balance of current accounts. The increase in the outright purchase will be decided based on the target amount, changes in funds demand in the market, and the market response expected from the possible increase. The effects of an increase in the amount of outright purchase will last for a certain length of time, and in the meantime, the number of other market operations can be reduced. However, outright purchase of JGBs can sometimes trigger a rise in interest rates depending on market conditions. Thus, the amount of increase in the outright purchase of JGBs should be decided based on market conditions.

The Bank decided to extend the maturity of bills purchased in outright bill purchasing operations to increase the effectiveness of money market operations by expanding funds-supplying tools to fully meet funds demand of operation counterparties. In outright bill purchasing operations, the Bank purchases bills backed by pooled collateral submitted by operation counterparties in advance. Operation counterparties can therefore substitute collateral at any time, and thus these operations are suitable for supplying long-term funds.

The Bank has also announced that it will explore ways to improve the environment for corporate financing, but I cannot comment much on this today since we have not yet decided on specific measures. However, we fully understand that the Bank's provision of ample funds has not adequately reached firms outside the financial system, although it is contributing to stabilizing financial markets. We also see a possibility that firms will temporarily experience greater difficulty in raising funds as the process of NPL disposal accelerates. The Bank will continue to endeavor to find ways to alleviate this situation.

B. Monetary Policy in the Future

The debate on whether to introduce inflation targeting has emerged again recently. I am still against the adoption of inflation targeting. Price developments are said to be a monetary phenomenon. That is, if money were supplied constantly, the general price level would eventually increase. For example, suppose if the government implemented a large-scale tax reduction and issued Japanese government securities to finance it, and the Bank purchased them. After repeating this process for some time, the money supply could increase constantly and inflation could occur. In this case, the Bank alone does not create inflation; it merely has a part in the creation of inflation through monetization of the fiscal deficit. However, with fiscal policy as an external factor, the Bank can increase the amount of the money supply by creating demand for money by the following process. The Bank provides liquidity in exchange for financial assets and thereby lowers interest rates, and in turn, increases various asset prices. Economic activity is thus stimulated, and demand for money is increased.

This creation of money through monetary policy can be found in any macroeconomics text book. However, where there is very little room for short-term interest rates to decline, a central bank might not be able to achieve the results it intended in influencing the direction and magnitude of changes in asset prices, such as long-term interest rates, stock prices, and real estate prices, even if it tried to do so directly. Under such conditions where there are very few policy options for the central bank, it cannot commit itself to achieving a certain level of inflation within a specified period, and even if it did, its actions would not be considered credible. Some advocates of inflation targeting point out the effect on expectation as the merit of adopting inflation targeting, but the Bank has already been adopting this idea in its policy and has made a commitment to the extent to which the Bank can be accountable in the current circumstances. Specifically, the Bank has made a commitment in terms of policy duration to continue drastic monetary easing until the consumer price index can record year-on-year increases of zero percent or more on a sustainable basis. This has contributed greatly to stabilizing medium- to long-term interest rates.

I am not saying that the Bank will not adopt any unconventional money market operations in the future, nor have I strongly objected to any such measures in the past. There have been suggestions, for example by market participants, for unconventional measures the Bank could take such as to influence various asset prices, and I have explained my views on them. These measures were, almost without exception, difficult to adopt because their effects were uncertain, or their negative side effects were too great. An example is the purchase of stocks as a means of monetary policy, which would push up stock prices, but the central bank should avoid intervening directly in the heart of the market economy except in an emergency. In the current situation, it is not a possible option from my point of view.

Thank you very much for your kind attention.