Toshihiko Fukui: Restructuring Japan's economy
Speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Naigai Josei Chousa Kai
(Research Institute of Japan), Tokyo, 28 October 2003.
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The foundation for a gradual recovery in Japan's economy is being laid as the environment for exports
and business sentiment have improved. This development occurs against the background of a cyclical
rebound in global demand for IT-related goods as well as the progress of structural adjustment,
including the improvement of corporate profitability.
Structural adjustment of Japan's economy is but halfway complete, and many issues remain to be
resolved. Persistent adjustment pressures have weighed heavily on the self-sustaining recovery of
domestic demand, which needs to be duly taken into account in the conduct of monetary policy.
Under such circumstances, the Bank of Japan will continue to firmly maintain its quantitative easing
policy until the consumer price index registers stably zero percent or an increase year on year. We
think it important to ensure that the current nascent economic recovery is put on a sustainable path. In
this regard, on October 10, the Bank decided to take such measures as raising the upper limit of the
target balance of current accounts in the interest of more flexible and timely monetary operations.
We need to put the issues facing Japan's economy, including structural adjustment, into a historical
perspective that encompasses such issues as globalization and the maturity of Japan's society and
economy. Hence, today I would like to look back upon the process of structural adjustment in the
Japanese economy, and address current problems with a focus on three key concepts, "value added,"
"risk" and "sustainability."
I. The Path to Date of the Japanese Economy
A. High Economic Growth
Let me start by reviewing the high economic growth period between 1955 and 1970. During this
15year period, real GDP almost quadrupled with an annual growth rate of nearly 10 percent. Such high
growth was only possible because of the potential endowed to Japan's economy as well as favorable
historical and geographical conditions at that time.
Japan's endowment included a relatively high technological capacity and a diligent work force.
Moreover, it was willing to absorb technology and culture from abroad. Japan's potential in this regard
was evidenced by the rapid industrialization after the Meiji Restoration and the subsequent economic
development.
In terms of historical and geographical conditions, it should be noted that because the Cold War put a
number of countries under the influence of communism, Japan could continue to play the role of "the
world's factory" in the market economies during the period from the late 1950s to the end of the 1960s.
Furthermore, Japan increased its business fixed investment at a rapid pace because World War II had
erased a large amount of domestic capital stock.
The period of high economic growth in Japan coincided with the baby boomers' entrance into the labor
force. In fact, the labor force increased from about 40 million in 1955 to about 50 million in 1970.
Furthermore, population growth around that time followed a bell-shaped curve, which led to a relatively
light burden being imposed by the pension and other social security systems compared to other
industrialized countries.
B. Shift to a Floating Exchange Rate System and the Two Oil Shocks
From the 1970s through the early 1980s, the Japanese economy experienced several major
disturbances, including the revaluation of the yen triggered by the "Nixon Shock" and the subsequent
shift to a floating exchange rate system, and the two oil shocks. In particular, the First Oil Shock
combined with the excess liquidity of the time to produce rapid inflation.
In contrast, Japan managed to overcome the Second Oil Shock smoothly, perhaps we can say the
most smoothly among the industrialized countries. Behind this was not only a timely macroeconomic
policy response, but also the fact that Japanese industry, having learned the lesson of the First Oil
Shock, actively improved energy efficiency. As a result of these efforts, Japan's economy became the
least dependent on oil among the industrialized countries, and at the same time succeeded in making
energy-efficient technology a new source of value added. This can be cited as a classic example of
Japan turning a problem to be overcome into a source of strength by using its technological capability.
The success of Japan's economy in overcoming the Second Oil Shock contributed relatively smoothly
to raising its international reputation.
C. Stronger Yen and the Emergence of the Bubble Economy
In the latter half of the 1980s, the Plaza Agreement triggered the large-scale correction of the strong
U.S. dollar at the time, and Japan experienced a period of economic stagnation caused by the yen's
appreciation. This stagnation, however, ended rather quickly, and, as is well known, what followed was
economic expansion accompanied by asset price bubbles.
The coexistence of high economic growth and low inflation throughout this period suggested gains in
productivity, and we observed widespread optimism that Japan had overcome the adverse effect of
not only the oil shocks but also the yen's appreciation. In reality, however, many structural adjustments
were simply postponed, in contrast to the period of the oil shocks during which a strong sense of
imminent crisis had speeded the adjustment process.
During this period, the environment surrounding the Japanese economy had already begun to change
significantly. The Cold War structure had begun to be dismantled, as captured most vividly in the
pulling down of the Berlin Wall, and the industrialization of emerging economies continued to move
forward. As shown by these facts, the conditions surrounding Japan's economy began to undergo
such sea changes as globalization and intensified competition.
These changes should have brought about the strengthening of corporate earnings power and the
efficient reallocation of resources through active entry into and exit from markets and industries. Rising
asset prices and overheated domestic demand, however, distorted various signals for economic
adjustment and weakened investment discipline. Rather, a large amount of business fixed investment
was made based on an excessively optimistic outlook for demand. In this, we can detect the source of
the future problems, such as excess capacity, excess debt, and excess labor.
On the financial front, intensified global competition should have led to development of the market for
financial intermediation, which would have supported the entry of companies into markets and
industries and promoted more careful evaluation of the risk and return profiles of various projects. The
latter half of the 1980s should have been a period during which financial intermediation progressed
from a bilateral transaction basis to a market transaction basis.
The rise in asset prices, however, expanded bank lending using real estate as collateral, the classical
bilateral transaction type of financial intermediation. When asset prices finally began to fall, expanded
bank lending created the nonperforming-loan (NPL) problem, which has adversely affected the
economy since the early 1990s. And households became quite hesitant to provide risk capital when
they observed scandals involving securities companies and the large volatility of stock prices.
The birth rate declined sharply from 1.81 in 1984 to 1.54 in 1990, leading to the rapid graying of
society. Of course, there are a variety of factors behind this. One of them seems to have been the rise
in the number of women playing an active role in the workplace. With a great many companies still
adhering to such employment practices as the seniority system, taking time off from work to raise a
child often became a decision with serious consequences. Thus, the institutional set-up did not lend
itself to checking the declining birth rate.
In spite of these demographic changes, the pension and other social security systems remained
largely based on the bell-shaped population curve.
As far as the structure of public finance is concerned, both the United States and the United Kingdom
made progress toward "a smaller and more efficient government" under severe economic conditions
during the latter half of the 1980s. In direct contrast, Japan enjoyed an increase in tax revenues due to
the overheated economy and higher asset prices, which led to a delay in reviewing the structure of
public expenditure.
II. Restructuring Japan's Economy
A. Economic Stagnation since the 1990s
Since the 1990s began, the end of the Cold War and the progress of IT have brought about an
acceleration in the globalization of market economies. Under such circumstances, the Japanese
economy has been put under very severe adjustment pressures on a number of fronts, including the
deflationary impact caused by the bursting of the asset bubbles and intensified competition with
emerging economies.
These adjustment pressures may be divided into three broad categories.
The first is the adjustment pressure that has emerged as the result of various excesses during the
bubble period and their subsequent bursting. The problems of excess capacity, excess debt, and
excess labor of the corporate sector as well as the NPL problem of financial institutions fall into this
category. These problems have exerted downward pressure on domestic demand and adversely
affected financial system stability.
The second is the adjustment pressure stemming from broad changes in economic conditions such as
market globalization and domestic demographic changes. While preserving the high-cost structure
created during the high economic growth and the bubble periods, Japan has begun to face intensified
competition from neighboring East Asian economies, which have been growing at a fast tempo
recently. The rapidly changing structure of the Japanese population has also suppressed expected
future growth.
The third category is the adjustment pressure resulting from the need to overhaul the institutional
infrastructure, including the legal system, the structure of public finance, and the pension and other
social security systems, with a view to making the infrastructure more responsive to the needs of a
mature society and economy.
B. Progress in Corporate-Sector Adjustment
Although many problems remain to be resolved, it should be noted that Japanese companies have
been making steady, albeit gradual, progress in some areas. In fact, many companies have made
efforts to reduce their debt overhang by restraining business fixed investment as well as cutting labor
costs, in order to improve their earnings power.
The larger the original adjustment pressure, the greater energy and longer time these efforts will
require. A reduction in investment and labor costs is indispensable for companies to recover their
earnings power. If aggregated, however, such reduction will work to exert downward pressure on
domestic demand and thus hinder the recovery of overall business conditions.
I think the efforts of companies to restructure their businesses have finally begun to bear fruit recently.
Corporate profits have been increasing since last fiscal year. At present, the ratio of current profits to
sales has approached almost its highest level since the bursting of the bubble. This implies that
Japanese companies have been succeeding in lowering the break-even point by restructuring and
adapting their business structure so that they can secure profits even when sales are sluggish.
C. Search for New Business Models
Japan's proximity to rapidly growing East Asia has an interesting implication from the viewpoint of the
corporate response to changes in the global environment. On one hand, such proximity exerts a
strong impact on competition and prices through the inflow of less expensive imports. On the other
hand, it strengthens the competitiveness of domestic industries rather quickly.
Although Japanese companies are significantly handicapped by higher labor costs compared with
companies in East Asia and other emerging economies, many export items, such as electrical
machinery and transportation equipment, still maintain strong international competitiveness, and the
trade surplus remains. Behind this, Japanese companies have been producing high value added by
creating new business models through a combination of their own technology, quality control
expertise, the production capability of East Asian economies, and the ability in terms of design to
respond to consumer needs in various countries.
In the domestic market, including the nonmanufacturing sector, new business models have emerged
in which overseas production and distribution channels are consolidated. Some of the products
created under such new business models are beginning to attract consumers and gain market share.
D. Institutional and Legal Measures
It should be noted that institutional and legal measures have been taken, which allow active entry and
exit as well as intensified consolidation of the corporate sector.
For example, in dealing with the bankruptcy and reconstruction of companies, it is important to make
use of market discipline and create a framework that maximizes the interests of all concerned, while
retaining the value of companies on a going-concern basis to the greatest possible extent. In line with
this view, enactment of the Civil Rehabilitation Law and other adjustments to the legal framework have
been effected, and legal procedures expedited. In the area of corporate law, revision has been
undertaken to help firms reorganize more easily.
For financial system stability, various safety nets, such as the establishment of a framework for
injecting public funds into financial institutions, have been improved in light of the difficulties that we
have faced since the 1990s.
E. Current Economic Situation
Progress in restructuring seems to be having a positive effect on the current economic situation.
As I stated at the outset, the foundation for a recovery is now being laid. Corporate profits have been
increasing, and business fixed investment has shown signs of improvement. Exports are once again
on the rise, particularly in the IT-related goods area. Uneasiness surrounding the financial system has
also subsided compared to some time ago.
Some argue that if prices started falling, corporate profits would be squeezed due to the downward
rigidity of nominal wages, and there would be a high probability of a deflationary spiral emerging.
Actual experience, however, reveals that Japanese companies have adjusted nominal wages rather
flexibly and increased profits. Private consumption remains flat, with the decrease in household
income being offset by an increase in the propensity to consume.
I believe that an autonomous adjustment mechanism in Japan's economy has been functioning. This
fact has significant implications for the conduct of macroeconomic policy.
III. Key Issues and Outlook for Japan's Economy
A. Structural Issues
The Japanese economy still faces a number of structural issues, which it is striving to overcome.
These may be summarized as follows.
The first issue is the reallocation of economic resources to improve the efficiency of the economy and
foster the development of leading industries for the next generation. This may be a necessary process
of dealing with the legacy of the bubble economy and strengthening the underlying business structure.
But, at the same time, it may create a problem in that the domestic capital equipment of Japanese
companies will become obsolete relative to that of other major countries. Thus, once Japanese
companies recover their earnings power to a certain extent, their next challenge will be to make their
capital equipment more productive through new investments.
Many Japanese companies have also reduced labor costs by restraining the hiring of new regular
employees. Such labor restructuring tends to put an undue burden on the younger generation, and
entails the risk that the vitality of the economy might be impaired if the situation persists and the
younger generation's willingness to participate in the labor force diminishes. Thus, it is imperative to
enhance labor market flexibility not only at the level of individual companies but also through the entire
economy, and expand job opportunities for the younger generation.
The second key issue is the reactivation of the financial intermediary function. This includes
overcoming the NPL problem and improving the infrastructure of market-based credit intermediation.
Although steady progress has been made, there still remains a fairly long way to go before we feel
confident that the NPL problem is fully resolved. The complete removal of blanket deposit insurance is
still being postponed. Market-based credit intermediation, which can function as a substitute or
complement for bank lending, has not yet fully developed.
The third issue is to redesign various systems so that they adapt to the needs of a new age. In
particular, it is an urgent task for Japan to reform various systems, including the social security
systems, the national tax system, and the relationship between the central government and local
governments.
Redesigning these systems tends to raise the conflict of interest problem among generations. During a
high-growth period such as that experienced in the past, a compromise solution to this problem can be
found relatively easily as the economy is expanding. Recently, however, it is increasingly difficult to
resolve the conflict based on the premise of economic expansion.
B. Importance of Creating Value Added
Although these issues are not easy to overcome, let me offer a few comments regarding the key to the
solution.
The first is the need for Japan to strengthen its ability to create value added in various areas. Of
course, creating value added is not limited to the economic problem, but also includes more
comprehensive concepts such as cultural and political activities. Here, I would like to focus my
remarks mostly on value added related to the economic problem.
As a country becomes richer and the people's standard of living improves, labor costs tend to rise. For
continued economic prosperity, it is thus vital whether or not Japan can create high value added
comparable to the increase in labor costs. In addition, the nation's total population is expected to start
declining from around 2006 and hence we cannot expect much contribution from the population front
to future economic growth. This is an added reason why raising the capacity to create value added is
such a pressing item on the agenda.
This agenda must be achieved in the context of globalization. Globalization means that the division of
labor proliferates globally. In this regard, we must ask ourselves seriously in what area Japan should
play a role in creating value added.
With the advancement of the IT revolution, the costs of obtaining and duplicating information across
borders have been significantly reduced. Thus, producing similar items will not yield high value, which
naturally leads to limited profit opportunities. At the same time, precisely because of the advance of IT,
if unique items are somehow produced, they can easily be spread globally. Under such circumstances,
it becomes very important to produce things unique to Japan or things that only Japan can produce.
I believe that Japan has sufficient capability to continue creating unique items, at least in the economic
area, and is equipped with several advantages.
Since World War II, Japanese manufacturers have applied their advanced technologies exclusively to
nonmilitary rather than military use. This has been one of the major features distinguishing Japan's
application of advanced technology compared with the United States and European countries.
There is no country other than Japan that is more enthusiastic about applying advanced technology to
every corner of daily life. Examples include not only automobiles, home appliances, ticket vending
machines and passenger gates, but also mobile phones with Internet and photographic functions and
digital cameras.
In the context of emerging economies with large populations, people's lives are increasingly affected
by new technologies such as IT as their economies develop. In this regard, the technologies
developed and applied to daily life in Japan may make large contributions to emerging economies.
This may be particularly applicable to the case of East Asian countries, which are geographically close
to Japan. Japanese consumers are said to be among the most demanding in the world. If we can
effectively combine Japan's technology and expertise, which are approved in the demanding domestic
market, with the production capability and local consumer demand in East Asian countries,
geographical proximity as well as historical and cultural linkage with Asian countries will likely work to
Japan's advantage. We have already seen some signs of such a combination materializing.
Let me digress a little and touch briefly on a serious question of whether the world economy from the
21st century onward is sustainable in view of the energy and environmental problem. Recently, strong
interest has been expressed with respect to the development of recyclable energy and the restraint of
carbon dioxide emissions. Considering the size of the economy and the tempo of growth in Asia, it is
highly likely that Asia will be the first region to face squarely the question of whether or not the global
economy is sustainable.
Measures to deal with the energy and environmental problem should not be considered simply in
terms of costs. From the viewpoint of maintaining the sustainability of the global economy in the future,
these measures are in themselves a source of value added. As I mentioned earlier, the experience of
overcoming the Second Oil Shock allowed Japan to find a new source of value added in energy
efficiency and environmental protection technology. I am confident that we can make use of such
value added in a variety of areas.
As long as there remain issues to be resolved and needs to be addressed, we have infinite
opportunities to create value added.
C. Risk-Resilient Financial Intermediation System
My second comment concerns the need to provide a framework sufficient to support private economic
agents in their efforts to find and develop these opportunities. In this regard, dealing with risks involved
in economic activity is an extremely important issue.
Since it is impossible to fully forecast the future, economic activity to produce value added will
inevitably entail uncertainty. When adequate measures for dealing with the uncertainty are in place,
economic agents can launch forward-looking plans with confidence. Creating value added and
managing risks are in fact two sides of the same coin.
The framework for the diversification of risks among economic agents has been developed as
fundamental infrastructure for economic development. For instance, modern corporate law, based on
the idea of limited liability of shareholders, can be regarded as the framework that enables risks
pertaining to economic activity to be absorbed by a wide range of economic agents. Undoubtedly,
these systems have played an important role in supporting economic development in many countries
in the modern era.
In the coming age in which risks pertaining to economic activity will grow as globalization advances,
financial intermediation systems will play a very important role in constructing a framework for the
efficient diversification of risks and their absorption by the overall economy.
Companies and other economic agents diversify risks stemming from economic activity by combining
various means of financing. Financial institutions make judgments about how to provide the best
financial services by examining the profitability and risk of economic activity. If such judgments
together with those of investors are eventually revealed in market prices such as lending rates and
bond yields, economic activity will be disciplined and the efficient allocation of resources achieved.
For the efficient reallocation of resources in an economy as a whole, the financial intermediation
system must be capable of appropriately evaluating profitability and risks, and such evaluation must
be duly reflected in lending rates and credit spreads.
When an economy is experiencing high growth, financial institutions need not pay much attention to
the ability to evaluate profitability and risks, because risks can be absorbed rather easily through larger
revenues if these institutions maintain a certain volume of assets. Market financing may tend to remain
as the secondary source of funding.
When an economy moves to a new stage with an intensified competition and metabolism, we
commonly observe the active entry and exit of companies as well as the transformation of business
models. Under such circumstances, the financial intermediation system must be equipped with a
strong capability to deal with risks, and needs to contribute to improving the power to create value
added through the efficient allocation of resources. Toward this end, financial institutions will be
severely tested in their ability to evaluate credit risks, develop new financial services, and manage
risks. In addition, it is vital to develop market-based financial transactions, which enable a variety of
investments to be evaluated by multiple investors.
D. Fairness
My third comment concerns the need for fairness. This is the key concept for resolving conflicts of
interest in the reform process of various systems by balancing benefits and burdens.
In the process of reforming such systems to adapt to economic maturity, we cannot avoid a conflict of
interest to a certain extent. When economic growth is decelerating, it becomes increasingly difficult to
avoid such a conflict.
For example, pension system reform is a kind of agenda that inevitably creates a conflict of interest
among generations. Individual economic agents tend to focus on their own benefits and burdens
rather than the adverse effect on the economy due to the delay in reforming the system. This makes it
difficult to forge a consensus for the necessary reform.
Under such circumstances, we need to be aware of the question of whether or not the fairness
between benefits and burdens is maintained when we try to reach nationwide agreement on the
revision of the social security system, tax system and other economic systems.
In addition, a blueprint needs to be developed showing what kind of society and economy Japan aims
at, and a consensus must be obtained. Then, we must strive to effect policies consistent with the
blueprint.
IV. Concluding Remarks
Before concluding, allow me to mention three points that need to be borne in mind when conducting
monetary policy in light of the issues faced by the Japanese economy.
First, maintaining price stability, which is the fundamental mission of the Bank. Economic agents will
pay increasing attention to the problem of uncertainty stemming from global economic activity. In this
regard, it is important to make price stability an anchor for the economy and remove the largest
impediment to people's activity to create value added. Bearing this in mind, the Bank continues to
work to overcome deflation, which is the most pressing item on the agenda.
Second, maintaining financial system stability. The meaning of financial system stability has evolved
over time. During the high growth period, the convoy system was the norm, in which the primary
objective was to prevent exit from the industry by restricting competition among financial institutions.
Now, financial institutions are required to perform efficient funds intermediation, while strengthening
their ability to evaluate profitability and risks as well as improving their risk management capability
through competition. Systemic risk must be contained. Thus, both active risk-taking and financial
system stability are necessary.
The financial system in Japan is still on the path to revitalization, and the risk-taking capability of
financial institutions is not yet sufficient. Financial institutions need to accelerate their efforts by April
2005 when the blanket guarantee of deposit insurance will be completely lifted. In light of the various
demands of the new era, the Bank aims to enhance prudential policy as well as the conduct of on-site
examinations and off-site monitoring.
The third issue is how to improve the financial market. In the new economy in which companies
compete in creating value added, it is necessary to understand the needs of the time and the
evaluation of one's own business model from the "signals" transmitted by various markets. The market
mechanism serves as an "antenna" and enforces discipline, which is indispensable for the Japanese
economy's future prosperity.
Looking at this from a financial standpoint, financial institutions need to strengthen their risk-taking
ability. At the same time, we require a framework in which the optimum allocation of resources is
realized through the markets.
The Bank aims to contribute actively to this end. Since lending by financial institutions is an
overwhelming part of the financial intermediation channel, it is both pragmatic and effective to start
developing new credit markets, including a market for asset securitization. Accordingly, the Bank has
already begun to implement concrete measures along this line.