Mr Hayami outlines recent economic conditions in Japan and gives his thoughts on the role of a central bank and its balance sheet  (Central Bank Articles and Speeches, 22 Dec 98)
Central bank: boj | Type: speech | Date: 1998-12-22

## Mr Hayami outlines recent economic conditions in Japan and gives his thoughts on the ro of a central bank and its balance sheetSpeech by the Governor of the Bank of Japan, Mr Masaru Hayami, at the Kisaragi-kai meet Tokyo on 22/12/98.

## I.

IntroductionI am truly honored to have this opportunity to speak to you.

I will begin wit outline of recent economic and financial developments in Japan and then give my thoug today's topic, the role and balance sheet of a central bank.

## II.

Economic Conditions and Monetary Policy Management

## A.

Current Economic and Financial ConditionsJapan's economy still remains in a severe situation.

Recently, however, the economic deterioration has moderated somewhat, thanks to increased public investment exports.

The decline in production has decelerated, reflecting some progress in i adjustment.

With regard to financial developments, the temporary increase in concer corporate fund-raising toward the year-end has eased gradually, on account of the gove expansion of credit guarantee system and the Bank's introduction of new market oper measures and lending facilities.Thus, there have been some bright signs for Japan's economy.

However, it is still at this stage whether these suggest an escape from the current vicious circle, or j before further hardship.

The results of the December Tankan --Short-Term Economic Survey of Enterprises in Japan--published in mid-December showed that the majority of firms had a cautious view of the economic outlook.The key to economic recovery lies in whether private demand can lead to a self-su recovery of the economy while the public sector is underpinning it.

However, giv continued deterioration in corporate profits as well as employment and income cond developments in business fixed investment and private consumption require close att Prices continue to be weak, reflecting a widening output gap in the economy.

Therefore, to be carefully watched whether or not the implementation of the emergency economic pa and other measures will have the intended effect of improving business and hous confidence.In the financial markets, concern over credit and liquidity risks continues to manifestation of this is the market interest rates on instruments maturing after the fi in March 1999, which are likely to remain high.Under these circumstances, the Bank will maintain the current decisive easy st monetary policy, and continue to do its best to support economic activity and financial

## B.

The Bank of Japan's Balance SheetThe failure of some financial institutions in autumn 1997 was followed by inc anxiety about the stability of the financial system, which has had a dampening infl economic activity.

The Bank has responded to this situation by implementing a var monetary policy measures, including an additional lowering of the target call rate on 9, 1998 and continued provision of ample liquidity under the relaxed policy stance.The Bank has also taken the following measures in its money market operations. the Bank has injected large amounts of longer-term funds to ease the upward pressure on interest rates maturing beyond the end of the semiannual accounting term in September end of the calendar year in 1998.

This has caused the Bank's balance sheet to expand by percent over the year.

Second, the Bank has adopted some new measures to facilitate c financing, such as increasing commercial paper (CP) repo operations and introduc temporary lending facility in November 1998.

As a result, there has been a continuing r proportion of private-sector debt to the asset account on the Bank's balance sheet.

Th of its efforts to maintain financial stability, the Bank has expanded special lending under Article 38 of the Bank of Japan Law of 1997.

The function of these loans, whi provide emergency liquidity to ensure financial system stability, has recently been tak loans to the Deposit Insurance Corporation (DIC).The Bank's balance sheet has thus changed dramatically over the past year.

The ch a reflection of the Bank's constant efforts to combat the economic downturn and the i uncertainty about financial stability.

However, the expansion of the balance sheet has rise to a significant number of questions and criticisms focusing on a perceived th financial soundness of the Bank.

I would therefore like to devote the rest of my speech detailed examination of the Bank's role and its approach to provision of credit, in changes in the Bank's balance sheet.

## III.

Extension of Credit by the Bank of Japan

## A.

The Role of a Central Bank and Its Balance SheetBefore explaining why the soundness of the Bank's balance sheet has become an is need to refer to the mission of a central bank.In brief, the mission of the Bank of Japan, the central bank of Japan, is banknotes, ensure the functions of the currency, and contribute to the sound developme Japanese economy.

Perhaps 'ensuring the functions of the currency' sounds a little too Specifically, the Bank must first ensure the stability of the currency's value, and sec an appropriate framework for its circulation.

Referring to these two requirements, th central bank is often defined as maintenance of price stability and financial system stOn a day-to-day level, the Bank seeks to fulfil its mission by engaging in activities that are similar to those of commercial banks.

When the economy is expe inflation or deflation, the Bank tries to restore and maintain a non-inflationary deflationary situation--that is, a situation of price stability--by influencing the qu money in circulation and the levels of various interest rates.

The Bank achieves this o influencing interest rates in the financial markets.

And this is done basically by absorbing the appropriate amount of funds through the purchase or sale of financial as activity by the central bank is called 'market operations.' The same is true of t activities to maintain an orderly financial system.

When the stability of the financial risk due, say, to failure of a commercial bank, the Bank of Japan acts decisively to m ensuing disturbance by injecting funds into the system.

The principal tool the Bank e such cases is lending.As with commercial banks, the activities of the Bank are clearly reflected in its liabilities shown on its balance sheet.

For instance, when the Bank drastically eases order to avert deflation, as is the case at present, the Bank increases provision ofmarkets by increasing its purchase of financial assets.

This naturally causes the Bank sheet to expand.The key question is whether or not people will trust their central bank and be hold the country's currency (including banknotes, which bear no interest).

This dep whether or not the central bank's behavior has measured up to the expectations of the p whether or not it continues to do so.

One source of clues for making such a judgmen balance sheet, and it is therefore natural that people in Japan and abroad take a kee the Bank's balance sheet.The Bank's balance sheet can be discussed from various perspectives.

From viewpoint of people's confidence in a central bank, it is most important that the fina the Bank holds are adequate to secure the banknotes issued.

This adequacy, I believe, two specific points.

First, the Bank's assets must be sound and its financial base must -the latter means that the Bank must have a sufficient capital base--in order for the continue to act decisively as a central bank in total independence of intervention by a Second, the Bank must have a sufficiently liquid asset portfolio to flexibly inject funds as necessary.I believe that the Bank's balance sheet has also attracted growing attention countries.

Some observers have expressed concern over the expansion of the Bank's b sheet as a sign of deterioration in its assets.

This may be because a rapid growth of sheet is associated in people's minds with an increase in nonperforming assets that n disposed of at a substantial loss.

But as I stated at the beginning of my speech, s technical factors, the recent expansion of the Bank's balance sheet is primarily th active provision of liquidity under the easing policy.

Nevertheless, mere suspicion erosion of asset quality can be a serious problem if it undermines people's confiden central bank and, in turn, in the national economy.

Such loss of confidence could, fo result in Japan's commercial banks and firms paying an unnecessary premium when rai funds in other countries.

That is why the Bank recognizes the need to be vigilan deterioration in its assets.

The Policy Board, the Bank's decision-making body, c deliberates whether the various measures implemented to fulfil the Bank's mission jeopardize the Bank's credibility because of the resulting changes in its balance sheet.

## B.

Three Key Principles of the Bank of Japan's Portfolio SelectionI will next talk about the philosophy that guides the Bank in portfolio select other words, the key principles in selecting a central bank's portfolio.

There are threeThe first principle is to maintain the soundness of the Bank's assets.

In oth assets and collateral held by the Bank must be of high quality.The Bank has devised a number of methods to achieve this.

When supplying funds financial institutions through loans, the Bank acquires financial assets that are tr collateral.

When providing funds through market operations, it purchases financial as financial institutions or other sellers based on repurchase ( gensaki or repo) agreements.

The only exception to this rule for market operations is when the Bank makes outright purch government bonds.

Thus, the credits provided by the Bank are secured by the creditworth plural entities: not only by the creditworthiness of financial institutions to which t directly, but also by that of the government or the entities in the non-banking pri which are the issuers of the debt instruments.

This approach is common among central ba the Bank of Japan, it is called 'the double-name principle.'Where the collateral for the Bank's loans and the financial assets purchased i operations are issued by such entities as private-sector firms, the Bank assesses the these assets according to its own criteria--that is, its internal ratings--and reviews once a year.

If a firm's financial performance deteriorated, the financial debt of thi no longer be acceptable as collateral or as an instrument of market operations, even if been deemed to be suitable for such purposes.Of course, these measures alone are not enough.

The double-name principle might r the probability of defaults, but taking a firm's debt as collateral is not sufficien creditworthiness is bolstered by the support of the commercial bank to which the Bank is lending.

Nor is it desirable for the Bank's assets and collateral to be concent liabilities of firms in a particular industry.

The Bank pays careful attention not soundness of individual assets but the entire portfolio, ensuring that its assets and not exposed to linkages of risk or excessive risk concentration.The second principle is to maintain neutrality with respect to resource allocat Bank held an excessive quantity of certain types of financial assets, price making an allocation in the market might be distorted.

In view of its role in the economy, the B do its best to minimize such influences.

The supply of funds by the Bank of Japan in t of monetary policy management is aimed at influencing the overall level of market inter Furthermore, provision of funds for the purpose of maintaining an orderly financial aimed solely at containing systemic risk and preventing disruption of the entire financThe third principle is to maintain liquid assets.

The assets of the Bank must b can be liquidated at reasonable cost whenever necessary.

This is so that the Bank is respond to any sudden policy decisions.

In the management of monetary policy, if the Ba control interest rates in rapidly moving financial markets, it must be able to acquire financial assets instantly in order to supply or absorb funds.

The same principle ap provision of funds to maintain an orderly financial system.

Asset liquidity is vital t capacity to make flexible policy responses while maintaining the Bank's financial soundnBearing in mind these three principles that guide the Bank in its selection of collateral, the Bank has made great efforts to adopt new market operations measures an collateral requirements to accommodate current policy agenda.

One example of th introduction of new market operations tools to contribute indirectly to the develo financial markets.

Another is the Bank's 'New Measures for Money Market Operations Response to the Recent Situations in Corporate Financing Activities,' decided on Novemb 1998.

As stated in the press release, the aim of these measures is to contribute to corporate financing activities by devising new methods of market operations and lending.

## IV.

Some Related IssuesHaving outlined the Bank's principles, I would now like to examine its approach i specific terms by addressing some frequently asked questions relating to the balance she

## A.

Government Debt or Private-Sector Debt?The first question is whether a central bank should primarily hold safe assets government debt.

Some believe that holding private-sector debt reduces the quality of of Japan's assets, and that the Bank should buy more government bonds.In fact, the Bank already holds a very substantial amount of government securi holding at the end of November 1998, including short-term securities (financing billsamounted to approximately \52 trillion.

This, together with the government securiti about \5 trillion borrowed through repo operations, accounted for approximately two t total assets.

However, such a high ratio is not typical of central banks.

In fact, th bank having a higher proportion of government securities in its portfolio is the Feder of the United States.

The central banks in continental Europe primarily purchase priv debt such as bills and deeds in providing liquidity, and therefore government securitie a smaller proportion of their portfolio.

The European Central Bank (ECB), which will ad a common monetary policy for the countries participating in the European Monetary Union January 1999, will also accept both government securities and corporate-sector debt a assets.Historically, the concept of a central bank dates from when the Bank of England e from a commercial bank into a central bank.

The traditional activities of central b included provision of funds through the rediscounting of bills discounted by commercia Thus, they have long successfully employed corporate-sector debt as collateral for s funds by adequately managing the risks involved, although this has not always been easy large-scale issuance of government bonds began in Japan, the Bank of Japan in fact mad use of corporate-sector debt, especially bills, in providing funds.The important issue in the portfolio selection of a central bank is not the choi government and private-sector debt, but rather the avoidance of distortions in resource in the respective financial markets.

Based on this principle, the Bank intends to make of selected, sound private-sector debt as market operations instruments or as collate deems this necessary to achieve current policy objectives, such as the development markets.

## B.

Transaction CounterpartiesThe second question is whether the central bank should make direct contact only w banking sector, and influence the economy indirectly.

Some argue that direct contact corporate sector is undesirable in that it creates a potential for arbitrary behavior bank, or for the prolongation of the life of inefficient firms.This is a matter of principle of whether a central bank should limit its counte banks, or whether it should also deal with the non-banking sector.The concern seems to have originated in the Bank's active use of private-sect through such means as expansion of CP repo operations, which may have given the impre that the Bank is excessively involved in corporate fund-raising.

But this concern a contain a slight misunderstanding.

Although the Bank is indeed buying CP--which is a f of corporate-sector debt--through market operations, it buys the CP from financial inst including banks, and therefore the counterparties in its operations have not Furthermore, the Bank does not specify the individual CP issues to be submitted, but r counterparty financial institutions offer issues of their choice from among those deeme by the Bank.

Purchasing CP is no different from providing commercial banks with loans o in the sense that the Bank supplies funds to commercial banks by refinancing corporate dHowever, it merits consideration whether participation in market operations an Bank transactions should be made open to non-bank entities.

If we look at examples ove appears that the ECB will carry out its market operations only with banks.

In the Unit however, the Federal Reserve conducts market operations with so-called primary sec dealers, many of which are securities companies that do not have accounts at Federalbanks.

A key point in considering this counterparty issue is whether the emphasis is on transactions or open market transactions.

If a central bank primarily conducts transactions, the counterparty will naturally be the banking sector.

Yet it seems tha trend is a growing preference by central banks for open market transactions.

In Japan, selects counterparties according to its own eligibility criteria from among banks, companies, tanshi companies (money market broker-cum-dealers), and other institutions have accounts with the Bank.In the final analysis, I think that the rational solution to this issue is counterparties to banks, but choose them from a wider range of entities in order to ac and certain permeation of policy effects and adequate control of counterparty risk, wh into account such factors as changes in the financial structure.

It is certainly ess money market, where the central bank makes transactions, be sufficiently developed qualitative and quantitative terms.

In this regard, Japan will soon have a fully fledge with the introduction of a public auction system for FB issues.

As such open market tra expand, leading to diversification of financial services providers, the Bank will selection of counterparties in the Bank's market operations.

## C.

Corporate Bonds and EquitiesThe third question is whether the Bank should purchase corporate bonds and equit view of the critical state of the Japanese economy.

This argument is based on the fac stock market was at one time supported by the public sector's purchase of equities.

It view of the advocates of such intervention that, if the Bank is concerned about risks, for government guarantees.First of all, I would like to emphasize that a central bank can create liquid capital.

There is intrinsically a definite limit to the extent to which a central ba private-sector risk.

Assuming such risk and compromising the quality of its assets mig the Bank's credibility, which is needed to fulfil its mission.

This is why the Bank of of 1997, like the previous law, does not allow the Bank to buy equities, which are subje credit and price volatility risks.

Accordingly, the Bank cannot purchase equities and j should not provide funds in a manner that would involve a similar degree of risk.

For reason, it also believes that it is inappropriate for the Bank to purchase corporate b and hold them until maturity.Placement of government guarantees is not a perfect solution.

Although this reduce credit risks, purchase of corporate bonds and equities yet involves another prob might lead to the long-term fixing of assets on the Bank's balance sheet.

For examp extended to the DIC are increasing rapidly, but the Bank cannot justify extending th longer term than necessary just because they are government guaranteed.

The prolonged h of such assets would reduce the Bank's flexibility in money market operations.

Moreove balance sheet were left expanded, it would arouse concern about a decline in asset qual event, the outcome would be an impairment of Japan's credibility, which would force Ja banks and firms to pay unnecessarily high financing costs overseas.In view of the current state of Japan's financial system, the Bank is prepared the DIC with necessary liquidity in order for the corporation to perform its role However, I believe that the DIC should subsequently secure longer-term funds by s replacing the Bank's loans with government-secured bond issues or commercial bank loans Bank must always be ready to carry out flexible money market operations and serve the fof the lender of last resort whenever necessary.

And for this, it is essential that t fixing the massive loans to the DIC on its balance sheet.

## V.

Rebuilding Japan's Economy and Financial SystemI hope my remarks today have been able to clarify some of the issues concerni Bank's balance sheet.

Before ending my speech, since the end of 1998 is only a week would like to discuss Japan's policy agenda for the new year and emphasize the commitment to it.The most important task for 1999, given the current state of the Japanese econom be to rebuild the economy and the financial system.

The role of the Bank will be relentlessly to (1) support the rebuilding of the Japanese economy by maintaining th easy stance on monetary policy; and (2) continue to supply sufficient liquidity to stability of the financial system.The fundamental problem confronting the Japanese economy is not a shortage liquidity, but a shortage of capital and reluctance to take the risks that would he expansion.

The cure for these, as I have stated many times, is firstly to strengthen th of financial institutions and restore their financial intermediary functions, and sec promptly to create in the capital market an environment that makes it easier for inves risks.

As an essential first step toward improvement in these two areas, household and confidence must be restored.In the currency field, January will see the debut of the 'euro'.

As a result, th have three major currency areas--those of the dollar, the euro, and the yen--each backe its own giant economic sphere.

Overcoming the aforementioned problems is a prerequis making the yen more usable and reliable internationally, enhancing its integrity.

T extremely important step in accomplishing further development of the Japanese econom utilizing the world's capital and innovative management techniques.To repeat, the priorities in 1999 will be to rebuild Japan's economy and financia and thereby lay the foundation for a globally credible yen.

The Bank of Japan is dete support these efforts through its monetary policy and financial system policy.