Hiroshi Nakaso: Development finance in the economy facing double
trilemmas
Article by Mr Hiroshi Nakaso, Deputy Governor of the Bank of Japan, contributed to the Joint
IMF-Bank Indonesia Conference "Future of Asia's Finance: Financing for Development
2015", 2 September 2015.
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Accompanying charts can be found at the end of the speech or on the Bank of Japan's website.
Introduction
It is a great honor for me to contribute to the Joint IMF-Bank Indonesia Conference. Under
the title "Future of Asia's Finance: Financing for Development 2015", I will first look back at
Japan's post-war experience of financing for the development of specific industries, and will
then explain lending behavior of Japanese banks including their involvement in project
finance for emerging Asian countries in the last two decades. Based on these two examples
regarding Japan's financial intermediation function, I will finally share my views on policies for
the stability of development finance in emerging economies facing double trilemmas, i.e.,
Mundell's and Schoenmaker's trilemmas.
Evaluation of the priority production system in Japan after World War II: Importance of
price stability
A period of strong economic expansion known as the "Asian Miracle" ensued in the aftermath
of World War II, characterized by a "flying geese" pattern of development. This began in the
1960s with high growth in Japan, followed by economic take-off in other Asian countries. To
begin with, I would like to look at the situation during the period of post-war reconstruction in
Japan.
The situation immediately after the end of World War II in Japan was characterized by a
combination of severe problems such as ruined infrastructure, a sluggish recovery in goods
production, and high inflation. For example, as shown in Figure 1, the level of industrial
production dropped significantly to about 30% of the peak level before the war (1934-36).
The stagnation of production at that time was caused not so much by a lack of production
facilities as by a shortage of raw materials such as coal and steel. The coal production level
in domestic mines dropped below 40% of the peak level before the war (1934-36) due to the
lack of digging materials made of steel. In turn, the steel production industry remained
stagnant due to the coal shortage.
In order to overcome this situation, the Japanese government at that time applied the "priority
production system", in which resources such as materials, funds and labor were mobilized
intensively and with priority being given to key industries such as coal and steel in order to
reconstruct Japan's post-war economy. This policy was applied from 1947 to 1949.
The priority production system is considered to have had a stimulating effect on Japan's
economy. However, most funding for the priority production system was central bank money
provided through the "price-support subsidy system" and the Reconstruction Finance Bank.
In the price-support subsidy system, the government provided subsidies to suppliers of
important materials such as steel for the differentials between sales prices and production
costs in order to enhance production, and these subsidies were financed through borrowing
from the Bank of Japan. The Reconstruction Finance Bank was a government-sponsored
bank established in 1947 to lend to the aforementioned key industries such as coal, and
most of its funding also depended on financing by the central bank.
Both the price-support subsidy system and the Reconstruction Finance Bank supported the
priority production system and contributed to the reconstruction of Japan's economy, but
their dependence on central bank money became a factor causing high inflation (Figure 1).
Inflation heightened the opportunity cost of holding deposits, with deposit avoidance behavior
being observed among a large proportion of households. The decrease in deposits then
caused a decline in private financial institutions' lending to firms in comparison with GDE
(Figure 2). In sum, the inflation tolerant aspect of the priority production system weakened
the financial intermediation function and impeded fund flows from household savings to
corporate investments, thereby having a negative impact on the economy. The net effect of
the priority production system on economic reconstruction was lessened due to high inflation.
Japan's experience of post-war reconstruction suggests that price stability is a necessary
condition for a stable financial intermediation function, and that policy-makers should pay
attention to price stability in order to fully realize the effect of mobilizing resources for
financing development.
Role shared by public finance and private finance in the context of infrastructure
investment
After overcoming the period of post-war confusion, Japan entered a period of rapid growth
(during the 1960s). In its initial stage, funding by the World Bank supported Japan's
engagement in big infrastructure projects such as construction of the Shinkansen, the bullet
train line, the Tomei (Tokyo and Nagoya) Motor Expressway, and several power plants. This
kind of social capital then improved the productivity of the Japanese economy, leading to a
virtuous economic cycle.
Development finance during the period of rapid growth was also served by the so-called
"guidance policy finance" of the Fiscal Investment and Loan Program (FILP). Postal savings
funds deposited with the Ministry of Finance's Trust Fund Bureau were on-lent to the FILP,
and the Development Bank of Japan, which acquired the assets of the Reconstruction
Finance Bank in 1952, allocated funds for industrial development to meet national and
regional development goals, as one of the major recipients of FILP funding.
Since the 1970s, social infrastructure investments have been financed through the issuance
of Japanese government bonds. Many empirical analyses suggest that the productivity effect
of social capital is significant and contributes to a rise in potential growth of the Japanese
economy. While the government-led system worked well in Japan in the latter half of the
20th century, an important issue to be tackled emerged as outstanding government debt
continued to rise significantly and fiscal conditions became severe: how to introduce private
funds and the necessary know-how to social infrastructure development. In order to tackle
this problem, the PFI (private finance initiatives) Law was promulgated in 1999, and an action
plan for the drastic reform initiatives of PFI/PPP (public private partnerships) was launched in
2013. By making use of PFI/PPP, safer, convenient, and resilient social infrastructure will be
developed efficiently.
Loans to emerging countries by Japanese banks
Asian countries face issues similar to Japan's, i.e., how to increase PPP from the economic
efficiency perspective in addition to effective utilization of financing from foreign countries. As
there is huge demand for infrastructure funding in Asian countries, Japanese banks have
recently been actively increasing their project financing and syndicated loans, which have
contributed to promoting infrastructure projects in these countries.
However, we should also be mindful of the historical record of fluctuation in the amount of
lending to Asian countries by Japanese banks. When the Asian financial crisis broke out in
the late 1990s, Japanese banks drastically reduced their lending to Asian countries
(Figure 3). The background factors include a decline in both their lending capacity and
demand for funding in the Asian region.
Limits on the funding capacity of Japanese banks and the deterioration of their equity capital
was the most significant factor at that time, considering that the scale of the reduction in
loans by Japanese banks was much bigger than that among U.S. and European banks. For
Japanese banks, the burden of disposing of domestic non-performing loans that had
mounted up after the bursting of the asset bubbles resulted in erosion of their equity capital.
The Japanese financial crisis in the late 1990s led to a decline in their creditworthiness and
hence the loss of their funding capacity in foreign currencies.
Since the mid-2000s, Japanese banks have returned their balance sheets to soundness and
started to increase their loans to Asian countries (Figure 3). In contrast to U.S. and European
banks, among which lending to Asian countries was disrupted after the Lehman crisis due to
their deteriorating balance sheets, Japanese banks have been constantly engaged in project
finance and have increased their share of syndicated loans.
Financing for development and stability of the global financial system
As I have discussed so far, the financial system of emerging countries has been affected by
the lending behavior of advanced countries' banks, and this trend will continue. Therefore, as
a prerequisite to the stability of development finance in emerging countries, stability must be
maintained in the financial intermediation function of advanced countries' banks and
domestic banks.
As the financial globalization process evolves, it is important for us to pay attention to two
kinds of trilemmas in order to stabilize the financial system and facilitate development finance
in emerging countries (Figure 4). As Japan's post-war experience, which I explained in the
first part of this article, suggests, price stability is important for fully realizing the effects of
financing for development. However, in emerging countries, monetary tightening against the
backdrop of inflationary pressure due to overheating of the economy often induces carry
trades and accompanies a rapid increase in capital inflows from advanced countries. This
boosts the economy further and/or leads to a surge in asset prices and financial imbalances.
In such conditions, it is difficult for policy-makers facing Mundell's Trilemma to achieve price
stability by choosing the combination of national monetary policy and capital mobility.
Therefore, it is important to use macroprudential policy tools in order to mitigate the effect of
capital flows on the real economy and the financial system, and this then contributes to the
stability of development finance.
When conducting macroprudential policy, global (or regional) financial coordination is
important beyond the national-level financial policy framework. In a country faced with
Schoenmaker's Trilemma, it is impossible to simultaneously achieve national financial policy,
capital mobility and financial stability including the stability of development finance1
Therefore, a global (or regional) macroprudential perspective is indispensable for maintaining
financial stability while allowing for capital mobility. The Chiang Mai Initiative - a multilateral
currency swap arrangement among Asian countries - and cross-border usage of collateral
assets, which are eligible instruments for central banks, are notable examples of regional
financial coordination to complement macroprudential policy of each country.
In addition to global financial coordination, when considering macroprudential policy, global
financial regulation is also a key factor. If the financial intermediation function of
internationally active banks subject to macroprudential regulation is stable, then financing for
development is also expected to be stable in emerging countries.
During the Asian financial crisis, U.S. and European banks filled lending gaps that Japanese
banks had left as a result of their withdrawal from the cross-border lending arena, whereas
during the recent global financial crisis, these roles were reversed. This kind of substitution
by internationally active banks may have somewhat mitigated the shortfall in financing for
development in emerging countries. However, it's not beyond the realms of possibility that all
internationally active banks might cut lending simultaneously in the next crisis. It is desirable
that as many internationally active banks as possible constantly maintain their lending
without severe disruptions. To this end, global regulations are expected to play a crucial role
from a longer-term perspective.
Finally, in relation to global regulation, let me share my views on an ongoing issue. Last
December, the BCBS (the Basel Committee on Banking Supervision) published a
consultation document entitled "Revisions to the standardised approach for credit risk". In
this document, it is proposed that the risk weight for corporate exposures, project finance,
and equities be heightened. Not a few market participants have sent comment letters to the
BCBS, pointing out that a significant increase in risk weight leads to a decrease in banks'
capital ratios, and the potential impact on financing for development can be huge. While I
understand that the revisions proposed by the BCBS were made to reflect the experience of
the last global financial crisis, a thorough cost-benefit analysis including an examination of
the impact on financing for development is necessary.
Conclusion
As the Japanese case shows, the productivity effect of social capital is significant, and stable
development finance supported by price stability contributes to an improvement in potential
economic growth. In order for emerging countries to stabilize development finance, not only
price stability but also effective utilization of financing from advanced countries' banks is
indispensable. Facing the double trilemmas, an adequate combination of monetary policy
and macroprudential policy is needed to achieve price stability and stabilize capital flows
including those banks' loans, which will contribute to higher potential growth among
emerging economies.
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