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The Challenges Facing Japan's Economy and the Monetary Policy Response

Based on a speech given by Shin Nakahara, Member of the Policy Board, at the Keizai (Economic) Club in Osaka on November 21, 2002. It is a translated and revised version of the Japanese text released on November 22.

December 30, 2002
Bank of Japan


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It is my very great pleasure to speak to you today about the Japanese economy and monetary policy. Before I begin, I would like to say first what an honor it is to be here at the Keizai (Economic) Club in Osaka where there have been so many illustrious speakers over the years. I would also like to offer my warmest thanks both to Toyo Keizai, Inc. for giving me this opportunity to speak, and of course to all of you for coming here today.

To begin with, I would like to discuss what lies ahead for the Japanese economy toward the end of this fiscal year and into the next. For your reference, my discussion will draw upon the "Outlook and Risk Assessment of the Economy and Prices" (hereafter the Outlook Report) released in October 2002 by the Bank of Japan. This report represents the opinion of the majority of the Policy Board. Of course there are some small differences of opinion among the nine members of the Board, and there are some subtle distinctions in where individual members would choose to place particular emphasis. Today I shall be offering you my own personal interpretation of these matters.

Next, bearing in mind the current state and the outlook for the Japanese economy, I will be considering what the Bank has done and what it ought to do.

Perhaps for many of you in today's audience, the first thing that springs to mind when conversation turns to the Bank's policies is the announcement in September to purchase stocks from banks. I have heard a variety of opinions on this subject, both for and against the Bank's policy. For example, some are critical: "Is this type of measure really appropriate for a central bank?" they ask. Others misunderstand the policy: "The Bank is finally looking to support stock prices with this policy," they say.

Then there was the Bank's adoption of quantitative easing measures, a policy unprecedented for a central bank, aimed at increasing the outstanding balance of current accounts held by financial institutions at the Bank. I am aware that there are those who doubt the effectiveness of this policy: "What is it for?" they ask; "It doesn't seem to be doing any good at all for the economy."

Today, I would like to narrow the gap of understanding between us at the Bank and those who voice such criticism and have such doubts. At the same time, I hope to be able both to describe in detail the structural problems confronting the Japanese economy, and to explain what needs to be done, in the process of dealing with these problems, to place Japan on a self-sustained recovery path.

I. Current State and Outlook for the Economy

A. Current State of the Economy

First of all we should look at current economic conditions and at the Outlook Report. Of course, talking about the economic state of affairs always involves an element of instinctive feeling. It is possible, however, I think, to sum up the current situation as "although the economy has finally found the bottom, with a number of pitfalls scattered around in the shape of various risks, the economy has not yet bottomed out."

With a recovery in overseas economies and the restocking of inventories for IT-related goods abroad, Japan's economy started to show signs of stabilizing earlier than expected in the first half of this fiscal year. This is evident from Chart 1, which shows developments in exports and industrial production in the first half of fiscal 2002. However, uncertainty about the outlook has been growing with a decrease in the pace of the recovery in overseas economies and the fall in world stock prices. If we look more closely at the state of upstream industrial activity reflected in the figures for real exports and the industrial production index in September, we see a pause in growth in real exports and production. Looking at machinery orders and shipments of capital goods between September and October, it is evident that, in spite of the recovery in corporate profits, firms' stance on business fixed investment remains tight. The contribution of business fixed investment to GDP was negative, although only slightly, in the July-September quarter.

Turning to the employment situation, overtime hours worked continues to increase and new job offers have also been increasing. However, the improvement in the employment situation has been marginal and limited to increases in overtime hours worked and in numbers of non-regular employees, with firms' stance on the reduction of personnel expenses taking firmer hold. Thus, the employment and income situation of households remains severe overall. Under these circumstances, in the downstream sector of the economy, consumer confidence and hence private consumption are weakening. This weakening is evidenced not only by the Cabinet Office's Consumer Confidence Index, but also by a consumer confidence index from a survey carried out by a private research institute.

In the United States, not only did real GDP expand relatively strongly in the July-September quarter, but housing investment has been firm and further positive effects from anticipated tax cuts and interest-rate cuts are expected. However, looking at the economic indicators, a growing number of indexes suggest that we should not be too optimistic. If you look at Chart 2, you will observe not only that industrial production has been decreasing for three consecutive months, but also that the capital utilization rate has fallen almost as far as it did during the last recession in 1990-1991 and that corporate profits have also been weak. A fall in the capacity utilization rate and a drop in corporate profits indicate a delay in recovery in business fixed investment. At the same time, private consumption, which has hitherto been supporting the U.S. economy, is starting to show signs of slowing as household sentiment continues to deteriorate due to the fall in stock prices. According to electrical-appliance makers manufacturing digital versatile disc (DVD) players and liquid crystal televisions, the flow of goods in preparation for the pre-Christmas shopping season has not been brisk. Expected further tax cuts following the mid-term election, a reduction in the federal funds rate to 1.25 percent, and stable housing prices may all be considered positive factors. Yet it remains questionable whether these positive factors will be enough to make up for the reductions in other components of demand, and whether they will be enough in themselves to guide the whole economy in a positive direction. The key point is whether private consumption will remain resilient until the corporate sector gets back on the road to recovery. In the meantime, uncertainty about the economic outlook is growing, with a dark shadow being cast over the economy by heightening tensions in the Middle East, high crude oil prices, a weakening of the U.S. dollar, and a fall in stock prices.

Meanwhile, in the Euro area, although economies in the area have hit bottom, the pace of increase in exports and production has begun to taper off. In Asia, countries such as Korea, China, and Thailand have strong domestic demand, but in the NIES countries, which depend so heavily on exports to the United States, there are some signs that exports are weakening.

In the Outlook Report released in April, the following were listed as potential sources of risk: the uncertainty regarding the strength of domestic private demand; the strength and sustainability of recovery in overseas economies; developments in dealing with NPLs; developments in key asset prices such as stock and land prices and long-term interest rates; and the uncertainty associated with the progress of structural reform and its effects. Although there have been differences in the degree, it is fair to say that all of these risks have materialized to some extent, and that their influences on the economy are indeed being slowly felt.

B. Outlook and Risk Assessment

As described above, Japan's economic recovery, whose momentum is dependant on external demand, has begun to run out of steam, and concerns are growing that exports and production may peak out before the recovery extends to domestic demand such as business fixed investment and private consumption. The Outlook Report predicts that "Japan's economy is not expected to demonstrate clear signs of recovery during the remainder of fiscal 2002." To put it another way, it predicts that "the economy will hold out at the current low level." The current recovery, like the one preceding it in 1999, has been driven by external demand. However, while in the previous economic recovery in Japan, both private consumption and the corporate sector--which was enjoying the IT boom--were firm in the United States, this time around it is only private consumption that is firm in the United States. During this economic recovery, exports started to recover earlier than expected but also slowed earlier as the recovery in overseas economies weakened. About ten months have past since the recovery of the Japanese economy started, but consumption is still weak and business fixed investment, although it appears to have hit bottom, does not seem to be expanding. This is why we expect the pace of economic recovery to remain weak.

Next, we need to think about what will happen in fiscal 2003. Will we see the recovery strengthening clearly? Or will fiscal 2003, like fiscal 2002, be characterized by an extremely gradual recovery followed by a move back toward recession?

Looking at the world economy, both advanced and developing countries show a marked tendency toward deflation, and, to a greater or lesser extent, are beset by structural problems. It would also be fair to say that, given the risks implicit in a rapidly changing international political situation, the external environment surrounding Japan is unstable. Furthermore, on the domestic side, adjustment pressures on the supply side look set to become, if anything, somewhat stronger, as a result of NPL disposals, corporate restructuring, and the weeding out of nonviable firms.

The scenario drawn up by the Policy Board in early fiscal 2002, of the Japanese economy entering a gradual recovery phase, based on a recovery in overseas economies and supported mainly by external demand, does not basically need to be changed. So long as external demand does not suddenly fall sharply, I think the momentum for recovery will be maintained throughout fiscal 2003. However, the recovery will filter through to nonmanufacturing industry, business fixed investment, and private consumption only extremely slowly.

In the Outlook Report released in October, we listed five risk factors that may affect the basic scenario for recovery.

The first of these is developments in the U.S. and overseas economies. The Chinese economy is currently continuing to grow strongly and rapidly. The NIES countries, which depend so much on exports to the United States, have been just about managing to get by on the strength of the increase in their exports of intermediate goods to China. On the other hand, as I pointed out earlier, the economic outlook for the United States and Europe does not look so bright. As the U.S. recovery depends heavily on private consumption, developments in asset prices such as stock prices and housing prices are a cause for concern. Attention must be paid to developments in emerging markets too. Economic and financial turmoil continues in Argentina and financial markets and the political situation in Brazil also requires close attention. In places such as Indonesia and the Philippines, where recent terrorist incidents have raised concerns over deteriorating security, stock markets have plunged and currencies have weakened.

The second risk factor is the strength of the recovery in domestic private demand components, such as private consumption and private business fixed investment. The absence of fresh sources of demand is the most substantial problem. For example, the market for mobile phones, the driving force behind the growth of IT-related industries, suddenly appears to be increasingly saturated, and sales of next generation mobile phones are not looking promising. There is a concern that, with a deterioration in the environment surrounding employment and income, uncertainty about the future may grow and both business sentiment and consumer confidence may spiral downward as in 1997.

The third risk factor is the progress in dealing with NPLs, and the effects on the economy. Although it hardly needs repeating, disposal of NPLs and dealing with the structural problems that underlie these is a task that the Japanese economy has to overcome if it is to recover fully. However, if the measures adopted for dealing with these problems are too abrupt, and if due account is not taken of the state of the Japanese economy, then the concomitant effect on the economy will be substantial.

The fourth factor springs from the impact on the economy of fiscal developments, including fiscal reform and the balance of fiscal income and expenditure. The ratio of the total outstanding public debt to GDP now exceeds 130 percent. Thus, it is most important to continue efforts to reduce government deficits through policies for government bond issuance that gain public confidence. However, despite weak private demand, the government has decided to increase, from fiscal 2003, the share of social welfare costs such as medical expenses to be borne by individuals. Given the circumstances, I think that deeper consideration about the most appropriate role for fiscal policy is required.

The last risk factor is developments in financial markets. U.S. stock prices have been weak, and thus Japanese stock prices have also dropped sharply and continue to be unstable. A further fall in stock prices would damage the financial strength of firms and financial institutions, hence weakening Japanese industries and jeopardizing the stability of the financial system.

Although it depends on the extent to which these five risk factors actually materialize, we should be aware of the possibility that the economy might once again move toward recession in fiscal 2003.

II. Role of Monetary Policy

A. Purpose behind Quantitative Easing Measures and Their Effectiveness

I would first like to look back on monetary policy to date before discussing how we should conduct monetary policy in Japan's economy bearing in mind the various risks described above.

After the Bank terminated the zero interest rate policy in August 2000, the economy fell into recession in line with the rapid deterioration in the world economy that started around the end of 2000. Under the constraint that interest rates cannot go below zero, in March 2001 the Bank changed the operating target of monetary policy, shifting from the overnight call rate to the outstanding balance of current accounts at the Bank. This is the so-called quantitative easing policy. In the current situation, such a policy can be described as a zero interest rate policy with a quantitative target for the outstanding balance of current accounts at the Bank of around 20 trillion yen. It was, of course, adopted based on the understanding that it was theoretically an easier monetary policy than the previous zero interest rate policy, which simply targeted the short-term interest rate at zero. However, the aim of such a quantitative easing policy may not be easy to understand. Let me explain about it a little further. Chart 3 illustrates the supply and demand of money, and gives us an idea of the circulation of money through the economy. Demand for money increases in line with declines in interest rates. This is because, when interest rates decline, firms become more willing to increase business fixed investment by borrowing funds, and households become more inclined to take out loans to build houses. By raising or reducing interest rates, therefore, it is possible to control the demand for money, and as a result, the amount of money in circulation. Looking at the situation the other way around, we can also say that interest rates are determined by the amount of money in circulation. If the amount of money in circulation exceeds demand, this acts to reduce interest rates; while when the amount of money in circulation does not satisfy demand, this in turn acts to raise interest rates. It is only the Bank of Japan that can initiate the process of creating money, and it is only banks that can lend far larger amounts of money to firms and individuals than they have initially deposited. Therefore, interest rates are determined by the amount of funds provided to banks by the central bank and by the amount of funds these banks in turn release to firms and households to meet their demand for money. Interest rates and the quantity of money in circulation are, therefore, two sides of the same coin. However the relationship between the two completely broke down when the overnight call rate fell close to zero percent. This was because the zero interest rate prevented the Bank from controlling the amount of money in circulation by moving interest rates. In addition, the motivation of firms and households to exchange their money for goods (in other words, to engage in consumption), became increasingly weak. Deflation, or continuous price falls, persisted, and both firms and households preferred for the time being to contract their economic activities and take a wait and see stance, rather than to borrow money to make new investments or to consume.

Given the situation, described above, in which the amount of money could no longer be controlled by interest rates, the Bank decided in March 2001 to increase the provision of funds to banks. The reason for this decision was as follows. Since the source of money in circulation, or the amount of money needed by firms and households, was the central bank's provision of funds to banks, by increasing the outstanding balance of current accounts at the Bank, the Bank would thus encourage banks to increase lending to firms and households or to invest in corporate and foreign bonds. At the same time the abundant liquidity would raise firms' and households' expectations of coming price rises and hence encourage early spending. In short, by increasing the amount of its funds provision to banks, the Bank aimed to raise prices through an increase in the amount of money in circulation.

The Bank made a commitment to continue the new policy "until the consumer price index (excluding perishables, on a nationwide statistics) registers stably a zero percent or an increase year on year." The intention underlying this commitment was as follows. Interest rates can be broadly divided into two types: short-tem interest rates and all other longer interest rates. Interest rates on instruments with longer maturities are affected by expected future short-term rates. Expected future short-term rates are based on the Bank's policy stance and developments in the economy. We thought it appropriate to stabilize interest rates on instruments with longer maturities given the weak economic situation. For interest rates with longer terms to remain stable, it is necessary to remove factors that make it hard to predict the course of the economy. We thus decided it would be appropriate to remove such factors, so that the market would be able to predict the Bank's policy stance even if the economic outlook were uncertain. We aimed to keep interest rates with longer terms stable at low levels by making clear the Bank's commitment to maintaining its easy monetary policy stance, and thus forming market expectations that the zero interest rate would continue for the time being.

Within the context of this quantitative easing scheme, since March 2001 the Bank has implemented five additional easing measures in light of the deterioration in the economy and the terrorist attacks in the United States. The target for the outstanding balance of current accounts at the Bank has been raised to 15-20 trillion yen from the original 5 trillion yen, and, to achieve this target, the Bank has diversified the way of providing liquidity to banks. Through its market operations, the Bank exchanges banks' assets for those with greater liquidity. Specifically, the Bank purchases assets from banks and then credits their current accounts at the Bank with the equivalent amount of funds. The Bank has tried to provide more money to the market by diversifying assets it accepts as collateral, introducing a new Lombard-type stand-by lending facility, increasing the frequency of money market operations, and by starting to accept instruments with longer maturity. For example, the Bank increased its outright purchases of long-term Japanese government bonds (JGBs) and started to accept asset-backed securities that were not previously accepted as collateral for the Bank's provision of funds.

There are several findings that have emerged from the current quantitative easing policy. First, interest rates, including those on instruments with relatively long maturities, have been stable at extremely low levels. This is due to the Bank's clear commitment about policy duration that it would continue its quantitative easing policy until the consumer price index registers stably a zero percent or an increase year on year. Given this commitment, the market has expected that the easy monetary policy would continue for the time being and hence that interest rates would remain low. In other words, the low level of long-term interest rates, including those on instruments with relatively long maturities, is evidence that the market has confidence in the Bank's commitment. As a result, financial markets remained stable even when faced with the failures of some financial institutions and large firms at around the end of fiscal years and the first half of fiscal years.

The second finding, which became evident over the course of several raisings by the Bank of the target for the outstanding balance of current accounts, was that although there were instances when the Bank was unable temporarily to provide the amount of funds that it had originally intended due to undersubscription, where bids fell short of the Bank's offers in its market operations, eventually the Bank always achieved the target balance. This was partly because the Bank was able to provide more funds by diversifying its market operations. In addition, there was strong potential demand for funds by financial institutions due to concerns about failures of financial institutions and a disruption in the operation of payment and settlement systems. However, whether the Bank can provide the amount of funds it intends as it raises the target for quantitative easing is a different issue.

The third finding is that abundant funds at banks do not necessarily flow into economic activity in the private sector, such as investment and consumption. The increase in the monetary base, or the provision of funds by the Bank, has not led to an increase in the money stock, which provide the basis for private-sector economic activity. Theoretically, an increase in the monetary base brings about an increase in the money stock, because ample funds provided to financial markets stimulate the demand for money. In practice, however, signs that the transmission mechanism of monetary policy was functioning fully, such as an increase in financial institutions' willingness to lend and in inflation expectations, have been conspicuously absent. As I mentioned earlier, these effects are expected theoretically, but in practice they are not taking place. Chart 4 shows that, although there have been continued year-on-year increases in the monetary base of around 20 percent, this has not led to an increase in the money stock (consisting of cash, demand deposits, and negotiable certificate of deposits). Given continuing deflation and their severe view of the economic outlook, firms are not making investments even when investment costs are low, while households are not increasing spending despite the effective rise in their purchasing power due to the decline in prices. An unanticipated and negative side effect to the implementation of quantitative easing measures has been a rapid contraction of the call market, where financial institutions lend or borrow short-term funds with each other. In November the amount outstanding of transactions in the call market was 14 trillion yen, its lowest level since 1987. This was because financial institutions did not need to raise funds through the market, as the Bank had been providing ample funds through its market operations, dispelling any market concerns about the availability of funds. Specifically, the Bank has implemented a series of measures, including broadening the range of eligible collateral for market operations, increasing purchases of long-term JGBs, and introducing a Lombard-type stand-by lending facility through which the Bank extends loans at the request of financial institutions holding current accounts at the Bank under terms and conditions pre-specified by the Bank. It is, however, necessary to consider carefully the side effects of the quantitative easing monetary policy. We need to monitor not only whether or not the decrease in the functioning of the call market impacts unfavorably upon market participants' confidence that they can raise funds in the market as long as they have sufficient credit standing in the market, but also whether it reduces the effectiveness of the monetary easing measures themselves.

B. Additional Monetary Policy Measures

The quantitative easing measures have been successful in giving the market confidence about the availability of liquidity, and stabilizing interest rates at low levels. The Bank has so far achieved its target for the outstanding balance of current accounts at the Bank, but we have not yet observed the effects of this filtering through to an increase in the money stock, while we have observed a negative consequence of the measures, the contraction of the call market. Bearing these facts in mind, let us consider what monetary policy measures we should take from now on.

The success of the quantitative easing measures in giving the market confidence about the availability of funds and in maintaining interest rates, including those on instruments with relatively longer maturities, stable at low levels suggests that these measures themselves have gained the confidence of the market. Economic entities, given a certain framework, try to maximize profit within that framework. It is not appropriate to change the framework frequently. Therefore, as long as market confidence is maintained about the Bank's commitment to continue the current policy, it is important to retain this current policy of aiming at a quantitative operating target. Although it is scarcely possible to claim that the quantitative easing measures are working through the transmission mechanism to affect the economy through an increase in the money stock, nevertheless there is no doubt that the provision of ample funds by the Bank is contributing to the stability of the financial system and thus acting to support the economy.

One of the options available to enhance the effectiveness of the quantitative easing policy would be to diversify the measures used for achieving the target balance of current accounts. Specifically the measures in question would be the Bank's choice of tools for its open market operations. This choice, whether it is to extend the maturities of instruments used in the Bank's market operations, or to broaden the range of collateral eligible for these operations, is very important. When the Bank accepts a new type of asset, which has not previously been eligible as collateral for its market operations, it eases financial institutions' anxieties about credit risk. Apart from the direct effects of the tools themselves, the Bank can also use its choice of tools to convey its policy intention to the public. In addition to their quantitative easing effects, such measures would increase market confidence by showing that the Bank is both concerned about fluctuations in credit risk and also making efforts to facilitate firms' financing activities.

Of course, the conventional measures hitherto employed by the Bank, including outright purchases of long-term JGBs, have not yet reached the limit of their usefulness. Despite the negative side effects, there is still room for the Bank to raise its operating target further, with the effects of a further such raise depending largely on market expectations. Another option for overcoming deflation is to indicate a price level that the Bank considers desirable in a medium- to long-term framework, and to influence expectations of the market and the public toward such price level. Such an option is different from inflation targeting. Inflation targeting, as I will discuss later, involves the establishment of a specific inflation target that the Bank is obliged to reach within a given period and for which it therefore employs every means at its disposal to achieve. What we are discussing here is simply an announcement regarding the price level, which would serve to enhance transparency in monetary policy and give confidence to the market and the public. It does not oblige the Bank to achieve that price level. As I said, the Bank's clear commitment about the duration of the current policy is contributing to maintaining interest rates on instruments with longer maturities stable at low levels, however there is also a view that this same commitment is strengthening the public expectation that deflation will continue. In the overall context of communicating to the public the Bank's thinking about the price level, we need to consider the most effective way of utilizing this commitment.

Imagine a situation where, due to some external shock, the economy deteriorates rapidly, exacerbating deflation. What should the Bank do when the transmission mechanism for quantitative easing does not function effectively or when the negative side effects of the quantitative easing measures become too pronounced? The natural choice in such circumstances would be to implement unprecedented measures, for example, shifting from the current policy of aiming to achieve the quantitative operating target to a new policy that would directly affect the prices of assets such as long-term JGBs, corporate bonds, stocks, and the exchange rate. This might include purchasing a large volume of long-term JGBs to directly affect long-term interest rates, intervening in the foreign exchange market to weaken the yen, and purchasing corporate bonds and stocks directly from the market. However, each of these entails difficulties.

First, although the Bank would be able to affect market sentiment, it would be very difficult to completely control long-term interest rates, since long-term interest rates are affected also by other developments in the economy. Second, the Bank of Japan Law does not allow the Bank to control foreign exchange rates as part of its monetary policy. Also, if Japan were to adopt a policy to stabilize its currency regardless of the market situation for the sake of the economy, this might stir up international controversy. Such a policy is possible only when a strong diplomatic initiative achieves international agreement and cooperation, such as was achieved with the Plaza Accord. Third, purchases of stocks and corporate bonds by the Bank for liquidity provision entail large price fluctuation risk. The purchase of stocks or corporate bonds requires the ability to assess accurately the individual credit risks that attach to firms in the private sector, as firms that need funds are typically those to whom relatively high credit risk attach. With a capital base of only about 5 trillion yen, there should be a limit to the Bank's discretionary purchase of such risky assets. Generally, such measures are only deemed acceptable in the exceptional case when, in coordination with the government, the central bank is acting in response to a disruption in financial markets or to the credit contraction that results when the economy has fallen into a strong deflationary spiral.

As I mentioned earlier, there has also been discussion about the introduction of inflation targeting, under which the Bank would commit itself to achieve a given yearly increase in the price level within a specified timeframe. It is, however, far from clear how the Bank should achieve such an inflation target in the current situation where the effects of monetary easing are hardly spreading to the economy. It is probably impossible unless the Bank implements measures that would have extremely large negative side effects, and the effects of such measures on market and public sentiment are uncertain. In this situation, the introduction of inflation targeting, which involves the Bank making a commitment to achieve the target, risks raising concerns in the market that the Bank is set to take unexpected actions, thus dispelling the confidence that has prevailed since the introduction of the quantitative easing measures. When we discuss the adoption of inflation targeting, it is necessary that the Bank remains fully aware that the cost of the negative side effects would be borne by the public. Therefore, the adoption of inflation targeting should be discussed in such a way that the public is able to decide for itself the appropriateness of the measures.

We must follow the duty stated in the Bank of Japan Law: "Currency and monetary control shall be aimed at, through the pursuit of price stability, contributing to the sound development of the national economy." We must also pay attention to the Bank's own financial soundness, and at the same time keep in mind the full range of measures available to us. Although the scope for conventional monetary policy measures is currently extremely limited, we will continue discussing the possibilities at Monetary Policy Meetings. There has been some criticism that the Bank loses credibility when it suddenly takes measures that it had previously said were impossible. Such criticism misses the point. While there may be little room for monetary policy to maneuver, nevertheless the Bank looks at all the possible measures at its disposal at any given time, giving due consideration to the prevalent economic and financial situation. There are, therefore, cases when it becomes appropriate to adopt a measure that was previously impossible, and vice versa. I would like you to understand that, in spite of the limitations facing conventional monetary policy measures in the current environment, we are doing our utmost to test and to extend the range of policies available to us.

III. Structural Problems and the Nonperforming-Loan Problem

A. Background to Structural Problems

Looking at the current state of, and outlook for, the economy, and considering the effectiveness of the Bank's monetary policy, one must acknowledge the need to take other measures, in addition to monetary policy measures, in order to overcome deflation, the single most important obstacle facing the Japanese economy in overcoming its current difficulties. Structural problems and the presence of nonperforming loans (NPLs) complicate the problems associated with deflation, causing them to become more entrenched and to affect a broader area of the economy. Furthermore, the method adopted for dealing with these problems will itself be a most important risk factor affecting the future course of the economy. An acceleration in the resolution of the NPL problem would not only adversely affect the economy through credit contraction, but could also induce a significant deterioration in business sentiment and consumer confidence through a fall in stock prices and an increase in the numbers of bankruptcies and the unemployed. Given the tendency for credit contractions and economic deterioration to prove mutually reinforcing, the Japanese economy would certainly slide into a deflationary spiral. The question then becomes what actions should be taken to avoid such a development, and it is this question which I would like to go on to discuss.

Before thinking of measures to address structural problems, I would like first to clarify what the problems are and why they have occurred. I define structural problems as existing when there is "a situation in which prices are stable, but where the optimal distribution of resources such as labor, capital, and technology necessary for medium- to long-term economic growth is not achieved, or factors impeding the optimal distribution are not removed." I think the cause of the deep gloom lying over the Japanese economy is a failure to achieve optimal resource distribution. The Japanese economy has incorporated the so-called "redistribution function." This function facilitates the redistribution of income earned in urban areas, such as foreign exchange earned by manufacturers and the surplus profits of highly productive nonmanufacturers, to industries and firms in rural areas or to less profitable firms. The well-trained and hard-working Japanese public, supporting the high productivity in private sector firms, saved up the wealth thus distributed to them, offering it as a resource to fund firms' investment in new fields. It seems that this mechanism held true not only for the Japanese economy as a whole, but also for each industry and each firm. So long as the company as a whole was making profits, firms have tended to preserve unprofitable sections of their company, justifying the action with claims that these sections provide business synergies or help fulfill the company's diversification strategy. The assumption is that they preferred to avoid, as far as possible, the conflicts that might arise by transferring employees or by changing their business counterparties. As I suggested above, structural problems exist in situations where optimal resource distribution is not achieved; in other words where resources such as labor, capital, and technology are put into declining industries and are not shifted to industries with potential growth. Japan has tried to preserve its traditional resource distribution system both in the economy as a whole and at the individual firm level, and as a result, labor, capital, and other resources have been kept in declining industries and areas.

The Japanese system, defined along these lines, worked well enough when the economy was expanding and unrealized profits on assets were growing, and when the dominant business structure was one that aimed for long-term profit sharing and peaceful co-existence between large firms and their subcontractors, and between main banks and borrower firms. However, the situation changed significantly in the 1990's. With the plunge of asset prices due to the bursting of the bubble, there has been a trend toward the introduction of mark-to-market accounting and business management focusing on the interest of shareholders. With these changes we have seen calls for improved corporate governance and greater transparency in the management of firms' financial affairs and business relations, and as a result it has become more difficult for firms to retain surplus profits. In addition, the Japanese economy has faced further challenges related to its high costs of production, with competition in global markets intensifying after the end of the cold war, which brought cut-backs in advanced countries' budgets for military spending, and with the introduction of market economy in formerly socialist economies, which opened access to their inexpensive resources. To make up for their high costs of production, Japanese firms needed to engage in higher value-added production in order to compete successfully with foreign products. However, they have proved to be less successful in differentiating and adding higher value to their products as they have been accustomed to carrying out business based on the idea of mass production and mass consumption. Where firms are able to differentiate their products from those of foreign manufacturers, they succeed in adding higher value and are thus able to set prices in accordance with their business strategies. However, those that are unable to differentiate their products lose their price-setting power, and their fixed costs of production, from capital stocks, labor, and debt, become a heavy burden. In such a situation, there are only two ways for firms to survive: either to reduce costs or to increase value-added.

Those most affected by these kinds of structural problems are small firms and regional economies. Small firms are, naturally, vulnerable to external shocks. This is evident from charts 5, 6, and 7. These charts compare large and small firms in terms of labor (the share of labor in income distribution), capital stock (the ratio of sales to fixed assets), and debts (financial debts relative to annual cash flows). It is clear from these charts that there are significant differences between large and small firms. Small firms have excessive employee numbers, capital stock, and debts. Figures for large firms seem to have been improving, but those for small firms have not yet improved. In addition, large firms that placed orders with small firms have shifted their production bases overseas to reduce costs, or have shifted resources away from manufacturing production and toward areas that are more intellectually intensive and thus have higher value-added. Hence, small firms have received fewer orders and have also faced constant price-cutting pressure from imported products.

Some may argue that it is up to small firms to create their own value-added. However, whereas in the past the large firms with which smaller firms maintained business relations as subcontractors tended to cooperate with them in the development of new products and technologies, hence supporting their efforts to increase value-added when times were hard, recently small firms have been less and less able to rely on such relationships. Furthermore, regional industrial concentration of small firms has disappeared due to the increasing numbers of bankruptcies and closures. For example, in Tokyo's Ota ward where there is a heavy concentration of small firms, an increasing number of firms are changing business or closing down due to poor performance or because they are unable to find a successor. In the past, firms in Ota ward received orders from large firms for highly technical products, such as parts for rockets and central processing units (CPUs), and when orders came, several firms worked together, with each contributing its own expertise to the project. Mr. A would design the product; Mr. B in the next block would make molds; Ms. C from across the street would locate the ideal materials for the product; while Mr. D, living two blocks away, would increase the durability of the product by twisting or making notches. Today, however, Messrs. A, B, and Ms. C have all changed business or closed down. When some of the key experts are missing, there is no strength in the concentration of small firms, nor can they add high value to products. The situation may be very much the same here in Osaka where small firms have contributed to the activities of internationally-competitive firms in the electronic industry. Despite some improvements in the economy compared to last year, the rate of unemployment in Osaka has reached a new high of 7.6 percent, the highest among the ten districts in Japan.

In rural areas, where in comparison to metropolitan areas there have always been a greater number of small firms, many of these have played a supporting role to large firms in the production of hardware. Therefore, when large firms that are looking to move into areas of higher value-added activity or to shift their production bases overseas started to reduce their capital stock and numbers of employees, this led to a contraction of small firms' production. Furthermore, the contraction of a region's core manufacturing industry leads, via a decline in the number of employees using local services, to a contraction in these service industries and market exit. Needless to say, further side effects of such contraction include an accelerated reduction in public works spending and in various government subsidies for the regional economy, as well as a decline in the number of young people, an important source of new demand.

B. Dealing with the NPL problem

The structural problems of the economy that I have described are reflected clearly in the financial sector in the form of the NPL problem.

Chart 8 shows changes over time in the figures for Japanese banks' total NPLs, as released by the Financial Services Agency. Since 1992 when the NPL problems of housing loan corporations (jusen) were revealed, banks have disposed of more than 80 trillion yen in NPLs (in loan write-offs and loan-loss provisions), and more than 10 trillion yen in public funds have been injected into banks by the Deposit Insurance Corporation (DIC) based on the Financial Function Early Strengthening Law. Banks have also carried out corporate restructuring for the resolution of the NPL problem (chart 9). Despite these efforts, the amount of NPLs outstanding has been increasing. Amounts of loans outstanding to categories of borrowers that "need attention" and that "need special attention" have increased at the end of March 2002 compared to the results of the book closing at end-September 2001. These loan categories correspond to "Standard" and "Special Mention" under the examination manual of the Federal Reserve. So why has the amount of NPLs not decreased? Chart 10 provides us with a clue. The chart shows the share of new NPLs that emerged during each accounting period to the amount of NPLs outstanding at the end of each accounting period. The ratio was around 30 percent at the end of fiscal 2000 but it rose to nearly 50 percent at the end of fiscal 2001. New NPLs are emerging rapidly even as financial institutions are taking measures to address their existing NPLs. This is why the amount of NPLs outstanding has not been decreasing.

What significance does the emergence of new NPLs have? In the past, a large proportion of NPLs emerged due to the bursting of the asset-price bubble. Today, however, loans newly classified as NPLs are not restricted to those firms caught up in the asset-price bubble, but are increasingly loans made to small firms or firms in rural areas facing structural problems. In other words, the emergence of new NPLs is attributable not only to the bursting of the asset-price bubble and the weak economy, but also to structural problems. Thus, in resolving the NPL problem, it is incumbent upon us to address the structural problems of the Japanese economy as a whole, and not to view the problem as merely one restricted to individual banks or the banking sector.

Needless to say, the resolution of the NPL problem is essential for the maintenance of financial system stability. However, as measures to tackle the NPL problem are implemented, the lending attitude of financial institutions toward firms struggling with structural problems will become severe. Looking at surveys conducted by the Japan Finance Corporation for Small Business and The Japan Chamber of Commerce and Industry, many firms in rural areas and small firms responded that lending attitudes had become stricter, with interest rates being raised and provision of additional collateral being required. Of course, it is perfectly rational for a financial institution to vary the interest rate it charges so as adequately to reflect the degree of credit risk involved in the loan. Furthermore, as dealing with NPLs requires the use of management resources, financial institutions are less inclined to allocate resources to firms in rural areas and small firms for whom monitoring costs are relatively high. However, cutting off the funding for such firms without providing adequate relief for small companies and regional economies could not only destroy financial institutions' profit bases, it could also damage the Japanese economy substantially. Small firms account for 99 percent of Japanese firms and their employees account for 78 percent of all employees in Japan; while in terms of GDP, small firms account for more than half of all the value added by industries in Japan.

Dealing with the NPL problem is a necessary condition if the Japanese economy is to get back on track for self-sustained economic growth. However, it is not a sufficient condition. As I mentioned earlier, trying to deal with NPLs without due regard for the structural problems that underlie them would risk the economy falling into a deflationary spiral.

How then should we address the NPL problem while paying due regard to structural problems? The key term here is "reconstruction," which means helping viable firms through financial assistance while encouraging nonviable firms to withdraw from markets. Specifically, we must ensure that funds flow into small firms struggling with structural problems, and at the same time, since "reconstruction" inevitably involves the weeding out of some firms, we must also establish a safety net, for example, for the unemployed to ease the pain arising in the process.

I think the basic principles for addressing the NPL problem shown in the "Program for Financial Revival" recently released by the Japanese government are aimed in the right direction. The principles require financial institutions to assess assets strictly and in a timely manner, to make loan-loss provisions appropriately in accordance with the result of the assessment and at the same time to strengthen their capital bases. If, in the process of the above measures, any institution should become undercapitalized, public funds will be injected into such institutions. First of all, financial institutions should prepare against NPLs they currently have.

Chart 11 shows the capital base of large financial institutions. If we look closely at the breakdown of the capital base, it is evident that their core capital, i.e., Tier I, is vulnerable. Nearly half their core capital takes the form of deferred-tax assets, which are expected tax returns against future profits, and injected public funds, which need to be repaid in the future. Financial institutions must increase their profitability and strengthen their capital.

There is some criticism that the government's revival program was in the end watered down, after the draft program met with strong opposition. I do not think that this is the case. Although the proposed implementation of a restriction on the inclusion of deferred-tax assets into capital is still pending further discussion, I think the overall program will be highly effective. However, the program looks to employ some extremely powerful tools, and these, if wielded unwisely, could have a fatal impact on the Japanese economy. At the same time, if they are not used properly the NPL problem might not be dealt with effectively.

I would like to discuss some of the more controversial points of the revival program. One of the key issues is the discounted cash flow (DCF) method. When Japanese banks assess loans to borrowers that "need attention" or "need special attention," it has been a practice to use expected rates of loss based on their loan records. Based on their assessments, they made required loan-loss provisions for loans to borrowers in danger of bankruptcy or to borrowers in lower category; the required provisioning is 70 percent or 100 percent of principal value of loans that are not secured by collateral. The program presents the DCF method, which takes the credit risk of assets into account, as the basic measure with which to strictly assess assets. Since the revival program was made public, it seems that the DCF method is perceived as the most accurate way to calculate the necessary amount of loan-loss provisions, but we must consider also its effectiveness and limitations. Many assumptions need to be in place before it is appropriate to apply the method collectively to lending such as short-term loans that are rolled over to provide operating funds and loans to small firms.

The thinking behind the U.S. accounting rules is to recognize as loss the difference between the book value of a loan and the present value of total cash flows that are or may be impaired due to the restructuring of the loan or the financial condition of the borrower. How it would be implemented would largely depend on how the DCF method is going to be defined in Japan. However, it should be noted that the method is not a panacea, and that, if not implemented appropriately it could leave the impression of arbitrariness in the methodology for dealing with NPLs. I think that clear guidelines are necessary, setting out the types of loans for which the DCF method is applicable and specifying the procedures to be used in its application. These guidelines should also take into account the situation in Japan. In this regard, I look forward to seeing the guidelines to be prepared by The Japanese Institute of Certified Public Accountants by the end of January 2003.

Another controversial issue regards a proposal to make the practice of including deferred-tax assets as a part of capital as strict as that in the United States. In the United States, the amount of deferred-tax assets that can be included in financial institutions' capital is restricted. While this practice is restricted in the United States, tax-deductible write-offs of nonperforming assets from balance sheets are more broadly permitted than in Japan. Tax treatment of such costs is also different in the two countries. In the United States, write-offs of NPLs are, in principle, regarded as tax-deductible losses. In Japan, loans to borrowers classified as effectively bankrupt are removed from balance sheets, but these are not usually regarded as tax-deductible losses. This is because Japanese bankruptcy and tax laws set extremely strict limitations on cases where NPL write-offs can be considered tax-deductible. Given that the aim of allowing financial institutions to include deferred-tax assets as part of their capital was to make it easier, under the current stringent tax rules, for financial institutions to deal with their NPLs, it is in some aspects inevitable that we see some accumulation of deferred-tax assets. If financial institutions were required to make a simultaneous across-the-board reduction of these accumulated assets, it could cause, albeit temporarily, a credit contraction. On the other hand, since all firms, including financial institutions, run their businesses as going concerns, it would not be desirable to have deferred-tax assets making up too large a part of capital, defined in a narrow sense. The inclusion of deferred-tax assets as part of capital, and limitations on the inclusion, should clearly be considered within the context of the current tax framework. It should be noted that it is not possible to restrict tax-deductible disposals strictly and at the same time to limit the inclusion of deferred-tax assets into capital.

Another key issue, also related to the assessment and provisioning of NPLs and to capital adequacy, is how to determine borrowers' viability. Specifically, a question of particular importance is how to treat loans to borrowers that "need special attention," for whom financial assistance is provided by banks to help them reconstruct their business. If a specific date is set by which financial institutions must dispose of these loans, this could raise concerns that financial institutions might choose to downgrade the loans to borrowers in the "in danger of bankruptcy" category or lower in order to get tax deduction, instead of taking the time to help borrower firms reconstruct their business--in other words to shift the category of borrowers from those who "need special attention" to "normal." The risk weight of loans to borrowers that need special attention will increase under the New Basel Capital Accord, which will come into effect in 2006. Loans to small firms facing structural problems account for a large part of loans to borrowers that need special attention. Financial institutions should consider all the measures at their disposal for addressing NPLs, paying due attention to the condition of borrowers.

It is also extremely important to protect settlement facilities used by small firms. As is currently being deliberated in the Diet, a safety net should be established for settlement facilities to ensure that transactions and settlement are carried out as planned even in the event of the failure of a financial institution with which firms had concluded loan contracts or entrusted settlements of transactions.

Having looked at what is involved in dealing with NPLs and stabilizing the financial system, we recognize the vital importance of policy measures for the reconstruction of firms and revitalization of industries in conjunction with the resolution of the NPL problem. The reconstruction and revitalization will not be possible without public policy measures to promote structural adjustment in a broader sense. To this end, the government is examining the establishment of an institution called the Institution for Industrial Revival (tentative name). Although there are a number of problems that need to be solved before the institution is established, it has the potential to be highly effective if it functions as one of the engines on a twin-engined craft steering a course toward Japanese economic revitalization, where the other engine is the policy measures for accelerating the resolution of the NPL problem. What is important, I think, is to minimize the involvement of the public sector, and to incorporate market mechanisms in the process of corporate reconstruction by making full use of the functions of firms' main banks. At the same time, while taking measures to prevent moral hazard, we should not hesitate to use public funds when and where necessary. Rather than persisting with a piecemeal approach, decisive measures should be taken to create a strong momentum for improvement.

Whether the reconstruction of firms and industries is promoted by the Institution for Industrial Revival or by other institutions, public policy measures should be taken to facilitate the smooth provision of funds to viable small firms necessary to help them reconstruct their business. In addition, we should also consider introducing a policy framework and tax system that promote new business start-ups and the closure or transfer of inefficient firms. With discussion of a supplementary budget having now started in the Diet, we must hope for a budget whose size, content, and distribution are all designed to maximize its effect on the economy.

Small regional financial institutions have been valuable because of their ability to judge the condition of small firms by meeting their owners directly. Thanks to such institutions, small firms that had no collateral but their willingness to work hard or borrowers that wished to start their own business after 30 years of apprenticeship were given access to funds. I am concerned that the ability to make such judgments may be lost as these small regional financial institutions are reorganized, or in particular cases, weeded out. In order to promote new business start-ups, it is thus essential for the public sector to strengthen the framework for supplementing small firms' collateral or providing credit guarantees. Efforts have been made at the national and local government level to facilitate corporate financing for small firms, for example by introducing provision of loans collateralized by accounts receivables and securitization of account receivables. However, these efforts do not seem to be sufficient. Measures should be taken swiftly to advance structural reforms for revitalizing regional economies, creating new businesses and jobs and encouraging younger generations to move into the regions, by, for example, designating some regions as "special structural reform areas." In the process of overcoming the structural problems faced by small firms and regional economies, it is inevitable that some firms will be weeded out. Safety nets that facilitate structural adjustment, such as unemployment insurance and better provision of employment opportunities, also need to be improved. If fiscal spending is necessary for this purpose, there is no time to be wasted.

Amid these developments, the Bank will consider policy measures to maintain a sound banking system, which supports private-sector economic activities, and thereby the stability of the financial system. In particular, as progress toward the resolution of the NPL problem accelerates, the Bank will look proactively at furthering its own contributions to the stability of the financial system. In this regard, some suggest that the Bank could provide funds to the Deposit Insurance Corporation (DIC). There seems to be some misunderstanding involved in this view. First, a framework for the Bank to lend funds to the DIC is already established. And second, since its debts are guaranteed by the government, the DIC has little incentive to borrow funds from the Bank because it can raise funds from markets at extremely low interest rates.

The Bank will certainly continue to explore the boundaries of its policy options for financial system stability. The Bank's decision in September to purchase stocks from financial institutions was an example of precisely such an exploration. The Bank's purchase of stocks held by financial institutions is aimed at maintaining a sound banking system and maintaining the stability of the financial system that supports transactions between financial institutions and private economic entities. There was a risk that financial institutions, with weak capital bases and excessive exposure to the risk of stock price fluctuations, would not therefore be able to extend sufficient credit to economic entities. A stable financial system provides the infrastructure for transactions conducted between economic entities, and it is therefore a prerequisite for self-sustained economic recovery. This is why the Bank decided that it was necessary to free financial institutions from the risk of stock price fluctuation. Besides its purchases of stocks from financial institutions, as NPL disposals accelerate the Bank will be able to contribute further to the creation of a smooth and stable corporate financing environment through flexible adoption of its policies on eligible collateral.

IV. Conclusion

I have talked about the current state of the economy, possible future risk factors, structural problems, the background to NPL disposal, and also the appropriate policy response.

So what type of economic system should we ultimately be aiming for with these policy measures? I think the answer is that Japan must rebuild itself, taking full advantage of its accumulated stock. The problem with which Japan is currently struggling is, in simple words, that the country is not making the best use of its economic stock. Japan is failing to manage effectively the human resources, capital stock, and wealth that were accumulated, mainly in the manufacturing sector, during the period of high economic growth. Faced with the announcement of possible downgrading of Japanese government bonds by foreign credit rating agencies, many claim that Japan has nothing to worry about because it has net external assets of more than 1 trillion U.S. dollars and personal financial assets of some 1,400 trillion yen. However, I wonder whether this complacency is really justified. Markets judge our economy not by the assets we have, but by how well we are utilizing them. Are we really utilizing our external and personal financial assets effectively so that these assets can bear fruits for future generations? Almost 1,400 trillion yen of our personal financial assets are not being utilized for the purpose of forward-looking investment, but are merely being stored. This is what I mean by saying that Japan is not making the best use of its economic stock. I am, of course, aware that in its economic stock there remains some stock that grew out of the bubble economy and some assets that do not produce any cash flow. It is urgently required that such stock or assets are removed from the economy and at the same time that our 1,400 trillion yen in personal financial assets is utilized effectively. In fact, this is precisely what the disposal of NPLs and the revitalization of industries seek to achieve.

The imminent task for Japan's economy is to achieve simultaneously two mutually contradictory objectives in a situation where the economy is losing its momentum for recovery. Specifically, it has to advance structural adjustment and NPL disposal, and at the same time minimize the deflationary impact of these and return the economy to a path toward self-sustained recovery. It is a task that requires the careful and flexible prioritization of economic polices and fine-tuning of the tempo of policy implementation, in response to changes in the economic environment.

The basic idea is to establish an economic framework that enables the maximum utilization of the stock economy by the flow economy, and vice versa. Promotion of NPL disposal in conjunction with industrial revitalization helps to maximize the contribution made by the stock economy to the flow economy. Income gained in the flow economy will eventually increase wealth as a stock. We all know the ultimate goal. Adam Smith, famous for his phrase about "the invisible hand," wrote in his book entitled "The Wealth of Nations," that the ideal economy is one where individuals try, compete, and ultimately become wealthy. The challenge to us is to create an economic structure in which firms and households, confident that the time and pain involved in structural reform will be ultimately beneficial to them, are able therefore to undertake, using their accumulated wealth, economic activities that bear fruit in the future without fear.

Thank you.