Mr. Matsushita reports on recent financial and economic conditions in Japan
Speech by the Governor of the Bank of Japan, Mr. Yasuo Matsushita, to the Japan National Press Club in
Tokyo on 12/12/97.
I. Introduction
I truly appreciate this opportunity to address this distinguished audience at the Japan
National Press Club.
The circumstances of the Japanese economy and financial system have increased in
severity in the past six months. The economy has not shown any definite signs of recovery since its
reaction to the rise in the consumption tax rate in April 1997. Rather, economic recovery appears to be
decelerating. The currencies and financial markets of South-East Asian countries, which have been the
high-growth area, have been in turmoil since summer of 1997, and an adverse impact on the Japanese
economy has been anticipated. In addition, recent successive failures of large Japanese financial
institutions have once again aroused concern about the stability of Japan's financial system in Japan and
abroad. Thus, it is not easy to judge where the Japanese economy is headed and to draw up a prescription
for each problem.
In such a situation, it is important that the circumstances be analyzed carefully so as to
perceive the underlying mechanism. This is because developments in the economy and the markets
-even, or particularly, when they suggest confusion or disruption -- often provide important indications or
warnings that lead to a better solution of the problem.
Today, I would like to discuss and explain the Bank's thinking on three topics: issues
concerning Japan's financial system, the turmoil in the Asian currencies and financial markets, and the
domestic economic situation. These are three independent issues that in a way are closely correlated. I
would like to explain them with a view to clarifying the underlying mechanism.
II. Issues Regarding Japan's Financial System
A. Resolution of Failed Financial Institutions
I would like to start with issues regarding Japan's financial system.
The successive failures of Japanese financial institutions since the fall of 1997 have once
again emphasized domestically and internationally the severity of the situation facing the Japanese
financial system, temporarily increasing the tension in the financial markets.
First, I would like to explain the measures the Bank has taken to deal with this situation
and the thinking behind them.
When a financial institution fails, the most important task is to contain systemic risk. In
other words, it is crucial to prevent the failure from affecting other financial institutions or the markets as
a whole, disrupting the entire financial system, through widespread anxiety of depositors and market
participants or through a chain reaction of defaults.
In order to contain systemic risk, two requirements must be satisfied. First, it must be
ensured that smooth repayment of deposits be made by the failed financial institution. Second, it is
important to avert liquidity contraction to ensure the stability of the entire financial system. Failure of
financial institutions causes market participants to become overly cautious, making it difficult for
transactions to come to terms. As a result, upward pressures tend to be placed on interest rates. Therefore,
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in order for these two requirements to be satisfied, the Bank took decisive measures in response to the
financial institution failures.
To meet the first requirement, the Bank extended special loans as necessary to several
failed institutions -- for example, Hokkaido Takushoku Bank and Yamaichi Securities -- under Article 25
of the Bank of Japan Law, without requiring the usual collateral.
The Bank has committed itself to providing funds for the purpose of ensuring the
stability of the financial system only in cases where all of the following four conditions are met: (1) there
is a strong possibility that systemic risk -- a risk that failure of one financial institution to settle
transactions with another may trigger a chain reaction of defaults -- will materialize, and that as a result,
confidence in other sound financial institutions will be undermined, or that runs on deposits will occur;
(2) credit extension by the Bank is indispensable, as there are no other sources of funds; (3) measures are
taken to prevent moral hazard; and (4) the financial soundness of the Bank will not be threatened.
In the cases of the recent financial institution failures, the Bank judged it appropriate to
extend special loans after thoroughly examining these four points.
While the Bank had previously extended special loans to depository institutions, the loan
extension to Yamaichi Securities should be regarded as an extraordinary measure. This is because the
failure of a non-depository financial institution such as a securities company differs in several ways from
the failure of a depository institution. Customers of a securities company conduct stock and bond
transactions through the securities company, and are not in a creditor-debtor relationship with the
company. They do deposit money and securities with a securities company, but unlike bank deposits,
these are not means of payment. Accordingly, it is usually unlikely that the failure of a securities
company would directly give rise to systemic risk.
Yamaichi Securities' decision to close down its business, however, is significant in that
the company is one of Japan's four largest securities companies. Furthermore, considering the fact that
the Japanese financial system is being viewed more critically and that Yamaichi conducted a wide range
of business in domestic and overseas markets and had a large number of customers, any difficulties in
returning customers' assets or in settling outstanding transactions in the process of closing down the
company were quite likely to lead to withdrawal of customer assets from other securities companies or
disrupt market transactions. If no measures had been taken to prevent such a situation, the credibility of
the Japanese financial system could have been seriously eroded and disruptions could have been caused
in domestic and overseas financial markets, in the end seriously affecting overall economic activity in
Japan. Against this backdrop, the Bank decided to provide Yamaichi with necessary liquidity under
Article 25 of the Bank of Japan Law in order to minimize the adverse impact of the closing down of the
company's business on the domestic and overseas financial markets as well as the Japanese economy.
The Bank's measures had their intended effect: payment and settlement were executed
smoothly by the failed institutions, and thus the materialization of systemic risk was avoided. However,
the failures of large depository institutions and a securities company made the behavior of market
participants very cautious, and as a result, it became difficult for transactions to come to terms, placing
upward pressures on market interest rates.
Therefore, to fulfil the second requirement in containing systemic risk, the Bank exerted
itself to its utmost to avoid declines in market liquidity through market operations. The Bank utilized
various market operations means to provide sufficient liquidity in the markets, to thereby support smooth
market transactions and stable formation of market interest rates.
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Since September 1995, the Bank has conducted market operations in order to maintain
the uncollateralized overnight call money rate at a level on average slightly below the official discount
rate. However, demand for funds in the market heightened following the series of financial institution
failures, and at the end of November 1997, the call money rate rose far above this targeted level. The
Bank therefore made continuous efforts to supply sufficient liquidity to the market, and as a result the
rate has recently declined to the targeted level.
Rates on longer-term money market instruments, however, especially 1-month rates on
end-of-year funds, remain high due to a rise in the "Japan premium" -- the extra funding cost that
Japanese banks have to pay compared to leading U.S. and European banks due to a decline in their
creditworthiness in international markets. The Bank would like to emphasize that it will continue to take
a firm stance in its market operations toward the end of the year to ensure the stability of money market
rates.
The Bank, in cooperation with the government, will continue to commit itself to
maintaining the stability of the financial system, and strongly hopes that the public and market
participants will act calmly.
B. The Implications of Recent Financial Institution Failures
Significant progress has been made toward the solution of the nonperforming-loan
problem, and it can be said that the recent failures of financial institutions occurred amid this notable
progress. Therefore, these failures can be considered to have important implications for the strengthening
of Japan's financial system and for the restoring of domestic and international confidence in the system.
The disclosed amount of total nonperforming loans held by the Japanese depository
institutions decreased from ¥38 trillion as of the end of March 1995 to ¥28 trillion as of the end of March
1997. Of this, the amount that needs to be disposed of, or those not covered by collateral or loan loss
reserves, has been reduced from the ¥18 trillion in 1993 to ¥4.5 trillion. While this amount is still
substantial, it is fair to say that there has been steady progress in the disposal of nonperforming loans.
A matter of concern is that the pace of disposal differs among financial institutions. For
example, some financial institutions have completed removal of nonperforming loans from their balance
sheets. Many other institutions seem to be planning to record net losses for the accounting term ending in
March 1998 to dispose of a considerable amount of nonperforming loans. The overall progress in solving
the nonperforming-loan problem, together with enhanced disclosure practices, has sharpened the contrast
between institutions that are being prompt in dealing with their problem and those that lag behind.
Under such circumstances, there seem to be two requirements in restoring confidence in
Japan's financial system at home and abroad.
First, it is necessary for financial institutions to further improve disclosure and thereby
enhance the transparency of their management. Depositors, creditors, and other market participants are
scrutinizing the financial conditions of Japanese financial institutions with increasing severity, and the
scheduled introduction of Prompt Corrective Action in April 1998 and the implementation of the
Japanese "Big Bang" deregulation measures are likely to encourage such tendency. Therefore, it is vital
that individual financial institutions accelerate the disposal of nonperforming loans and the
implementation of restructuring measures to ensure the market's confidence.
As for the disclosure of nonperforming loans held by financial institutions, a uniform
standard has been established based on a recommendation by the Financial System Research Council to
allow comparison between financial institutions, and the range of disclosure has been expanded in line
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with this standard. To increase the transparency of financial institution management and to thereby
strengthen the market's confidence, however, it is essential that institutions expand the range of
disclosure on their own initiative, not only with respect to nonperforming loans but also to the
implementation of their restructuring measures, and thereby provide the market with a convincing
explanation of how they intend to improve, or how they have improved, their financial strength.
Second, the recent series of financial institution failures has highlighted the importance
of preventing the surfacing of systemic risk and of thereby ensuring the stability of the entire financial
system. It must be remembered that in the financial system, an appropriate balance must be struck
between the need to draw out the dynamism of the market mechanism and the need to ensure the stability
of the system.
As I stated earlier, the financial strength of financial institutions is being more severely
examined in anticipation of the implementation of the Japanese "Big Bang". To maintain the stability of
the financial system under these circumstances, it is extremely important to ensure that even if the market
were to pass a hard judgment on an institution, this would not shake the entire financial system.
In this regard, the provision of emergency liquidity for preventing any serious
disturbance from occurring in the system, which I mentioned earlier, is the responsibility of the central
bank as the "lender of last resort".
When the failed institution has a negative net worth, there is the problem of how to
dispose of the ultimate losses. However, credit extension by the Bank is aimed solely at providing
temporary liquidity, and not at making up for losses. Therefore, it is required that a loss-covering scheme
be in place before swift repayment of deposits can be made and resolution of the failed institution be
carried out smoothly.
The deposit insurance system is one of the frameworks made available for such schemes,
and various measures have been taken to enhance the functions of the Deposit Insurance Corporation.
There could be cases, however, where losses are too large for this system to bear. In such cases overseas,
public funds have been used subject to certain conditions to solve the problem.
In view of those examples abroad and the current situation of Japan's financial system,
an argument has been put forward that public funds should be utilized for the early and fundamental
solution of the nonperforming loan problem, triggering serious debate in the Government and Diet. The
Bank considers the argument to carry great significance for the domestic financial system, and therefore
hopes that a national consensus on the matter will be reached through wide discussions.
The global and domestic conditions facing Japan's financial system are becoming
increasingly harsh, as represented by the expansion of the "Japan premium" in international financial
markets. Thus, Japan's financial system is at a critical juncture that will determine whether it can restore
domestic and international confidence, with financial institutions further enhancing disclosure and
accelerating the disposal of nonperforming loans, and the authorities ensuring the stability of the
financial system.
III. Financial Conditions in Asia and Their Impact on the Japanese Economy
A. The Background of the Turmoil in Asian Financial Markets
Let me next discuss the recent developments in other Asian economies. In this section, I
will refer to Asian economies on the basis of excluding that of Japan. To confront the turmoil in the
Asian financial markets which started in summer 1997, various measures have been taken -- each country
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has been adjusting its macroeconomic policy and setting out measures to stabilize the financial system,
and international assistance has been provided under the leadership of the International Monetary Fund
(IMF). However, instability remains in the financial and foreign exchange markets of these countries, and
uncertainty prevails as to how their economies will evolve under the various economic measures. Today,
therefore, I would like to examine the background of the Asian turmoil and its possible impact on the
Japanese economy.
First, I would like to emphasize that it is not appropriate to perceive the currency
turbulence in Asian countries as having been caused by speculative attacks by global investors on
specific currencies and financial markets, and to emphasize the instability of international financial
markets. Turmoil in the international financial and foreign exchange markets has occurred several times
in the past: the demise of the postwar fixed exchange-rate system, established by the IMF in the 1970s;
and the currency crises in the European Monetary System in 1992 and in Mexico in 1994.
In all the above cases, before the turbulence arose in the markets, there had been for
some time a gap between the exchange rate of the country's currency and the real economic condition of
the country, with that gap expanding gradually preceding the turbulence. Immediate adjustment of the
foreign exchange rate is inevitable once market participants detect the situation. In the adjustment
process, the exchange rate may overshoot, giving the impression that the market is in disruption.
However, it is important that the grounds for such large fluctuations be clearly identified, or otherwise,
the warning signals sent out by the market, which are pointing to the expanding gap in this case, will be
overlooked.
With the emergence of the Asian currency turmoil, some have questioned the previous
achievements of East Asian economies. This view also seems to be rather extreme. It appears that the
potential growth rate of East Asia remains high, supported by its high-quality labor, high savings rate,
and solid market and industry infrastructures. Although East Asian economies will face adjustment
pressures in the short term, they can be expected to establish a foundation for further growth by carrying
out various structural reforms based on their recent experiences.
What, then, can be considered to be the background of the recent turmoil in Asian
currencies? While Asian countries differ from each other in many ways, one common factor is that most
Asian currencies were pegged to the U.S. dollar, and under the peg, large amounts of foreign funds
flowed in during the 1990s. This in turn led to excessive financial and investment activities, overheating
of the economy, and accordingly, deterioration in the external balance.
It cannot be denied that there was a sense of euphoria, or an overexpectation of economic
growth, in East Asia. When there is an influx of abundant funds based on such expectations, upward
pressure is exerted on the foreign exchange rate of the country's currency. To maintain the pegged
exchange rates, countries were under pressure to ease money to lower domestic interest rates or at least
avoid monetary tightening. Such policy response fuelled financial and investment activities, and this may
have upheld the euphoria for a certain period of time.
Inflation rates in Asian countries rose due to overheated economic activity, and under
their fixed exchange rate system, their currencies became overvalued. Consequently, the international
competitiveness of these economies declined gradually and current account deficits expanded. The
deficits in the current accounts were not a problem as long as they were financed by foreign capital.
However, as soon as market participants began to doubt the sustainability of the external imbalance and
the economic boom in the area, foreign funds were abruptly withdrawn from the countries, putting severe
pressures on foreign exchange rates and stock prices. Against this backdrop, many countries were
compelled to abandon their exchange rate pegs to the U.S. dollar and adopt a floating rate system.
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Several important lessons can be drawn from this experience with regard to ensuring the
stability of international financial markets. Obviously, preventing an overheating of economic and
financial activities through proper macroeconomic policies is the most important prerequisite for securing
the stability of one's own economy as well as the international financial markets. It is equally important
to ensure flexible foreign exchange developments, promote information disclosure to allow the market
mechanism to check the appropriateness of economic policies, and establish a sound financial system by,
for example, reviewing the framework of financial institution supervision.
Based on these lessons, East Asian countries have embarked on the restoration of their
economies and financial systems with international support. The Bank of Japan, too, continues to play an
appropriate role in the framework in which the IMF takes the initiative. In terms of cooperation among
Asian central banks, the Executives' Meeting of East Asia and Pacific Central Banks (EMEAP) was
established in 1991. The governors' meeting has taken place annually since 1996; the first being held in
Tokyo and the second in Shanghai. Taking the opportunity of such meetings, the Bank intends to
strengthen its ties with other Asian central banks by exchanging views and extending technical assistance
in various fields.
B. Impact on the Japanese Economy
Next, I would like to discuss the impact of developments in the Asian economies on that
of Japan.
The economic relations between Japan and other Asian countries have been intensifying,
and the region is now the largest trade partner of Japan. Of Japan's total exports, those to Asia's Newly
Industrializing Economies (Asian NIEs) and the member countries of the Association of South East
Asian Nations (ASEAN) account for about 35 percent, exceeding the share of exports to the United
States and to the European Union, 30 percent and 15 percent respectively. As for Japan's imports, the
share of imports from Asian NIEs and ASEAN countries has grown to almost 20 percent, approaching
the 22 percent from the United States, which holds the largest share.
Accordingly, it is inevitable that the depreciation of the currencies and the economic
slowdown due to the implementation of adjustment measures in these countries will affect the real
economy of Japan. At present, demand in other regions such as China, the United States, and Europe is
firm, and the average exchange rate of the yen (weighted by the value of trade with each country) remains
stable. Thus, the export environment is not significantly deteriorating as a whole. However, exports to
Asia, especially to Thailand and the Republic of Korea, have started decreasing.
Furthermore, slowdown of economic growth in East Asian countries is bringing about a
fall in international commodities prices, especially those of raw materials. This is beginning to affect the
profits of materials manufacturers in Japan, and as a result, some of these firms are planning to curtail
production. Thus, careful observation of economic trends including these kinds of indirect impact is
necessary.
In addition to developments in the real economy, the problem of nonperforming loans is
surfacing in the Asian countries, although the degree differs from country to country.
According to statistics compiled by the Bank for International Settlements (BIS), the
total credit exposure of Japanese banks to Asian countries amounts to US $270 billion, which accounts
for about 30 percent of the total exposure of world's financial institutions to Asia.
However, these figures include Japanese banks' credits to Asian branches and affiliates
of Japanese, U.S., and European financial institutions. Furthermore, a large portion of business credits of
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Japanese banks are extended to Japanese affiliates with a guarantee given by their parent companies.
According to the Bank's survey, Japanese banks' credit exposure to non-Japanese firms and local banks
in Asia appears to be around 30 to 40 percent of the total credit exposure reported in the BIS statistics.
Moreover, most of such credit is loans to sound major banks and firms and project finances, which are
unlikely to turn into nonperforming loans.
As discussed above, the impact of the currency and financial turmoil in Asia on the real
economy and financial market of Japan has been limited to date. However, the economic situation in this
region remains unstable. Therefore, the degree of economic slowdown and developments in the
nonperforming-loan problem in these countries must continue to be monitored.
IV. Recent Financial and Economic Conditions and Monetary Policy Management in Japan
A. Domestic Financial and Economic Conditions
I would now like to move on to today's last topic -- the recent economic situation in
Japan.
The decelerating trend of Japan's economic growth since April 1997 has been
intensifying recently. In final demand, exports and business fixed investment continue to be on an
upward trend, supporting economic activity. However, household spending such as personal
consumption and housing investment, which fell substantially following the rise in the consumption tax
rate in April 1997, is recovering only at a very slow pace. In personal consumption, outlays on services
such as travel services have shown a moderate increase, while outlays on goods, as indicated by sales of
automobiles and household electric appliances as well as department store sales, have remained sluggish.
In addition, housing starts have declined more recently to 1.3 million from the 1.5 million per annum
level prevailing until spring 1997.
With such weakness in final demand, inventory adjustment pressures remain in the
consumer durables- and construction-related industries, and thus industrial production has been declining
slightly. Such developments seem to be gradually affecting employment and income.
However, this year's temporary economic slowdown is inevitable in that the economy is
at a phase in which the downward pressures of fiscal tightening appear most strongly. The concern is
how these developments will affect the momentum of the self-sustained economic recovery in 1998. At
present, corporate profits and employment income, which form the basis of the self-sustained recovery,
continue to be on an upward trend. Therefore, it is unlikely that the economy has entered a recession.
However, there is some weakening of the virtuous circle of production, income, and expenditure, and if
this trend continues, it may undermine the strength of the self-sustained recovery. The Bank will
therefore continue closely to monitor the pace of recovery in consumption, progress in inventory
adjustment, and developments in household and corporate sentiment.
Meanwhile, prices have remained stable on the whole. Domestic wholesale prices have
continued to decline slowly, particularly those of construction materials. Consumer prices, after
excluding the effect of the rise in the consumption tax rate, have been at a level slightly above that of the
previous year, and corporate service prices remain at the previous year's level.
In view of such economic and price conditions, the Bank is determined to observe
developments carefully in managing monetary policy, placing emphasis on strengthening the foundation
of the economic recovery. In the conduct of market operations, the Bank intends to continue supplying
sufficient liquidity to the financial market, to thereby ensure smooth transactions and stability of market
interest rates.
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B. Lending Attitude of Financial Institutions
With regard to the recent financial situation, there have been various discussions
concerning the cautious lending attitude of financial institutions.
Today, financial institutions are faced with many challenging management issues, such
as expeditious disposal of nonperforming loans, as well as implementation of measures to deal with the
Japanese "Big Bang" financial reform and with the introduction of Prompt Corrective Action. Therefore,
with a view to enhancing the soundness and efficiency of management, an increasing number of financial
institutions are strengthening their risk management and attaching more importance to profitability in
their extension of loans. These efforts by financial institutions are indispensable for strengthening Japan's
financial system. However, it is a matter of concern whether the cautious lending attitude of financial
institutions has reached the point where it hinders the recovery of the economy as a whole.
To date, partly because of weak corporate demand for funds, there has been neither any
significant shortage of funds in corporate financing nor an overall rise in lending rates due to a squeeze in
lending. Therefore, the Bank believes that the cautious lending attitude of financial institutions is not
hampering economic recovery at present. However, risk management systems of financial institutions are
being further reinforced. In addition, the influence of developments in financial markets, such as low
stock prices and the rise in the "Japan premium", on financial institutions' lending activity requires due
attention.
While the current lending activity of financial institutions is not hampering economic
recovery, it is not positively contributing to the recovery as it did during past periods of monetary easing.
This fact offers a significant point for discussion when considering the interaction between financial
activity and real economic activity, because the expected role of financial institutions goes beyond
merely responding passively to corporate demand for funds.
Financial institutions are expected to actively support forward-looking business
activities -- for example, by helping corporations find new business opportunities and accepting financial
risks when new businesses are started. In fact, such functions of financial institutions played a significant
role in promoting economic recovery in the past. While it is true that financial institutions went too far in
these activities, leading to the emergence of the economic "bubble", it is also undeniable that in the
present phase of economic recovery financial support for economic activity has been weak. In order to
ensure economic recovery, it is important to strengthen the functions of financial institutions and the
financial market, thereby restoring a strong and efficient financial system. I would like to point out that
the cautious lending attitude of financial institutions, causing the so-called "credit crunch", should
therefore be discussed in connection with the issue of strengthening the financial system.
C. The Significance of Stronger Confidence in the Economy
The Bank's primary concern regarding the economy is the fact that the confidence of
firms and households in the Japanese economy and its outlook seems to be deteriorating.
It is very difficult to measure accurately the level of confidence of economic entities.
However, the financial and asset markets offer some important information. Asset values, for example,
reflect the expectations of market participants as to the future profits which may be earned by holding
such assets.
How, then, should we see the recent low level of stock prices? Corporate profits are at a
significantly higher level today compared with those in 1995, when there were concerns about a
deflationary spiral. However, stock prices are close to the 1995 level. This suggests that confidence in the
economy has weakened compared with that in 1995. Under such circumstances, firms and financial
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institutions would be inclined to hold back from forward-looking activities that involve risks. Weakened
confidence would also reduce the effects of monetary easing.
However, it seems unnatural to assume that the potential growth rate of the Japanese
economy in the medium to long term has declined significantly in the past two years. In 1995, for
example, there were strong concerns over the future of Japanese industry, due to increasing competition
with other Asian economies and anxiety over a hollowing-out of industry, but Japanese firms are
responding by building new global networks of production and parts procurement, utilizing the new
international division of labor. Also, with the depreciation of the yen, apprehension about the
international competitiveness of Japanese industry seems to have receded considerably.
In view of these conditions, the weakening confidence in the economy that is reflected in
the low stock prices must be attributable to some other factor. A clue in finding the answer is the fact that
the "outlook for the economy" does not reflect only the estimated potential growth rate, but also
uncertainty regarding its realization.
For example, even when similar levels of profit growth are expected, stock prices will
decline when there is greater uncertainty about the realization of the expected profit growth, in other
words, when the risk premium expands. The same phenomenon can be observed in the economy as a
whole. Uncertainty regarding future developments significantly undermines confidence in the economy.
Thus, it can be said that the present weakness of confidence in the economy is related to
the fact that the Japanese economy is at a critical phase of various structural reforms, including financial
system reforms. There are many uncertainties surrounding economic entities -- such as the developments
in the financial system, the progress of structural