Mr Hayami outlines recent economic conditions in Japan and gives his thoughts on the role
of a central bank and its balance sheet
Speech by the Governor of the Bank of Japan, Mr Masaru Hayami, at the Kisaragi-kai meeting in
Tokyo on 22/12/98.
I. Introduction
I am truly honored to have this opportunity to speak to you. I will begin with a brief
outline of recent economic and financial developments in Japan and then give my thoughts on
today's topic, the role and balance sheet of a central bank.
II. Economic Conditions and Monetary Policy Management
A. Current Economic and Financial Conditions
Japan's economy still remains in a severe situation. Recently, however, the pace of
economic deterioration has moderated somewhat, thanks to increased public investment and
exports. The decline in production has decelerated, reflecting some progress in inventory
adjustment. With regard to financial developments, the temporary increase in concern over
corporate fund-raising toward the year-end has eased gradually, on account of the government's
expansion of credit guarantee system and the Bank's introduction of new market operations
measures and lending facilities.
Thus, there have been some bright signs for Japan's economy. However, it is still unclear
at this stage whether these suggest an escape from the current vicious circle, or just a pause
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 still
had a cautious view of the economic outlook.
The key to economic recovery lies in whether private demand can lead to a self-sustained
recovery of the economy while the public sector is underpinning it. However, given the
continued deterioration in corporate profits as well as employment and income conditions,
developments in business fixed investment and private consumption require close attention.
Prices continue to be weak, reflecting a widening output gap in the economy. Therefore, it needs
to be carefully watched whether or not the implementation of the emergency economic package
and other measures will have the intended effect of improving business and household
confidence.
In the financial markets, concern over credit and liquidity risks continues to exist. One
manifestation of this is the market interest rates on instruments maturing after the fiscal year-end
in March 1999, which are likely to remain high.
Under these circumstances, the Bank will maintain the current decisive easy stance of
monetary policy, and continue to do its best to support economic activity and financial stability.
B. The Bank of Japan's Balance Sheet
The failure of some financial institutions in autumn 1997 was followed by increased
anxiety about the stability of the financial system, which has had a dampening influence on
economic activity. The Bank has responded to this situation by implementing a variety of
monetary policy measures, including an additional lowering of the target call rate on September
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. First,
the Bank has injected large amounts of longer-term funds to ease the upward pressure on market
interest rates maturing beyond the end of the semiannual accounting term in September and the
end of the calendar year in 1998. This has caused the Bank's balance sheet to expand by about 40
percent over the year. Second, the Bank has adopted some new measures to facilitate corporate
financing, such as increasing commercial paper (CP) repo operations and introducing a
temporary lending facility in November 1998. As a result, there has been a continuing rise in the
proportion of private-sector debt to the asset account on the Bank's balance sheet. Third, as part
of its efforts to maintain financial stability, the Bank has expanded special lending since 1997
under Article 38 of the Bank of Japan Law of 1997. The function of these loans, which is to
provide emergency liquidity to ensure financial system stability, has recently been taken over by
loans to the Deposit Insurance Corporation (DIC).
The Bank's balance sheet has thus changed dramatically over the past year. The change is
a reflection of the Bank's constant efforts to combat the economic downturn and the increasing
uncertainty about financial stability. However, the expansion of the balance sheet has also given
rise to a significant number of questions and criticisms focusing on a perceived threat to the
financial soundness of the Bank. I would therefore like to devote the rest of my speech to a fairly
detailed examination of the Bank's role and its approach to provision of credit, in light of the
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 Sheet
Before explaining why the soundness of the Bank's balance sheet has become an issue, I
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 to issue
banknotes, ensure the functions of the currency, and contribute to the sound development of the
Japanese economy. Perhaps "ensuring the functions of the currency" sounds a little too abstract.
Specifically, the Bank must first ensure the stability of the currency's value, and second maintain
an appropriate framework for its circulation. Referring to these two requirements, the role of a
central bank is often defined as maintenance of price stability and financial system stability.
On a day-to-day level, the Bank seeks to fulfil its mission by engaging in banking
activities that are similar to those of commercial banks. When the economy is experiencing
inflation or deflation, the Bank tries to restore and maintain a non-inflationary and
nondeflationary situation--that is, a situation of price stability--by influencing the quantity of
money in circulation and the levels of various interest rates. The Bank achieves this objective by
influencing interest rates in the financial markets. And this is done basically by supplying or
absorbing the appropriate amount of funds through the purchase or sale of financial assets. Such
activity by the central bank is called "market operations." The same is true of the Bank's
activities to maintain an orderly financial system. When the stability of the financial system is at
risk due, say, to failure of a commercial bank, the Bank of Japan acts decisively to minimize the
ensuing disturbance by injecting funds into the system. The principal tool the Bank employs in
such cases is lending.
As with commercial banks, the activities of the Bank are clearly reflected in its assets and
liabilities shown on its balance sheet. For instance, when the Bank drastically eases money in
order to avert deflation, as is the case at present, the Bank increases provision of funds in the
markets by increasing its purchase of financial assets. This naturally causes the Bank's balance
sheet to expand.
The key question is whether or not people will trust their central bank and be willing to
hold the country's currency (including banknotes, which bear no interest). This depends on
whether or not the central bank's behavior has measured up to the expectations of the people, and
whether or not it continues to do so. One source of clues for making such a judgment is the
balance sheet, and it is therefore natural that people in Japan and abroad take a keen interest in
the Bank's balance sheet.
The Bank's balance sheet can be discussed from various perspectives. From the
viewpoint of people's confidence in a central bank, it is most important that the financial assets
the Bank holds are adequate to secure the banknotes issued. This adequacy, I believe, involves
two specific points. First, the Bank's assets must be sound and its financial base must be solid-
-the latter means that the Bank must have a sufficient capital base--in order for the Bank to
continue to act decisively as a central bank in total independence of intervention by a third party.
Second, the Bank must have a sufficiently liquid asset portfolio to flexibly inject or withdraw
funds as necessary.
I believe that the Bank's balance sheet has also attracted growing attention in other
countries. Some observers have expressed concern over the expansion of the Bank's balance
sheet as a sign of deterioration in its assets. This may be because a rapid growth of the balance
sheet is associated in people's minds with an increase in nonperforming assets that need to be
disposed of at a substantial loss. But as I stated at the beginning of my speech, setting aside
technical factors, the recent expansion of the Bank's balance sheet is primarily the result of
active provision of liquidity under the easing policy. Nevertheless, mere suspicion about an
erosion of asset quality can be a serious problem if it undermines people's confidence in the
central bank and, in turn, in the national economy. Such loss of confidence could, for example,
result in Japan's commercial banks and firms paying an unnecessary premium when raising
funds in other countries. That is why the Bank recognizes the need to be vigilant against
deterioration in its assets. The Policy Board, the Bank's decision-making body, constantly
deliberates whether the various measures implemented to fulfil the Bank's mission could
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 Selection
I will next talk about the philosophy that guides the Bank in portfolio selection--in
other words, the key principles in selecting a central bank's portfolio. There are three.
The first principle is to maintain the soundness of the Bank's assets. In other words,
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 to
financial institutions through loans, the Bank acquires financial assets that are trustworthy as
collateral. When providing funds through market operations, it purchases financial assets from
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 purchases of
government bonds. Thus, the credits provided by the Bank are secured by the creditworthiness of
plural entities: not only by the creditworthiness of financial institutions to which the Bank lends
directly, but also by that of the government or the entities in the non-banking private sector,
which are the issuers of the debt instruments. This approach is common among central banks. At
the Bank of Japan, it is called "the double-name principle."
Where the collateral for the Bank's loans and the financial assets purchased in market
operations are issued by such entities as private-sector firms, the Bank assesses the eligibility of
these assets according to its own criteria--that is, its internal ratings--and reviews it at least
once a year. If a firm's financial performance deteriorated, the financial debt of this firm would
no longer be acceptable as collateral or as an instrument of market operations, even if it had once
been deemed to be suitable for such purposes.
Of course, these measures alone are not enough. The double-name principle might reduce
the probability of defaults, but taking a firm's debt as collateral is not sufficient if the firm's
creditworthiness is bolstered by the support of the commercial bank to which the Bank of Japan
is lending. Nor is it desirable for the Bank's assets and collateral to be concentrated in the
liabilities of firms in a particular industry. The Bank pays careful attention not only to the
soundness of individual assets but the entire portfolio, ensuring that its assets and collateral are
not exposed to linkages of risk or excessive risk concentration.
The second principle is to maintain neutrality with respect to resource allocation. If the
Bank held an excessive quantity of certain types of financial assets, price making and resource
allocation in the market might be distorted. In view of its role in the economy, the Bank should
do its best to minimize such influences. The supply of funds by the Bank of Japan in the context
of monetary policy management is aimed at influencing the overall level of market interest rates.
Furthermore, provision of funds for the purpose of maintaining an orderly financial system is
aimed solely at containing systemic risk and preventing disruption of the entire financial system.
The third principle is to maintain liquid assets. The assets of the Bank must be such as
can be liquidated at reasonable cost whenever necessary. This is so that the Bank is ready to
respond to any sudden policy decisions. In the management of monetary policy, if the Bank is to
control interest rates in rapidly moving financial markets, it must be able to acquire or liquidate
financial assets instantly in order to supply or absorb funds. The same principle applies to its
provision of funds to maintain an orderly financial system. Asset liquidity is vital to the Bank's
capacity to make flexible policy responses while maintaining the Bank's financial soundness.
Bearing in mind these three principles that guide the Bank in its selection of assets and
collateral, the Bank has made great efforts to adopt new market operations measures and review
collateral requirements to accommodate current policy agenda. One example of this is
introduction of new market operations tools to contribute indirectly to the development of
financial markets. Another is the Bank's "New Measures for Money Market Operations in
Response to the Recent Situations in Corporate Financing Activities," decided on November 13,
1998. As stated in the press release, the aim of these measures is to contribute to facilitating
corporate financing activities by devising new methods of market operations and lending.
IV. Some Related Issues
Having outlined the Bank's principles, I would now like to examine its approach in more
specific terms by addressing some frequently asked questions relating to the balance sheet.
A. Government Debt or Private-Sector Debt?
The first question is whether a central bank should primarily hold safe assets such as
government debt. Some believe that holding private-sector debt reduces the quality of the Bank
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 securities. Its
holding at the end of November 1998, including short-term securities (financing bills, or FBs),
amounted to approximately \52 trillion. This, together with the government securities worth
about \5 trillion borrowed through repo operations, accounted for approximately two thirds of
total assets. However, such a high ratio is not typical of central banks. In fact, the only central
bank having a higher proportion of government securities in its portfolio is the Federal Reserve
of the United States. The central banks in continental Europe primarily purchase private-sector
debt such as bills and deeds in providing liquidity, and therefore government securities comprise
a smaller proportion of their portfolio. The European Central Bank (ECB), which will administer
a common monetary policy for the countries participating in the European Monetary Union from
January 1999, will also accept both government securities and corporate-sector debt as eligible
assets.
Historically, the concept of a central bank dates from when the Bank of England evolved
from a commercial bank into a central bank. The traditional activities of central banks have
included provision of funds through the rediscounting of bills discounted by commercial banks.
Thus, they have long successfully employed corporate-sector debt as collateral for supplying
funds by adequately managing the risks involved, although this has not always been easy. Before
large-scale issuance of government bonds began in Japan, the Bank of Japan in fact made active
use of corporate-sector debt, especially bills, in providing funds.
The important issue in the portfolio selection of a central bank is not the choice between
government and private-sector debt, but rather the avoidance of distortions in resource allocation
in the respective financial markets. Based on this principle, the Bank intends to make greater use
of selected, sound private-sector debt as market operations instruments or as collateral when it
deems this necessary to achieve current policy objectives, such as the development of new
markets.
B. Transaction Counterparties
The second question is whether the central bank should make direct contact only with the
banking sector, and influence the economy indirectly. Some argue that direct contact with the
corporate sector is undesirable in that it creates a potential for arbitrary behavior by the central
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 counterparties to
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-sector debt
through such means as expansion of CP repo operations, which may have given the impression
that the Bank is excessively involved in corporate fund-raising. But this concern appears to
contain a slight misunderstanding. Although the Bank is indeed buying CP--which is a form
of corporate-sector debt--through market operations, it buys the CP from financial institutions
including banks, and therefore the counterparties in its operations have not changed.
Furthermore, the Bank does not specify the individual CP issues to be submitted, but rather the
counterparty financial institutions offer issues of their choice from among those deemed eligible
by the Bank. Purchasing CP is no different from providing commercial banks with loans on bills
in the sense that the Bank supplies funds to commercial banks by refinancing corporate debt.
However, it merits consideration whether participation in market operations and other
Bank transactions should be made open to non-bank entities. If we look at examples overseas, it
appears that the ECB will carry out its market operations only with banks. In the United States,
however, the Federal Reserve conducts market operations with so-called primary securities
dealers, many of which are securities companies that do not have accounts at Federal Reserve
banks. A key point in considering this counterparty issue is whether the emphasis is on interbank
transactions or open market transactions. If a central bank primarily conducts interbank
transactions, the counterparty will naturally be the banking sector. Yet it seems that the global
trend is a growing preference by central banks for open market transactions. In Japan, the Bank
selects counterparties according to its own eligibility criteria from among banks, securities
companies, tanshi companies (money market broker-cum-dealers), and other institutions that
have accounts with the Bank.
In the final analysis, I think that the rational solution to this issue is not to restrict
counterparties to banks, but choose them from a wider range of entities in order to achieve swift
and certain permeation of policy effects and adequate control of counterparty risk, while taking
into account such factors as changes in the financial structure. It is certainly essential that the
money market, where the central bank makes transactions, be sufficiently developed in both
qualitative and quantitative terms. In this regard, Japan will soon have a fully fledged FB market
with the introduction of a public auction system for FB issues. As such open market transactions
expand, leading to diversification of financial services providers, the Bank will review its
selection of counterparties in the Bank's market operations.
C. Corporate Bonds and Equities
The third question is whether the Bank should purchase corporate bonds and equities in
view of the critical state of the Japanese economy. This argument is based on the fact that the
stock market was at one time supported by the public sector's purchase of equities. It is also the
view of the advocates of such intervention that, if the Bank is concerned about risks, it can ask
for government guarantees.
First of all, I would like to emphasize that a central bank can create liquidity but not
capital. There is intrinsically a definite limit to the extent to which a central bank can take on
private-sector risk. Assuming such risk and compromising the quality of its assets might impair
the Bank's credibility, which is needed to fulfil its mission. This is why the Bank of Japan Law
of 1997, like the previous law, does not allow the Bank to buy equities, which are subject to large
credit and price volatility risks. Accordingly, the Bank cannot purchase equities and judges that it
should not provide funds in a manner that would involve a similar degree of risk. For the same
reason, it also believes that it is inappropriate for the Bank to purchase corporate bonds outright
and hold them until maturity.
Placement of government guarantees is not a perfect solution. Although this would
reduce credit risks, purchase of corporate bonds and equities yet involves another problem--it
might lead to the long-term fixing of assets on the Bank's balance sheet. For example, loans
extended to the DIC are increasing rapidly, but the Bank cannot justify extending them for a
longer term than necessary just because they are government guaranteed. The prolonged holding
of such assets would reduce the Bank's flexibility in money market operations. Moreover, if the
balance sheet were left expanded, it would arouse concern about a decline in asset quality. In any
event, the outcome would be an impairment of Japan's credibility, which would force Japanese
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 to provide
the DIC with necessary liquidity in order for the corporation to perform its role effectively.
However, I believe that the DIC should subsequently secure longer-term funds by swiftly
replacing the Bank's loans with government-secured bond issues or commercial bank loans. The
Bank must always be ready to carry out flexible money market operations and serve the function
of the lender of last resort whenever necessary. And for this, it is essential that the Bank avoid
fixing the massive loans to the DIC on its balance sheet.
V. Rebuilding Japan's Economy and Financial System
I hope my remarks today have been able to clarify some of the issues concerning the
Bank's balance sheet. Before ending my speech, since the end of 1998 is only a week away, I
would like to discuss Japan's policy agenda for the new year and emphasize the Bank's
commitment to it.
The most important task for 1999, given the current state of the Japanese economy, will
be to rebuild the economy and the financial system. The role of the Bank will be to work
relentlessly to (1) support the rebuilding of the Japanese economy by maintaining the current
easy stance on monetary policy; and (2) continue to supply sufficient liquidity to ensure the
stability of the financial system.
The fundamental problem confronting the Japanese economy is not a shortage of
liquidity, but a shortage of capital and reluctance to take the risks that would help economic
expansion. The cure for these, as I have stated many times, is firstly to strengthen the capital base
of financial institutions and restore their financial intermediary functions, and secondly to act
promptly to create in the capital market an environment that makes it easier for investors to take
risks. As an essential first step toward improvement in these two areas, household and business
confidence must be restored.
In the currency field, January will see the debut of the "euro". As a result, the world will
have three major currency areas--those of the dollar, the euro, and the yen--each backed by
its own giant economic sphere. Overcoming the aforementioned problems is a prerequisite to
making the yen more usable and reliable internationally, enhancing its integrity. This is an
extremely important step in accomplishing further development of the Japanese economy by
utilizing the world's capital and innovative management techniques.
To repeat, the priorities in 1999 will be to rebuild Japan's economy and financial system,
and thereby lay the foundation for a globally credible yen. The Bank of Japan is determined to
support these efforts through its monetary policy and financial system policy.
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