Hirohide Yamaguchi: Recent economic and financial developments and
the conduct of monetary policy
Speech by Mr Hirohide Yamaguchi, Deputy Governor of the Bank of Japan, at a Meeting with
Business Leaders, Otaru, 25 March 2009.
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Introduction
I would like to thank the financial and business communities in Otaru for giving me the
opportunity to speak here today. I would also like to thank you for your close cooperation with
our Sapporo Branch in providing information on the economic and financial situation of the
region. The information is very valuable in enabling us to accurately grasp current economic
and financial conditions in Japan and formulate the conduct of monetary policy.
I visited Otaru previously a number of times in connection with the closing of the Bank of
Japan's Otaru Branch in 2002 and its remodeling as the Bank of Japan Otaru Museum.
Closure of the branch was not easy for the local community to accept, but I am very glad to
hear that the museum has become well known and welcomed its 500 thousandth visitor in
May 2008, five years after its opening. This successful transition owes a great deal to the
understanding and cooperation of the local community.
Before we exchange views, I will speak about recent economic and financial developments in
Japan and abroad and also about policy responses in major countries. In particular, I will
describe my view of the current substantial economic downturn and the economic outlook,
and how the authorities worldwide, including the Bank, have acted, as well as the thinking
behind their actions.
I. Global financial markets and economic developments
A. The background of the turmoil in global financial markets and economic
downturn
I will start with developments in global financial markets and the world economy.
The turmoil in global financial markets began in the summer of 2007, but the situation
worsened suddenly when the markets were hit by the failure of Lehman Brothers Holdings
Inc. in September of last year. Market participants' and investors' concerns about the
creditworthiness of their trading partners, or counterparty risk, intensified, and as a result the
volume of market transactions dropped sharply and market liquidity dried up. These
developments subsequently caused a widening of credit spreads on corporate bonds and a
chain reaction of financial institutions' failures and deteriorating performance in many
countries, with prices of financial products - especially securitized ones - dropping and these
products eventually becoming nonperforming assets of the financial institutions holding them.
As you know, the turmoil in global financial markets and the subsequent global economic
downturn was triggered by the U.S. subprime mortgage problem, which surfaced in the
summer of 2007. This problem, however, was merely a prominent example of corrections to
various financial and economic imbalances that had accumulated.
Looking back, the world economy enjoyed favorable conditions until a couple of years ago,
and unprecedentedly high growth rates of around 5 percent continued from 2004 through
2007. Notwithstanding the high growth, prices were generally stable due mainly to an
expansion of global supply capacity resulting from the entry of emerging economies into the
market economy. Amid the high economic growth and low inflation, interest rates worldwide
remained low for a prolonged period.
In this continued benign environment of high growth, low inflation, and low interest rates with
growing optimism about prospects, financial and economic activity overheated and
imbalances accumulated. This overheating caused a number of things to happen. For
example, the rapid growth of emerging economies significantly increased the demand for
resources such as crude oil, and led to a surge in commodity prices. Investors and financial
institutions eased their credit standards, and a global credit bubble emerged, as seen in the
U.S. subprime mortgage problem. Looking at developments in final demand on a global
basis, not only industrialized economies in North America and Europe but also emerging and
commodity-exporting economies experienced robust private consumption, particularly of
durable consumer goods, and also very strong business fixed investment. These were all
indications of the overheating of financial and economic activity. The current global financial
crisis and the large economic downturn can therefore be viewed as part of the process of
correcting imbalances that had accumulated.
These developments suggest that the current financial crisis and economic downturn were
essentially caused by the cycle of the generation and bursting of a global credit bubble, or
the cycle of the overheating and corrections of financial and economic activity, similar to
cycles that occurred repeatedly in the past. Looking back over the previous two decades, we
can see many boom-and-bust cycles: Japan's asset price bubble in the late 1980s, the Asian
currency crisis in the late 1990s, and the global IT bubble in the early 2000s. But the most
recent cycle has brought a worldwide economic downturn that is much larger than any in
recent history, with distinctive features of "simultaneity" and "rapidity."
I will now describe the background of this simultaneous and rapid downturn of the world
economy in terms of three features: the progress of globalization in financial activity; the
progress of globalization in economic activity; and IT innovations.
Taking the progress of globalization in financial activity first, financial institutions and
investors around the world now carry out a large volume of cross-border financial
transactions and invest in a variety of financial assets. The U.S. subprime mortgage problem
had immediate repercussions also on Western European financial institutions because they
made large investments in securitized products backed by U.S. subprime mortgages.
Financial institutions and investors in the United States and Western Europe had an
important role channeling funds to emerging economies in regions such as Central and
Eastern Europe and in Latin America. Since these financial institutions suddenly scaled back
their exposures to emerging economies, the financial crises of the United States and
Western Europe have spread to the rest of the world.
The second feature of the background is the progress of globalization in economic activity.
Since the 1990s, emerging economies - the NIEs, the BRICs, the ASEAN countries, and the
former centrally planned economies - have become full-fledged members of the market
economy. Although these economies continued to enjoy a level of growth higher than the
industrialized economies until recently, they have now decelerated significantly due to the
outbreak of turmoil in global financial markets and the drop in their exports caused by the
downturn in the U.S. and European economies. Emerging economies increased their
presence in the global marketplace not only as production bases of durable consumer goods
and parts for industrialized economies but also as a huge market for the latter's products.
Consequently, the decrease in the industrialized economies' exports to emerging economies
has aggravated the economic deterioration in the industrialized economies. It is clear that an
interregional adverse feedback loop between trading partners - a process in which both
imports and exports of individual countries decline, resulting in a further economic stagnation
of all countries involved - is now operating around the globe, irrespective of the level of
economic development.
The third feature of the background is IT innovations, which have supported the progress of
globalization in financial and economic activity. The widespread use and popularization of IT
systems has supported globalization through the increased speed of transactions, reductions
in the interregional information gap, and a global network of transactions. The breakthrough
in information processing capacity has enabled the formation of massive financial trading
systems as well as payment and settlement systems, both of which process an enormous
amount of trading information in a second. Ironically, these sophisticated systems perform
equally well in times of contraction in financial transactions and economic activity. In the
current environment, they accelerated the speed of contraction and may have caused a
sudden unwinding of imbalances, leading to the rapid economic downturn.
B. The current state of and outlook for the world economy
With the abrupt contraction of credit and the drop in commercial trade around the globe,
many economies are inevitably facing either recession or a slowdown. U.S. economic
conditions have deteriorated significantly. The housing market has been undergoing
adjustments, and business and consumer spending behavior has become cautious reflecting
tight funding conditions and greater uncertainty about economic prospects. In European
economies, in addition to a decrease in exports, domestic demand has also been declining
partly due to financial institutions' tightening of lending standards. Emerging economies and
commodity-exporting economies, as I described earlier, have been slowing because their
exports have decreased reflecting the U.S. and European economic deterioration and also
because financial conditions have worsened reflecting increased capital outflow. Thus, in
many economies an adverse feedback loop is operating - a process in which production,
income, and expenditure spiral downward with a decrease in, for example, exports as a
starting point. Simultaneously operating worldwide is yet another adverse feedback loop,
between financial and economic activity - a process in which worsening economic conditions
due to financial institutions' tightening of lending standards squeeze the institutions' profits,
and this in turn further tightens their lending standards.
We are often asked whether the current global economic downturn might evolve to become
as serious as the Great Depression of the 1930s. The difference between the Great
Depression and the current economic downturn is relatively clear if one looks at the policy
responses by the relevant authorities worldwide. Unlike the time of the Great Depression,
when the authorities could not take effective measures in response to failures of financial
institutions, the authorities in many countries today have already formed a framework to
protect depositors and are expeditiously injecting public funds into financial institutions in
distress. Other differences are that currently governments and central banks in major
countries are promptly taking fiscal and monetary policy actions and the system of free trade
between nations is being basically maintained. However, the following questions should
continue to be kept in mind: (1) whether the actions that have been taken to date to secure
financial system stability are sufficient when the adverse feedback loop between financial
and economic activity is still operating; (2) what specific means should be employed to
compensate for the weakness in effective demand; (3) whether current financial conditions
are sufficiently accommodative relative to the severity of the deterioration in economic
conditions; and (4) whether protectionism will reemerge, with too much support being given
to domestic industry. I think it is important to continue analyzing the current difficult situation
coolly from a contemporary perspective, neither overstating nor understating developments,
and referring to the lessons learned from the past rather than trying to make imperfect
comparisons with the past.
Looking ahead, since the current financial crisis and economic downturn are a process of
correction of various imbalances that had accumulated over the past several years, the
present severe situation will likely continue for some time. For the world economy to return to
a recovery path, the following conditions need to be fulfilled: (1) the U.S. and European
financial systems will have to regain stability, reducing downward pressures on the world
economy from the financial side; and (2) at the same time, adjustments in asset prices,
production, and excessive capital stock will have to make progress, paving the way for a
recovery in aggregate demand. However, there are lingering concerns about the U.S. and
European financial systems, and the drastic disposal of nonperforming assets has only just
begun. There is no clear sign of improvement in indicators for major economies at this point,
and it will be some time before fiscal and monetary policy actions in these economies fully
take effect. The Bank expects that, from the latter half of fiscal 2009, global financial markets
will regain stability and overseas economies will move out of their deceleration phase.
However, given the current state of the global economy, it is inevitable that uncertainties
about the outlook are great.
II. Economic and financial developments in Japan
A. The current state of and outlook for Japan's economy
Now I will discuss economic and financial developments in Japan.
Japan's economy started to decelerate from the spring of last year, and since the autumn
exports and production have been experiencing one of the sharpest drops ever. In January
this year, exports and industrial production fell by 15.8 percent and 10.2 percent respectively,
on a month-on-month basis, both showing a decline comparable to the sharpest falls in
history. In addition, domestic demand has become weaker against the background of
declining corporate profits and the worsening employment and income situation in the
household sector. Against this background, the Bank's assessment is that Japan's economic
conditions have deteriorated significantly and are likely to continue deteriorating for the time
being. Real GDP contracted in the October-December quarter last year by 12.1 percent on
an annualized quarter-on-quarter basis, the sharpest decline since the period immediately
after the first oil crisis, and this figure supports the Bank's assessment. The rates of real GDP
growth for the United States and the euro area in the same quarter were minus 6.2 percent
and minus 5.7 percent, respectively, and the fact that Japan's economy contracted more
sharply underscores the severity of the country's current economic conditions.
The fact that the downturn is more severe in Japan than in the U.S. and Western European
economies, from which the global economic turbulence stemmed, seems to be due mainly to
the growth mechanism of Japan's economy that has operated for some years.
Japan's economy continued to grow from early 2002 until recently, moderately perhaps, but
uninterruptedly. The background to this long period of growth was provided by - in addition
to Japanese firms' efforts to reduce excessive debt and capital stock - the favorable
environment of a rapidly growing world economy. In this situation, Japan established an
economic growth mechanism that is primarily based on production for export of durable
consumer goods and capital goods, especially automobiles, electrical machinery, and
general machinery. I believe that this may be due partly to the following facts: (1) due to the
declining birthrate and the aging population, rapid growth of domestic demand could not be
expected; and (2) the yen was on a depreciating trend until the middle of 2007. In fact, the
industries manufacturing the three types of products I just mentioned account for about half
of industrial production in Japan, while the share of their counterparts in the United States is
only about 20 percent. About 65 percent of all domestically produced automobiles were
exported in 2008, a great increase from about 55 percent in 2002. With regard to general
machinery, external orders, led by strong demand from member countries of the European
Union (EU) and commodity-exporting and emerging economies, grew steadily from 2002
until 2007, increasing by slightly over 50 percent during the period.
The ongoing global economic downturn has delivered a blow to this growth mechanism of
Japan's economy. A large drop in real GDP in the October-December quarter was also
observed in South Korea, Taiwan, and Germany - all of which have economies with a high
share of manufacturing industries sensitive to changes in exports, such as those producing
durable consumer goods, capital goods, and parts for both. In addition, in the case of Japan,
it seems that the rapid appreciation of the yen from the summer of last year has amplified
downward pressure on exports that already existed due to a drop in final demand overseas.
Furthermore, in Japan the share of domestically produced parts and materials is higher than
in other countries such as the United States, and therefore a decrease in exports tends to
adversely affect even industries that are not export-oriented.
These industries are cutting production sharply to reduce excessive inventories, and
therefore production is likely to continue decreasing for the time being. Business fixed
investment, particularly for expanding production capacity, is also likely to decrease for the
time being, as firms have increasingly regarded their capital stock as excessive. Labor
market conditions are slackening, and developments warrant careful monitoring as
adjustments in the labor market, in terms of both wages and the number of employees, might
spread from manufacturers to nonmanufacturing firms.
Japanese households, whose savings ratio is high, own large amounts of financial assets,
but they are not under pressure to make large-scale balance sheet adjustments, unlike their
U.S. counterparts, which are suffering from falling land and home prices. However, the
worsening employment and income situation has been gradually taking its toll, and this may
exert additional downward pressure on private consumption. Furthermore, attention should
be paid to the possibility that recent unstable stock prices and the deteriorating employment
situation may weaken consumer confidence further.
Prices are on a downward trend. In the summer of last year, CPI inflation, in terms of the
year-on-year rate of change, rose to 2.4 percent, its highest level since the first half of the
1990s. Thereafter, however, it moderated reflecting declines in the prices of petroleum
products, falling to 0 percent in January this year. It is projected to become negative soon
with the increasing slackness evident in supply and demand conditions due to the severe
economic situation.
As for the outlook for the economy, the Bank's baseline scenario projects that it will start
recovering from the latter half of fiscal 2009, with price declines abating as global financial
markets regain stability and overseas economies move out of their deceleration phase.
However, a high level of uncertainty surrounds this scenario, involving some risks.
Japan's production is likely to continue decreasing for the time being, but it is also likely that
the pace of the decrease will slow gradually as inventory adjustment pressures diminish. In
this situation, whether final demand will start to recover rapidly when the adjustment is
completed is the key to the recovery of Japan's production and the economy as a whole. As I
just mentioned, it is highly uncertain when and how the world economy will begin recovering,
and therefore it is also unclear to what extent recovery in exports will bring economic
recovery in Japan. If recovery in final demand - including exports - is long delayed, or if the
degree of the recovery is small, this may cause a decline in firms' medium to long-term
growth expectations and a consequent increase in adjustment pressures on capital stock and
employment, eventually depressing domestic private demand further. With regard to prices, if
downside risks to the economy materialize and the rate of change in prices continues to be
negative for a long period of time, firms' and households' medium- to long-term inflation
expectations may decline. The Bank will continue to carefully examine developments as well
as various downside risks.
B. The financial environment in Japan
Next, I would like to talk about the current financial environment.
Financial conditions in Japan have remained tight since the failure of Lehman Brothers. I
would like to focus on recent developments in corporate financing, which is most relevant to
today's audience.
The first issue is the levels of interest rates applied to borrowing by firms. They are declining
due mainly to the effects of the reductions in the policy interest rate since the autumn of last
year and improvements in the CP market. CP issuance rates, which surged through the end
of last year, have declined since the turn of the year, and banks' lending rates have also
declined slightly, partly reflecting reductions in short-term prime lending rates. On the other
hand, credit spreads are increasing or remain elevated, counteracting the effects of the
policy interest rate reductions.
The second issue is the amount of borrowing by firms. Firms are inclined to compensate for
a decline in cash flows by borrowing and also to increase cash in hand in view of the
uncertainty of the future. In this situation, there have been some improvements in the issuing
environment for CP and bonds, but issuance of these instruments as a whole has been
below the previous year's level. By contrast, bank lending, especially to large firms, has
continued to increase rapidly.
On the lender banks' side, however, they are becoming increasingly conscious of their capital
constraints against the background of expanded securities-related losses and higher credit
cost caused by a deterioration in the business performance of borrower firms. In this
situation, an increasing number of firms have reported that their financial positions are weak
and lending attitudes of financial institutions are severe. Various research results show that
small firms, lending to which has remained below the previous year's level, see their financial
positions as having deteriorated and financial institutions' lending attitudes as having
tightened as much as in 1998 and 2002, and the Bank needs to pay due attention to
developments.
The financial condition of Japanese financial institutions has been relatively stable even after
the emergence of the U.S. subprime mortgage problem, because they have generally made
progress in the disposal of nonperforming assets since the bursting of the economic bubble
and also because their investments in overseas securitized products have been limited. In
fact, unlike in the United States and Europe, failures of financial institutions and their rescues
by injection of public funds have not occurred in Japan. Notwithstanding this, given that the
economic downturn is likely to continue for the time being, attention needs to be paid to the
possibility that the financial health of Japanese financial institutions may worsen and their
risk-taking ability may decline gradually, in turn reducing their lending capacity. The Bank will
continue to carefully examine whether the financial intermediation function of Japanese
financial institutions and the financial system in Japan will be maintained so that the adverse
feedback loop between financial and economic activity will not intensify.
III. Policy responses
Having explained economic and financial developments at home and abroad, I would now
like to move on to recent policy responses in major countries to those developments.
Major countries have been taking policy measures to cope with problems in their financial
systems. Increased strains in global financial markets and heightened concerns about their
financial systems have prompted them to take various measures since the autumn of last
year. The U.S. and European authorities, the governments in particular, have taken a wide
range of measures: injection of public funds into financial institutions in distress; expansion of
deposit insurance coverage; and purchases of nonperforming assets from financial
institutions. The increased capital constraints that I mentioned earlier have made
strengthening financial institutions' capital bases all the more important also in Japan, even
though its financial system remains stable compared with those of the United States and
Europe. Against this background, the revised Act on Special Measures for Strengthening
Financial Functions was passed by the Diet in December to improve the framework for
utilizing public funds.
Many of the measures being taken in the United States and Europe at present are very
similar to those adopted in Japan to fight the financial crisis in and after the second half of
the 1990s. In that sense, I believe that Japan's experience has been reflected in the
measures being taken in foreign countries today. Lessons learned from Japan's experience
include the fact that, when an adverse feedback loop is at work between financial and
economic activity, policy responses to ensure the stability of the financial system might not
by themselves resolve the problem completely. The key is to launch a comprehensive policy
package to prevent intensification of the loop. In such a policy package, measures in different
areas will need to be implemented simultaneously: not only measures to strengthen financial
institutions' capital bases, but also measures to resolve excesses in the corporate sector as
well as support its revitalization, and others to underpin overall economic activity. In this
regard, the Bank will continue to find opportunities to explain to other countries the lessons
Japan has learned.
Major countries have been taking decisive measures as well in fiscal policy. In the United
States, the new Obama Administration has launched large-scale fiscal stimulus packages
equivalent to about 75 trillion yen. The Chinese government has announced measures
equivalent to about 60 trillion yen to boost the economy. The Japanese government also
intends to implement 12 trillion yen in fiscal measures and 63 trillion yen in financial
measures. In the conduct of fiscal policy, generally speaking, it is important to examine ways
not only to create demand in the short run but also, for example, to improve the
infrastructure, which will enhance productivity, eventually increasing the growth potential of
the economy in the long run. Moreover, as indicated in the statements of the latest G-7 and
G-20 meetings of finance ministers and central bank governors, it is also important that the
measures be consistent with medium- to long-term fiscal sustainability.
As for monetary policy, major central banks have been taking appropriate measures in a
timely manner, varying in accordance with the economic and financial situation in each
country. The Bank has been conducting monetary policy in three main areas: reductions in
interest rates; provision of ample liquidity to stabilize financial markets; and facilitation of
corporate financing by influencing individual financial markets. Taking each area in turn, I
would now like to explain the measures the Bank has implemented since the autumn of last
year.
With regard to reductions in interest rates, the first area, the Bank reduced the target for the
uncollateralized overnight call rate - its policy interest rate - to 0.1 percent, from 0.5 percent.
It also worked on the interest rates on term instruments by devising methods for liquidity
provision, and as a result they have been slightly lower than at the beginning of this year,
even though demand for funds tends to increase as the fiscal year-end approaches.
The second area is ensuring stability in financial markets by providing ample liquidity. The
Bank has been conducting U.S. dollar funds-supplying operations in a coordinated action
with other central banks, and has also been providing ample funds in yen by, for example,
purchasing Japanese government bonds (JGBs) outright. Following December's decision to
increase outright purchases of JGBs from 14.4 trillion yen per year to 16.8 trillion yen, the
Bank decided, at the Monetary Policy Meeting held last week, to increase the amount further
by 4.8 trillion yen to 21.6 trillion yen per year. Last week's decision was made because, given
the likelihood that the markets will remain under stress in the new fiscal year, the Bank
judged that continued provision of substantial liquidity is required to ensure stability in
financial markets. With this decision, the Bank would make greater use of its long-term
funds-supplying operations, thereby facilitating smooth money market operations.
Regarding the third area, measures for facilitating corporate financing, the Bank has been
conducting since January 2009 new operations called "special funds-supplying operations to
facilitate corporate financing." These enable financial institutions to obtain funds with a
maturity of up to three months with no explicit ceiling on the total quantity of funds available,
although the maximum amount borrowed by an individual financial institution may not exceed
the value of the corporate debt it has pledged as collateral. The interest rate on these funds
was set at 0.1 percent, lower than the market rates for funds with corresponding maturities.
In addition, the Bank expanded the operations in February by, for example, increasing the
frequency of the operations to once a week from twice a month and standardizing the
duration of each loan to three months instead of one to three months; these changes were
aimed at encouraging a decline in longer-term interest rates, which are the rates actually
applied to firms' borrowing, and relieving firms' funding concerns.
Furthermore, in January the Bank decided to conduct outright purchases of CP totaling 3
trillion yen from financial institutions. Last month, it also decided to purchase outright 1 trillion
yen of corporate bonds with a residual maturity of up to one year. The Bank took these
measures based on its recognition that a decline in the functioning of CP and corporate bond
markets was causing a tightening of overall corporate financing conditions. These measures
are expected to encourage financial institutions to sell CP and corporate bonds they hold and
thus expand their lending capacity.
The Bank's outright purchases of corporate debt, however, involve a relatively higher
probability of imposing costs on taxpayers by incurring losses, and deepen the involvement
of the Bank in microeconomic resource allocation among individual firms. In addition, they
involve higher risks, compared to other policy measures, of damaging the financial health of
the Bank by causing it to incur losses and ultimately undermining confidence in the currency
and monetary policy. Since they are an exceptional measure for a central bank, the Bank has
been purchasing CP and corporate bonds outright based on certain necessary conditions for
the implementation of such purchases.
The U.S. Federal Reserve and the Bank of England (BOE) have also been purchasing
corporate financing instruments, as is being done by the Bank of Japan, although the size
and range of corporate financing instruments purchased vary according to the differences in
the degree of the decline of market functioning and in the structure of financial
intermediation. Furthermore, the Fed and the BOE both announced the introduction of
largescale outright purchases of government bonds from this month, although there are
differences in the policy objective and the thinking behind the introduction. I would not be
exaggerating greatly if I said that, to address the present economic downturn, major central
banks have been going beyond the boundaries of conventional monetary policy and stepping
into a new sphere of policy conduct.
In addition to these measures in the three main areas, the Bank has been taking decisive
measures to ensure the stability of the Japanese financial system, in view of its recognition
that persisting strains in global financial markets and the deterioration in economic conditions
at home and abroad have been adversely affecting financial institutions' business
performance and financial intermediation function. Specifically, last month the Bank resumed
its purchases of stocks held by banks. Based on the recognition that reducing market risk
associated with stockholdings remains an extremely important issue for financial institutions'
management, the Bank aims to support their future endeavors to reduce such risk. Moreover,
last week it decided to explore a new framework to provide banks with subordinated loans,
which constitute part of their capital bases. The aim of this measure is to provide banks with
a way to maintain adequate capital bases - a