Toshihiko Fukui: Toward achieving strong economic growth in Japan
Summary of a speech given by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Keizai
Doyukai (Japan Association of Corporate Executives) Members' Meeting, Tokyo, 13 May 2005.
* * *
Introduction
Semiannually in April and October, the Policy Board of the Bank of Japan decides the text of the
Outlook for Economic Activity and Prices, or the Outlook Report as we call it, and releases it. This
report describes the Bank's outlook for economic activity and prices which provides the basis for
conducting monetary policy. We decided to extend the projection period for the April issues of the
Outlook Report by one year to two fiscal years, and hence the report released at the end of April 2005
covers the outlook for fiscal 2005 and 2006. In deciding on the extension, the Bank gave consideration
to the fact that it takes a certain amount of time for the effects of monetary policy to spread to
economic activity and prices, and also looked at the practice of other central banks for reference.
Today, I would like to explain first the current situation and the outlook for Japan's economic activity
and prices, particularly the content of the April Outlook Report, focusing on the underlying mechanism
of developments in economic activity and prices. I will then talk about the conduct of monetary policy
in such an economic and price situation.
I. The current situation and the outlook for Japan's economic activity and prices
The Bank's projections for fiscal 2005 and 2006 presented in the April Outlook Report were, in
summary, that the economy is expected to experience a relatively long period of growth, albeit at a
moderate pace. The economy is currently experiencing the third recovery phase since the bursting of
the bubble. In the past two recovery phases, the recovery soon ran out of steam, and the economy
slipped back into recession. This time, however, the economy has been on a relatively long recovery
trend, and this is likely to continue.
Recently, Japan's economy has been experiencing a temporary pause, with the real GDP growth rate
standing almost at the same level for three consecutive quarters from the second quarter of 2004. The
major factor behind this is the progress in global adjustments of production and inventories of
IT-related sectors. This has been evidenced by the sluggishness of exports of capital goods and parts,
particularly those for semiconductor manufacturing equipment, and of IT-related goods such as
electronic parts, and the continued decrease in production of IT-related goods. Given this situation,
there was a view that the current economic recovery might stall.
However, exports have started to pick up and production has stopped declining recently, and it is
gradually becoming clear that the current pause is only a temporary one, leading to a sustainable
growth path in the not so distant future, and not the prelude to a descent into an economic recession.
Adjustments in IT-related sectors are likely to be completed around the middle of 2005 on the whole,
although the degree of progress has differed by type of product: while adjustments for digital
appliances have shown considerable progress, there has not been much in the case of mobile
phones. Compared to the time of the bursting of the IT bubble in 2001, the current adjustments are
likely to be mild and completed in a shorter period of time. Learning from the lessons of the IT bubble,
firms have improved their global inventory management and were cautious about building up
inventories. In addition, they started to make adjustments in inventories at a relatively earlier stage as
soon as signs of weak demand emerged. All this contributed to alleviating the degree of adjustment.
Furthermore, unlike the situation at the time of the IT bubble when demand concentrated on personal
computers, there is a wider range of demand for IT products, such as digital appliances, in which
Japan has a comparative advantage. This demand-side factor has also contributed greatly.
Next, I would like to explain the background to the Bank's outlook that the economy is expected to
experience a relatively long period of growth, albeit at a moderate pace, after adjustments in IT-related
sectors are completed in the not so distant future and the economy emerges from the temporary
pause.
Our projection of continuing recovery is based on the fact that, in summary, both the economic and
financial fundamentals have been strengthening.
On the economic side, there has been progress in adjustments of firms' excessive production
capacity, holdings of labor, and debts. Corporate profits have exceeded the level at the end of the
bubble period and excess production capacity as perceived by firms has almost been eliminated, as
was evidenced in the March Tankan (Short-Term Economic Survey of Enterprises in Japan). In
addition, the diffusion index for employment conditions indicated that the number of firms that
perceived they had insufficient holdings of labor exceeded those that perceived they had excessive
holdings of labor for the first time since the 1992 survey on an all industries basis.
On the financial side, measures have also been taken to restore the soundness of the financial
system, particularly in terms of reducing nonperforming loans (NPLs), and these have made good
progress. Against this background, blanket deposit insurance was fully lifted in April 2005 and the
financial environment to support positive corporate activity is being established.
Despite these improvements, the behavior of firms remains cautious on the whole. Although it may
sound paradoxical, the economic recovery is projected to be sustainable but remain moderate against
the background of such behavior. Business fixed investment continues to grow, and some firms have
started to show a positive stance in their investment, however only to a limited extent. The majority of
firms are still placing priority on using the high level of corporate profits to reduce interest-bearing
liabilities and, in most cases where firms increase investment, the amount does not exceed cash flow.
Given this cautious stance of Japanese firms, the tempo of the economic recovery is likely to remain
moderate. At the same time, the moderate pace of recovery itself implies that Japan's economy is
expected to experience a relatively long period of growth. While external shocks played a significant
role in some past large fluctuations in the economy, there were cases where changes in domestic
demand amplified cyclical fluctuation. When over-optimistic expectations about future growth emerge
and an excessive level of business fixed investment and inventory investment is encouraged in the
situation where the economy is becoming more active, it helps to boost the peak of the business cycle,
but causes the trough to be deeper through additional adjustment stemming from the overshoot. Such
large swings in the business cycle stemming from changes in domestic demand are not likely to occur
in the current economic recovery, owing to the cautious behavior of firms.
To translate this view into actual figures, the GDP growth rate is expected to be around 1.5 percent for
both fiscal 2005 and 2006, slightly above the potential growth rate.
As for the outlook for prices, the cautious behavior of firms, particularly firms' stance on restraining
labor costs, will also play an important role.
The rise in the prices of commodities at home and abroad, including crude oil, has pushed up
materials costs, and therefore awareness of a risk of inflation on a global basis has begun to increase.
However, the rise in materials costs has been significantly offset by increases in productivity in the
corporate sector and by the restraint on labor costs.
Particularly in Japan, the consumer price index (CPI) has not increased. Japanese firms are making
more efforts to increase their productivity. Even though the percentage share of labor costs compared
to the total added value created by the corporate sector has declined to the level recorded in the early
1990s, many firms seem to be maintaining their cautious stance of restraining labor costs. In addition,
the effects of the decline in rice prices and the reduction in electricity and telephone charges are
expected to continue for a while. The projected rate of change in the CPI on a year-on-year basis is
around zero percent for fiscal 2005, and slightly positive for fiscal 2006, as these factors are having a
strong effect on consumer prices, although gradual upward pressures basically continue reflecting the
strength of the economy.
II. Positive and negative deviations from the projected outlook
As I have said before, our most likely projection is that Japan's economy will experience a relatively
long period of growth, albeit at a moderate pace.
Of course, in the two-year projection period, the possibility cannot be ruled out that shocks significantly
affecting economic activity and prices might occur and cause upward or downward deviations from the
projected outlook. The Outlook Report pointed out factors to which the Bank should pay due attention,
as they could cause economic activity to deviate: developments in energy and materials prices,
developments in the U.S. and Chinese economies, and developments in domestic private demand. I
would like to comment on two points regarding the downside risks, namely, developments in energy
and materials prices and developments in the world economy.
With regard to the first point, nominal crude oil prices have been at historically high levels, although on
a real basis they are substantially below their historical peak. This basically reflects the tight
supply-demand situation due to a decline in spare production capacity in oil-producing countries with
continuing expansion in the global economy. From a broader perspective, China and East European
countries have joined the global market economy since the 1980s, and dramatically expanded their
production capacity of various goods using their comparative advantage in labor costs. These changes
have been putting downward pressure on the prices of final goods, and they have been causing the
prices of raw materials to rise significantly by consuming substantial amounts of natural resources. It
should be said, however, that some speculative movements have been observed in the recent rise in
crude oil prices as evidenced in the fact that there were sharp price reactions to weather forecasts in
the United States and Europe and reports on oil inventories in the United States.
As evident in the fact that the crude oil consumption per unit of real GDP in Japan is only about
70 percent of that in the United States, Japan's energy efficiency is high compared to other
economies, and this alleviates the negative effect of high crude oil prices on the economy. In addition,
the yen's appreciation in the past two years has partially restrained the rise in crude oil prices
denominated in yen. However, closer monitoring is required of the risk of downward deviation of the
economy, due to possible emergence of a profit squeeze and decline in real purchasing power, as the
price of Middle Eastern crude oil, which accounts for a significant proportion of Japan's imports, has
risen in the current situation unlike during the price hike last year. In addition, as evident from
continuing high price levels in the futures market, the possibility cannot be ruled out that expectations
that crude oil prices will remain high may become more widespread. If the high price is actually
sustained, the trajectory of global economic growth might deviate downward, and we need to be aware
of the indirect effects of any deceleration of the global economy on the Japanese economy through
the resulting reduction in exports.
The second point I would like to discuss as downside risk is the outlook for the world economy.
The world economy continues steady expansion, occurring mainly in the United States and China, and
it is thought very likely that it will continue expanding at a rate roughly equivalent to the potential
growth rate. At the meeting in April, the G-7 countries concurred that global expansion remained
robust and economic growth in 2005 is likely to be solid. The IMF forecast of real GDP growth for 2005
and 2006 is 4 to 5 percent. Regarding price developments, the rise in energy and materials prices,
including crude oil, has so far been absorbed by the corporate sector partly through productivity
increases, and as a result, inflation has been contained.
However, with the possibility of high materials prices continuing for a considerable period, awareness
of a risk of inflation on a global basis has begun to increase. In the U.S. economy, although
inflationary pressures are most likely to be contained, due consideration has been given to a possible
increase in inflation expectations, since productivity growth has been decelerating and unit labor cost
has been increasing in a situation where domestic supply-demand conditions are already tight. The
U.S. Federal Reserve indicated its judgment on prices in the press release issued after the policy
change in May as follows: "Pressures on inflation have picked up in recent months and pricing power
is more evident. Longer-term inflation expectations remain well contained." The Bank will closely
monitor, with consideration of their implications for the Japanese economy, changes in the global
circumstances surrounding prices and the effects on the global economy through financial markets, for
example, a rise in long-term interest rates.
In China, strong economic growth is continuing supported by firm domestic and external demand.
However, it is pointed out that fixed asset investment continues relatively high growth and there is the
risk of an infrastructural bottleneck arising, for example from the shortage of electricity. China has
structural problems, including the large income gap between metropolitan and rural areas. The
Chinese economy should be watched carefully from the viewpoint of whether it can continue to
achieve sustainable growth.
III. Characteristics of corporate behavior and future prospects
One of the characteristics of Japan's current economic recovery is that the economy is growing at a
moderate pace. As I have already mentioned, this is against the background of cautious corporate
behavior. In other words, if corporate behavior becomes more active, it could cause the outlook for
economic activity and prices, which I have just explained, to deviate upward.
One might wonder why firms continue to be cautious even in a situation of continued economic
recovery with improved profitability. I will present some possible explanations for their cautious
behavior.
First, it is rational of firms to want to repay interest-bearing liabilities and increase capital as
appropriate, because they have become more conscious of business risk and financial risk after
experiencing the severe downturn in the business cycle after the bursting of the bubble and instability
in the financial system. Firms have been strongly aware of the necessity of strengthening their
resilience to unexpected shocks by squeezing inventories and fixed costs. They have also been
making efforts to reduce their debt-to-capital ratios in light of the heightened awareness of credit
ratings and financial markets' evaluation with the progress of globalization of financial markets.
Second, the intensified global competition accompanying emerging economies' transition to market
economy, which I mentioned earlier, is likely another factor.
Cautious corporate behavior can be seen in most advanced nations, including the United States,
though to a varying degree. The yield spread derived by subtracting the expected earnings on stocks
from long-term interest rates has been on a declining trend in these countries. This means that the
stock markets' expectations for economic growth have been declining.
While corporate scandals in the United States related to accounting rules and delayed structural
reforms in Europe may also have had some effect on investors' sentiment, intensified global
competition seems to have contributed to the cautiousness of corporate behavior.
It is quite natural for Japanese firms to feel that they are most exposed to global competition pressure
partly due to Japan's geographical proximity to other Asian countries. In addition, there is increased
awareness that there will be greater changes in the business environment in the future, such as further
population aging as well as the lower birth rate resulting in a decrease in population. With the
experience of a prolonged period of low economic growth, expected growth for the Japanese economy
may have declined somewhat. According to a survey of firms conducted by the Cabinet Office, the
expected growth rate over the next five years was declining from the level of 4 percent in the early
1990s. Although it has recently bottomed out and started to increase slightly, it is still at around
1 percent.
Third and last, some point out that the present high profitability of firms has been supported by the
extremely low interest rates and that this situation cannot continue forever.
However, with advances in the process of structural adjustment, an environment is in fact being
established for firms to take positive action.
On the financial front, firms have been making progress in reducing debt. The ratio of corporate debt
outstanding to sales for nonmanufacturers has declined, but is still slightly higher than in the first half
of the 1980s. As for manufacturers, the ratio has declined to lower levels than in that period. In this
situation, an uptrend in the capital ratio has become more marked for both manufacturing and
nonmanufacturing firms. Firms have recently been active in equity financing, which has been a primary
factor promoting these developments. In the extremely low long-term interest rate environment since
2000, the cost of corporate debt has declined significantly due to the progress in repayment and
refinancing of past borrowings with high funding costs. Some say that the cost of corporate debt may
have declined as far as it can. On the other hand, the profitability of large firms is above the levels
during the bubble period and even that of small and medium-sized firms is at the highest level since
the bursting of the bubble. As a result, profitability exceeds the cost of debt. This means that an
environment is being established that encourages firms to use cash flow for business fixed investment
rather than repaying debt.
In view of the situation, an increasing number of firms are expected to use free cash flow for business
fixed investment and other investments, and research and development, both for the purpose of
growth, rather than for repaying their debt, with a view to enhancing corporate value in the medium to
long term. Firms that have developed a strategy to diversify their business may make use of mergers
and acquisitions. Due partly to strengthening corporate governance, firms may increasingly buy back
their own stocks or increase their propensity to pay dividends, both of which would increase payouts to
shareholders. An increasing number of firms will be taking a more positive attitude to business activity
with funds they raise, taking advantage of an accommodative financial environment.
On the employment front, an increasing number of firms may raise nominal wages and bonuses and
recruit a larger number of new graduates in order to ensure that they have a sufficient number of
skilled workers and to better attain a more balanced composition of workers.
Such movements should spread in the process of the economy taking a balanced growth path, and
this is in turn expected to enhance economic growth, creating cyclical momentum.
So far, I have focused on corporate behavior in relation to overall economic activity. I intend to pay
close attention to how these developments in the corporate sector affect prices.
Looking at factors that push down prices, the price fall in Japan in 2001-02 was, to a large extent, due
to the weakness in demand. Recently, however, downward pressure on prices stemming from weak
demand has been abating, and that stemming from other factors is increasing. While the reduction in
electricity and telephone charges against the background of deregulation is one of the factors,
significant factors behind the fall in prices of final goods and services are higher productivity and,
above all, firms' persistent stance of restraining labor costs.
Two notable characteristics of the recent Japanese economy - that the economy is growing at a
moderate pace and that consumer prices remain relatively unresponsive to the output gap - are both a
reflection of firms' cautious behavior. Therefore, close attention should be paid to whether firms'
activities become more positive and whether their stance of restraining labor costs might change. As
expected economic growth increases, views on prices are expected to change. In fact, deflationary
expectations of households and firms have been subsiding steadily since they peaked in 2001, as
evident in recent surveys that show an increase in the percentage of individuals and firms expecting a
rise in prices. The fact that land prices in the Tokyo metropolitan area are beginning to rise after the
decline came to a halt may be a sign of an increase in expected economic growth. Attention should
also be paid to how price expectations and land prices will develop in the future.
IV. Monetary policy
The Bank currently implements a quantitative easing policy with the outstanding balance of current
accounts held at the Bank as the main operating target. The framework is based on the following two
key elements.
First, the Bank continues to provide ample liquidity to the money market. To be more specific, it has
been providing ample liquidity so that the outstanding balance of current accounts at the Bank
substantially exceeded the amount of required reserves, which is about 6 trillion yen at present. This
will continue to generate confidence among market participants about raising funds and has resulted
in an overnight call rate of almost zero.
Second, the Bank has made a commitment, unprecedented in the history of central banks, to continue
this policy until the year-on-year rate of change in the CPI (excluding fresh food, on a nationwide
basis) registers zero percent or higher on a sustainable basis. This commitment will continue to have
the effect of lowering longer-term interest rates by causing market participants to expect short-term
interest rates to remain at zero for longer.
V. The effects of monetary policy
More than four years have passed since the Bank adopted the quantitative easing policy. While the
framework of the policy has remained unchanged, the policy effects should continue to change over
time depending on developments in economic activity and prices, and also the conditions of financial
markets and the financial system.
At around the time of the introduction of the quantitative easing policy, the real GDP growth rate was
minus 1.1 percent year on year and the CPI decreased by 1.0 percent year on year for fiscal 2001.
Furthermore, anxiety about financial system stability persisted as financial institutions were burdened
with a large amount of NPLs. In this situation, there was a risk of a credit crunch as financial
institutions became extremely cautious about extending credit to firms unless they were confident
about raising enough liquidity, and there was strong awareness of the risk of the economy falling into a
deflationary spiral.
In such an economic and financial situation, the Bank needed to firmly maintain an accommodative
financial environment by providing ample liquidity flexibly and in a timely manner, thereby easing the
public's and market participants' concerns about the availability of funds and ensuring stability in the
financial markets. As a result of the Bank's provision of ample liquidity, financial markets remained
stable and rapid tightening in corporate financing was not observed, even when financial institutions'
liquidity demand had continued to rise in a situation where, for example, bank stocks plunged and
there was heightened uncertainty regarding measures to deal with the NPL problem in the fall of 2002.
During this period, in a sense, the policy effects stemming from the ample liquidity provided by the
Bank, through which concern about the availability of liquidity was eased, may have been greater than
those of the Bank's policy commitment, namely, its commitment in terms of policy duration.
Since then, both the economy and the financial situation have been on an improving trend. Since fiscal
2002, the year-on-year growth rate of real GDP has been positive, and the year-on-year rate of decline
in consumer prices has diminished to almost zero percent. An accommodative corporate financing
environment has been supporting these developments. Together with an increase in financial
institutions' capital adequacy ratios and an improvement in firms' financial strength and profitability,
increased confidence among financial institutions and firms about the availability of funds brought
about by the quantitative easing policy has produced this desirable environment.
The quantitative easing policy framework provides stronger support for economic recovery, the more
the economic recovery gains momentum. Here, the effects stemming from the Bank's commitment in
terms of policy duration are gradually playing a larger role than those stemming from ample liquidity
provision by the Bank.
Interest rates usually rise with an improvement in economic activity and an increase in prices. The
Bank's commitment, however, keeps longer-term interest rates low by stabilizing expectations about
the future level of interest rates, and this will allow firms to continue to enjoy low funding costs. While
funding costs remain low, the rate of return on investment increases with economic recovery, and,
accordingly net returns on investments in economic activity will improve.
The quantitative easing policy has continued to contribute to the Japanese economy with some
changes in the way it affects the economy, as I have just described. Recently, the market situation that
surrounds the policy is changing significantly with the enhanced soundness of the financial system
and abatement of anxiety about financial system stability. Financial institutions have become more
confident about raising funds in the market. Furthermore, they are increasingly placing emphasis on
strengthening their profitability with a view to improving their credit ratings and raising stock prices,
and this may have been reducing their incentive to maintain funds in current accounts at the Bank that
yield no interest.
As financial institutions' demand for liquidity has been declining, their demand for funds supplied
through the Bank's market operations has decreased. Recently, as a result, undersubscription, where
financial institutions' bids fall short of the Bank's offers, has occurred frequently in funds-supplying
operations. This phenomenon can be considered as an encouraging sign that the conditions
surrounding the financial system have improved.
This situation, in turn, is causing difficulty in providing funds through the Bank's market operations. At
Monetary Policy Meetings, Policy Board members have been discussing whether to maintain the
current high target range for the outstanding balance of current accounts at the Bank. I must stress
that the discussions have been from the viewpoint of examining what is the most appropriate way for
the Bank to maintain the current quantitative easing policy framework, in response to the current
situation where financial institutions' demand for liquidity is declining and financial market conditions
are changing. The Bank will firmly maintain the framework whereby the Bank provides ample liquidity
significantly exceeding the required reserves in accordance with its commitment based on the CPI,
thereby firmly maintaining monetary easing.
I would like to explain our thinking in relation to the timing of the change in the policy framework.
As I explained earlier, the forecasts of Policy Board members for the year-on-year rate of change in
the CPI are around zero percent for fiscal 2005 and slightly positive for fiscal 2006. Price
developments may deviate from the forecasts due to deviations of economic activity from the projected
path, and also to factors unique to prices, for example, emergence of inflationary sentiment or the
effects of various measures to promote competition such as deregulation. Therefore, it is not certain
whether the conditions in the Bank's commitment will be fulfilled and there will be occasion to change
the present framework of the quantitative easing policy during the projection period covered in the
April Outlook Report. However, assuming that our projections regarding prices in fact materialize, it is
likely that this possibility will gradually increase over the course of fiscal 2006.
Nevertheless, if economic activity and prices continue to be in line with our projections presented in
the Outlook Report, that is, higher productivity and other factors continue to contain to a large extent
upward pressure on prices as the economy follows a sustainable and balanced growth path, this will
likely give the Bank latitude in changing the policy framework and in conducting monetary policy
thereafter.
I hope that the management of Japanese firms, including those of you present at this meeting, will
take advantage of the current accommodative financial environment and take up new business
opportunities in a more positive manner. I am confident that this will lead to more dynamic
development of the Japanese economy.