Masaaki Shirakawa: Advanced and emerging economies - two-speed
recovery
Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Bauhinia
Distinguished Talk hosted by the Bauhinia Foundation Research Centre, Hong Kong SAR,
23 November 2010.
* * *
I. Introduction
Good evening. Today, I am indeed honored to have this precious opportunity to give a
speech here in the beautiful and dynamic city of Hong Kong. I would like to begin by
expressing my heartfelt thanks to the Bauhinia Foundation Research Centre and the
Chairman, Mr. Anthony T. Y. Wu for kindly providing such an honorable occasion to speak in
front of our distinguished audience.
As you are well aware, financial business is the biggest industry in Hong Kong. Did you
know, however, that the financial relationship between Hong Kong and Japan was forged
shortly after Hong Kong appeared in modern history? In 1871, three years after the
foundation of the Meiji Government, Japan began to issue its first modern currency. The
government of the time acquired its minting machinery from the former English Minting
Authority in Hong Kong, and invited the engineers to Japan, asking them to issue silver coins
of the same weight and quality as those used in Hong Kong. While there are a variety of
stories claiming to account for the origin of the name of the Japanese currency, the yen, one
of these stories tells us that in fact the yen derives its name from the silver Hong Kong one
yuan coin (Slide 1). Financial institutions have also been active since the very early days in
helping build close associations between Hong Kong and Japan. The Hong Kong and
Shanghai Banking Corporation Limited, familiar worldwide as HSBC, was established in
Hong Kong in 1865. In the following year, 1866, HSBC opened its branch in Yokohama, and
this contributed greatly to the development of trade finance in Japan. Among Japanese
banks, the former Yokohama Specie Bank Limited, which is said to have been modeled after
HSBC, opened its local office in Hong Kong in 1896.
The strong economic ties between Hong Kong and Japan are not limited to financial services
but extend also to trade in goods and services. Hong Kong is currently Japan's fifth largest
export partner (Slide 2). It must also be pointed out that this trade in products is not confined
merely to industrial goods. Believe it or not, despite its total population of less than ten
million, Hong Kong is the primary export destination for Japanese agricultural products, some
of which may be re-exported to other regions, including mainland China. Japanese luxury
fruits are very popular among Hong Kong's gourmet residents.
There is also a long-term relationship between Hong Kong and the Bank of Japan. The Bank
of Japan opened a representative office in Hong Kong in 1957, aiming to ensure close
appreciation of economic developments in the Asian region (Slide 3). Since then, our
representatives at the Hong Kong office have been providing extremely valuable and
enlightening reports to the Tokyo Head Office on monetary and economic developments in
Hong Kong and East Asia, including those on the Asian currency crisis in 1997. We have
been enjoying a very close and friendly relationship with the Hong Kong Monetary Authority,
and I myself have solicited advice for today's speech from my very close friend,
Mr. Norman T. L. Chan, Chief Executive of the Hong Kong Monetary Authority.
Let me now move on to the main subject. The title of my speech today is "Advanced and
Emerging Economies: Two-speed Recovery," and I would like to take this opportunity to
express my views on the outlook for the global economy. I will also briefly touch upon several
challenges for Asia and Japan from the perspective of ensuring economic developments
between the two.
II. Current state of the global economy
I will start with the current state of the global economy. The global economy has been
recovering at a modest pace, following its rapid decline after the Lehman shock. The current
state can most accurately be described by what has already become a rather worn-out
phrase, the "two-speed recovery." According to the IMF World Economic Outlook released in
October, the growth rate of the global economy was minus 0.6 percent in 2009, followed by a
forecast plus 4.8 percent for 2010, and plus 4.2 percent in 2011 (Slide 4). Approximately
70 percent of the growth is contributed by emerging and resource-rich economies. Among
those, the growth of Asian emerging economies stands out, and it can be said that Asian
emerging economies are currently the growth center for the global economy, and have been
a great driving force for its recovery since the global financial crisis.1
Meanwhile, Japan's economy has also benefited significantly from the growth of the Asian
emerging economies. Japan's exports dropped sharply from the end of 2008 to the beginning
of 2009, owing to the financial crisis. However, after the spring of 2009, exports showed a
significant increase, mainly to China, the ASEAN, and other major Asian economies
(Slide 5). The Japanese economy has recovered at the fastest pace among the advanced
economies, and one of the main reasons for this has been the significant increase in exports
to Asia.
Now, what projections can we make about future global economic developments? While the
future of the global economy is fraught with uncertainty, I focus particularly on the following
three points in making a projection.
The first point relates to the advanced economies, especially to an assessment of their
balance sheet adjustments. The credit bubbles in the mid-2000s were on a very large scale,
particularly in the U.S. and the U.K. economies, and for that reason, it may well take some
time for them to recover. Assessment of the effectiveness of macroeconomic policies in
advanced economies is also an important element. There is already very limited room for
deployment of monetary and fiscal policy in these economies. Given these circumstances,
when can we expect the advanced economies to return to a full-fledged recovery path, and
how robust will this return be?
The second point I wish to raise relates to the growth prospects for the emerging economies.
The growth potential of emerging economies may seem very large, but without the appropriate
policy taken, the risk of a bubble cannot be ruled out. In addition, although this is not a
pressing concern, the smooth transition from a high-growth economy to a mature economy
will become one of the important policy challenges for the emerging economies in the longer
term.
The third point, which interlinks with the above two points, is the issue of capital flows and
exchange rates, or more simply, the currency conflict under the "two-speed recovery."
III. Perspectives from the experience of the Japanese economy
Japan's experience over the past few decades offers a range of ideas when considering
these three points. One of the most debated topics of economic policy over the past several
months has been the large-scale asset purchase program implemented by the Federal
Reserve. Meanwhile, many commentaries by economists and policy makers suggest that the
program was intended to avoid "Japanese-style deflation" or "the lost decade in Japan."
Incidentally, if you search the keyword "Japanese-style deflation" on Google, the results have
increased rapidly from about four hundred thousand entries during the first half of this year,
to about a million during the period from July to mid-November. However, many are
interested not only in Japan's experience of deflation or "the lost decade." When I talk to my
friends in China, it surprises me to learn that in-depth studies are carried out on Japan's
experience during the high-growth period and after the Plaza Accord.
Now, I would like to express my views on the above three points, by making reference to
Japan's experience.
Balance sheet adjustments in advanced economies and their aggressive monetary
easing
Let me start with the issue of balance sheet adjustments or repair in advanced economies,
particularly in the United States. Balance sheet adjustments were indeed an issue that Japan
struggled to resolve after the burst of the bubble. Real GDP growth in Japan after the burst of
the bubble decreased significantly to an annual average of 1.5 percent in the 1990s, down
from 4.4 percent in the 1980s (Slide 6). After entering the 2000s, real GDP growth picked up
somewhat to an average of 1.7 percent until 2007, but dipped again owing to the Lehman
shock. Average real GDP growth for the 2000s was merely plus 0.7 percent. As for the
inflation rate in Japan, the consumer price index has been on a mild downward trend since
1998 (Slide 7). As such, Japan's economic performance has not been impressive in recent
years, and this is why discussions in the United States often take place in the context of
"avoiding the Japanisation" of the U.S. economy. However, such framing of the discussions
occasionally makes me feel that Japan's experience and its lessons may be misread.
My understanding of the main causes for the decline in Japan's growth rate can be summed
up in the following three points.
The first cause can be attributed directly to the burst of the bubble. During the formation of
the bubble, driven by excess optimism about the future, firms expanded their business
capacity and employment, and increased their debt. After the eventual bursting of the bubble,
the so-called "three excesses" remained, namely excesses in business capacity,
employment, and debt. The economy continues to suffer downward pressure as long as
"such excesses" remain. It was not before the resolution of these "three excesses" in 2003
that Japan returned to a full-fledged recovery path (Slide 8).
The second cause is the failure of Japanese firms in adapting to the changes in overall
trends that took place globally from the late 1980s through the 1990s, namely deregulation,
globalization, and the information and technology revolution. During this period, global
markets were further integrated, and divisions of labor in production processes were
extended on a global scale. Foreign firms increased their value added by optimally
rearranging their production base and sales channels, and reduced costs by effectively
expanding outsourcing. On the other hand, it was a significant challenge for Japanese firms
to adapt to such circumstantial changes, since their business models were based on
centralized control and integrated team production. The industrial model in Japan was
supported by a highly skilled domestic labor force under the lifetime employment system.
However, since Japanese firms were trapped in the memory of their past successes, they
were left behind in adapting themselves to the major trend changes in the global economy.
The third cause is the aging and declining population (Slide 9). There are a variety of
channels through which demographic changes affect the economy. However, with other
conditions being equal, domestic demand will naturally decrease in line with a decrease in
population. Likewise from the supply side, a decrease in labor supply will reduce the growth
rate. Owing to Japan's rapidly aging population, the growth rate of productive population
turned to be negative in 1995, and was minus 0.9 percent in 2009 on a year-on-year basis.
The decline in population will also increase the fiscal burden on the working generation.
How should we assess the risk of deflation, a question which relates to the debate on "the
lost decade"? In fact, Japan has experienced a mild price decline of about 3 percent on a
cumulative basis over a decade. However, the country has not experienced a deflationary
spiral, where a decline in prices induces a decline in economic activity, thereby leading to a
further decline in prices. This deflationary spiral is the strongest reason for fearing deflation.
Instead, in terms of length, Japan experienced its longest post-war period of sustained
recovery from 2002 to 2007, though not necessarily spectacular. Hong Kong has also
experienced an increase and decline in prices in recent years. For every jurisdiction, it is not
appropriate to isolate the issue of deflation from economic structure, in particular from wage
setting. If we compare consumer price inflation between Japan and other advanced
economies, the rate difference is mainly attributed to the development in the price of services
(Slide 10). As the inflation rate declined, wages were set in a more flexible manner in Japan.
This flexibility in wage setting was attained not only through a reduction in bonus payments
and an increase in the number of non-regular workers, but also through the downward
revision of fixed remuneration for regular workers in a flexible manner. Since services are
more labor-intensive than the production of goods, the flexible adjustment of nominal wages
resulted in a decline in the price of services, which became a cause of the deflation. Since
the latter half of the 1990s, corporate management and employees in Japan have given
priority to ensuring employment, and a decline in wages has therefore been accepted by the
workers. As a flipside to a decline in wages and mild deflation, Japan has experienced an
increase in its unemployment rate which is currently at 5.0 percent, but this increase has
been much smaller than in the U.S. and European economies.
Let me summarize the above argument by highlighting the implications for the current U.S.
economy.
First, it takes a significant time after the burst of a large bubble for an economy to complete
its balance sheet adjustments and return to the path of full-fledged recovery. In this regard,
the current U.S. economy may require some more time to repair its balance sheets.
Aggressive monetary easing could reduce some of the pain arising from on-going balance
sheet adjustments, but it will not extinguish the need for those adjustments.
Second, even during the process of balance sheet adjustments, it is essential not to forget
paying attention to the importance of the supply side of the economy. Although
accommodative monetary policy is important so as to avoid sharp declines in demand,
prolonged low interest rates may hinder the growth of productivity by devitalizing economic
regeneration. In the longer term, the trend in economic growth rates is determined by supply
side factors, namely the growth of the labor force and productivity. On this point, the United
States seems to have the advantage over Japan in terms of its more flexible economic
structure as well as higher population growth of approximately 1 percent, which is higher
than that of Japan in the post-bubble period. However, during the prolonged economic
downturn period after the burst of a bubble, policies that may harm long-term efficiency are
often introduced in the climate of accumulated social frustrations. Preventing a decline in
growth potential appears to be the key to avoiding "the lost decade" situation, although this is
not an easy task for any economy.
How long will the high growth of emerging economies be sustained?
The above are my views on the balance sheet adjustments in advanced economies, which is
the first point I wish to make in projecting the future developments of the global economy. My
second point is on the sustainability of economic growth in emerging economies. Emerging
economies have achieved remarkable growth in recent years. If we mathematically
extrapolate from the average growth rates of the global economy and BRICs economies for
the last ten years, the global share of the BRICs economies will reach more than 80 percent
in 2040, although this is considered to be unrealistic. Even these high-growing economies
will mature at some stage. Let me now make a simple comparison of Japan's high economic
growth in the past and China's economic growth in recent years. Roughly speaking, China's
population is ten times greater than that of Japan, China's per capita nominal income is
onetenth of that of Japan, and, accordingly, the nominal GDP for the two countries is about the
same. Japan's high economic growth era started in the mid-1950s, and ended in the early
1970s. The average annual growth rate for this fifteen-year period reached about 10 percent
(Slide 11). On the other hand, China's high growth era began in the early 1990s, and the
average annual growth rate for the first fifteen years was roughly the same as that of Japan
during its high growth era. The difference between the two is that China is still continuing its
high growth at an average of more than 10 percent. During a period of high growth, the
supply of labor from rural agricultural areas is one of the key factors. If we compare the urban
population ratios of Japan and China from this perspective, the current ratio for China is
about the same as that of Japan during high growth era of the 1960s.2 The automobile
diffusion ratio for China has also reached about the same level as that of Japan in the 1960s,
which indicates a consumption boom owing to improvements in income level. Based on such
simple comparisons, China's high economic growth is likely to continue for the time being.
However, one of the important prerequisites for maintaining high growth is to avoid the
formation of a bubble. The authorities in China are well aware of this. I would then like to
share my understanding on how the bubble was formed in Japan in the latter half of the
1980s. It was a phenomenon that arose from the complicated interaction of the following
factors.
The first factor was the overconfidence that became so pervasive throughout Japan. Japan's
growth rate gradually declined after its high growth era ended in the early 1970s, and yet
growth rates remained far greater than those of other advanced economies up until the
1980s. Inflation rates were quite subdued, and therefore, Japan boasted of itself being an
honor student. It may sound like a joke, but there were even calculations in the late 1980s
that the land value of the Tokyo metropolitan area alone was sufficient to purchase the whole
United States. This economic background fostered overconfidence, and increased the
aggressive behavior of many economic entities.
The second factor was the lack of a sufficiently prudent financial supervision. Financial
institutions considerably increased their lending to the real estate, construction, and
nonbank sectors, and loosened their underwriting standards on loans, including collateral
evaluation. As a result, the exposures of the financial institutions' portfolios became
extremely vulnerable to fluctuations in land prices.
The third factor was the prolonged accommodative monetary policy. However, it is not so
meaningful to simply state that monetary easing was one of the factors that contributed to the
bubble. We need to examine in depth the social and economic background as to why
monetary easing was continued for such a prolonged period. One of the reasons is the
continuance of the low inflation rate. Another reason is that Japan had been under strong
external pressure to squeeze its current account surplus. In order to reduce its current
account surplus, Japan needed to expand domestic demand, and strong arguments
developed around implementing accommodative monetary policy. Even after the economy
had improved, concerns were often expressed, mainly by exporting firms, regarding the
appreciation of the yen. These factors stood in strong opposition to withdrawing the
accommodative monetary policy.
If there are lessons for high-growing emerging economies to learn from Japan's experience,
which might help them avoid a bubble, these can be summarized in the following three
points. First, society, as a whole, needs to maintain a sense of discipline in order to avoid
overconfidence, particularly in times of high growth. Second, I put an emphasis on the
importance of the financial regulation and supervision. Especially given that each bubble is
different, it is absolutely essential to have a supervisory framework from the perspective of
macro-prudence to accurately grasp the overall risk. Third, monetary policy has to aim at
domestic stability, which amounts to sustainable economic growth under price stability. We
must bear in mind that focusing on foreign exchange rates and current accounts can be
detrimental to the stability of the domestic economy.
Financial and capital market developments under the "two-speed recovery"
Let us now move on to my third point in making projections for the global economy. The third
point relates to issues arising in financial and capital markets owing to the "two-speed
recovery." Currently, advanced economies, including Japan, are conducting extremely
accommodative monetary policies to ensure their economic recovery. On the other hand,
emerging economies are experiencing increasing capital inflows from advanced economies
(Slide 12). These capital inflows mainly reflect the high growth prospects of emerging
economies, together with the influence of interest rate differentials between advanced and
emerging economies. A number of Asian emerging economies have observed their stock
prices reaching new historical peaks (Slide 13). Real estate prices have increased at a
substantial pace, and the rising trend in global commodity prices is also observed. In terms of
the increase in asset prices, Hong Kong is no exception.
Given these circumstances, emerging economies have been expressing concerns over the
accommodative monetary policy in advanced economies, as it could lead to overheating in
their domestic economies and the emergence of a bubble, and further to a possible reversal
of capital flows in the future. Advanced economies are, on the other hand, expressing
concerns that the foreign exchange rates of emerging economies are less flexible, and this
may eventually threaten global sustainable growth by enlarging global imbalances. For
reference, the foreign reserve assets of Asian emerging economies dropped slightly
immediately after the Lehman shock, but recovered again and increased dramatically
(Slide 14).
How should we address this currency issue? Textbooks provide clear-cut answers, but have
never sufficiently covered the variety of dilemmas that we have actually experienced in
recent years, including carry trades, where low interest rate currencies are borrowed as a
funding currency and invested in the financial assets of high-yield currencies. Even if the
textbooks did provide us with clear-cut answers, these would not instantaneously help
resolve the problems we face, as there are no binding powers to ensure their policy
implementation across jurisdictions. In this regard, I would like to emphasize that a deep
understanding of the textbook principles is important, but at the same time, thinking in a
textbook manner alone is not sufficient.
Allow me now to confirm a very basic principle from the textbooks. Central banks in every
jurisdiction bear the ultimate responsibility for the price stability and economic stability of their
jurisdiction. Whether an advanced or an emerging economy, it is natural and legitimate for
central banks to take accommodative monetary policy to be strengthened further or
otherwise corrected, depending on each economic situation. In relation to exchange rate
fluctuations, under the free movements of international capital, fixing the exchange rate
would inhibit autonomous monetary policy. Therefore, if the capital inflows to the emerging
economies are causing overheating, the textbook answer for them would then be either to
accept the appreciation of the currency, or to tighten monetary policy in response to the
extent that it affects domestic prices and economic activity.
This principle is indeed important. However, the textbooks we have do not consider the
important economic reality at this moment, namely the zero interest rate bound and balance
sheet adjustments. Given the zero interest rate bound, and given also that there are many
economic entities exposed to balance sheet adjustments, it may be more difficult than in
other circumstances for monetary easing policy to take effect through domestic economic
entities. Rather, it tends to take effect through external channels, such as capital outflows
and currency depreciation. The reality for those emerging economies receiving capital
inflows is that, although the growth of their financial and capital markets may indeed have
been remarkable in recent years, their markets are still small and less liquid compared with
those of advanced economies. Hence, when there are large uncovered capital flows into the
local currency stock and bond markets of emerging economies, the exchange rate and the
price of securities tend to rise simultaneously. This further accelerates the inflows in a
selffulfilling manner, as speculative money seeks the capital gains of currency as well as
securities. Such superfluous capital inflows force down domestic bond yields, creating
downward pressure on the lending rates of domestic banks, and may lead to a rise in asset
prices. Allowing the currency to appreciate may help to deter capital inflows, but if inflationary
pressures were suppressed by such currency appreciation, the low interest rate period may
be extended owing to the apparent stable price conditions, resulting in the inability to prevent
the overheating of the economy and the creation of a bubble. This would suggest that
currency appreciation is also not a panacea. In either case, if emerging economies
experience the formation and the burst of a bubble, the influence will also rebound to
advanced economies.
Several years ago, when Japan was implementing its quantitative monetary easing policy,
there were criticisms from Asian colleagues that such a policy was promoting carry trades.
There have been similar arguments, expressed even more vigorously, since the Federal
Reserve recently implemented its large-scale asset purchase program. Although it is
understandable for advanced and emerging economies to have their different views, what is
essential for us is to acknowledge that we are all in the same boat when it comes to the
globalized economy. There is as yet no clear-cut answer to these difficult issues, but I
believe it is important that each jurisdiction embraces the following approach when
implementing monetary policy.
First, advanced and emerging economies need to rethink the meaning of domestic stability of
both prices and economic activity, before actually implementing monetary policy. Every
central bank aims at ensuring domestic stability for its jurisdiction at any time. However, in
order to attain this objective under circumstances of economic and financial globalization, it is
becoming important for central banks to take into account the impact that their own monetary
easing or lack of flexibility on foreign exchange rates might have overseas, as well as the
feedback effects on their jurisdictions.
Second, it is also important to implement measures from a prudential policy perspective. In
this regard, the Hong Kong Monetary Authority (HKMA) has sounded a warning since last
year about the rapid increase in real estate prices, implementing a variety of policy
measures, such as the lowering of the Loan-to-Value (LTV) ratio. These macro-prudential
measures are particularly essential for Hong Kong, where a fixed foreign exchange rate
regime has been adopted. An issue currently of global importance is how to design
macroprudential measures appropriate to the situation of each domestic economy and to the
degree of development in financial markets.
IV. Economic development in Japan and other Asian economies
So far, I have expressed my views on the outlook for the global economy. Next, in the little
time remaining, I would like to change the topic and talk briefly about economic
developments in Japan, with particular reference to the economic relationship with other
Asian economies.
The Japanese economy is facing a number of difficult challenges, as indicated by the
declining trend of GDP growth rate. We, Japanese people, often tend to be rather
selfreflective, which is also considered a virtue, but I feel that this tendency has been going too
far recently. We should avoid being excessively either optimistic or pessimistic.
Therefore, I will start by emphasizing the strengths of Japan's economy. First, the growth
rate of real GDP per worker in Japan, namely the growth rate of productivity, still bears
comparison with that of the United States, although it is no longer what it once was
(Slide 15). Second, Japan's financial system is sound. Looking back at the time of the
Lehman shock in the fall of 2008, Japan's financial system was relatively more stable than
those of the U.S. and European economies (Slide 16). Third, Japan has high technological
competitiveness. For instance, Japan is at the global forefront of advances in environmental
technology. Japan has also made advances, during the process of urbanization for example,
in areas of high technology associated with infrastructure, including water supply, roads,
railways, and harbors. Fourth, Japan has strong economic and historical ties with, and is
geographically close to East Asian economies which together currently enjoy the most rapid
growth in the world. Recent experience of the global economy suggests that, even in the age
of globalization, the importance of geographic closeness still counts.
After highlighting these strengths of Japan's economy, I have to admit that it nonetheless
faces many challenges. The most pressing challenge is, I think, coping with its demographic
changes. Japan's working population has been declining since the latter half of the 1990s,
and the number of workers has also shown a declining trend since 1998. Under these
circumstances, I believe, the particularly important issues we have to deal with are
maintaining a sustainable fiscal balance, and increasing the rate of participation in the elderly
and female workforce.
Meanwhile, it is also vital that Japan continues to make efforts towards realizing the potential
strengths that I mentioned earlier. Strengthening our cooperation with Asian economies is
likewise crucial for this issue. Looking at the weight of East Asian economies in exports from
Japan, it has increased from 30 percent in 1990 to 40 percent in 2000, and further up to
51 percent in 2009 (Slide 17). The weight of Asia in foreign direct investment from Japan has
also been increasing steadily. As such, Japan's relationship with Asian economies has been
deepening further. Economic strategy in Asia is one of the important pillars in the Japanese
government's "New Growth Strategy" which was recently issued. As an example, I would like
to mention again environmental technology. Japan was once plagued by low energy
efficiency, which resulted in large fluctuations in the real economy as the energy price
changed. This also caused serious environmental problems, including air and water pollution.
In order to overcome these problems, mainly after the first oil shock, Japan made strenuous
efforts to develop energy-efficient and environmentally-friendly technologies by bringing
together both public and private sectors. As a consequence, energy unit efficiency in Japan
has improved dramatically, and has become the most efficient in the world (Slide 18).3 This
has reduced the impact of resource price changes on domestic prices and the real economy
while at the same time bringing environmental benefits, as there are now far fewer
environmental disruption problems. The Asian emerging economies have much to improve in
terms of environment, and I think there are many areas in which Japan can make a
contribution.
In terms of cooperation with Asia, finance is an equally important area. In fact, one of the
recent key strategies for major Japanese financial institutions has been the strengthening of
their business activities in East Asian economies. Developing financial markets in the region
is also an important policy issue. According to a BIS survey as of April 2010, global foreign
exchange transactions increased by 20 percent compared with that of three years ago.
Among them, the share of Asian currencies in foreign exchange transactions is only less
than 4 percent (Slide 19). However, given the significant presence of Asian economies in
trade in goods and services, this share is expected to increase much further. As such,
developing financial markets is important for the Asian region. For instance, there are still
limits on the number of Asian currencies that can be settled via the international foreign
exchange settlement system called Continuous Linked Settlement (CLS). It is also our task