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Realizing an Open Economy and Society

Excerpts of a Speech Given by Atsushi Mizuno, Member of the Policy Board, at a Meeting with Business Leaders in Oita on February 28, 2008

April 21, 2008
Bank of Japan

Contents

  1. I. The Conduct of Monetary Policy
  2. II. Realizing an Open Economy and Society
    1. A. Making Japan a Country with a Stronger Financial Sector
    2. B. India: The High-Growth Center of the Global Economy alongside China

I.  The Conduct of Monetary Policy

Japan's economy has been facing problems both at home and abroad.  Domestic problems include the decrease in disposable income due to the abolition of the across-the-board income tax credit; the effects of institutional changes such as the revision of the Building Standard Law and the Money-Lending Business Control and Regulation Law; and the adverse effects of the rise in crude oil prices and other materials prices.  On the other hand, external problems include the turbulence in global financial markets stemming from the U.S. subprime mortgage problem; the rapid deceleration in the U.S. economy; and the heightening of uncertainty regarding global economic developments.  Faced with these problems, Japan's economy appears to be in a lull.

In relation to this, at the Monetary Policy Meeting of the Bank of Japan's Policy Board held in December 2007, I decided to temporarily stop advocating that the Bank should advance the normalization process of the Bank's monetary policy.  This was because the adverse effects from Japan's economy of the revision of the Building Standard Law and other institutional changes as well as from higher materials prices had been larger than expected, and it was therefore necessary to examine whether the virtuous circle of growth in production, income, and spending would remain in place.

Recent developments in the stock and foreign exchange markets are one important aspect that should be watched closely in the conduct of monetary policy.  These markets have been unstable even after entering February, and if volatility remains high in these markets, this is likely to have a negative effect on economic activity through deterioration in business and consumer sentiment.

Looking at developments in global financial markets since the beginning of the year, downside risks to the global economy have increased mainly due to the prolongation of the U.S. subprime mortgage turmoil, the further slowdown in the U.S. economy, and the negative effects of continuing high crude oil prices, and as a result adjustments in global stock prices have intensified.  In this situation, the Federal Reserve has cut the federal funds rate target substantially.  Despite such moves in the United States, where downside risks to the global economy originated, the recovery in stock prices in emerging economies has been weak.

In credit markets in Japan, the United States, and Europe, credit default swap spreads have widened substantially.  In contrast, stock prices, which have fluctuated, have not been on a continuous downtrend.  This contrast suggests that there is a discrepancy in the outlook for the global economy between participants in different markets.  In other words, there seems to be no convergence in market participants' views regarding the outlook, and it can be said that global financial markets are in an unstable equilibrium.  Therefore, I will pay close attention to developments in global financial markets.

Turning our attention to the Japanese economy, there are expectations of an interest rate cut among some market participants.  However, the financial environment remains sufficiently accommodative, given the relatively low interest rates across the yield curve and the relaxed lending standards of financial institutions.  In addition, the Japanese economy has become less sensitive to interest rates partly due to the ultra-low interest rate policy in place throughout the past decade.  In this situation, it is uncertain whether an interest rate cut would provide additional support to the economy.  If we were to discuss any such cut amid the ongoing accommodative financial environment, we would need to fully take any potential side effects into account.

Indeed, it is undeniable that, at the time when the Bank introduced the quantitative easing policy in March 2001, there was anxiety about financial system stability and the risk of a deflationary spiral.  Compared to the situation then, however, there is a marked difference in the macroeconomic environment.

I believe that at present the virtuous circle of growth in production, income, and spending, and the transmission mechanism of the positive influence of the strength in the corporate sector feeding through into the household sector, remain in place.  However, this does not mean that I am optimistic with regard to the outlook for economic and financial developments.  Exports have been the source of the ongoing economic expansion, and in this situation, the growing downside risks to the U.S. economy, the prolongation of the U.S. subprime mortgage turmoil, and deteriorating soft data in Japan have been increasing the downside risks to Japan's economy.

The Bank will, in the April 2008 Outlook for Economic Activity and Prices, present its projection for economic and price developments in fiscal 2009 as well as the underlying assumptions and mechanisms, based on careful examination of all available hard and soft data.  Based on this projection, I will decide on the most appropriate conduct of monetary policy in light of the economic and financial situation at each Monetary Policy Meeting.

Central banks conduct monetary policy in accordance with their assessment of overall economic trends, including developments in asset prices, and do not focus solely on economic and price indicators.  However, the conduct of monetary policy by central banks has become increasingly difficult due to the progress in economic globalization in the past few years.

Examples of global developments in recent years affecting the conduct of monetary policy include the following.  First, general prices in major economies have remained stable thanks to the increase in inexpensive imported goods from emerging economies.  In this situation, monetary policy in major economies has tended to be accommodative partly due to their steady expansion, and it seems that central banks have been less attentive to asset prices such as housing and stock prices.  Second, asset prices have risen globally due to structural factors such as the widening distribution of international investment, the higher investment from emerging and oil-producing economies, and the surplus in global savings.  Third, international commodity prices have surged against a background of high growth in emerging economies, and this has increased inflation pressures in major economies.  Fourth, excessive liquidity and the decline in market volatility have caused excessive risk taking, or a "credit bubble," as the presence of non-banks in the financial system increased.  Fifth, the adoption of the originate-and-distribute model by European and U.S. financial institutions with a view to increasing return on equity and the emergence of "fund capitalism," in other words, the prominence of hedge funds and private equity funds, have gone too far.  As a result, the balance sheets of major banks have expanded substantially.  Sixth, the bursting of the U.S. housing bubble affected securitization and other innovations in financial technology as well as rating agencies and monoline insurers, which support the financial infrastructure, and as a result, credit conditions tightened in the United States and Europe.

The above review of global economic developments in the past few years highlights the growing importance of a forward-looking monetary policy.

II.  Realizing an Open Economy and Society

Japan's economy is facing growing pressure for change: challenges on a global level include increased competition due to globalization and global warming, while on a domestic level they include the acceleration in the ageing of the population and the decline in the birthrate.  In this situation, Japan needs to continue its structural reforms and make efforts to realize an open economy and society, and at the same time strengthen its financial sector and take advantage of rapidly growing external demand.

A.  Making Japan a Country with a Stronger Financial Sector1 

In order to make Japan a country with a stronger financial sector, the following issues must be addressed.  First, public awareness must be raised that Japan is lagging behind in responding to economic and financial globalization, and furthermore, the financial services industry should play a key role.  Second, Japan must make efforts to increase the flow of foreign risk capital into Japan's markets.  And third, the financial infrastructure should be improved to match international standards.

Economic globalization is accelerating as seen, for example, in the growing presence of emerging economies, and financial markets are becoming increasingly borderless.  As for Japan, the population is ageing rapidly and will soon start to decrease.  In such a situation, there is an urgent need for Japan to achieve a more open economy and society so that it can continue developing.  However, I believe the public lacks awareness of this issue.  This is apparent from how it views the financial services industry.  Asked where Japan's strengths lie, many would probably answer, "In manufacturing industries with high international competitiveness."  On the other hand, with regard to the financial services industry, one often hears harsh criticism such as "Japanese banks make too much profit although their profitability is lower than that of major U.S. or European financial institutions" or "the financial services industry makes easy money."

Yet, the financial services industry is expected to contribute to the efficient allocation of resources in the economy.  Since Japan will soon enter an era of population decline, it is important to build a stronger financial sector so that the financial services industry can fully play this role.  Currently, Japan's financial services industry is dealing with various issues in response to the coming into force of the Financial Instruments and Exchange Law and the amendment to the Money-Lending Business Control and Regulation Law and, in addition, faces increased difficulties in accurately assessing credit risks due to widening disparities between firms and regions.  Against this background, financial services companies need to carefully assess borrower firms' prospects and profitability and provide advice before any problems arise. 

Given that it would be difficult for Tokyo to immediately become an international financial center on a par with New York and London, I believe that Japan should first aim to become the financial center of Asia.

Becoming the leading financial center in Asia, which is now a major engine of global economic growth, is of substantial significance.  To achieve this, it is important to make it a national policy goal and, moreover, raise awareness among the public that Japan is lagging behind Hong Kong and Singapore, which are attracting overseas investors such as investment funds by offering a favorable environment in terms of financial infrastructure, regulation, and taxation.  Considering the potential of the Chinese economy, Shanghai may become one of the financial centers of Asia regardless of its disadvantage as a non-English-speaking location.

To compete in this environment, Tokyo needs to make considerable efforts.  I do not think that young businesspeople working for Japanese financial institutions lag behind in their ability, nor do I believe that Japan should simply imitate the business model of Hong Kong and Singapore, which have much smaller populations and where there is a public consensus with regard to building a stronger financial sector.  What is important is to be aware that the financial services industry encompasses a great number of related industries and to establish a system where financial professionals (fund managers, international lawyers, and consultants), products, funds, and information gather in Japan from all over the world.

To make Japan a country with a stronger financial sector, accepting more risk capital -- which is invested from a long-term perspective to achieve higher returns through risk taking -- is indispensable.  To achieve this, it is essential to identify investment opportunities that have a high expected rate of return; to encourage the provision of risk capital by Japanese investors and encourage foreign investors to come to Japan; and to foster entities that manage risk capital.

The Japanese people tend to treat people differently according to their nationality.  However given the progress in financial innovation and the diversification in the types of products, and also since Japan is lagging behind Singapore and Hong Kong as an international financial center, Japan should encourage foreign risk-capital providers and financial professionals, who contribute to an increase in investment opportunities, to come to Japan, regardless of nationality.  There is also an urgent need to further expand financial product variety and to put in place regulatory and tax systems and transaction practices that are in line with those in other international financial centers.  This would also help to dispel the impression that Japan is backtracking on its structural reforms.

Moreover, in order to provide the right training for people to work in financial services in Japan, the financial literacy of the public needs to be enhanced.  The first step is to drastically improve financial and English education.  In this regard, it is important to build a shared consensus in communities -- extending beyond schools and households -- on how to handle money in order to lead a comfortable life, in other words, how to earn, save, spend, and invest.  This is also important from a perspective that sees the need to balance work and life.

Another important element is to improve the infrastructure of metropolitan areas.  I think there is significant potential demand for large office space with high resistance to earthquakes.

An airport with fast access to central Tokyo that acts as a hub is also crucial.  Narita International Airport has not sufficiently fulfilled this role.  Haneda Airport should ideally be expanded at an early stage and become a truly international airport that acts as a hub 24 hours a day.

Many issues need to be addressed in order to make Japan into a country with a stronger financial sector, but solutions are at hand.  However, it would be unrealistic to blindly follow examples of successful international financial centers with different historical, cultural, and geographical circumstances from Japan's.

One solution is to identify investment opportunities with a high expected rate of return.  One area would be the manufacturing sector, where Japan has many industries that are highly competitive on a global level.  In addition, given that the 21st century is sometimes called the "age of the environment," in which the protection of the environment and energy conservation are major concerns, Japan should make use of its comparative advantage in environmental, energy-saving, and safety technologies.  It is worth considering the establishment of large investment funds through tie-ups between manufacturing firms that possess such superior technologies or expertise and financial institutions to develop investment projects that are risky but also have a high expected rate of return.

Another solution is to increase the flow of foreign risk capital into Japan's markets.  Looking at developments in global financial markets, there has been a remarkable growth in the number of huge investment funds and investment management companies managing assets in excess of 100 billion U.S. dollars.  With the surge in crude oil prices and the increase in foreign exchange reserves, new types of market players such as petrodollar funds and sovereign wealth funds have increased their presence in financial markets.  In other words, the balance of power in global financial markets is shifting from major economies to emerging economies with such new market players.  Assets managed by sovereign wealth funds currently amount to roughly 3 trillion U.S. dollars and are likely to expand to 10 trillion U.S. dollars -- an amount equivalent to the assets managed by pension funds of industrialized countries.  I hope that Japanese financial institutions will take a step forward and become business partners with sovereign wealth funds to receive more risk capital.

It is said that the CEOs of major European and U.S. banks spend more than one-third of their week in private jets visiting major financial centers such as New York, London, and Hong Kong.  This type of pattern is not limited to the world of finance, and compared with their counterparts from the United States and Europe, Japanese leaders -- from both the public and private sectors -- visit developing countries less frequently for top-level diplomacy and discussions related to specific business deals.

To increase the flow of risk capital into Japan's markets, it is also important to carry on with reforms in the investment trust business and the pension system and to enhance the international competitiveness of securities exchanges.  For example, asset management financial services, which have a high growth potential, could be invigorated by making the business of pension fund management, trust management, and investment advisory services more independent from the banking, securities, and insurance business. 

Competition among exchanges has become widespread, not only among securities exchanges trying to attract foreign firms to list, but also among exchange groups comprised of exchanges of various types of products ranging from stocks, interest rates, foreign exchange, and financial derivatives to commodity derivatives.  In this situation, innovation in IT is a key prerequisite.

Among European and U.S. securities exchanges, cross-border reorganization and collaboration have been under way to raise the large amount of funds necessary for investing in system development.  In Japan, legal preparation for the establishment of consolidated exchanges made significant progress last year.  This will open up the possibility of consolidation among securities exchanges, futures exchanges, and commodity exchanges as well as tie-ups with other exchanges, including those abroad.  A reorganization of exchanges so that they can deal with various types of securities and products would, I believe, help to strengthen the competitiveness of Japanese exchanges.

It is important for Japanese exchanges to implement business strategies that contribute to attracting risk capital from abroad.  Such strategies could include, for example, (1) establishing a transaction system that anticipates future transaction needs and has the fastest data processing ability; (2) enhancing business continuity planning based on, for example, strong back-up facilities; (3) strengthening clearing corporations; (4) constructing stock indexes composed of stocks of major Asian firms or venture capital firms; (5) listing exchange-traded funds other than those that track the performance of stock indexes, for example, commodity-based exchange-traded funds; (6) providing a full line of products made possible through strategic tie-ups with exchanges in other countries; (7) establishing simple rules and regulations; and (8) accepting public offerings in English and financial statements that comply with international accounting standards.

Lastly, I would like to suggest drastic reforms of the legal framework, including regulations and the tax system, to strengthen Japan's financial sector.  For example, it is worth considering the tax exemption of incomes earned abroad by nonpermanent residents implemented by the British government between 1986 and 2006.  Another example is the case of the Hong Kong government, which abolished inheritance taxes in 2005 as one of its measures to attract the inflow of assets and investments from abroad, a step followed by the Singaporean government on February 15, 2008.  The implementation of such measures will encourage hedge funds and investment management companies to establish their business bases in Tokyo, and this will lead to an expansion of employment opportunities in the financial field and an increase in tax revenues.

The role of financial administration is also crucial in accomplishing Japan's initiative to become a country with a stronger financial sector.  There is increasing need for financial authorities to take a forward-looking approach in designing the future shape of the financial system.  Financial authorities have made efforts in the area of legal and regulatory compliance, the sophistication of risk management techniques, and investor protection, but at the same time, financial institutions' efforts are also essential.  For example, European and U.S. financial institutions have been able to dispose of huge losses caused by the subprime mortgage problem mainly because of their sound capital bases, high profitability, and the adoption of robust business models that diversify sources of income.  Therefore, the lesson to be drawn from the subprime mortgage problem is that it is important not only to restrain investment in securitized products but also to encourage financial institutions to shore up their profit bases to be prepared for unexpected events.

Reflecting the thriving activity in global financial markets, a new generation of financial professionals has grown worldwide.  Speaking from my own experience based on having worked for several foreign financial institutions, the talents of those working for Japanese financial institutions are not inferior to those employed by their foreign counterparts, but I see room for improvement in the incentive system, including salaries and bonuses, as well as in management techniques. 

In recent years, not only the industrialized countries but also emerging economies have come to see it in their national interest to develop their financial markets and strengthen their financial services industries.  While other Asian financial markets were attracting foreign risk capital, Japan's stock markets suffered from the "Japan passing" phenomenon.  This phenomenon reflected investors' disappointment over the poor profitability of Japan's financial services industry, and I am concerned that Japan may have been left behind by other Asian economies.

Since the summer of 2007, the subprime mortgage problem has been causing turmoil in global financial markets.  Many European and U.S. banks have been recording huge losses, and as a result they may need to sell assets and business divisions, leading to a global restructuring of the financial sector.  The effects of the subprime mortgage problem on Japanese financial institutions have been relatively small, and this may give them time to catch up with their European and U.S. counterparts.  Japanese financial institutions are given the opportunity to, for example, allocate economic capital to priority business areas in which they enjoy a comparative advantage or become active buyers in cross-border merger and acquisition activities.

Last year, the government finalized the "Plan for Strengthening the Competitiveness of Japan's Financial and Capital Markets" after holding a series of discussions, including those at the Financial System Council.  However, the interests of the parties involved in the process of implementing measures to make Japan a country with a stronger financial sector do not necessarily meet, and thus a public consensus is needed to achieve this goal.  I hope that the importance of making Japan into a country with a stronger financial sector by encouraging the inflow of risk capital will be actively discussed not only within the government but among the wider public as well.

  1. See A. Mizuno, "Kin'yu Rikkoku no Jitsugen ni wa Kokuminteki Consensus ga Fukaketsu (A Public Consensus Is Indispensable for Realizing a Country with a Stronger Financial Sector)," Kin'yu, Japanese Bankers Association, January 2008.

B.  India: The High-Growth Center of the Global Economy alongside China

As a country seeking to realize an open economy and society but at the same time on the verge of entering an era of population decline, Japan needs to harness external demand.  In this context, the role of India alongside that of China cannot be overlooked.  I would therefore next like to comment on the economy of India based on my brief visit there, which gave me the opportunity of experiencing the country's vigorous growth.

China and India are among the most rapidly growing economies in the world.  Despite negative factors such as the surge in materials prices and the slowdown in the U.S. economy, India has continued to grow rapidly at a pace above its potential growth, registering annual growth rates within a range of 8-10 percent.  India has achieved remarkable growth across a wide range of areas not only in the well-known IT business but also in steel, chemicals, and textiles.

A breakdown of India's GDP indicates that the economy has been driven by domestic demand, particularly gross fixed capital formation and private consumption.  Fixed capital formation has been increasing steadily, mainly in raw material- and automobile-related sectors, reflecting the removal of restrictions on foreign capital in the manufacturing sector and the subsequent inflow of foreign capital.  Private consumption has also continued to be on an increasing trend against the background of a rise in wages of middle-income households in addition to high-income households.  India is turning into a consumer society consisting of roughly 300-400 million people, and this is becoming the driving force of the economy.  This aspect is in marked contrast with China's economy, which is being led by external demand and gross fixed capital formation.

India is also more attractive than China in terms of demographics.  Its population is not only large, standing at approximately 1.1 billion, but also young, with an average age of 26, and the ratio of the working-age population to the total population is expected to remain on an increasing trend until around 2050.

It has also been pointed out that the anticipated rise in the ratio of the working-age population holds the promise of a rise in the potential rate of economic growth through its effect on private consumption, one of the driving forces of the Indian economy.  Indeed, during my recent business trip to India, I learned that many top-ranking officials from industrialized countries and CEOs of major corporations were paying visits there.

However, looking at the number of Japanese firms that are active in India, it stands at little more than 400, a mere 1 percent of the number of Japanese firms active in China. Of course, part of the reason is that many obstacles to entering the Indian market persist.  For example, the infrastructure, such as electricity, ports, roads, and railroads, requires significant development, and the legal system needs to be improved in various areas.  Leading a life in Indian society is not easy either.  Nevertheless, given India's high current economic growth and its potential, European countries and the United States are aiming to harness India's growing demand.  In light of this situation, I gained the impression that India had been expanding by selecting appropriate business partners in accordance with its own needs.  I see no reason why Japan should not seize this opportunity to benefit from India's growth potential, especially at a time of friendly relations between the two countries on a governmental and private level and also among the public.

Japan continues to face the critical demographic challenge of an ageing population and a declining birthrate.  In order to continue achieving sustainable growth, Japan needs to increasingly harness demand from economies with a high growth potential while at the same time weighing the associated costs and risks.  To ensure that the next generation can continue to live in an affluent society, Japan should not fixate on its past success as a major economic power.  It is only a matter of time before countries with large populations, such as China, India, and Brazil, grow into major economic powers like the United States.  In addition, there is a limit to competing with these future economic powers in terms of GDP.  Thus, I believe that Japan should continue to maintain friendly relations with such emerging economic powers, strengthen its comparative advantage in technology, environmental policy such as with regard to the efficient use of energy, branding power, and human resources, and, from a long-term perspective, strive to be a medium-sized economy where people can lead affluent lives.