November 7, 2019
Bank of Japan
Japan's Experience and Its Implications for China
-- Monetary Policy and Financial System --
Speech at the PBC School of Finance, Tsinghua University
Masayoshi Amamiya
Deputy Governor of the Bank of Japan
Introduction
Good afternoon everyone. It is a great honor to have this opportunity to speak to you today
at the esteemed Tsinghua University.
China and Japan are only separated by a narrow body of water. This nearness has
historically enabled us to interact actively, and our two countries have been learning from
each other for a long time. However, knowledge and culture have flowed in one direction or
the other over time. During the 19th and 20th centuries, western-style science and
technology were transferred through Japan to China, as Japan advanced in its modernization.
But before that, over the centuries, Japan had learned a great deal from China. The legacies
are still evident in many parts of our society today. For example, learning Chinese classical
literature and poems is a part of student life in Japan. When I was a student, I remember
struggling to recite poems written by Li Bai or Du Fu and reading Chunqiu or the Analects
of Confucius.
I would like to quote a phrase in Chinese that has remained with me over the years.
为穷而不困(Wèi Qióng Ér Bú Kùn)、忧而意不衰也(Yōu Ér Yì Bù Shuāi Yě)
Never become troubled in adversity, never become depressed when worried.
These are words from Xunzi. The calligraphy in Slide 1 was written by Yasushi Mieno, the
26th Governor of the Bank of Japan (BOJ), who had a deep understanding of China. He
gave this calligraphy to me when I served as his secretary. These words were originally
intended to explain the attitude toward learning. Mr. Mieno, however, found in them the
importance of fulfilling the responsibilities of the central bank with determination. He
always said "one should not run away even when faced with great adversity."
Mr. Mieno enjoyed a good relationship for a long time with Liu Hongru, who was Deputy
Governor of the People's Bank of China (PBC) at that time (Slide 2). Mr. Mieno once told
me that, upon the two of them having drunk their hotel dry, Mr. Liu gave Mr. Mieno a
Liàng xiān
nickname, "Mr. Prodigious Drinker (海量先生<Hǎi sheng>)." As you are aware,
Mr. Liu not only made great contributions to financial system reform in China, but also
made efforts to establish and develop the Graduate School of the PBC, which is now the
PBC School of Finance here at Tsinghua University.
With these close connections in mind, today I would like to share Japan's experience and
lessons learned from a central bank's perspective.
The main themes of my speech are monetary policy and the financial system. On monetary
policy, I will explain the transition of the BOJ's monetary policy instruments from the 1980s
to the early 1990s in response to financial liberalization. On the financial system, I will talk
about how Japan responded to the financial crisis that occurred after the collapse of the
bubble economy and continued through the 1990s and the early 2000s. I will then close my
speech by introducing an example of financial cooperation between our two countries;
namely, the currency swap agreement between the BOJ and the PBC that was concluded
last year.
I. Monetary Policy: Toward Further Utilization of Interest Rate Instruments
Let me start with a discussion on monetary policy. I would like to talk about the experience
and lessons regarding the transition of the BOJ's monetary policy instruments in the process
of financial liberalization.
Japan's Experience
Up until the mid-1990s, interest rates on bank deposits and loans in Japan were regulated
based on the BOJ's loan rate to commercial banks. This loan rate was referred to as the
official discount rate. At that time, the BOJ conducted monetary policy by adjusting the
official discount rate. However, during the period of rapid economic growth, demand for
funds constantly exceeded supply. It was difficult to control banks' lending activities by
simply adjusting the official discount rate. For this reason, in 1957, the BOJ introduced an
instrument that directly influenced banks' lending behavior. Specifically, it set the amount of
loan growth for individual banks. This policy tool was called window guidance.
At that time, this was a very effective monetary policy instrument. By the late 1980s,
however, the effectiveness of window guidance declined. This is because, on the back of
financial liberalization, the financial intermediary channel for the corporate sector became
diversified and overseas funding expanded. To begin with, there was a prominent shift in
corporate finance from bank loans to the issuance of corporate bonds (Slide 3). Furthermore,
there was a rapid increase in lending by non-banks, which were difficult for the central bank
to control directly (Slide 4). In addition, foreign currency and Euroyen lending, which was
called "Impact Loans," also increased sharply during this period on the back of capital
account liberalization (Slide 5). In response to these changes, the BOJ expanded the scope
of window guidance to various types of bank lending activities. Nevertheless, managing the
complex flow of funds of financial institutions amid financial liberalization was not feasible,
and the effectiveness of window guidance declined.
For this reason, the BOJ shifted from quantity control to interest rate control through open
market operations. This is because interest rate instruments can affect not only bank lending
but also overall financial activity. Window guidance was finally abolished in 1991.
Implications for China
In China, financial liberalization has made progress steadily in recent years. The size of the
short-term money market and the bond market has been increasing. As a result, short-term
interest rates, as well as primary and secondary interest rates on government bonds, are
being formed in the financial markets. The benchmark interest rates set by the PBC still
seem to have a certain impact on bank deposit and lending rates. However, the regulation,
which requires that deposit and lending rates be kept within a certain range vis-à-vis the
benchmark interest rates, has already been abolished. In addition, gradual capital account
liberalization has made both overseas funding and investment easier than before.
Under such circumstances, the PBC has been increasing the role of open-market operations
in conducting monetary policy in recent years. At the same time, it also continues to use
guidance such as macro-prudential assessment (MPA), which exerts a direct influence on
bank lending. The PBC recognizes MPA as an important element of its financial control
framework, which consists of monetary policy and macro prudential policy. In fact,
Governor Yi Gang mentioned last December that China's monetary policy is still on the way
of shifting from quantity control to price control and that quantity control remains very
important at this stage.1
The current situation in China bears some similarities to that of Japan from the late 1980s to
the early 90s when the BOJ increased the role of open market operations while giving a
supplementary role to window guidance. Based on the BOJ's experience during the
transition phase, I would like to emphasize the following three points.
(1) Effectiveness of Central Bank's Guidance to Influence Bank Lending under
Financial Liberalization
The first point is that the effectiveness of direct control of bank lending inevitably declines
as financial liberalization progresses.
As I have mentioned, the effectiveness of window guidance by the BOJ decreased as firms
diversified their funding sources on the back of financial liberalization. I would like to
introduce my own experience related to this.
In the late 1980s, I was part of a team at the BOJ responsible for implementing window
guidance. At that time, Japanese banks were very active in providing loans. I still remember
how they repeatedly emphasized that the demand for funds was strong on the back of robust
economic activity. We tried to check whether that demand was based on sound economic
activities or on speculative investments. We also examined whether the increase in bank
lending was justified given the diversification of firms' funding sources. However, it was
almost impossible to examine every single loan thoroughly. Meanwhile, once banks were
granted a certain amount of increase in lending, they used up the full allotment. They took
the approval by the BOJ as though they had been given the green light for an increase in
loans. In addition, since the BOJ only controlled the increase in lending, the outstanding
amount of bank lending itself always exceeded the previous year's result even though the
BOJ asked for a restrained stance. As a result, bank lending and money stock continued to
grow rapidly in the late 1980s (Slide 6). In retrospect, I think that the BOJ's window
guidance not only failed to adequately curb the expansion of credit but also contributed to
the formation of the asset-price bubble to some extent.
In China in recent years, corporate bond issuance has been increasing (Slide 7). Non-bank
lending, often called shadow banking, has also been surging (Slide 8). In addition, there has
been an increase in funding from foreign markets through the bond issuance by overseas
subsidiaries (Slide 9). In this context, it is necessary to be well aware that the development
of these alternative funding methods in China could make the central bank's quantity control
less effective.
(2) Financial Liberalization and Importance of Interest Rate Instruments for Monetary
Policy
The second point is that, as financial liberalization proceeds, interest rate control becomes
more effective with a view to controlling financial conditions.
It was not just because of the diversification of corporate funding channels that window
guidance became less effective in the late 1980s. At that time, the BOJ was quite hesitant
about raising interest rates due to several reasons, such as subdued inflation and fear of
sharp appreciation of the Japanese yen. From 1987 through 1988, the BOJ required banks to
take a disciplined lending approach through window guidance and gradually strengthened
the guidance. However, with the official discount rate being unchanged, the effect was very
limited.
My sense is that the desirable policy effects could have been obtained if the official
discount rate had been appropriately raised at that time. This is because changes in interest
rates affect a wider range of financial activities, including those not directly affected by
window guidance. Also, as liberalization of deposit and lending rates proceeds, banks'
lending stance and firms' funding needs become more sensitive to changes in interest rates.
Based on its experience, the BOJ shifted to interest rate control in conducting monetary
policy. At the same time, the policy rate was changed from the official discount rate to the
short-term market rate that should be guided through open market operations.
At present, the PBC uses a quantity control instrument for exerting direct influence on bank
lending while putting more importance on interest rate control through open market
operations, as mentioned earlier. The former policy tool of quantity control plays an
important role in supplementing interest rate-based monetary policy during the transition
phase of financial liberalization. Nonetheless, based on Japan's experience, interest rate
instruments need to be utilized with a view to affecting a wide range of financial activities,
including bank lending.
In this regard, the PBC announced this August that banks reporting the Loan Prime Rate
(LPR), which is the reference rate for interest on bank lending, should determine their
lending rates by referring to the rate of money market operations conducted by the PBC.
The PBC also stated that all financial institutions should determine interest rates on new
loans based on the LPR. The announcement is expected to make banks' lending rates change
more flexibly than in the past, and it could lead to further utilization of interest rate
instruments.
(3) Importance of Developing Financial Markets
The third point is that it is important to develop financial markets so as to raise the
effectiveness of monetary policy using interest rate instruments.
In order to increase the policy effectiveness of guiding short-term interest rates, the
transmission mechanism of interest rates should be firmly established. In other words,
changes in short-term interest rates in the interbank market need to be transmitted
effectively through various interest rates, including the government bond yields. To achieve
this, it is necessary not only to liberalize various interest rates, but also to improve the
functioning of the financial markets and thereby facilitate arbitrage transactions across
markets.
In the case of Japan, the BOJ has made various efforts to develop financial markets. Our
efforts focused not only on short-term money markets but also on bond markets and
derivatives markets including futures (Slide 10).
In China today, various financial markets are also being developed. In light of our
experience, I would like to point out some issues that are particularly important going
forward.
First of all, increasing the diversity of market participants is critical. Liquidity of financial
markets will improve when there are more transactions among diverse market participants
with different business models, asset and liability structures, and views on the future course
of interest rates. In addition to developing domestic institutional investors, encouraging
entry by foreign financial institutions has great significance. In Japan, the entry of foreign
financial institutions into bond markets has increased since the 1980s, and they have
contributed to the smooth and flexible formation of both short- and long-term interest rates.
Moreover, communication and cooperation between the central bank and market
participants is vital. It is necessary to take into account the needs and burdens of market
participants when establishing transaction rules, statistics, and payment systems. The BOJ
has engaged in frank discussions with market participants through regular meetings and
forums with specific themes.
In this regard, it is very encouraging to see that such initiatives are already being taken in
China. For example, financial markets have become increasingly open to foreign investors,
especially since last year. Liquidity of financial markets will increase significantly as
participation by foreign financial institutions increases. Furthermore, the relevant authorities,
including the PBC, have started to make efforts to increase market liquidity, such as
allowing more banks to trade bonds via stock exchanges. These efforts are expected to
develop a market environment with enhanced market mechanisms.
II. Financial System: Preparation for an Orderly Exit of Insolvent Banks from the
Market
Now, I would like to move on to the next theme, the financial system. Financial
liberalization has a significant impact on the business environment and behavior of financial
institutions. As the liberalization proceeded in Japan in the 1980s, financial institutions
became concerned about the decline in profitability and the competition among them
became fierce. As a result, they started lending aggressively, which eventually led to the
creation of the asset-price bubble (Slide 11). After the burst of the bubble, Japan
experienced a severe financial crisis and several major financial institutions failed.
Let me review a series of events leading to the financial crisis.
Japan's Experience
After the burst of the bubble, small and medium financial institutions began to fail in 1991.
The main cause of this was their excessive lending during the bubble period, and the
consequent piling up of nonperforming real estate loans. In 1995, the resolution of non-bank
housing loan companies, which had a significant amount of nonperforming loans, became a
serious issue. At that time, however, the injection of public funds was not supported by the
general public. Meanwhile, business conditions of financial institutions perceived as sound
started to deteriorate. From 1997 to 1998, the default of a middle-sized securities firm
triggered a series of failures of major banks and a major securities firm. In fact, the number
of failures of Japanese financial institutions increased sharply in the late 1990s (Slide 12).
In February 1998, belatedly, the necessary legislation was put in place to inject public funds
into the financial system. However, the amount of public funds injected into major financial
institutions was not sufficient and their soundness continued to deteriorate. Finally, a firm
resolution framework was established in October 1998, for the smooth processing of failing
financial institutions including temporary nationalization. Several major financial
institutions with serious problems were nationalized temporarily, and a large amount of
public funds was injected into other major financial institutions. In 2002, the Japanese
government introduced a program that encouraged the acceleration of disposing
nonperforming loans. With these measures, Japan's financial crisis finally took a turn for
resolution. The nonperforming loan ratio started to decline (Slide 13).
During the financial crisis, the BOJ provided necessary liquidity as the "lender of last
resort." In addition, it provided equity-type funds such as capital and subordinated loans,
which was beyond the traditional role of a central bank. These capital injections by the BOJ
were unusual but necessary steps to prevent the materialization of systemic risk at the stage
before the establishment of the aforementioned resolution framework, including the bailout
by public funds.
Implications for China
In China today, the business environment of financial institutions is changing rapidly due to
financial liberalization and the slower economic growth. In addition, with the heightened
uncertainty about the global economy, the business conditions of financial institutions might
be affected in the future. Given the relatively high level of debt, it is important to be well
prepared for the potential risk that failure of individual financial institutions might become
systemic and have a significant impact on economic activity.
Based on Japan's experience, I would like to emphasize the following three points.
(1) Importance of Establishing Financial Safety Nets
The first point is the importance of building institutional frameworks that contribute to the
stability of the financial system, namely, financial safety nets.
In order to prevent failure of individual financial institutions from spreading through the
financial system, it is necessary to have a quick and smooth resolution framework. In
addition, various prudential schemes are needed for maintaining the soundness and
confidence of the entire financial system.
In Japan, a deposit insurance system was established at a relatively early stage in 1971.
However, other key financial safety nets were introduced belatedly after Japan faced and
dealt with the financial crisis caused by the burst of the bubble. The main examples of these
safety nets included the resolution mechanism for financial institutions, the mandatory
disclosure scheme on nonperforming loans, accounting standards for the adequate write-off
of nonperforming loans, and the prompt corrective action framework (Slide 14).
In the case of Japan, the government established these safety nets while dealing with the
failure of financial institutions and the financial crisis. As a result, it took a long time to
restore financial stability. In particular, there was no legal framework for injecting public
funds into financial institutions. Moreover, in the beginning of the crisis, the general public
was strongly opposed to the idea of injecting public funds. Therefore, business conditions of
financial institutions deteriorated further until the injection was realized.
In China, a deposit insurance system was established in 2015. Now, it is important to
develop financial safety nets further while the financial system is sound.
In this regard, China introduced measures this year to encourage financial institutions to
increase capital through the issuance of perpetual bonds. This approach is in line with
actions taken by other financial authorities around the world. At present, based on the
experience of the global financial crisis, a common understanding among the authorities is
that financial institutions should secure adequate capital on their own, relative to their size,
rather than rely on public funds in the case of financial stress. In order to ensure the
effectiveness of capital reinforcement, regardless of the source of funds, financial
institutions need to monitor their own financial conditions carefully and, if necessary, raise
capital proactively. In the case of Japan, since financial institutions initially underreported
the amount of public funds they needed, the government was not able to inject sufficient
funds for capital reinforcement at an early stage. This experience shows the importance of
establishing an accounting standard of nonperforming loans and appropriate disclosure.
(2) Dispelling the Myth that Banks Never Fail
The second point is the importance of the recognition within society that, although
individual financial institutions could fail, just like non-financial firms, the stability of the
financial system can be maintained.
If the general public perceives that "banks are fail-safe," a moral hazard is caused among
depositors and banks, leading to the accumulation of risk for the financial system.
Looking back, there was a myth in Japan that banks could not fail. In other words, the
possibility of a bank's failure was not considered realistic. In fact, deposit insurance had not
been triggered for 20 years, since its establishment until 1991.
If we look back further, Japan experienced a severe financial crisis caused by a series of
financial institution failures in the 1920s. Based on this experience, the Japanese financial
authorities adopted an administrative approach called the "convoy system." This system
strictly regulated competition among financial institutions with respect to interest rate
setting and business operations in order to ensure that even financially weak institutions
would not fail. The myth that Japanese banks could not fail was formed by this "convoy
system" and by undue trust in financial authorities. In addition, there was another myth that
land prices could never fall. In fact, the business conditions of Japanese banks were also
supported by this "land price myth."
It was not until the burst of the bubble and subsequent financial crisis that these two myths
were debunked. Things changed all of a sudden, and the impact of a series of bank failures
and the credit crunch in corporate finance on the Japanese economy was extremely severe.
If there is a myth in China that banks never fail, it is important to dispel it in normal
circumstances. At the same time, it is also important to build trust among the general public
that financial stability as a whole will be maintained even if individual financial institutions
fail. For example, one approach is to encourage financial education, including promoting
better understanding of the deposit insurance system among the public.
Until this year, China had not seen any bank failures since that of Hainan Development
Bank in 1998. After Baoshang Bank was temporarily nationalized this May, there was a
case of one major national bank acquiring an urban commercial bank. Accumulating
examples like these would help raise social awareness of how the financial stability is
secured apart from the failure of individual banks.
(3) Deep Understanding of the Markets' Reaction
The third point is that it is important to pay attention to how financial markets respond to
various policy measures for strengthening financial stability.
When faced with financial stress, the resolution of financial institutions, the disposal of a
large amount of nonperforming loans, and financial system reform are inevitable in order to
protect and strengthen the financial system. However, the authorities' actions could cause
strong reactions by the financial markets, which might have counter-productive effects on
financial stability itself. Let me introduce two cases from Japan's experience.
The first case is the default of Sanyo Securities in the interbank market in 1997. Sanyo
Securities, a medium-sized securities firm, was not a depository institution, and the amount
of the default was relatively small. Nevertheless, the impact on the financial markets was
significant. As this was the first-ever default in the Japanese interbank market since World
War II, market participants became skeptical that those to whom they lent money might fail
at any time. Financial institutions showed strong reluctance to provide even short-term
funds, and as a result a severe credit crunch occurred. Actually, the financial crisis in Japan
was triggered by this small default event in the financial markets.
The second case relates to what was called the Japan premium. In 1997 to 1998, when a
number of major financial institutions failed, Japanese banks were required to pay a
premium for raising funds in U.S. dollars. At that time, the Japanese government was
promoting deregulation of financial markets under the "Big Bang" reform programs and
expediting the painful disposal of the nonperforming loans of financial institutions. Market
participants were concerned about whether or not financial institutions were able to
withstand the drastic reform and the disposal. In this situation, the Japanese banks,
including even those with strong balance sheets, had to pay a premium of up to 100 basis
points when raising funds in U.S. dollars. This was a heavy burden for the Japanese banks,
and some market participants were concerned about a spillover of the financial crisis in
Japan to the rest of the world, which fortunately did not happen.
These examples show that financial markets sometimes react strongly to events when faced
with financial stress. As a result, their reaction itself may amplify financial instability or
make it difficult for the authorities to promote financial sector reform.
In China today, the authorities have started to tackle the resolution of financially weak
banks, as I mentioned earlier. They have also been promoting "financial supply-side
structural reform" to further strengthen the financial system. Both efforts are steps in the
right direction. However, when tackling the resolution and promoting financial sector
reform, it is important to pay attention to the market's reaction, and to communicate
carefully with the financial market.
Conclusion
Today, I have described Japan's experience and its implications for China by focusing on
monetary policy and financial stability. In closing, I would like to talk about the importance
of mutual learning and cooperation between Japan and China.
At present, China is simultaneously facing a transition from rapid economic growth to
slower growth, financial liberalization, and a declining birthrate and aging population.
Japan has already experienced all of these events. Meanwhile, the two countries are now
experiencing the same sorts of changes; for example, the digital revolution. In particular, the
development of the digital economy in China has been remarkable, and this has drawn the
attention of many Japanese companies. It will become more and more important for Japan
and China to cooperate and learn from each other. In the beginning of my speech, I
explained that knowledge and culture have flowed in one direction or the other between
Japan and China over time. Compared with the past, the time now seems ripe for us to learn
from each other by sharing our knowledge and experience.
Furthermore, as the economic and financial ties between the two countries grow stronger,
there are increasing opportunities for the two central banks to cooperate in addressing
common issues. I will give you an example.
In October of last year, the BOJ and the PBC signed a currency swap agreement, allowing
for the exchange of local currencies between the two central banks of up to 200 billion
renminbi, or 3.4 trillion yen (Slide 15). By utilizing the swap agreement, the BOJ would be
prepared to provide liquidity in renminbi should Japanese financial institutions face
unexpected difficulties in renminbi settlements, and vice versa with provisions of yen by the
PBC. The agreement is designed to enhance the financial stability of the two countries, and
hence support economic and financial activities for economic development in each country.
Lastly, I would like to conclude my speech by referring to the words from Xunzi again. The
passage that I mentioned in the beginning of my speech continues in this way (Slide 16).
知祸福终始而心不惑也(Zhī Huò Fú Zhōng Shǐ Ér Xīn Bú Huò Yě)
This means that "the aim of learning is to understand misfortune and fortune, ending and
beginning, and ultimately, to be able to guide yourself." In this world of great uncertainty, I
feel that these words have marked relevance to the continuing efforts of Japan and China to
learn from each other and deepen mutual cooperation.
Thank you for your attention.