The Euro Seen from the Japanese Central Bank

-- Remarks by Shinichi Yoshikuni, Chief Representative in Europe, Bank of Japan, before the 13th European Finance Convention at the House of the Estates, Helsinki, 25 November, 1999 --

December 3, 1999
Shinichi Yoshikuni

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There is a famous remark of the late Chinese Premier Chou En Lai. When asked for his views on the French Revolution, he replied "It's too early to evaluate it." Although I am not as patient as Premier Chou, I would definitely say that it is too early to evaluate the euro less than a year after its launch. I will, however, try to provide some personal and preliminary observations of a Japanese central banker about this historic event of the creation of the euro.

I will first touch upon the role of the euro in the international monetary system. Then I will discuss the monetary policy of the European Central Bank (ECB), particularly in comparison with that of the Bank of Japan (BOJ) and the Bank of England (BOE). Finally, I will conclude by saying a few words about the implications of the euro for the Japanese economy.

First, on the role of the euro, some economists, particularly the so-called Eurosceptics, have tended to downgrade the euro as an international currency, given its weakness on the foreign exchange markets. In my opinion, however, the weakness of the exchange rate does not necessarily mean that the currency cannot play an international role. As a good example, despite the fact that the exchange rate of the U.S. dollar has declined sharply on many occasions in the past decades, we have not so far seen any clear sign of international use of the dollar diminishing seriously.

As Mr. Duisenberg, the president of the ECB has reiterated, the fall of the euro exchange rate was explainable by rational factors: firstly, the gradual correction after the Europhoria at the beginning of the year, secondly the remarkable strength of the U.S. economy, and thirdly the unexpected pickup of the Japanese economy. Of course, there were some instances when the weakness of the euro did not seem to be explained by economic fundamentals. Such cases were, however, rather limited and we have not seen a general loss of confidence in the new currency.

On the other hand, we have already seen a clear benefit of the euro in the recent changes in the European capital markets. As a good example, the issuance of euro denominated bonds has increased dramatically and is now almost equal to that of U.S. dollar denominated bonds.

In this connection, while the introduction of the euro has facilitated the global issuance of bonds, we should not overlook the fact that the basic framework of EMU has greatly contributed to the increasing volume of issues of corporate bonds. By limiting the scope for deficit financing of the public sector, the Maastricht Treaty has reduced the fiscal deficit, thereby reducing long-term interest rates in the euro area. This, in turn, has induced investors to seek alternative opportunities for higher returns on their investment, and, as a result, paved the way for the expansion of the corporate bond markets. In other words, we are seeing a "crowding-in" effect of the reduced fiscal deficit across the euro area.

In fact, one of the salient features of the European capital markets after the introduction of the euro is the issuance of bonds by relatively low rated companies that hitherto had no access to the capital markets. This new trend in the capital markets has also contributed to the recent surge in M&A activities, as evidenced by the case of Olivetti and Italian Telecom, where bond financing played an important role.

Meanwhile, the introduction of the euro has made short-term money markets more efficient across Europe. In this connection, the efforts of the ECB and the central banks of the euro area in constructing the target system should be much commended. In the same vein, they are also trying to improve the clearing system of the securities markets. Providing deep and liquid financial markets is one of the essential roles of central banks, and euro financial markets should serve as an important infrastructure not only for Europe but also for global financial markets as a whole.

I would add that Finland is one of the countries that has demonstrated the benefit of the single currency. During the global financial crisis in the autumn of 1998, the exchange rate of the Finnish Markka was the most stable among the Nordic currencies. Given its relatively strong economic relationship with Russia, this can only have been due to the fact that Finland was the only Nordic country in the euro area.

Given such positive developments, it would be fair to say that the introduction of the euro, or precisely speaking, the whole process of EMU including the euro, has already rendered European financial markets more efficient and global. Under these circumstances, it is clear that the necessary conditions for the euro to become one of the international currencies are now firmly established.

It would, however, be too early to say that the economy of the euro area has reaped the full reward of monetary union. In my opinion, the true success of monetary union depends crucially on whether European countries can remove structural rigidities in their economies. By doing so, European countries could exploit the enormous opportunity offered by what Chairman Greenspan of the U.S. FRB called a "once in a century change in information technology."

There is no doubt that the most important beneficiary of this technology change is the United States, and, the U.S. has been able to make it because of the flexible labor market and competitive corporate environment, during the unrelenting process of economic reform since the 1980s. As far as I can see, this process has only just begun in Europe. Here, again Finland is ahead. Despite its relatively small economy, this country has quite a few leading IT companies, one of the most famous being NOKIA. In addition, a student of the University of Helsinki has led the development of LINUX, which is now threatening the monopoly of WINDOWS.

Having said that, I would now like to move on to the next important issue of the euro area, i.e., the historic experiment of the single monetary policy. Since its establishment at the beginning of this year, the monetary policy of the ECB has been discussed extensively on many occasions. Interestingly enough, two of the other industrial country central banks, i.e., the BOE and the BOJ have undergone fundamental changes at almost the same time as the ECB. So, as the chief representative in Europe of one of these three central banks, I would like to offer some preliminary thoughts about what is happening in the area of central banking.

First, it is not a mere coincidence that such basic reforms of central banking took place simultaneously. A fundamental change in the political and economic environments has made it necessary for modern economic society to change the modus operandi by which monetary policy is conducted. Particularly important are two basic developments, one being the increasing role of information in the economy, the other the growing public desire for more involvement in the decision making process of modern democratic society.

In the context of monetary policy, the role of expectation has become crucial, and this requires central banks to clarify policy objectives and the way monetary policy is actually implemented. Also, given their unique relationship with politics, central banks have been subject to stronger public pressure for more transparency than other administrative bodies. It is against this background that the structures of the three central banks have the following common characteristics.

(1) All three central banks have made it clear that domestic price stability is the single most important goal of monetary policy and, in pursuit of this goal, they are independent from government or political influence. Accordingly, central banks are explicitly prohibited from directly financing the public deficit.

(2) To make the decision making process more accountable while at the same time ensuring the high quality of policy discussion, monetary policy is determined by a majority vote of a policy board consisting of qualified members with various profiles. In the case of the BOE and the BOJ, some members are from outside the central bank, while the policy board of ECB, the Governing Council, consists of six executive directors of the ECB, and eleven governors of the central banks of euro area.

(3) To make the monetary policy process transparent and accountable to the public, the three central banks clarify policy objectives and explain in detail their view of the economy and how the decision is made. Both the BOJ and the BOE publish the minutes of the policy board meetings including the results of voting. Although the ECB does not publish minutes, the President of the ECB explains the basic contents of the discussion fully at a monthly press conference held after the meeting.

On the other hand, there is some interesting variance among these three central banks.

First and foremost, there is a difference as to the specific target of monetary policy. At one extreme, in Britain, the government determines a single and symmetrical inflation target, and the central bank has operational independence in its achievement. At the other extreme, in Japan, there are no numerical targets.

The ECB is halfway in between, since it has set a quantitative definition of price stability and adopted two pillars of policy strategy, namely a reference value for the growth of broad money, and analysis of a broad range of economic indicators to assess the prospect for price developments.

It is important, however, that we should not exaggerate such differences. First, there is much room for maneuver even under the strict targeting scheme. For example, the inflation targeting of the BOE is not on the actual rate, but on the expected rate of inflation after two years, which has provided the central bank with much leeway to cope with the various shocks to the economy. In fact, the BOE has decided to raise short-term interest rates twice since September. These decisions were made when the actual inflation rate was declining, on the grounds that the inflation forecast of BOE staff indicated a sharp increase in prices two years ahead. Also, in this "forward looking inflation targeting," the BOE has been able to take account of various economic indicators, for example, asset prices, in deciding monetary policy.

Second, although the BOJ has no numerical targets, the Governor has reiterated that the Bank wants neither inflation nor deflation, and the actual inflation rate as measured by the CPI has been very stable for the past decade. Some economists compare the current Japanese economy with that of the U.S. in the Great Depression. However, as far as the core rate of inflation is concerned, we have not experienced such a dramatic decline as in the U.S. in the 1930s.

Next, as already mentioned, the ECB has a different view on transparency, and has refused to publish the minutes of the Governing Council, particularly the voting results. This point has been discussed on many occasions, and I have not much to add. In general, I fully share the concern of the ECB about the possible politicization of monetary policy if results are published. However, I am also tempted to mention that this discussion of publication would allude to a fundamental paradox rooted in the Monetary Union, i.e., the paradox of the single monetary policy supported by the central banks whose original purpose is to serve the national interests of the sovereign states. Unless the euro area becomes the United States of Europe, in which case there would be a fundamental review of the central banking structure, the monetary policy of the euro area cannot fully escape from this paradox.

So far, the monetary policy of the ECB seems to have succeeded in gaining the support of the general public and financial markets, as evidenced by the generally stable bond markets after the recent rise in the short-term interest rates. It is particularly impressive that, so far, the problem of the two-speed economy in the euro area has not become an obstacle to the single monetary policy. In my view, this is partly due to the flexibility of the economies of the small countries.

For example, the Irish economy has a very efficient buffer in the overseas Irish population that has alleviated the strain on the labor market. Similarly, the economy of Luxemburg can benefit from the potential labor supply from neighboring countries. Thus, so far, these small countries with strong economies and inflationary pressure have been able to absorb the adverse impact of the reduction in interest rates. Now that the possible direction of the interest rate is upward, the question is whether the countries with weak economies such as Germany and Italy are able to cope with the tightening of monetary conditions. Since these countries are also required to implement vigorous structural adjustment, the success of the single monetary policy will depend on whether a strong political will can be maintained in such an environment.

With those remarks, I will now turn to the last topic, i.e., the implications of the euro for the Japanese economy.

As you may be aware, there have been quite a few indications that the Japanese economy has passed the worst stage. Aided by the extraordinarily loose fiscal and monetary policy, economic activity has now begun to pick up. On the financial front, the financial revitalization plan has worked to contain the banking crisis by injecting capital while at the same time closing insolvent banks. In this connection, we have greatly benefited from the experience of Nordic countries including Finland.

It remains to be seen, however, whether the economy will get back onto a sustainable growth path supported by domestic private demand. The most important obstacle to such a scenario would be the three excesses of the corporate sector, i.e., excess capacity, excess debt, and excess employment. Unless Japanese corporations address these problems through vigorous restructuring efforts, we are not able to envisage a resumption of robust private investment. To help such structural adjustments, macroeconomic policy should strike a delicate balance between the need to offset its deflationary impact, and the need to avoid the moral hazard that would discourage the adjustments.

Assuming such a favorable scenario, Japan will continue to serve as one of the leading economies of the world in the 21st century. It is in this context that the effect of the euro on Japanese economy should be discussed, and I will devote the remaining part of my speech to this issue.

Firstly, the Japanese monetary authorities, including the Bank of Japan, strongly believe in the importance of the international use of the yen and are prepared to implement the necessary measures. For example, we have recently introduced various new measures to make Japanese financial markets more efficient, including in particular the public auction of short-term government bills, and abolition of the withholding tax levied on interest income of non-residents. While we do not wish to encourage internationalization through such means as administrative guidance, we are determined to remove any obstacles to it.

Secondly, we do not think that the euro and the yen are enemies. With the euro, the financial and capital markets of the euro area have provided enormous opportunities, not only to the euro area but also to the outside world including Japan. Conversely the internationalization of the yen will benefit the world by mobilizing the large pool of Japanese domestic savings.

In other words, the efforts of countries to promote the international use of domestic currency should not be viewed as a "zero sum game." Rather, they will have a positive contribution to the world economy by enhancing the efficiency of the global financial markets.

Nevertheless, there is one caveat that, for the euro area to truly contribute to the global economy, it is essential that the countries of the euro area abide by the principle of free trade of goods and capital. We recall that, in the aftermath of the Great Depression of the 1930s, formation of economic blocs among major industrial countries exacerbated the economic plight of many countries. We should not repeat such a mistake. In this connection, I appreciate the recent agreement to welcome China into the WTO.

Before concluding, I want to tell you about the dream of the Austrian writer, Stefan Zweig. According to his biography, he once said that some day Europe would reconstruct the "Tower of Babel" by which he meant that Europe would be integrated under one common goal. In a sense, the introduction of the euro can be regarded as the achievement of his dream. In fact, we call the ECB building the Euro Tower. Of course, we all know that the Tower of Babel collapsed and the mankind lost the common language. Today, instead of common language, the euro area has a common currency. Actually, the ECB even has a common language, English. I strongly hope that this time the Tower of Babel will stand forever.