Toshihiko Fukui: Prospects for the future of Japan's economy
Speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Kisaragi-kai, Tokyo,
23 July 2003.
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When I was appointed Governor of the Bank of Japan four months ago, I made a pledge that I would
do my best to contribute to reviving the Japanese economy. As we all know, Japan's economy is
currently beset with a number of formidable problems. By resolving each of these problems steadily
and patiently, I believe, prospects for the future of Japan's economy will be improved. With such a
vision in mind, today, I would like to talk about these problems and the steps the Bank has been taking
to address them.
1. Current situation and challenges facing Japan's economy
Current condition
Let me begin by briefly talking about the current condition of Japan's economy.
Economic activity, as a whole, remains flat.
On the bright side, corporate profits continue to improve, and business fixed investment is on a
gradual upturn. Indeed, according to the Bank's Tankan Survey released in early July, the ratio of
profits to sales is expected to hit a record high in fiscal 2003 since the bursting of the bubble,
surpassing the past highs of 1996 and 2000. And, the business fixed investment plan for fiscal 2003 is
the largest since fiscal 2000.
But, on a more subdued note, personal consumption remains lackluster. High corporate profitability
despite anemic sales implies that the effect of corporate restructuring in reducing labor and other costs
has been quite substantial. This, in turn, means that the household sector has been faced with harsh
labor and income conditions, which have adversely affected consumption.
Meanwhile, Japan's exports have not shown any clear movement either to rise or to decline. Thus, as I
described at the outset, economic activity overall remains flat.
But recently, uncertainties surrounding Japan's economy have been gradually abating. The
uncertainty surrounding overseas economies, an important factor for exports, has been declining in
the wake of the end of the war in Iraq and the containment of severe acute respiratory syndrome
(SARS). It is the prevailing view that despite lingering uncertainties, the growth of overseas economies
will pick up in the second half of this year.
Under such circumstances, we expect that a cyclical upswing in Japan's economy will begin to
materialize in tandem with the gradual improvement in exports and production. And, in the financial
and capital markets in and outside Japan, pessimism regarding the future course of the economy and
prices has been receding with the rise in stock prices.
Problems facing Japan's economy
Yet, there remain a host of long-term problems that must be overcome.
Though the growth of Japan's economy has been forced down at a lower rate since the bursting of the
bubble, there have, in fact, been several recovery phases. However, these nascent recoveries
repeatedly failed to lead to a full-fledged growth path because of recession overseas and concern
about financial instability at home.
One of the factors responsible is that such structural problems as debt overhang and excess labor
have yet to be resolved. For example, when production and corporate earnings increased amid vibrant
overseas economies, firms were forced to make, or strategically effected, the repayment of
outstanding debt, and there was no expansion of business fixed investment. And, efforts on the part of
the corporate sector to shed excess labor kept employment and income conditions severe, thereby
restraining personal consumption. In a nutshell, pressures to correct past excesses hampered
domestic demand from achieving a self-sustained recovery.
But, are these sufficient reasons explaining the prolonged stagnation of Japan's economy?
Looking at past history a little more closely, we have come to realize that the problems are more than
just the aftermath of the bursting of the bubble, such as debt overhang and excess labor. We are
actually facing more deep-rooted and difficult problems.
Since the late 1980s, the world economy has witnessed a sea change in the form of globalization and
revolution in information and communications technology. Thus, before we discuss possible
resolutions to the problems facing Japan's economy, it may be a useful exercise to put them in a
global and historical context.
On a global scale, a disinflationary trend is intensifying. For example, the average growth rate of the
consumer price index in G7 countries decreased from around 7 percent in the first half of the 1980s to
the 3 percent level in the second half, and to a less than 2 percent level between 1996 and 2002. This
certainly shows that central banks' conduct of monetary policy has successfully contained inflation.
More fundamentally, this trend may reflect the impact on price determination of globalization and the
revolution in information and communications technology.
The transition of emerging countries to market economies has greatly expanded global supply
capacity. Furthermore, firms with a dominant power in setting prices in various markets segmented by
region or by product no longer exist amid the advance of globalization and information and
communications technology. Consequently, firms in industrialized countries have become increasingly
under pressure to create high-value-added products amid global competition.
Coming back home, there have also been conspicuous changes in the conditions underlying Japan's
economy. They include the transition to a mature economy and demographic change. These changes
make it impossible for Japan's economy to revive high growth seen in the past, and, in this sense,
tend to lower prospects for its future. On an individual firm level, they tend to nullify old business
models established in the high-growth period, and also to force firms to construct new and more
innovative business models.
There are quite a few firms, mainly in the manufacturing sector, that are not plagued by debt overhang
and excess labor. But they also find it difficult to increase their production and investment until such
time as they become confident about their competitiveness.
The challenges facing Japan's economy are enormously complex and difficult because it is faced with
such idiosyncratic problems as the transition to a mature economy, demographic change, and the
aftermath of the bursting of the bubble, in addition to global issues.
Looking at prices, Japan's economy has passed a disinflationary stage, and has fallen into a
deflationary situation. Deflation will cause various distortions in the economy and society, in a different
way from inflation, even if modest.
To resolve the problems
To resolve the problems facing Japan's economy, we must construct a new and dynamic economic
system in which firms and individuals can have positive expectations for the future and boost their
economic activity. In addition, we must construct a mutually beneficial, new interdependent
relationship with neighboring countries in Asia. Here, I think there are two key concepts to keep in
mind. One is Japan's economy, which can create high-value-added, and the other is more unified
regional cooperation among Asian economies.
Moving forward, we need to metamorphose Japan's economy and society into one which is more
flexible so that resources will be smoothly reallocated to creative areas. Unfortunately, in Japan we do
not yet have frameworks that can reallocate various resources efficiently. In the private sector,
procrastination in the relaxation and abolition of regulations has been a major impediment. In the
public sector, the accumulation of vested interests has hampered budget reallocation.
There is a problem with the framework of corporate finance. In Japan, as a result of prolonged high
growth in the past, corporate finance has become extremely dependent on bank borrowing. In fact, it
has come to a point where borrowers hardly make any distinction between funds for risk-taking and
those for running operations. This is directly related to a distortion of corporate governance. And, I
think debt overhang can be considered as an extension of this problem.
Furthermore, productivity-related wages and a flexible labor market are essential elements for the
future of Japan's economy. It will be quite a challenge to balance these with the traditional system of
seniority-based wages and lifetime employment.
Needless to say, we must expand business opportunities. And, in the process, we need to create a
framework in which individuals and firms will be rewarded with commensurate returns when they take
on risks. It seems that the various systems that underpinned post-war growth such as corporate
governance, labor and wage practices, and the role of government and public institutions, can no
longer provide a sufficient risk-return incentive.
Finally, let me mention the relationship with other Asian economies. Japanese firms have already
dramatically changed their business strategy for Asia. These days, they not only use Asian countries
as a production base for exports, but also try to penetrate local domestic markets. In the last decade
or so, intra-regional trade has greatly expanded in Asia as evidenced by the ratio of such trade to the
nominal GDP for nine East Asian countries more than doubling, from 8 percent in the latter half of the
1980s to 17 percent recently. This ratio is almost comparable to that of the European Union (EU). But,
with regard to free trade agreements, Japan has fallen behind other countries. I thus hope the
government will make efforts to promote free trade agreements which would support the efforts of the
private sector.
There is another important issue to deal with when we create an environment in which economic
dynamism works, and that is to minimize future anxieties. For example, if individuals are uneasy about
their financial situation after retirement, including pensions, or if firms are concerned about potential
financial instability, they will be discouraged from aggressively taking on risks. Paradoxically speaking,
it is important to enable economic agents to take on risks without paying undue attention to future
anxieties.
In this regard, the government has a critical role. It can enhance incentives for risk-taking in the private
sector by eliminating impediments in regulatory and tax systems. On the budgetary front, it can
promote resource reallocation in the private sector by fundamentally reviewing government
expenditure. Furthermore, it can assuage future anxieties related to pension and other social security
systems. We thus need to promote broad-based reform, covering the socio-economic system at large.
Last month, the Council on Economic and Fiscal Policy decided to adopt "Basic Policies for Economic
and Fiscal Management and Structural Reform 2003" (the so-called third main reform guidelines). I
think it vital to accelerate the implementation of reform measures while taking account of these
guidelines.
As far as monetary policy is concerned, I think the Bank of Japan has a very important role to play in
this process, the details of which I am going to take up later.
Given that the government and the Bank of Japan do their best in providing a favorable environment,
firms are the main player in constructing a new and dynamic economic system. Or, to be more
precise, individuals could ultimately be perceived as the main player, since they own and manage
firms, they work at firms, and they monitor firms directly or indirectly. What lie at the core of a market
economy are the activities of firms and individuals in discovering new value-added demand, and
turning such into attractive goods and services and shouldering risks attached. These days, profit
opportunities are not something obtained just by following others as in the past, but something created
before others do.
Let me elaborate a little on this. After World War II, Japan's economic policies focused on sustaining
high growth and promoting exports, and firms vied for larger sales and higher market share rather than
higher profitability. As a result, a low-profit and high-cost structure took hold.
Then, with the prolonged high-growth period, this structure became so deeply embedded in the
economy that firms found it extremely difficult to find ways to correct the high-cost structure and create
new competitiveness. And, more recently, the bursting of the bubble economy in the early 1990s led to
debt overhang and excess labor, which further increased the burden of such adjustment.
We hear anecdotes that the delay in corporate restructuring has kept competent human resources in
existing firms, and this is one of the main reasons for the low rate of new business openings in Japan.
All these are formidable challenges. However, I believe they can be overcome, no matter how difficult
they may be, as long as the private sector makes steady efforts to display its creative power, and the
government and the Bank of Japan give strong support to such efforts.
Contributions of the Bank
The Bank of Japan would like to make a positive contribution to extricating the economy from a
deflationary situation and putting it on a sustainable recovery path, as well as to creating an
environment in which both firms and individuals will be able to realize their potential and economic
dynamism will work more effectively. Let me explain the policy measures the Bank has taken in three
areas.
First, our easy monetary policy. Here, we have made efforts to provide a financial environment in
which firms will be able to embark on as many forward-looking activities as possible even under the
continuing severe economic situation.
Second, we have been urging financial institutions to enhance their soundness. Financial institutions
are supposed to assume a pivotal role in the financial system, but its intermediary function has been
somewhat weak. Under such circumstances, firms might become reluctant to aggressively take on
risks as they are concerned about future funding or a recession in the wake of financial instability.
Third, we have been working to improve financial and capital markets. The key here is to improve the
market mechanism so that interest rates will be determined competitively. In other words, we should
strengthen the price discovery function of the market. An improved market mechanism would induce
firms to actively invest, thereby spurring economic dynamism.
Let me elaborate on these three contributions.
2. Maintaining easy monetary policy
Ample and flexible liquidity provision
The first contribution of the Bank is its maintenance of an easy monetary policy. The Bank has
aggressively pursued an easy monetary policy under the framework of quantitative easing by changing
its operational policy target from the short-term money market rate to the balance of current accounts
held by financial institutions at the Bank since the spring of 2001 when the short-term money market
rate declined to almost zero.
Since I became Governor, the Bank decided to substantially increase liquidity provision as an
emergency measure to respond to heightened uncertainties in the wake of the war in Iraq, the spread
of SARS, unstable movements in stock prices and foreign exchange rates, and the injection of public
funds into Resona Bank. (In April and May, the Bank increased the target balance of current accounts
in the total amount of 8 trillion yen, with the upper limit rising to 30 trillion yen.)
Such quantitative easing has been extremely effective in maintaining financial market stability while we
recognize its side effects, including a deterioration in the market mechanism.
It has also been effective in facilitating corporate funding. Looking back at the 1997-98 period, a series
of collapses of financial institutions triggered a credit crunch. At the time, being concerned about their
own funding, there were cases where financial institutions could not respond even to the funding
needs of large blue-chip firms. However, we have not confronted such a situation since we adopted
quantitative easing. I think the probability that a similar situation will occur is much smaller compared
with the 1997-98 period.
Through these channels, quantitative easing has been firmly supporting economic activity. But, we
should never be complacent. We are determined to make further efforts to improve the transmission
mechanism so that the effect of quantitative easing will permeate the economy to the fullest extent
possible. As part of such efforts, the Bank recently decided to purchase asset-backed securities
(ABSs). The necessary preparations having been completed, we will be ready to purchase the
securities in the near future.
Policy commitment
There are other measures to stabilize financial markets. For example, the Bank has committed itself to
continuing its current monetary easing framework until the growth rate of the consumer price index
(CPI) stably registers zero percent or above. This can be termed the "policy duration effect." With such
a commitment as a backdrop, interest rates for overnight to several years have been stable at very low
levels. In fact, the rise in medium-term interest rates has recently been relatively moderate despite the
substantial increase in long-term rates.
We fully recognize the importance of stabilizing public expectations about future policy directions, and
we will make further efforts to enhance transparency regarding the conduct of monetary policy.
3. Promoting financial system stability
The second contribution of the Bank is to secure financial system stability by urging financial
institutions to enhance their soundness.
For the past ten years, the financial system problem in Japan has been almost synonymous with the
nonperforming-loan (NPL) problem. However, it goes without saying that what is really important is for
financial institutions to overcome the NPL problem and transform themselves into a new financial
service industry equipped with renewed competitiveness. Major financial institutions must quickly
become competitive in the international financial market, and regional financial institutions should
provide new financial services to small firms which undertake or develop new businesses that
contribute to the development of local economies.
Having said this, it is true that the NPL problem is still formidable. In the paper titled "Japan's
Nonperforming Loan Problem" published in October 2002, the Bank pointed out that a comprehensive
approach would be indispensable to promote the resolution of this problem, centering on a more
appropriate evaluation of the economic value of NPLs, more stringent provisioning, and more vigorous
corporate rehabilitation. Subsequent efforts by financial institutions have more or less been in line with
this recommendation.
Regarding the past-due and restructured large loan assets of major financial institutions, provisions
have been made on a discounted cash flow basis, and the extent of provisions as a whole was also
raised. Disposal of NPLs by way of write-offs and sales has accelerated considerably, and the
outstanding balance has been substantially reduced. Furthermore, we have seen new initiatives
aiming at corporate rehabilitation, including the establishment of the Industrial Revitalization
Corporation of Japan. Recently, many financial institutions, including regional institutions, have
established special sections devoted to industrial rehabilitation.
In addition to the NPL problem, stock price volatility also poses a significant risk to the management of
financial institutions. It is the view of the Bank of Japan that the unwinding of cross-shareholdings is an
inevitable trend, and, as far as the shares held by banks are concerned, it is quite appropriate to
insulate the risk due to stock price volatility by expediting the sale of these shares. Since the latter part
of last year when stock prices began to fall, the Bank of Japan began purchasing stocks. By partly
utilizing our stock purchasing scheme, banks have been reducing their shareholdings, and a couple of
major banks have already reduced their shareholdings to below an amount equivalent to Tier 1 capital
as stipulated by regulation.
Needless to say, in view of the remaining problems, financial institutions need to continue making best
efforts to overcome them. At the same time, in addition to such backward-looking tasks, they must
strengthen their earnings power by reconstructing lending and other types of businesses. Like firms
must create value-added, financial institutions must provide high-value-added financial services, which
is the ultimate key determining their future.
It cannot be denied that the financial authorities tend to take the initiative in securing financial system
stability in view of the magnitude of the problem as well as inherent time constraint. While the severity
of the problem might have justified such a course of action in the past, it should be the private sector,
with its creative power, which deals with such problems as the disposal of NPLs, raising capital, and
corporate rehabilitation. The Bank has consistently been sending this message to financial institutions
so that they will be able to take the maximum initiative in tackling these problems. If financial
institutions put more weight on improving profitability, they will find it all the more difficult to achieve
without managerial independence. Through on-site supervision and monitoring, the Bank will strongly
support such a direction while urging financial institutions to make utmost efforts.
4. Steps toward future financial and capital markets
The third contribution of the Bank is the effort to improve financial and capital markets. Here I would
like to emphasize the importance of credit markets such as corporate bond and CP markets as well as
stock and other markets for risk money.
The current structure of corporate finance in Japan exhibits a heavy dependence on bank borrowing.
However, looking forward, we need to diversify financial intermediation channels to cope with the
various needs of investors and fund-raisers. In this regard, what is most important is that interest rates
will be determined competitively in the market. In other words, we must take full advantage of the price
discovery function of the market.
It is the intrinsic role of the market to display the risk-return relationship perceived by market
participants in the form of market price--interest rates in the case of credit markets. If the market
develops to the extent that it can fully perform the price discovery function, we will establish a
framework where we can obtain return commensurate with the risk involved in financial transactions.
At the same time, it will induce active investment on the part of firms, thereby spurring economic
dynamism.
Japan's financial and capital markets, particularly credit markets such as the lending, corporate bond,
and CP markets, do not seem to be performing a sufficient price discovery function in evaluating the
credit risks of borrowers. This is attributable to a variety of factors. Under the main bank system, credit
has been made mostly in the form of loans. Another factor might be the assumption of an
evergrowing economy in which loans have been extended based on the value of real estate collateral
rather than the stringent evaluation of firms themselves and the project under consideration. Some say
that corporate bonds and CP are sometimes regarded as another form of loans.
Recently, however, we have seen the expansion of new markets, including syndicated loans, ABSs,
and credit derivative markets, which seems to signal the transformation of credit markets in Japan. It is
anticipated that active credit markets will facilitate the intermediation of funds and risks, contributing to
the more efficient allocation of resources in the economy as a whole.
Undoubtedly, market improvements will lay an important groundwork for the future. Moreover,
considering that the intermediary function of financial institutions is far from perfect due to such factors
as the burden of NPLs, it is an important problem that is worthwhile tackling from the viewpoint of
further enhancing the effect of monetary easing as well as facilitating corporate funding.
Based on this thinking, the Bank of Japan, in cooperation with market participants, has made various
grass-roots efforts to improve the market by refining master transaction contracts and trading practices
as well as by compiling and publishing market-related statistics.
Furthermore, the Bank chose ABSs as an instrument with important monetary policy implications, and
will begin purchasing them shortly.
We believe that because of their product characteristics, ABSs will play an important role in the future
of financial and capital markets in Japan. ABSs is a generic term for any product that comprises
several types of bonds based on cash flows created by the most advanced financial engineering
techniques from a pool of relatively small-lot obligations, such as loans and leases extended to small
and medium-sized firms and the account receivables of these firms. By pooling the number of
obligations, risk will be reduced. ABSs qualify in meeting the needs of investors with a variety of risk
tolerance as securities can be issued in various combinations of high-risk, high-return and low-risk,
low-return bonds.
This product suits the current situation in Japan. For example, financial institutions play a central role
in originating these products, and the risk is borne directly by end-investors. In the case of Japanese
firms, small and medium-sized firms in particular, main banks and other similar financial institutions
are in the best position to grasp funding needs. One of the characteristics of ABSs is that while banks
originate these securities, the risk is shouldered by investors so that they are not susceptible to banks'
risk-taking ability. By using their own networks and assessment ability, financial institutions will act as
manufacturers and distributors by creating such products as ABSs and selling them.
We thus believe that ABSs will be the best candidate to build a bridge from the current bank-centered
system to next-generation financial and capital markets.
In fostering the market for ABSs, the Bank decided to shoulder the credit risk of private debt
obligations by directly purchasing such securities. This is mainly because the market is still in an
embryonic stage and hence there are very few participants willing to take on risks and, moreover, it is
difficult to originate the securities. As long as the central bank effects purchases in the market, such
action inevitably entails a sense of intervention. And, there is always the danger that it might distort the
price discovery function of the market, thereby jeopardizing its sound development. However, judging
from the information we have obtained so far, there is a possibility that purchases by the Bank may act
rather as a catalyst to increase both transactions and market participants so that the market function is
expected to strengthen in a self-generating way. We hope that such a virtuous cycle will be
engendered.
Concluding remarks
For Japan's economy to resolve the problems it faces and move forward, firms and individuals must
become active in seeking new value-added by taking on risks. It is the task of the Bank of Japan to
provide a financial environment favorable to the people who create the future course.
The more difficult the problems facing Japan's economy, the more aggressively the Bank of Japan
should pursue new policy options without being held hostage by precedent.
Quantitative easing is a policy option that no other central bank has ever taken and we also recognize
that the purchase of stocks held by banks is a policy option that is not conceivable under normal
circumstances.
Indeed, the purchase of asset-backed securities is an extremely unusual policy option in the sense
that the central bank directly shoulders the credit risk of private debt obligations. Traditional monetary
policy usually focuses on money, which sits on the liability side of banks' balance sheets, and hardly
looks at credit as an independent item. However, in the situation Japan faces, credit, which sits on the
asset side of banks' balance sheets, has become critically important in the conduct of monetary policy,
and it is in this area that the Bank of Japan is exploring new policy options.
We will continue to effect the appropriate conduct of monetary policy by always bearing in mind the
future vision of the economy. Let me close by stating my firm belief that Japan's economy will reveal
its true potential and we will be able to build a bright future, and also once again pledging that the
Bank of Japan will make every possible effort to revitalize the economy.