Sayuri Shirai: Recent gobal economic developments and monetary
policy in Japan - growing uncertainty over the European sovereign debt
issues
Speech by Ms Sayuri Shirai, Member of the Policy Board of the Bank of Japan, at a meeting
with business leaders, Yamanashi, 2 November 2011.
* * *
I. Global economic and financial developments
The world currently faces two pressing macroeconomic issues: one is a slowdown in global
economic growth, and the other is increased instability in international financial markets
triggered largely by fiscal and financial problems in Europe.
A. Outlook for the global economy
Let me start with the outlook for emerging economies. These economies continue to be the
main engine for global economic growth, although the pace of growth has slowed somewhat
in recent months. Their sources of economic strength arise mainly from (1) robust domestic
demand reflecting rising incomes and employment generation - phenomena commonly
observed in developing countries, (2) considerable leeway for expansionary fiscal policies
thanks to their relatively sound public finances, (3) abundant labor forces, and (4) the
potential for high labor productivity growth as part of the process of technological catch-up.
At the same time, some emerging economies are experiencing inflationary pressures, which
have been placing them in the dilemma of containing inflation or decelerating the pace of
economic growth when making a monetary policy decision.
By contrast, the pace of economic growth in advanced countries remains moderate. In the
case of the United States, economic growth so far has been slower than originally expected,
as exemplified by substantial downward revisions made by a number of international
organizations and think tanks - including the International Monetary Fund (IMF) - to their
projections for 2011 and 2012. U.S. economic growth declined sharply in the first half of
2011, due mainly to (a) a decline in automobile production caused by supply-chain
disruptions following the Great East Japan Earthquake and (b) a drop in real household
incomes reflecting the hike in gasoline prices. On the bright side, corporate profits have been
substantially strong, and production, business fixed investment, and exports have continued
to rise. Although some economic indicators suggest a deterioration in business sentiment in
recent months, the pessimism suggested by sentiment indicators appears to be greater than
actual corporate business conditions warrant.
Overall, the pace of economic recovery in the United States has remained modest, because
the deleveraging process or the adverse impact of the burst housing bubble on household
balance sheets persists. As housing loans and other debts remain excessive, debt servicing
exerts a huge burden on households, particularly since employment generation and income
growth have been sluggish. Moreover, given that about 30 percent of household financial
assets have been invested in stocks, the negative wealth effect caused by the recent
downturn in stock prices is likely to be considerable. Against this background, President
Obama in September 2011 proposed a jobs package worth 447 billion U.S. dollars - about
3 percent of GDP, although it is not clear whether the proposal will gain approval in
Congress. If not, fiscal stimulus to the economy in the coming year may be limited.
B. Instability in international financial markets
Not only has the pace of global economic growth been decelerating, in international markets
investors have been increasingly risk averse. This reflects growing concerns over the
economic performance of the United States as well as the worsening fiscal and financial
problems in Europe, which I will touch upon later.
Strains in international financial markets have intensified since the middle of 2011, in part
due to the prolonged debate in the U.S. Congress over the fiscal debt ceiling and deficit
reduction, and the resulting downgrading of the credit rating for U.S. Treasuries. Moreover,
high-level meetings of the European Union (EU), the Group of Seven (G-7) countries, and
the Group of Twenty (G-20) countries all failed to come up with a decisive solution to the
fiscal and financial problems in Europe. This series of events prompted global investors to
become even more risk averse. As a result, international financial markets have become
highly volatile: the prices of stocks - perceived as riskier assets - fell substantially around
the globe, while the prices of government bonds of major advanced economies - perceived
as safer assets - rose (or yields declined). Since October this year, however, stock prices
have recovered somewhat and yields on government bonds have risen.
Regarding corporate bond markets, credit spreads have widened, particularly in the United
States and Europe, and issuing conditions for low-rated corporate bonds have continued to
remain unfavorable. The number of initial public offerings (IPOs) also dropped sharply
around the globe. What is more, since September the price of gold - generally perceived as
a safe asset - as well as the prices of other commodities have declined as well. In the
foreign exchange market, meanwhile, the yen, together with the U.S. dollar, has appreciated
against a wide range of currencies of emerging and commodity-exporting economies on the
basis of the perception that it is a relatively safe international currency. Moreover, in some
emerging economies, cross-border capital flows have reversed, leading to a decline in stock
and bond prices as well as foreign exchange rates.
The main reason that instability in international financial markets has increased is a lack of
confidence in measures undertaken by the EU to resolve the fiscal and financial problems in
Europe. As I will explain in the next section, the problems in Europe are unlikely to be
resolved in the short term. Therefore, international financial markets are expected to face
continued strains for a while.
II. The fiscal and financial problems in Europe
So far, I have presented an overview of the outlook for global economic and financial
developments. Now, I would like to take a closer look at the fiscal and financial problems in
Europe, which have become the epicenter of the growing strains in international financial
markets.1
Before I go into details, I would first like to make sure that the difference between the EU and
the euro area is well understood. The EU is an economic partnership between 27 countries
and constitutes the world's largest economic zone. It has a population of about 500 million
and accounts for more than 20 percent of global GDP. People and money can move without
restrictions in the region. The euro area, on the other hand, is presently comprised of the
17 EU member states that have adopted the single currency called the euro. Countries with
large economies, such as Germany, France, Italy, and Spain, are among the members of the
euro area. The area has a population of about 330 million and accounts for about 15 percent
of global GDP. It is an economic zone almost as large as the United States. I will follow the
standard practice of distinguishing between "core countries" (such as Germany, France, the
Netherlands, and Belgium) and "peripheral countries" (such as Greece, Ireland, Portugal,
Spain, and Italy).
A. The three problems faced by the euro area
The fiscal problems in the euro area have now reached a critical stage. Looking back, the
fiscal problems of Greece surfaced in spring 2010, followed by those of Ireland in fall 2010
and Portugal in early 2011. As these countries - with large fiscal deficits and/or government
debts - faced a sharp increase in the cost of funding, they had no choice but to ask the EU
and the IMF to provide them with financial support. With regard to Greece, it became clear
from the middle of 2011 that its fiscal consolidation and economic reform program, to which it
had internationally committed itself, was far behind schedule. As a result, the Greek debt
crisis resurfaced.
In addition, market concerns over the fiscal position of peripheral countries intensified. This,
in turn, adversely affected the creditworthiness of European financial institutions with large
holdings of government bonds of these countries. As a result, these institutions faced a sharp
increase in their funding costs as well.
In response, the EU announced a comprehensive set of measures to address the sovereign
debt and financial problems at the end of October. This may be considered a step forward.
The measures appear to have won some support from financial markets. Nevertheless, more
time is needed to see whether they will help restore stability in international financial markets
by reviving the risk-taking appetite of investors in general. The euro area is not only a large
economic zone, but, like the United States, it is also home to the headquarters of many large,
globally active financial institutions. Given Europe's close economic and financial linkages
with other regions, the possible effects of volatile developments in the euro area on the
global economy and international financial markets are a matter of great concern. I would
next like to talk about the three main problems confronting the euro area.
1. Fiscal consolidation and economic reform in Greece
The first problem is the loss of market confidence in the ability of the Greek government to
pursue the fiscal consolidation and economic reform program, which triggered the problems
that the euro area is facing now. Greece had a high level of government debt even before
joining the euro. Moreover, in the latter half of 2009 it emerged that the Greek government
had understated the scale of its fiscal deficit by falsifying official statistics. The discovery of
such an act has given rise to skepticism toward the Greek government's capacity to properly
manage its economic and fiscal affairs, resulting in the successive downgrading by rating
agencies of its government bonds. The downgradings in turn brought about a hike in bond
yields, making it difficult for the government to raise funds from the market, and forced it to
ask the EU and the IMF for financial assistance in May 2010.
The financial assistance has been provided in installments on condition that the program is
monitored by the IMF and the EU through quarterly reviews and makes progress on
schedule. The disbursement of the sixth tranche was due to be approved in September
2011; however, the approval was suspended following findings that Greece would be unable
to achieve its budget deficit target for both 2011 and 2012. The Greek economy is in the
middle of a severe recession, and there is a strong likelihood that after facing four successive
years of contraction it will continue to shrink. As a result, tax revenues have not grown
despite increases in tax rates, thus undermining the government's fiscal reconstruction
efforts. Additionally, it has been pointed out that, partly because of problems associated with
the government's capacity to collect taxes, it is difficult to devise effective measures to raise
tax revenues. Against this background, financial markets are conscious of the possibility that
the program of fiscal consolidation and economic reform could stall unless the government
conducts more drastic expenditure cuts and takes decisive measures to raise revenues
through, for example, the privatization of government enterprises. The sixth tranche is likely
to be disbursed during the first half of November, following the passage in late October of a
bill by the Greek Parliament that provides for further reductions in the fiscal deficit, including
layoffs of public employees. Yet, how things develop remains to be seen.
When it was agreed in May 2010 to provide financial assistance to Greece, it was expected
that from 2012 Greece would be in a position to raise funds from the market on the
assumption that steady progress would be made in fiscal consolidation and economic reform.
This scenario looks increasingly unlikely now with Greek government bond yields remaining
at prohibitively high levels.
The EU, the IMF, and Greece, therefore, agreed on a second bailout package for
Greece - separate from the financial assistance mentioned so far - to provide funds from
2012 onward. In addition, it was agreed that given the sheer size of the government debt, the
provision of financial assistance alone was not enough to bring the Greek government debt
position to a sustainable level. Therefore, through the intermediation of the Institute of
International Finance (IIF), a global association of financial institutions, financial institutions -
private-sector creditors - with large holdings of Greek government bonds were asked to bear
a part of the burden on a voluntary basis. More specifically, holders of Greek government
bonds due to mature by 2020 were asked to exchange most of their holdings into new bonds
at a discount of some 20 percent of the present value; in other words, the debt was to be cut
by roughly 20 percent. In turn, the principal of the new bonds would be guaranteed and it is
reported that a large number of the bond holders represented by the IIF agreed.
More recently, however, some EU member countries voiced the view that, with Greece's
fiscal situation deteriorating more rapidly than had been anticipated, a steeper write-down of
Greek government bonds was necessary. In other words, it became increasingly clear that
reducing Greek debt by some 20 percent of the present value would be insufficient to sustain
the Greek government's ability to repay its debts. In view of this, meetings were held at the
end of October between the EU and the IIF, and it was agreed in principle that creditors
would write off 50 percent of their Greek bonds. At the same time, it was agreed that Greece
should implement further fiscal consolidation measures. In order to meet its international
commitments, Greece, with the economy already in a prolonged recession, was thus
required to introduce additional restrictive fiscal measures, which may intensify the vicious
cycle of economic contraction. Policies for the reduction of national debt are unavoidable, but
what the Greek economy needs more than anything else to break out of its vicious cycle is to
press ahead with growth-generating economic reforms and build a path toward credible fiscal
consolidation to regain market confidence.
2. Mechanisms to stop the Greek fiscal crisis from spreading
The second problem concerns mechanisms to stop the crisis in Greece from spreading to
other euro area member states. In response to the financial turmoil triggered by the collapse
of Lehman Brothers in 2008, European countries introduced various measures to help boost
the economy and rescue banks. Such measures inevitably led to increases in fiscal deficits
and government debts. It is in this context that the crisis in Greece spread to some peripheral
European countries, such as Ireland and Portugal, which were perceived to have relatively
greater difficulties in proceeding with fiscal consolidation and/or economic reforms.
In order to prevent the current fiscal and financial problems in the region from triggering a
chain reaction, the EU created the European Financial Stability Facility (EFSF) in 2010. The
EFSF can raise funds through the issuance of bonds, the proceeds of which can then be
used to provide loans at below-market interest rates to financially troubled euro area
countries. These bonds are effectively guaranteed by euro area member states that remain
financially healthy. So far, loans in this form have been extended to Ireland and Portugal,
which requested financial assistance, and the second bailout package for Greece is due to
use funds from the EFSF.
Subsequently, at the Meeting of Heads of State or Government of the Euro Area, it was
agreed to increase the size of guarantees for EFSF bonds, thereby raising the ceiling of the
facility's lending capacity. The EFSF is now able to purchase government bonds from the
market and to inject more funds into the banking system by, for example, recapitalizing
financial institutions. The agreement was ratified in October 2011.
In financial markets, however, concerns emerged about possible contagion of the crisis to
other euro area member states such as Spain and Italy. These countries have much larger
economies, and therefore the lending capacity of the facility already agreed at the Meeting of
Heads of State or Government of the Euro Area was perceived to be insufficient to fend off a
further spread of the crisis. However, an additional increase in the lending capacity was
difficult due to strong opposition led by Germany. At the Euro Summit, a meeting of EU and
euro area leaders held at the end of October, it was therefore agreed to leverage the
resources of the EFSF to enhance its ability to deal with critical situations.2 It will probably
take a while for the leverage plan to actually take effect, as details have to be worked out in
November and then need to be approved by each member state. Needless to say, building
mechanisms to prevent the fiscal crisis from spreading to the euro area as a whole is
extremely important for the stability of international financial markets. What matters is
whether the mechanism succeeds in gaining the confidence of the market.3
3. Fiscal problems leading to problems in the financial system
The third problem is that the fiscal problems in Europe are threatening the stability of the
financial system. What started out as a fiscal problem in Greece, coupled with concerns over
its ability to consolidate its finances and carry out economic reforms, has spread to other
European countries, with doubts arising regarding their creditworthiness. This, in turn, raised
concerns about the balance sheets of European financial institutions holding large volumes
of government bonds of peripheral countries. Consequently, European financial institutions,
including financial institutions from France and Belgium - core countries - began to find it
difficult to raise funds from markets. The fiscal problems in Europe have thus begun to
seriously undermine the stability of the financial system in the region.
In July 2011, the results of a stress test for financial institutions performed by the EU
confirmed that progress was being made in strengthening their capital bases. However, the
results did not mitigate investors' concerns over the soundness of the financial system. In
fact, the IMF has stressed the need for European financial institutions to make a substantial
capital enhancement based on its estimate of potential losses of 200 billion euros that
European financial institutions could suffer in the event of a collapse in the prices of
government bonds of peripheral countries such as Greece. However, given the current
weakness in stock markets, it is not easy for financial institutions to increase capital on their
own. As a result, concerns about counterparty risk have increased, causing some financial
institutions to reduce interbank market trading activities. In addition, uncollateralized
interbank trading, particularly of term instruments, has been declining, leading to an increase
in funding costs for European financial institutions, mainly for longer-term and U.S.
dollardenominated funds. In a comprehensive set of additional measures agreed at the end of
October, the EU decided to require European financial institutions to attain a Core Tier 1
capital ratio of 9 percent by end-June 2012, after accounting for market valuation of
sovereign debt exposures. It was also decided that when financial institutions are unable to
increase capital by themselves, national governments should provide support or, if they are
unable to do so, the EFSF should do so.
It would have been easier to come up with a solution if the problem had been contained to
fiscal deficits, as was the case for Greece at the beginning. The appropriate response would
have been to increase government revenue and reduce expenditure in the short term, while
pushing through a wide range of economic reforms in the medium to long term aiming to
achieve sustainable growth. However, when it comes to measures to stabilize the financial
system, things become much more difficult, because the impact on international financial
markets cannot be ignored. A major factor currently destabilizing international markets lies in
the daunting situation of having to deal with two crucial issues simultaneously - fiscal
imbalances and instability in the financial system.
B. Effects on economic activity in Europe
The problems in Europe have started to affect activity in the real sector of the economy (such
as production, business investment, and consumption), setting off a downward spiral among
the economy, the fiscal situation, and the financial system. Keeping this in mind, I will now
touch upon the current situation of and outlook for economic activity in Europe.
At present, the recovery in the European economy seems to be stalling due to the slowdown
in the domestic and global economies. Growth in exports, which had been the main engine of
economic growth, has slowed sharply, while growth in production and consumption has also
decelerated. Furthermore, corporate and consumer sentiment has worsened. Nevertheless,
the economies of core countries, particularly Germany with a strong manufacturing sector,
remain relatively robust on the back of firm business fixed investment. The employment and
income situation in Germany has also been improving, with the unemployment rate declining
to about 7 percent. In contrast, peripheral countries, such as Greece and Portugal, have
been suffering from short-term downward pressure on the economy due to additional
austerity measures following the downgrade of their sovereign debt ratings. Their
international competitiveness has long been weak, so that it will be a challenge for them to
achieve economic growth, and - as we have already seen - the market remains deeply
concerned about the sustainability of government finances in these countries.
With regard to the economic outlook for Europe, a very moderate recovery is expected on
the whole. Although private consumption is unlikely to grow because household incomes
remain under severe pressure, exports are expected to increase gradually based on steady
growth in emerging economies. In addition, business fixed investment in core countries is
expected to remain firm.
Nevertheless, restoring fiscal health is a challenge faced by all euro area countries. The
government-debt-to-GDP ratio for the euro area as a whole was 85.4 percent in 2010, well
above the euro convergence criterion of 60 percent. This wide gap highlights the need for
continued efforts to reduce fiscal deficits and the limited scope for expansionary fiscal
measures for the euro area as a whole. As for monetary policy, the policy interest rate is
already low at 1.5 percent, leaving little room for further reductions. In view of the limited
room for fiscal and monetary policy, it is necessary to be aware of the possibility of economic
instability continuing for a while.
III. Japan's economy and the Bank of Japan's policy measures
Based on the developments in the global economy and international financial markets
described so far, I will now talk about the current situation of and outlook for Japan's
economy and measures taken by the Bank. For details, please refer to Outlook for Economic
Activity and Prices released by the Bank on October 28, 2011.
A. Japan's economy
Following the earthquake on March 11, 2011, Japan's economy contracted sharply. This was
due to the following factors: (1) production activity fell significantly nationwide due to the
physical damage caused by the earthquake and tsunami to production facilities and the
distribution infrastructure as well as the disruption of supply chains in the manufacturing
sector, especially in the automobile industry; (2) the nuclear power plant accident led to
electricity shortages, which affected both manufacturing and non-manufacturing industries;
and (3) consumer sentiment weakened as a result of voluntary restraint following the disaster
and the problem of radiation due to the nuclear power plant accident.
1. The current situation
Japan's economic activity has been picking up steadily as the supply-side constraints caused
by the disaster have been gradually resolved. Supply-chain disruptions, for example, have
been easing at a faster pace than expected thanks to the efforts made by those involved.
Production and real exports have returned to their pre-quake levels, although their rates of
growth have moderated recently. While exports, particularly of automobiles, have increased,
those of iron and steel products as well as digital cameras have declined. Business fixed
investment has been increasing moderately and the results of the September 2011 Tankan
(Short-Term Economic Survey of Enterprises in Japan) showed that business fixed
investment plans, including those of small firms, were relatively firm. While the overall
damage caused by the flooding in Thailand is not clear at this stage, the impact on supply
chains warrants careful attention, given that Japanese firms, especially in automobile-related
industries, have expanded their overseas production facilities for finished goods and parts
and components, including in Thailand, in recent years. Meanwhile, although private
consumption has almost returned to its pre-quake level, weakness remains in some areas as
indicated by, for example, the fact that restaurant sales have not returned to their pre-quake
levels. Also, the number of foreigners visiting Japan has remained below pre-quake levels.
2. Outlook for economic activity and prices
Although adverse effects from the slowdown in overseas economies and the appreciation of
the yen may continue for the time being, Japan's economy is expected to return to a
moderate recovery path as reconstruction demand following the disaster gradually
materializes. Business fixed investment is likely to expand, provided that corporate profits
improve, domestic and overseas demand recovers, and government economic policies are
effective. Private consumption is also expected to gradually become firmer against the
backdrop of a gradual recovery in the employment and income environment.
The year-on-year rate of change in the consumer price index (CPI) has recently been around
0 percent, partly due to the change in the base year for the CPI in August 2011. As for the
outlook, the year-on-year rate of change in the CPI is expected to remain at around 0 percent
for the time being, with a factor in addition to the base-year change being that the positive
contribution from the rise in the tobacco tax and in charges for accident insurance has
dissipated since October 2011. Surveys of households, firms, and economists suggest that
medium- to long-term inflation expectations remain stable; however, future developments
warrant continued attention.
3. Risks to the outlook
While there are many uncertainties regarding the outlook for economic activity and prices,
the three risks that I think warrant the most attention are the following: (1) the risk that if the
fiscal and financial problems in Europe intensify they may affect Japan's economy through
various channels; (2) downside risks with regard to overseas economies other than those of
Europe; and (3) the possibility that firms' and households' medium- to long-term growth
expectations may decline in the longer run.
As for the first risk, there are two main channels through which Japan's economy could be
affected: an international financial markets channel and an international trade channel.
Let us start by considering the international financial markets channel. Japan's financial
markets have remained stable as a whole despite the instability in overseas markets.
Moreover, so far Japanese financial institutions' funding costs have not been affected by
developments overseas, because their exposure to Greece, Portugal, and Ireland in the form
of investment and lending is relatively limited. However, given the growing international
linkages in financial markets, if global investors' appetite for safe assets intensifies further,
prices of riskier assets (such as stocks) could decline globally. With global financial markets
being increasingly integrated, stock prices in Japan could fall as a result of developments in
other markets, and the foreign exchange rate of the yen - which is seen as a relatively safe
currency - against the U.S. dollar and the currencies of commodity-exporting and emerging
countries might rise further. Thus, there is a risk that, as a result, business and consumer
sentiment may deteriorate, pushing down economic growth. In fact, the diffusion index for
overseas supply and demand conditions in the September 2011 Tankan suggests that there
is a growing perception of excess supply.
With regard to the export channel, as I have already stated, there is a possibility that Japan's
exports to Europe might be directly affected if economic activity in Europe decelerates as a
result of the worsening of fiscal and financial problems in the area. It is important to bear in
mind that in this case the impact could be substantial, since Europe accounts for about
10 percent of Japan's exports. Moreover, there is the risk that Japan's exports might be
indirectly affected through a decrease in exports to Europe from Asian economies.
As for the second risk, there is concern that the slowdown in the U.S. economy could
continue given the weaker-than-expected employment situation and sluggish activity in the
housing market due to the persistent downward pressure on housing prices as seen in the
increasing number of home foreclosures. On the other hand, emerging and
commodityexporting economies, despite declining demand from the United States and Europe, are
likely to continue to grow thanks to potentially large domestic demand; however, with
inflationary pressures remaining strong, whether they can achieve a soft landing, that is,
achieve both price stability and economic growth at the same time, requires continued
attention. Attention also needs to be paid to a possible economic slowdown in emerging and
commodity-exporting economies as a result of capital outflows from these economies if
investors' risk aversion intensifies further due to contagion of the fiscal and financial
problems in Europe.
With regard to the third risk concerning firms' and households' medium- to long-term growth
expectations, Japan's economy has long been facing the challenge of a decline in the growth
rate due, among other things, to the shrinking and aging of the population. In addition, Japan
is now confronted with new challenges, such as uncertainty regarding the supply and
demand of electric power and the reconstruction effort needed following the earthquake. I am
of course anxious about the uncertainty regarding reconstruction-related demand, but what
concerns me more is the uncertainty surrounding electricity supply. Electricity supply during
this past summer, which was a cause of great concern, turned out not to impose
considerable constraints on the economy, not only because this summer was cooler than the
extremely hot summer last year, but also because of efforts by firms and households to save
electricity. In the longer run, however, the resumption of operations at nuclear power plants
that are or will be under regular inspection is still unclear. Given this and the possibility that
we might have an extremely cold winter or a heat wave next summer, uncertainty regarding
the supply of electricity therefore remains, and as long as this uncertainty lingers, corporate
activity could be restrained. In addition, attention needs to be paid to the possibility that a
further appreciation of the yen could exert downward pressure on corporate profits,
employment, and income, or accelerate the shift to overseas production, which could in turn
lead to a decline in firms' and households' medium- to long-term growth expectations and
increase the downside risks to the economy.
B. The bank's conduct of monetary policy and responses to the earthquake
Taking into account the situation mentioned above - economic conditions abroad and in
Japan, the outlook for Japan's economy, and the various risk factors - the Policy Board of
the Bank, consisting of nine members including myself, at the Monetary Policy Meeting on
October 27, 2011 decided to enhance monetary easing. I will now explain the policy
measures currently implemented by the Bank as well as the background of the decision.
1. Enhancement of the comprehen