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Japan's Economy and Monetary Policy

Summary of a speech given by Shin Nakahara, Member of the Policy Board, at the Chiba Chamber of Commerce and Industry in Chiba on October 27, 2003

December 10, 2003
Bank of Japan


I. Introduction

I am honored to have this opportunity to address this gathering of representatives of business leaders in Chiba Prefecture.

Prior to today's address, I had the opportunity to hold informal discussions with corporate executives in Chiba Prefecture. From them, I gained the impression that the term "regional economy" is insufficient as a summary of the prefecture, which has an economic structure of great diversity. Besides the abundant agricultural and fishery industries that provide a variety of foods to the Tokyo metropolitan area, the prefecture enjoys many tourism-related resources centered in its southern zone. In addition to steel, petrochemical, and other manufacturers in the coastal industrial region along Tokyo Bay, in advanced technology we find a concentration of leading biotech firms along the bay. There are also districts in which foreign retailers are aggressively investing. With respect to the business environment, materials-related manufacturers are increasingly busy in the coastal region, while, on the other hand, the older shopping districts and construction firms are experiencing difficulty. In an aging society with fewer young people, some areas are suffering from weak economies and stringent fiscal circumstances. If I had to sum things up, therefore, I would say that the issues presently facing the economy of Chiba Prefecture, which will have to be dealt with going forward, are the same as those facing Japan's economy. I would add that a well-diversified economic structure offers great potential for future prosperity.

Before turning to my main topics, I ask you to bear the following two points in mind. One has to do with the Bank of Japan's view of the economy and prices, and their risks, to be published at the end of this month as "Outlook and Risk Assessment of the Economy and Prices" (hereafter the Outlook Report). What I will talk about today has no relation to this outlook. The second is that I will try to keep this speech to within about 50 minutes, so that there will be more time to learn about what you expect from the Bank and your views on its monetary policy and economy. As the chamber's president mentioned in introducing me, I have served the Bank for nearly two and a half years, after working in the private sector for 40 years. I welcome this opportunity to further my knowledge of the actual economy and related activity. Recently, the chairman of a small industrial association in Tokyo told me, "Those who have never served as personal guarantors for others cannot understand the management and cash difficulties of small firms." What I hear today from you who conduct daily commercial dealings will therefore have considerable value as a reference when considering future monetary policy.

To start with, then, let's look at the current situation of Japan's economy and what the future might hold.

II. Current Situation of and Outlook for Japan's Economy

A. Current Situation of the Economy

The foundation for a gradual recovery in Japan's economy is being laid, and the trend line is at last beginning to point up. After bottoming out in January 2002, the overall economy had been recovering moderately. However, after the beginning of this year, uncertainty about the global economy increased, reflecting geopolitical risks, including the mounting tension over Iraq, and the impact of severe acute respiratory syndrome (SARS). Against this background, Japan's increasing exports, mainly to the rest of Asia, began to show slower growth. This, combined with the downward trend in stock prices and concerns over the stability of the financial system, caused a slowing pace of recovery in economic activity.

However, after the summer, uncertain overseas factors, such as geopolitical risks and the effects of SARS, abated and the world economy began to move forward. The recovery in the U.S. economy is becoming clear, particularly in private consumption, although the employment situation remains weak. China, which had been hard hit by the SARS epidemic, has returned to a strong growth path. Thailand appears to be enjoying strong domestic demand, and the newly industrializing economies (NIEs) are actively shipping IT-related goods.

Reflecting this background, Japan's exports, centering on those to Asia, have turned up. Private consumption remains weak, but employment and income levels have stopped falling. Restructuring has sent corporate earnings into a substantial recovery, and according to the Bank's recent Tankan (Short-Term Economic Survey of Enterprises in Japan) and other surveys, business fixed investment is likely to turn positive within this fiscal year. Stock prices recovered remarkably from the low posted in April as nonresidents' funds flowed into the stock market. As seen in the Tankan, corporate business sentiment continues to improve.

The Japanese economy certainly has begun to recover, but the recovery is still limited mainly to large firms and manufacturers with high export ratios and the recovery has not spread to broader sectors. It remains unclear whether this will operate to lift the overall level of the economy, including nonmanufacturers, small firms, and households.

However, we should also keep in mind that the sustainability of the moderate recovery could exceed expectations, because firms' management base and financial standing are improving considerably as a result of their enormous restructuring efforts over the years. In addition, banks now can afford to take more business risk, as disposal of nonperforming loans (NPLs) has progressed to a certain degree and stock prices have been rising.

B. Outlook for Domestic Demand

Let's now turn our attention to the outlook for the period from the latter half of fiscal 2003 through fiscal 2004, and what risk factors are conceivable. In looking at domestic demand components, business fixed investment is expected to recover gradually. An executive of a company supplying capital goods whom I talked to has the feeling that because of a highly selective investment stance and strong downside price pressure, business conditions are not improving in the same proportion as goods have begun to move. On the investor side, operating rates are still low, and as seen in the Tankan there is still an excess of facilities. It seems that there is no strength in final demand, and amid accelerating technological progress there is no confidence that returns on investment can be achieved. There are also increasing numbers of those preferring low-cost overseas sites for capital investment to boost production and develop capabilities. Conversely, as positive factors, we can cite abundant cash flow from favorable corporate earnings and greater aging of facilities. The executive I mentioned before pointed out that there is a strong need for differentiated products compatible with next-generation technology. With incentives both bullish and bearish, business fixed investment in the period from the remainder of fiscal 2003 through fiscal 2004 will not be for reinforcement and augmentation of capabilities but will center on investment reflecting technological innovation, new product development, and renewal of older facilities. Its growth will be no more than gradual.

What about private consumption? Among the factors influencing this, we see a cessation of declines and gradual improvement in employment indicators, such as the effective job offer ratio and household income. It can be said that strong corporate earnings could operate to push up income, but at the same time factors such as medical insurance premium hikes and pension reductions could work to reduce disposable income. More active debate about raising consumption taxes and pension reform may increase people's concern for the future. Amid a changing economic structure, even if employment rises the increase would comprise mainly part-time or other non-regular jobs. Under these circumstances, people's concerns about the employment situation are unlikely to diminish. As for asset values, stock prices are rising, while real estate prices are continuing to fall. Condominium sales, which were previously robust, appear somewhat to have run out of steam. Housing investment, strongly dependent on how taxation of housing loans is determined, is likely to slowly decrease. Against this background, consumer sentiment will not easily turn positive, and private consumption is expected to essentially remain flat.

C. Sustainability of External Demand

What about exports, which are the driving force behind current economic conditions? Exports can be said to depend on overseas business conditions, in particular the economies of the United States and Asia, which have high weightings among Japan's export destinations.

Regarding developments in the U.S. economy, prospects are for a tax cut-driven full-scale gain in private consumption in the second half of the fiscal year. Productivity continues to improve in the corporate sector, and from around the second quarter corporate profits have been recovering substantially. I believe the foundation has been laid for active cyclical corporate activity, such as production expansion, inventory buildups, and business fixed investment recovery. IT-related production and shipments are already far over year-earlier levels. For these reasons, from this year's third quarter it is appropriate to see the overall U.S. economy embarking on a stable growth course exceeding its potential growth rate.

There are, however, a number of points of concern. One resides in employment and income. The current recovery is reminiscent of the "jobless recovery" of the early 1990s, but in making that comparison in regard to the number of employees we see that the adjustment this time has been more stringent. The number of those in the manufacturing sector has declined without letup. What has supported the present recovery has been the wealth effect on consumption, as housing investment and housing prices have risen on the back of low interest rates. The problem resides in how far this will continue. Household debt might be reduced, since its outstanding balance is at a historically high level. We need to bear in mind forthcoming developments in long-term interest rates and the decline of the effects from the tax reduction.

An old yet new problem resides in the fact that both the federal budget and current account deficits, the so-called "twin deficits," have reached very high levels relative to GDP. This cannot coexist with sound long-term economic development, and it is one of the major risk factors for the U.S. economy.

In Asia, China is showing vigorous economic expansion. Growth continues, centered on construction investment and private consumption. Improving income levels will likely sustain this growth for the time being. I believe we can anticipate overall strong expansion, including domestic demand, in the Association of Southeast Asian Nations (ASEAN) and the NIEs, but this will be dependent on U.S. and Chinese economic developments.

D. Prices

The year-on-year decline in the domestic corporate goods price index (DCGPI) was 0.5 percent in September, narrowing the extent of the decline since May. On a month-to-month comparison, the index rose by 0.1 percent, marking a positive figure for the third straight month. These developments are due to a further recovery in the level of prices of raw materials, such as steel and pulp and paper, reflecting strong China-centered external demand. Management at a materials-related manufacturer told me, "Sales prices continue to trend well. In particular, products for China have been in short supply with prices higher than they have been in many years." The nationwide consumer price index (CPI), excluding fresh food, declined by 0.2 percent year on year in July and by 0.1 percent year on year in August reflecting special factors such as increases in the tax on cigarettes and medical fees. These factors contributed 0.3 percent to 0.4 percent, and it can be said that the year-on-year decline in the CPI would have been slowing even without these special factors. In the second half of the fiscal year, the pace of decline in the CPI might slow further, albeit temporarily, since the increase in the price of rice due to the cool summer could affect it.

While we can say that the DCGPI and the CPI downtrends have begun to stop, there are many special factors in the background and we must admit that for the time being there is no end to the deflationary trend. The output gap is basically narrowing, but the supply-demand balance is currently still considerably slack. In addition, with income not increasing, service prices are tending not to rise. Looking at competing import prices and other prices in the DCGPI, we see that the former have clearly shown substantial declines. Low-priced imports are on the increase, and major foreign distributors are carrying out direct investment in Japan. With domestic makers unable to hold dominant power in setting prices, these moves are a factor in pushing consumer prices down. If, moreover, the appreciation of the yen continues, it too will brake price increases.

Shifting our focus a bit to overcoming deflation, if we stress firms' behavior and dominant power in setting prices, we find deeper-rooted problems. When business is sluggish, most firms in Japan seek to tide over the difficulties by restructuring, rather than by increasing sales. There are relatively few that take the forward-looking stance of reinforcing sales by establishing brand power and developing new products. This shrinking tendency weakens dominant power in setting prices and gives rise to further deflation. If the future sees no activity to generate earnings by adding value, there could be no notable improvement in prices.

Recently the GDP deflator, especially the fixed investment deflator, has continued declining, with a marked divergence between the DCGPI and the CPI. However, rather than a signal of worsening of the deflationary trend, it is appropriate to view this as a reflection of a downward bias when using statistical methods, whereby the GDP deflator easily incorporates price declines due to technological progress.

E. Improvement in Corporate Profits

Corporate profits improved substantially in fiscal 2002. This was driven by restructuring. The Tankan as well shows that although sales are flat, current profits are increasing significantly. This tendency will likely continue. The break-even point for manufacturers is already below the levels seen in the previous recovery phase, and that for nonmanufacturers is declining considerably. In the September Tankan, in consequence, the diffusion indexes of business conditions of the major manufacturers turned positive for the first time in two years and nine months. Business conditions of small firms improved beyond expectations, although the level is still low. Above all, the earnings of major manufacturers of electronic equipment and components with high export ratios, and of steel and other materials, were very strong. However, as I mentioned earlier, permeation of these developments through other industries is limited, and we do not see this leading to any lifting of the overall economy, including nonmanufacturers and small firms.

What casts a shadow over the prospects of corporate profits is foreign exchange rates. According to the Cabinet Office's April 2003 "Questionnaire Survey of Corporate Activity," the yen rate for manufacturers' export profitability is around 115 yen against the U.S. dollar, so if the rate surpasses the current level of 110 yen, there is a risk that sales and earnings could fall below their targets. Since the current economic recovery is highly dependent on exports, there is concern that the yen's appreciation could impact economic developments. There are also fears about its effect on stock prices. If this exchange rate trend were extended in time, there would likely be greater import substitution and acceleration of hollowing-out of Japanese industry as production is shifted overseas. I will talk later about the relation between monetary policy and exchange rates, but we intend to give utmost attention to the impact of the appreciation of the yen on economic developments.

F. Developments in Financial Markets

Besides exchange rates, what should we bear in mind with respect to developments in financial markets, and their future course? This summer saw a sharp increase in long-term interest rates. This was a reaction to an overheated market in the spring, when the interest rates on 10-year Japanese government bonds (JGBs) plummeted to 0.4 percent, as well as abatement of uncertainty about the economic outlook and expectations for recovery, and unsettled views on the Bank's monetary easing stance. Currently, long-term rates and interest rates on term instruments have stopped increasing. This derives from renewed recognition of the weak demand for money and the real state of the economy, and the Bank's assurance to the markets that there is no change in its monetary easing posture. The markets have in fact returned to stability. Nevertheless, based on higher cumulative fiscal deficits, financial institutions' government bond holdings are extremely high, and in the near term we need to be wary of a situation wherein long-term rates may be subject to structural upside pressure.

One factor behind the sharp rise in long-term rates was upbeat developments in the stock market. After bottoming out at the 7,600 yen level in late April, the Nikkei 225 Stock Average has to date risen more than 40 percent. This was said to be driven by purchases of Japanese stocks by overseas institutional investors in the process of adjusting their portfolios against the backdrop of strong stock markets in Europe and the United States. The impression had gained strength overseas that Japanese equities looked undervalued, corporate profits were recovering and the injection of public funds into Resona Bank suggested that further bank collapses would be prevented. Overseas investors have continued their buying since then. Bank stocks in particular have broken out of their vicious cycle before March of bearish prices leading to anxiety about the stability of the financial system leading to weak stock prices.

A point to keep in mind in the near future is how long-term interest rates, the yen's exchange rate, and the stock market are correlated. This will have a great effect on an economy that has at least clearly embarked on a recovery trend. As expectations mount for such recovery, stock prices will rise, but this also puts upside pressure on long-term interest rates. The problem resides in whether higher interest rates are congruent with the recovery in economic developments. The ample liquidity supplied by the quantitative easing policy is concentrated in government bonds, increasing the ratio of such holdings by financial institutions. Should long-term interest rates rise sharply due to supply-demand factors or concerns about the need for fiscal discipline, it will be necessary to monitor the impact on financial institutions' management. And should this trigger a stock market decline, we cannot deny that financial institutions' risk-taking capabilities might decline correspondingly. At present, we are seeing abatement in the implied volatility of bond options and other indicators of future variability, but forthcoming developments require close monitoring.

Summarizing the foregoing, the standard scenario stated in the Outlook Report in April 2003--that Japan's economy is facing a gradual recovery centered on exports--remains valid. However, as I have said, various factors suggest instability ahead. Among corporate executives there are those who say, "The improvement in business conditions has been uneven. If we take an overview of the future, we see no straight-up growth but rather gradual improvements." I take the same view.

III. Quantitative Easing Policy and Future Conduct of Monetary Policy

A. Assessment of the Quantitative Easing Policy

Now we turn our attention to what policies the Bank has adopted toward the economic developments, and what policies it intends to devise.

In March 2001, the Bank adopted quantitative easing as its present basic framework for monetary policy. Its fundamental role is adjusting the money stock, the quantity of cash in circulation, in order to stabilize prices, which of course includes both controlling inflation and combating deflation. When interest rates are at positive levels, raising and lowering them affects the ease of fund-raising and bank lending attitudes, enabling control of the quantity of money. However, when interest rates have declined to close to zero, making them negative is unfeasible--although not necessarily impossible, it is nevertheless unrealistic to adopt a policy with various undesirable side effects. With business conditions deteriorating and prices declining in a so-called deflationary spiral, it becomes difficult to increase the money stock.

Starting in March 2001, the Bank has been implementing a new policy maintaining the deposit balances of financial institutions in their current accounts at the Bank far above required levels through funds-supplying operations, buying government bonds and bills from banks and securities firms. This is the so-called quantitative easing. If the outstanding balance of interest-free current accounts at the Bank is increased, it can be expected that banks would prefer interest-bearing assets in the private sector and start extending loans. The intended result would be increases in the money stock.

There were two other intended consequences that the quantitative easing policy initially aimed at. One was that ample liquidity would reduce financial market volatility and prevent financial system instability. At the time, disposal of NPLs was making little progress and stock prices were on a downward trend, causing mounting concerns about instability in the overall financial system. It was therefore necessary to show that there was ample liquidity, so that the credit crunch due to a liquidity shortfall would not occur. The other intended consequence was that medium- to long-term interest rates would move stably at low levels. The Bank aimed to induce market expectations that short-term interest rates would remain at virtually zero percent for a considerable time, by causing the overnight call rate to fall to effectively zero percent through ample liquidity provision and by committing itself to maintaining the policy framework until deflation was in fact ended. More specifically, the Bank committed itself to maintaining quantitative easing until consumer prices, excluding fresh food, became stable at zero or positive on a year-on-year basis.

Based on the quantitative easing framework, the Bank raised the target for the outstanding balance of current accounts at the Bank from the initial 5 trillion yen to around 30 trillion yen. To provide more liquidity to the market, the Bank raised the monthly amount of outright purchases of JGBs from 400 billion yen to 1.2 trillion yen. It also expanded eligible collateral for its money market operations, accepting loans to the Deposit Insurance Corporation of Japan and to the Government's Special Account for the Allotment of Local Allocation Tax and Local Transfer Tax. In addition, the Bank initiated policies to stabilize the financial system that were very unusual for a central bank: buying stocks held by banks, and purchasing asset-backed securities (ABSs) of small firms with a view to extending monetary easing effects to them and fostering the securitization market.

The results were market stabilization through supply of ample liquidity, and stable developments in medium- to long-term interest rates at low levels. Since the implementation of the quantitative easing policy, interest rate volatility has declined considerably and medium- to long-term interest rates have been reduced to low levels. However, we cannot say that there have been clear effects in terms of increases in the amount of money circulating in the market. The monetary base, the total of financial institutions' current account balances at the Bank and currency in circulation, has risen to a peak of more than 30 percent over year-earlier levels and is now showing growth of about 20 percent. The money stock, however, has increased only by about 2 percent year on year. Nevertheless, provision of ample liquidity has manifestly prevented financial system instability, stabilized medium- to long-term interest rates at low levels, and forestalled further worsening of deflation. Amid progress in the resolution of the NPL problem, the start of improvement in economic developments, and rising stock prices, there is no doubt that the maintained provision of ample liquidity will encourage financial institutions to be more positive in their lending activities.

B. Focus of Future Monetary Policy

The Bank's present mission is enhancing market confidence in economic developments by continuously supplying ample liquidity and stabilizing medium- to long-term interest rates until the economic recovery becomes solid and deflation is ended. The focus of monetary policy in the near future will be on keeping its commitment to maintaining quantitative easing until consumer prices, excluding fresh food, become stable at zero or positive on a year-on-year basis. At the Monetary Policy Meeting (MPM) on October 10, 2003, it was decided to extend the maximum maturity of the purchase of Japanese government securities with repurchase agreements, and to raise the upper limit for the target range for the current account balance to 32 trillion yen. Furthermore, the Bank's commitment in terms of policy duration was also clarified. These policy actions are based on the Bank's thinking that I have described. By making its commitment even clearer, the Bank intended to remove doubts among market participants regarding its determination to continue the quantitative easing policy. Raising the upper limit was intended to give additional scope for conducting funds-supplying operations in a flexible manner as necessary, thereby showing the Bank's strong intentions toward quantitative easing. In this sense, it should not be considered a further easing to avoid the risk of a downside shift in the economy.

There is a necessity for further study of detailed funds-supplying measures. I believe operations using new financial products such as ABSs and syndicated loans, or supply of money by collateralizing them, are further required. Now that at last business conditions are looking up and corporations are taking forward-looking stances, the provision of ample liquidity can be expected to add impetus to these moves. Should there be greater volatility in exchange rates and long-term interest rates, it will be difficult for monetary policy to control them directly. However, if they heighten concern about an adverse impact on business conditions, the Bank should respond to it flexibly within the quantitative easing framework.

Here I would like to touch on the relation between monetary policy and foreign exchange rates. Monetary policy does not pursue the control of foreign exchange rate levels directly, but if it generates concerns over negative effects on economic developments, then further easing measures should be taken. In that event, interest rates would be lowered if rates were positive. However, if the nominal interest rate is zero, the effectiveness of that response is debatable. Taking the U.S. dollar as an example, the foreign exchange market shows whether demand is stronger for it or for the yen. The demand is determined by multiple factors, so no simple generalization can be made, but theoretically the yen is expected to depreciate when the money stock is increasing, thereby boosting inflation or market expectations for inflation. In this event, it is questionable whether or not a quantitative easing policy is effective. The relation of the money stock and the monetary base, as a target of the quantitative easing policy, is currently uncertain, and it is not at all clear how the policy affects the foreign exchange market. Nevertheless, as economic recovery proceeds worldwide, should Japan maintain short- and long-term interest rates at low levels by reinforcing quantitative easing, it could produce an outlook for a lower yen. In any case, if there is a higher probability of an adverse exchange rate impact on the economic developments, we intend to consider new responses within the scope of the quantitative easing policy.

C. Monetary Policy Transparency

I will now review the concept of transparency in relation to monetary policy. Since enactment of the new Bank of Japan Law, the Bank has sought to improve the transparency of its decision-making process by publishing the minutes of the MPMs, and by various other means. At the latest MPM, the Bank decided measures to present its evaluation of developments in the economy and prices in a more timely and lucid manner, and clarify its commitment to continue the quantitative easing. The Bank should, however, continue to aim at improvement, as this is natural in return for being granted independence in monetary policy. The Bank's unceasing effort also contributes to enhancing the effectiveness of the monetary policy.

The basic concept for transparency improvement is, first, recognition of the necessity for a full explanation to market participants of why this sort of policy is being adopted at this time. Second, an environment must be created wherein market participants can easily forecast the Bank's objectives. Please do not misunderstand: this does not necessarily mean that the Bank expounds what policy will be adopted. More information regarding the Bank's view should be provided to the markets, so that they can adjust their forecasts naturally. In the course of these processes, market expectations will be stabilized, and negative effects on economic activity stemming from volatile developments in the financial markets will be avoided. This is a major reason why policy transparency is important. Naturally, these adjustments mean a greater likelihood of forecasting market reactions to monetary policy. In other words, the central bank also receives correct signals.

From the viewpoint of improving the transparency, one item of information I think the central bank should publish is a specific numerical value regarding the desirable price increase, within the definition of price stability. Rather than adopting a policy of setting a target and making its attainment mandatory within some fixed time period, it may be preferable to call such a value an "inflation reference value" to make clear that it is not an objective to be hastily met, which would risk a surge in long-term interest rates and other forms of economic destabilization. Such information is one way to show the central bank's intended direction, thus supporting market participants in making appropriate forecasts and stabilizing market expectations.

The improvement in transparency requires the Bank continually to think like a participant in the market. The Bank should also seek to avoid confusion in market forecasts and promote accurate understanding of its thinking. The central bank cannot and should not seek control over the economy.

IV. Current Issues Facing Japan's Economy

There are a multitude of issues currently facing Japan's economy, and here I would like to touch on three of them: polarization of the economic structure and problems concerning small firms; economic developments in China and their effects on Japan's economy; and the situation of NPL disposal and financial system stability.

The present recovery phase began in January 2002, and so has been underway for 20 months. Though there is little sense of buoyancy, its length is on a par with that of its predecessor. If the mechanism for self-sustaining recovery does not quickly become operative, then the recovery could be short-lived, as was also the case previously. For that mechanism to take effect, we need to see definite progress in terms of the three issues I have mentioned.

A. Polarization of the Economic Structure and Problems of Small Firms

As the economy becomes globalized and the market principle permeates through it, the polarization of economic structure proceeds on various levels. I sense steadily widening economic gaps in the degree of personal asset accumulation, mismatching of employment and human resources, economic vitality of cities and regions, corporate winners and losers, manufacturers and nonmanufacturers, and large and small firms. The benefits of the current recovery go mainly to export-oriented large manufacturers, and have not flowed through to small firms and nonmanufacturers. The Tankan's diffusion indexes of business conditions show repetitive cyclical moves for large firms, while the index for their small counterparts has been below average throughout all recent business cycles. It appears that the small firms are heavily affected by the economic slowdown, and gain little sense of buoyancy in times of recovery, as they move into the next economic cycle.

Against the background of this polarization between large and small firms, the hollowing-out of domestic industry in recent years in conjunction with globalization, and changes in the financial environment can be pointed out. Direct corporate investment in China is trending at high levels, with respect to both the number of cases and the value. Parent companies, formerly the stable customers of small subcontractors, are shifting their production sites overseas, and switching to a stance of not being particular about procurement sources as long as there are no problems with price and quality. Recently, a manager at a small firm in Chiba Prefecture described to me the severe business conditions by saying, "We are operating on the assumption that a customer will disappear tomorrow because the parent company shifts overseas." The outflow of investment and employment opportunities overseas means a diminution of domestic demand, and will heavily affect not only small firms but also nonmanufacturers, including large ones whose markets are domestic.

In financing as well, the environment has become severe for small firms, with their parent companies providing less credit, cash settlements increasing, and inter-company credit diminishing. In addition, banks have become cautious about lending to high-risk borrowers, or have increased their lending rates to secure returns congruent with perceived risks.

In terms of numbers of employees and employed persons, small firms and nonmanufacturers have a large weighting in Japan's economy. To increase employment opportunities and maintain social stability, I think it is extremely important to plan for the development of the nonmanufacturers and small firms that are relatively weak in Japan. I think a very difficult and very serious issue is how small firms, in particular, with their weak financial foundations and limited management resources, are to survive in the future. The other day, I heard a very interesting story from a member of the chamber of commerce of Ota Ward in Tokyo. The ward contains a number of global niche enterprises employing high technology, such as the incorporation of carbon nanotubes in silicon and microprocessing of optical fiber connection terminals, in addition to small firms with long histories. The person told me that such firms in the ward network with each other, concentrate in industrial zones, and promote mutual collaboration among multiple firms with a view to concentrating technology and cooperating to develop new fields. There are also cases in which small firms transcend their status as simple subcontractors of large corporations, and use their core technologies to develop new final products. For example, pressing manufacturers employ the squeeze technique to make illumination fittings, and texture wholesalers produce printable paper. To open up new business opportunities, this kind of application of external resources and cultivation of interactive linkages and networking seems necessary. Moreover, to add cost-competitiveness, increasing numbers of small firms are shifting low-valued-added processing overseas and outsourcing production to cooperating plants in China. I think it is necessary to support such moves. Providing such services to small firms that have little access to information is the role of public entities and financial institutions. There are a great many instances of small firms' failures in advancing abroad. Small firms have limited know-how about law, accounting, internal management, local business practices, and the like. Hitherto, when they have advanced overseas their parent companies or trading firms have taken on these indirect functions, enabling them to concentrate on the manufacture of their products. In recent years, however, the parent companies and trading firms can no longer undertake such assistance. Organizations that support small firms report numerous requests from them for education in the practicalities of trade and overseas advancement. It is thus imperative for public entities and private financial institutions to actively provide such expertise and know-how to small firms.

B. Measures to Cope with Industrial Hollowing-Out and Issues relating to China

The second issue facing Japan's economy relates to China. The locus of the exports driving the present recovery is Asia, particularly China. Among steel, chemicals, and other materials industries, there are those that describe China as almost the sole source of their good business results. The perceptions of an increasing number of firms are changing, as epitomized by statements such as "China should be seen not as a threat, but as a promising and attractive market of 1.3 billion people" and "Japanese production bases in China for exporting to the United States and Europe and reverse importing to Japan should become sales bases for the domestic Chinese market." In line with such perceptions, Japanese firms' advances into China are accelerating, and this is causing further hollowing-out of Japan's economy.

As I mentioned, this time investment in China differs from its predecessors in that there is an emerging awareness of China as a market, with the start of its World Trade Organization (WTO) membership. According to a survey by the Japan Bank for International Cooperation, the reason given for investing in China is shifting from "low-priced labor" to "market size and growth potential." Recently, moreover, those moving to China have not been labor-intensive industries but advanced high-value-added industries, and this can be identified as a distinctive characteristic of this boom. The high-value-added industries are export-oriented large manufacturers.

Given the fact of firms' advances abroad, it is expected that the effects of domestic hollowing-out will grow even more pronounced in the future. The phenomenon resulting from shifts of production sites to China is of course not limited to Japan. To a greater or lesser degree, it is also an unavoidable problem for the United States as well as Taiwan and other NIEs. Against this background, the U.S. trade deficit with China has risen sharply and the pressure on the upward revaluation of the Chinese renminbi has mounted. However, behind the surge in China's exports to the United States is a sharp gain in imports of raw materials and components from other Asian countries and Japan, and China's trade surplus in 2002 was a relatively moderate US$30 billion. Of course, it is well known that vast direct investment in China has pushed foreign reserves up appreciably. In Japan as well, many are pressing for the upward revaluation of the Chinese renminbi, but I have considerable doubt that simple revaluation would bring a halt to hollowing-out and adjust the balance of payments. Many large Japanese corporations are already doing business in China. Most are exporting from there to the United States, Europe, and Japan, rather than selling into the Chinese market. Would not the upward revaluation of the Chinese renminbi be in large part a negative for Japan? Would not many Japanese corporate managers be concerned about the effects of a revaluation shock on the Chinese economy? Among the small firms now entering China, there are many that have not done well in Japan and are seeking a fresh start there. A revaluation could dash their last hopes.

Revaluation, moreover, is a highly uncertain way of preventing the hollowing-out of Japan's economy. Considering the level of China's labor costs, which are 1/30th to 1/40th of those in Japan, and China's abundant labor resources, a small revaluation could not possibly narrow the cost gap and prevent the hollowing-out of Japan's economy. Given Japan's high labor costs, a revaluation would only alter the direction of overseas advances into other developing countries with low labor costs and weak currencies.

Economic fundamentals usually dictate currency revaluations in countries with high productivity, and devaluations in those with low productivity. Given the overwhelmingly large differentials between Japan and China in labor costs and productivity, I think the preferred direction is to make changes, over the medium to long term, to the market mechanism by which exchange rates are determined flexibly. However, based on the current situation of Japanese firms deploying into China, they must first be enabled to protect their intellectual property ownership rights and receive financial services. In financial services, it is desirable that restrictions on branch establishment by Japanese banks as well as limits on their Chinese renminbi operations and geographical limits be relaxed. Under present regulations, it is not worthwhile for Japanese banks to provide global cash management and other services to Japanese firms in Asia, including China.

Above all, it is important to change the sources of medium- and long-term growth for Japan's economy as a whole. As a source of employment, the service industry itself must enlarge the pie. In manufacturing, it is important to transfer low-value-added production processes overseas, and seek sources of value added in high-value-added fields in Japan, such as R&D or services related to products. To enhance this, policies that assist small firms, tax cuts for investment and R&D, and other incentives are needed.

Although some might say that the concept is clear but implementation might be too complicated in practice, I think the outcome depends on the approach. For example, combining goods with related services enables a linkage to employment. Cell phone shops can be seen anywhere in urban areas today, and many people work in them. This is an industry that did not exist 10 years ago, and its labor population was zero. The game software and contents industries are also new opportunities for employment now. Among small firms as well, a food processing equipment manufacturer informed me that most of its revenue is after-sales service income. For example, if rice cakes or sushi sell well at the large supermarkets to which the maker supplies equipment, the maker can maintain the equipment as part of its business. And housing manufacturers, for example, no longer sell only houses but also provide services and software in all related fields, including financing and leasing intermediation, management of maintenance, and remodeling. All these illustrate moves toward a business model of software allied to hardware.

C. Assessment of the Disposal of NPLs and the Future Management of Financial Institutions

My final point concerns the financial system and NPL disposal. From the 1990s up to recently, more than 80 trillion yen in NPLs has been disposed of, and more than 10 trillion yen in public funds has been injected. Yet the outstanding balance of NPLs has accumulated thereafter as well. This is because the situation has moved in parallel with changes in economic structure such as asset price depreciation, regional economy exhaustion, and weakness in nonmanufacturers and small firms. When business conditions were decelerating in 1997 and 2001, uncertainty over the financial system had a major adverse impact on the economic developments. In the present recovery phase, however, the situation is a little different. Comparing major banks' disclosed NPLs at the end of March 2003 with those of a year earlier, we see a substantial diminution to 20.9 trillion yen, from 28.4 trillion yen. Looking at the situation of the government's off-balance sheet policy for the 12 major banks, the rate of progress toward the 80 percent reduction ratio--for NPLs appearing in the first and second halves of fiscal 2001--required by next fiscal year-end is around 70 percent. The 50 percent target for such loans appearing in fiscal 2002's first half has already been achieved. In bank debtor categories, in some cases we see a fall in downgradings from "need attention" to "need special attention" or "in danger of bankruptcy," while there are more upgradings in terms of the number of cases and amount of NPLs. The primary factor behind this is that banks have been aggressive about NPL reduction, but this has also been backed in a real sense by more muscular corporate earnings structures. Banks are also extending positive support to customers, whose core business earnings are rising, considering them eligible for revitalization, not disposal.

Banks themselves are coming to grips with reinforcement of their management strength. The stockholdings of the major banks have been approximately halved, from 31.5 trillion yen at the end of March 2001 to 14.8 billion yen at the end of March 2003, partly because of sales to the Bank and to the Shareholdings Purchase Corporation. Capital increases and sales of stockholdings have markedly improved banks' resistance to share price fluctuations. The current stock market rally can also be considered a factor that has increased banks' business strengths. This is expected to bring about the overall financial system stabilization. Such stabilization and progress in NPL reduction would likely remove uncertainty about the economy.

Nevertheless, NPL reduction is still a work in progress. Nor have there appeared any conclusions about a number of problems presently confronting financial institutions' management.

One of these is the issue of public funds injection. The past two injections based on the Financial Function Stabilization Law and the Financial Function Early Strengthening Law, and the recent injection of funds into Resona Bank based on Article 102 of the Deposit Insurance Law, require rethinking of the purpose of those capital injections. Capital injections are basically for protection of depositors and stabilization of the financial system. If used for other purposes, their meaning must be clarified. The issue of the legal framework for injections of public funds to prevent bank failures ahead of the removal of blanket deposit insurance has been taken up by the Financial System Council. I think that in making public funds injections under a new scheme, it is necessary to clarify the original purposes and take full responsibility for explaining the effectiveness of the scheme.

Another issue in pursuing NPL disposal lies in the relation between banks and small firms, and improvement of banks' earnings power. Under the so-called "Takenaka Plan," banks have adopted a three-directional strategy of NPL disposals, asset reduction, and reinforcement of their profitability. In this situation, a natural consequence was that banks adopted cautious lending attitudes toward smaller firms with higher default risk, and lending rates were raised to gain returns commensurate with the risk. I often hear from small firms' managers that "small firms' borrowings have often been rolled over, and they are quasi-capital for small firms, but despite that, "banks come to us and demand repayment because the borrowings are in the form of a transferable single-name sight bill; if we cannot repay, banks say they will increase the lending rate." For now, the upturn in the economic environment has relaxed banks' lending attitudes somewhat, but according to the Bank's loan survey, many firms still face stringent lending conditions.

To improve this situation, small firms need to reform their management to adapt to the new economic structure. Strengthening their core businesses, for example, would be a wise option. At the same time, I think financial institutions should diversify their lending practices for small firms and seek to nurture them, a stance that was the finest component of the traditional relationship between banks and corporations in Japan. Recently banks have given signs of positive attitudes in this direction, but the relevant authorities should also reinforce further their stance of supporting this and coordinating it.

I would like to summarize the major changes in the operating environment for financial institutions in Japan, as a key focus in considering ways to improve their earnings power. First, information and communication technology has enabled easier entry into the financial sector from other industries, and barriers between industries are steadily coming down. How will such technology be used? Financial service using authentication and Web technology is still an expanding field, and as it grows in scale profitability will likely be increased. Second, regarding the financial assets of individuals, how will 700 trillion yen in deposits and savings be linked to business opportunities? In the personal asset management field, the principal customers in the coming years will be those in their mid-50s with superior financial knowledge. They are likely to seek not only attractive interest rates but also comprehensive products including securities and insurance. In this regard, banks have already begun to build up their investment trust and insurance window sales as one source of their earnings. Congruent with the individual life cycle, for example, I think there could be business opportunities in cross-selling, that is, providing a wide range of financial products, and up-selling, or providing sophisticated financial products. And third, amid a shrinking corporate finance pie, how should high-value-added financing services develop? Here too, I believe that transactions with small firms offer business opportunities. Owing to the lag in their financial restructuring, there should be great demand for such high-value-added financial services.

The writing-off of small firms' assets from their balance sheets by securitizing accounts receivable and liquidating assets has already started, but this kind of market can expand much further. Smooth financing of such firms and the improvement of banks' earnings are by no means incompatible. Now, when firms and banks are implementing significant changes, from disposal of assets to revitalization of their business, there are promising opportunities for "win-win" transactions compatible with trends in relationship banking.

One word I would like to add here is that, in banks' deployment of new business models, there must be a balance between expanding business and the compliance aspect. The loss of discipline because of conflicts of interest and abuse of collateral financing are important lessons that financial institutions learned from the 1990s. I would strongly emphasize the necessity of a strong sense of discipline when dealing with funds for corporate revitalization, due diligence, and the presence of internal financial advisers in dealings with individuals.

V. Conclusion

Currently, with the recovery trend looking steadily more certain, corporate executives seem to be more optimistic. For the Japanese economy as a whole, beset by a number of structural problems, this is a heaven-sent opportunity. Measures for addressing medium- and long-term issues should be clarified, and a self-sustaining and long-term recovery trend should be attained.

Japan's economy experienced a "lost decade" in the 1990s, and its difficulties have continued into the 21st century. I must say that the shackles on a so-far insubstantial economic expansion have been too great. The future will see major social and economic changes in Japan, such as advancing globalization, the accelerated aging of society with a decline in the number of children, and a rise in geopolitical risk. Nevertheless, Japanese firms that have weathered difficult times are becoming clearly stronger in the face of changes. I believe the driving forces of the current recovery are not progress in government structural reforms or financial institutions' NPL reduction, but corporate management reform and a resolute corporate entrepreneurial spirit. Individual awareness and household economic conduct are also likely to change greatly in the future. A bank's loan officer said to me, "I've recognized the courage of firms that have come through the severe situation with us over the past three years. For us, there is no alternative but to support them thoroughly. We are definitely willing to do that." The harsh economic environment and heightened competition have multiplied the number of resolute firms with the confidence to develop new products and cultivate markets that rank with any in the world. These are firms that can withstand hurricane-force winds. As a participant at the forefront of economic policy, I sense both tension and vast potential power.