Masaaki Shirakawa: Recent economic and financial developments and
the conduct of monetary policy
Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, to commemorate the
100th anniversary of the Kanazawa Branch, Kanazawa, 25 May 2009.
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Introduction
I am honored to have the opportunity to speak before business leaders in the Hokuriku area
today. I would like to express my deep gratitude for your close cooperation with the
Kanazawa Branch of the Bank of Japan.
In response to strong requests from three prefectures in the Hokuriku area, the Kanazawa
Branch was established in 1909 as the Bank's first branch in the districts of Honshu Island
along the Japan Sea. Since then, the Kanazawa Branch has been operating in tandem with
the development of the Hokuriku economy, and this year the branch celebrates its 100th
anniversary. The Bank has 32 branches, including the Kanazawa Branch, and 12 local
offices in Japan. Each of them conducts a variety of central banking operations, such as
smooth provision of banknotes and coins, settlement of funds, treasury funds services, and
research and analysis of financial institutions' business conditions and of economic and
financial developments in the region. Although these operations sound unspectacular, they
constitute a part of the important infrastructure that supports financial and economic activity
in each region. In fiscal 2008, the sum of receipts and payments of banknotes at the
Kanazawa Branch was around 2 trillion yen - 200 million notes of 10,000 yen bill. During the
last 100 years, the Kanazawa Branch has strived to maintain an uninterrupted supply of
banknotes in spite of occasional difficulties such as heavy snow and major earthquakes. We
have renewed our determination to continue to fulfill our role of providing firm support for
financial and economic activity in each region. I would like to express my gratitude again for
your support and would like to ask for your continued cooperation with the Kanazawa
Branch.
Before we exchange views, I would like to speak about the current situation of and outlook
for the Japanese and overseas economies and also about the Bank's thinking regarding its
conduct of monetary policy. I will mainly talk about economic and financial developments in
Japan and abroad from a macroeconomic viewpoint, but we do fully understand that the
situation varies significantly for different regions and industries, and also for different sizes of
firm. In fact, the Bank gathers microeconomic information about industries and firms in each
region from each branch, based on which the Bank assesses economic and price
developments from a macroeconomic viewpoint and conducts monetary policy.
I. Developments in the world economy
I will start with the current situation of the world economy. The pace of deterioration in
economic conditions around the world gradually accelerated from the beginning of 2008 and
they have deteriorated simultaneously and sharply especially since the failure of Lehman
Brothers in September. The sharp downturn in the world economy was overwhelming,
considerably exceeding the projections made by international institutions, governments and
central banks around the world, and private research firms. For example, the International
Monetary Fund (IMF) projection of world growth for 2009 was 3.9 percent in July 2008, a
rather high figure in retrospect. However, it was significantly revised downward to 0.5 percent
in January 2009, and further revised downward to minus 1.3 percent in April - a significant
downward revision of more than 5 percentage points in ten months.
Although many reasons are provided for the downturn in the world economy since last year, I
think that the following three factors are of great importance.
First is the global accumulation of excesses and their subsequent adjustments. During the
mid-2000s, financial and economic activity overheated against the background of the
continued benign environment of high growth, low inflation, and low interest rates, leading to
an accumulation of various excesses. For example, in the area of financial activity, risk
evaluation by investors and financial institutions became lax, leading to a global credit bubble
symbolized by the subprime mortgage problem. In a credit bubble, an increase in credit and
leverage, and overheating in economic activity are two sides of a same coin. Examples are a
substantial increase in housing investment in the United States and Europe and an
expansion in demand for durable goods, such as automobiles, around the world including
emerging and commodity-exporting economies. On the corporate side, production capacity
was augmented by an expansion in business fixed investment to match a substantial
increase in demand or by an assumption held by more than a few firms that a strong
increase in demand will continue. However, looking back, such high growth supported by the
credit bubble could not continue for long. When financial institutions, firms, and households
start the process of adjusting excesses in economic activity, spending activity such as private
consumption, housing investment, and business fixed investment will be reduced
substantially. Thus, the most basic reason for the current global economic downturn
exceeding many forecasts can be attributed to an unprecedented size of and the global
spreading of the accumulated excesses both in financial and economic activity.
Second is an extreme decline in the functioning of financial systems worldwide since the
emergence of the financial crisis triggered by the failure of Lehman Brothers last September.
Due to the failure of Lehman Brothers, provider of funds, such as financial institutions and
institutional investors, became extremely cautious to take counterparties' credit risks. This led
to a sharp decline in the volume of transactions, not only in the interbank market where
financial institutions exchange funds, but also in markets for housing loans and other
securitized products, and in the CP and corporate bond markets where firms raise funds,
leading to a situation of a de facto dysfunction of financial markets. In addition, banks, faced
with withdrawal of deposits and concerns over their financial positions in addition to the
impairment of their capital bases, suddenly tightened their lending attitudes. If the functioning
of the financial system declines substantially, in terms of its function to intermediate funds in
the financial markets and of extending credit by financial institutions, it is inevitable that
economic activity will be adversely affected. Furthermore, the deterioration in economic
activity further worsened the business conditions of financial institutions by turning housing
and corporate loans into impaired assets, and this in turn further aggravated economic
activity - an emergence of a negative chain reaction. This is the mechanism of the so-called
adverse feedback loop between financial and economic activity, which has been used to
describe the deterioration in global economic conditions from last autumn.
Moreover, a chain reaction of the financial crisis spread across the border to various
countries and regions. The spreading of the U.S. and Western European financial crises to
emerging and commodity-exporting economies, such as Central and Eastern Europe and
Latin America, was a background factor which further increased the severity of the global
economic downturn. Financial institutions in emerging and commodity-exporting economies
had not invested much in securitized products backed by subprime mortgages, which
became the direct cause of the current financial crisis, and, in this sense, the amount of
losses they incurred was limited. Therefore, at the beginning of the financial crisis, there
were views that the effects of the crisis on emerging and commodity-exporting economies
would be limited. However, U.S. and Western European financial institutions and investors
had been also assuming an important role in intermediating funds to these economies.
Therefore, the rapid decrease in loans extended to emerging and commodity-exporting
economies by U.S. and Western European financial institutions led to a significant credit
contraction and a sharp deterioration in economic conditions also in these economies. Thus,
the financial crisis that started in the United States and Europe spread to financial markets
around the globe including those in emerging and commodity-exporting economies, and
expanded the adverse feedback loop between financial and economic activity globally.
Third is substantial adjustments in production and inventories on a global scale. From last
autumn, firms were suddenly faced with a large build-up of inventories due to a sharp decline
in global demand. Under these circumstances, the only way to reduce inventories was to
substantially reduce production. Such reduction was most prominent in the area of durable
consumer goods and capital goods.
I have talked about three major factors that led to the current global economic downturn. But
the direct causes of the rapid downturn since last autumn were the second and third factors,
namely, the impact of the global credit contraction triggered by the failure of Lehman
Brothers and large adjustments in production and inventories. Most recently, with the effects
of these factors abating gradually, some signs of a slowdown in the pace of deterioration of
the world economy or a leveling out are being observed.
With regard to financial conditions, money markets are beginning to regain stability on the
whole due in part to the various measures taken by central banks such as provision of
abundant liquidity. Confidence in the soundness of financial systems seems to be turning
toward improvement after the announcement by the U.S. authorities of measures to stabilize
the U.S. financial system. To restore stability in countries' financial systems, disposing of
financial institutions' impaired assets and enhancement of their capital bases are necessary.
In the United States, examination of the adequacy of financial institutions' capital bases was
conducted by using the so-called stress test to test whether the current level of capital bases
was sufficient to withstand an increase in losses in the case of a deep recession. Based on
the results of the stress test, U.S. financial institutions are currently working on strengthening
their capital bases. Developments in the stock market since the release of the stress test
results seem to indicate that these measures to stabilize the financial system are generally
welcomed.
In addition, data and anecdotal evidence show that there has been appreciable progress in
the area of global-scale adjustments in production and inventories. For example, it is
confirmed that inventory adjustments of automobiles and electronic parts have made
progress in China and in emerging economies, such as South Korea, as well as in the United
States and Europe. It is expected that this will have positive effects on production, and in fact
some evidence of these effects is already observed in Japan and China.
Will the world economy level out and start to recover? If so, how sustainable will the recovery
be? Based on the factors that have contributed to the downturn of the world economy, which
I mentioned earlier, the keys in projecting the future path are how adjustments of
accumulated excesses proceed and when the adverse feedback loop between financial and
economic activity stops operating. Adjustments are currently being made gradually in the
housing market in the United States and Europe, and the saving rate of households in the
United States has recently started rising, indicating that there is progress toward reducing
excesses in consumption and debt. Needless to say, the amount of excesses cannot be
grasped accurately in advance. However, given that high economic growth continued in
many years prior to the current crisis, the possibility that adjustments of excesses will take
considerable time cannot be ruled out. In addition, reduction of excesses in economic activity
and resolving impaired assets in financial institutions are two sides of a same coin. Although
there has also been some progress made in the latter, as I mentioned earlier, it seems that
more time and efforts are necessary to see progress in the restructuring of the financial
system to the extent that one can conclude that the risk of adverse feedback loop between
financial and economic activity has receded. Of course, there is an economic cycle,
experiencing both an economic recovery and a downturn, even in the middle of the process
of adjusting excesses. In fact, economic recoveries were observed in the 1990s in Japan.
Nevertheless, only mild economic recoveries were realized until the adjustments of excesses
were completed. In order for the economy to start a full-fledged and autonomous recovery,
completion of adjustments of excesses and a firm footing toward the restructuring of the
financial system is a prerequisite.
Based on the factors that I have explained so far, the world economy is expected to start
recovering due to the effects of macroeconomic policies and financial system measures
adopted by governments and central banks around the world and to the progress in
adjustments of excesses in the private sector. However, the pace of recovery will likely be
only moderate, and we also need to fully bear in mind the fact that there are high
uncertainties regarding the scenario of the recovery itself.
II. The current state of and outlook for Japan's economy
Having explained the current situation of and outlook for the world economy, I will now move
on to developments in Japan's economy.
The slowing of Japan's economic activity accelerated from around spring last year. And after
the failure of Lehman Brothers last autumn, exports - particularly of automobiles, electrical
machinery, and general machinery such as engineering and construction machinery -
decreased sharply, and, as a result, production registered an unprecedented decline. The
reason for Japan's economic downturn being sharp relative to other industrialized countries
is that the manufacturing industries, especially high-tech ones, constitute a large part of
economy activity in Japan and they tend to be influenced most by developments in the world
economy. Recently, however, some brighter signs are beginning to appear in exports and
production, reflecting the signs of recovery in the world economy, despite the continued
deterioration in domestic economic conditions. Specifically, the pace of decline in exports
slowed and has recently leveled out against the background of recovery in demand from
China and progress in adjustments of overseas inventories such as automobiles and
electronic goods. Production also showed a monthly increase in March, due partly to the
progress in adjustments of inventories at home and abroad including automobiles and
ITrelated goods, after recording monthly declines of around 10 percent in January and
February. In addition, information provided at interviews with the management of firms
indicates that production will likely continue to increase going forward. We therefore judge
that exports and production are beginning to level out. On the other hand, domestic private
demand, such as consumption and business fixed investment, is likely to continue to
weaken, given that the situation in household income and firms' profits, which hold the key in
determining the future outlook for domestic private demand, is being adversely affected with
a lag by a significant decline in production and will remain severe for the time being.
Based on the above assessment, the pace of deterioration in economic conditions is likely to
moderate gradually, leading to a leveling out of the economy taken as a whole, given that
exports and production are expected to level out and start recovering and the effects of the
fiscal stimulus are likely to appear. Further ahead, from the latter half of fiscal 2009 onward,
assuming that the world economy will show a mild recovery, as I mentioned earlier, the most
likely outlook projects that Japan's economy will start recovering, supported partly by the
positive effects of measures to stabilize the financial system and of fiscal and monetary
policy measures.
Meanwhile, on the price front, the year-on-year rate of increase in the consumer price index
(CPI) for all items excluding fresh food rose to 2.4 percent last summer due mainly to the rise
in crude oil prices, but declined thereafter to around 0 percent reflecting the decline in prices
of petroleum products and the stabilization of food prices. Looking ahead, the year-on-year
rate of decline in the CPI (excluding fresh food) will likely accelerate through the middle of
this fiscal year reflecting the deterioration in demand conditions in addition to the fact that the
level of CPI at this time last year was elevated due mainly to the rise in prices of petroleum
products and food. Thereafter, however, assuming that medium- to long-term inflation
expectations remain stable, the rate of decline in the CPI (excluding fresh food) is likely to
moderate as the effects of the changes in the prices of petroleum products abate.
The above projections regarding future economic activity and prices continue to be attended
by considerable uncertainties. Those that demand attention are the downside risks. The
Bank will continue to carefully monitor developments in economic activity and prices bearing
in mind these downside risks.
III. Financial conditions
Developments in the world economy and in global financial markets are the major downside
risks to Japan's economy, but I have already elaborated on them and I will now turn to
Japan's financial conditions.
From last autumn, the effects of the financial crises in the United States and Europe spread
to financial markets in Japan. In the money market, tensions increased as can be observed
in wider spreads between interbank funding rates and short-term government security rates.
The issuing conditions for CP and corporate bonds sharply deteriorated.
The initial cause of the recent tightening in financial conditions was the global credit
contraction. Therefore, the recent changes in financial conditions are characterized by the
sharper deterioration in financial positions of large firms than in those of small firms. The
heightened pressures in the global financial and capital markets directly affected the financial
positions of large firms through increased difficulty in raising funds from foreign banks and
from the domestic CP and corporate bond markets. Large firms increased the volume of
borrowing from banks and tried to hold ample liquidity at hand due to increased concerns
over future financial conditions. The deterioration in financial positions of large firms
negatively influenced the financial positions of small firms through various channels.
In view of these assessments, the Bank took aggressive policy actions in order to provide
abundant liquidity in the money market and to facilitate corporate financing. These actions
include the outright purchases of CP and corporate bonds. Although CP and corporate bonds
are fund-raising tools used mainly by large firms, the revival of the functioning of these
markets is expected to gradually affect the financial positions of small firms through
improvements in banks' lending capability and in conditions for the provision of trade credit
by large firms. In fact, as a result of the provision of ample liquidity by the Bank, the money
market has gradually regained stability and the term interest rates, which are used as the
reference rate when firms actually raise funds, declined. With further assistance from the
Bank such as the outright purchases of CP, the issuing conditions for CP have been
improving. As a result of the failure of Lehman Brothers last autumn, market perceptions of
firms became increasingly severe, and firms were unable to issue CP unless it was offered
with large new issue spreads added on to the short-term government security rates.
However, the issuing conditions for CP started improving since around the end of last year
when the authorities, including the Bank of Japan, took several actions, and recently, the
new issue spreads for CP with high credit ratings have come down to the level prior to the
failure of Lehman Brothers. In the case of CP with lower credit ratings, the new issue
spreads have also been declining steadily. In addition, most recently, the new issue spreads
of corporate bonds have declined somewhat. Looking at the track record of corporate bonds
issued, while only some of the highest rated bonds could be issued during the period from
last autumn through the end of last fiscal year, bonds with lower ratings have been issued
recently, indicating a substantial improvement in the issuing conditions.
Since the issuing conditions for CP and corporate bonds have improved steadily and firms'
demand to hold ample liquidity has declined, the severity in the financial positions of large
firms has subsided. In addition, policy actions such as the emergency guarantee scheme
have played a role in supporting the financial positions of small firms.
Thus, the tension in the environment surrounding corporate financing has eased relative to
some time ago. However, we judge that conditions continue to be severe on the whole given
that a large number of firms are reporting that their financial positions are weak and lending
attitudes of financial institutions are severe against the backdrop of deterioration in corporate
profits. Going forward, given the continued severe conditions surrounding corporate profits,
there is a risk that, depending on future economic conditions, financial institutions and market
participants may become stricter with regard to taking on corporate credit risks. Furthermore,
we think it necessary to keep in mind the possibility of banks becoming strongly conscious of
capital constraints and tightening their lending attitudes if stock prices should decline
substantially. Therefore, it is necessary to continue to carefully monitor developments in
corporate financing.
IV. Conduct of monetary policy
I have so far explained financial and economic conditions here and abroad. Confronted with
the drastic changes in economic and financial conditions, countries around the world have
taken policy actions aggressively since last autumn. Central banks have also taken a variety
of policy measures. Reflecting the nature of the current economic crisis, where the world
economy faced a simultaneous and sharp downturn, policy responses of central banks
including the Bank of Japan have become quite similar. These can be broadly categorized in
three main areas.
First is the reduction in the policy interest rate. As you know, the Bank of Japan has reduced
its policy interest rate down to 0.1 percent, and central banks in other major countries have
also substantially reduced their policy interest rates. As a result, interest rates charged for
overnight funds in the interbank market now stand at 0.1 percent in Japan, 0.2 percent in the
United States, 0.25 percent in Canada, and around 0.5 percent in the euro area and the
United Kingdom. However, while major overseas countries have also reduced the level of
interest rates down to nearly zero, they are, at the same time, aware of the side effects that
extremely low interest rates may have on the functioning of money markets and the business
conditions of financial institutions. They, therefore, have not adopted the zero interest rate
policy which the Bank had adopted in the past where the policy interest rate was brought
down literally to within a hairbreadth of 0 percent.
Second is ensuring financial market stability through the provision of abundant liquidity.
Central banks have been providing abundant liquidity in their currency, while adopting
measures such as lengthening the terms of funds provided. Furthermore, in the current
financial crisis, central banks in major countries are providing dollar liquidity in coordination
with the Federal Reserve, and this measure seems to be making substantial contributions in
stabilizing financial markets.
Third is restoring the proper functioning of financial intermediation. In this regard, despite
their common aims, they differ in terms of where the priority is attached reflecting the
differences in the structure of financial intermediation in each country. At the end of 2007, the
ratio of bank lending relative to nominal GDP, which can be used as a guide to capture the
differences in the structure of financial intermediation, was 63 percent in the United States,
145 percent in the euro area, and 136 percent in Japan. On the other hand, the ratio of
outstanding bonds issued by the private sector relative to nominal GDP was 168 percent in
the United States, 81 percent in the euro area, and 94 percent in Japan. As these figures
show, the role of financial intermediation in the United States is carried out mainly by the
capital markets, whereas in the euro area it is bank lending. Japan comes in between the
United States and the euro area, but the share of bank lending is relatively high. Reflecting
these differences in the structure of financial intermediation, the Federal Reserve has been
conducting large-scale purchases of assets such as CP and real estate mortgage-backed
securities (RMBS) directly in the markets to restore the functioning of capital markets. The
Federal Reserve calls it a "credit easing policy." On the other hand, the European Central
Bank (ECB) has introduced measures to restore the financial intermediation function of
banks. Specifically, the ECB has expanded the range of eligible collateral that banks can
submit in order to acquire funds from the central bank, and has been providing banks with
unlimited amount of longer funds up to the value of eligible collateral at a fixed interest rate.
Meanwhile, the Bank of Japan has been taking actions to both restore the functioning of the
markets and strengthen the financial intermediation function of banks. In the area of restoring
the functioning of capital markets, the Bank has been conducting outright purchases of CP
and corporate bonds through banks, although the scale of purchases is small relative to the
United States where the degree of impairment of market functioning has been substantial. In
addition, in the area of strengthening the financial intermediation function of banks, the Bank,
similar to the ECB, has been expanding the range of eligible collateral, and has also been
providing long-term funds at low interest rates against corporate debt submitted as collateral.
Through these measures, the Bank is aiming to facilitate smooth extension of bank credit.
In addition to the measures in three main areas, the Bank has prepared facilities such as
purchases of stocks held by banks and provision of subordinate loans to banks. These
facilities are designed to serve as safety valves for the proper functioning of financial
intermediation by alleviating concerns over raising capital even in stress conditions where
individual banks become strongly conscious of capital constraints due to concerns over a fall
in stock prices. The purchases of CP and corporate bonds also have the function as safety
valves when corporate financing becomes tight. As I mentioned earlier, there are various
risks facing corporate financing, and a risk of another decline in the functioning of the CP and
bond markets cannot be ruled out. In the event, financial institutions that hold CP and
corporate bonds can submit them to the Bank for funding. Thus the purchases are designed
to serve as a safety net to restore the market functioning if the CP and corporate bond
markets should become unstable.
These are the policy measures that the Bank has taken and the thinking behind their
introduction. The Bank, paying attention for the time being to the downside risks to economic
activity and prices, will continue to exert its utmost efforts as the central bank, utilizing these
tools, to facilitate the return of Japan's economy to a sustainable growth path with price
stability.
Closing remarks
I have discussed the current financial and economic conditions in Japan and abroad as well
as the outlook, and our thinking regarding the conduct of monetary policy. If I may
summarize what I have explained earlier, the sharp deterioration in economic and financial
conditions in Japan and abroad since last autumn is starting to level out and there is a
prospect of a mild recovery ahead. However, considering the fact that the current economic
downturn has occurred during the process of the adjustment of various excesses that had
accumulated worldwide over the past several years, it is very likely that the severe economic
conditions will continue for some time, and the recovery thereafter will inevitably be mild and
attended by high uncertainty. Under these circumstances, policymakers around the globe,
including the Bank, have been taking a variety of actions. These actions are playing an
important role in temporarily mitigating the negative effects of economic and financial shocks
and preventing the economy from sinking even further. The future path of the economy after
recovering from the shocks will reflect the true strength inherent in the economy, that is, the
potential growth rate. The major factor determining the potential growth rate is growth in
productivity. Japan's economy cannot be expected to prosper without improving its
productivity through innovation. Fiscal and monetary policies are important, but they merely
assume a supporting role in facilitating adjustments of excesses and proactive efforts by the
private sector.
Needless to say, making the most of the market mechanism is a prerequisite in order to
realize innovation. Nevertheless, distrust in the market mechanism seems to be increasing,
due to the emergence of the global financial crisis and to the fact that excess financial activity
was one of the major factors behind the crisis. In the area of financial activity, appropriate
regulation and supervision are prerequisites for the financial markets and financial institutions
to properly fulfill their role of financial intermediation. I will not go into details on this point
because I have already expressed my opinion in my speech the other day.1 Active
discussions to redesign the frameworks for regulation and supervision have been held
worldwide, and the Bank has been taking part in many of such discussions. Through the
experience of the current financial crisis, I am deeply recognizing the importance of the
designing of the financial architecture that enables the market mechanism to function
appropriately as well as the significance of the implementation of economic policies based on
the market mechanism.
No one can predict exactly how the world economy will evolve after the current turmoil has
ceased. Needless to say, however, Japanese firms need to continue to strive to find new
frontiers, adapting to the changes in the global economy while making the most of their
advantages.
Only through these efforts can a full-fledged recovery in Japan's economy be attained. The
Bank would like to strongly support these efforts from the financial side to facilitate the
autonomous recovery of Japan's economy.
Thank you very much for your attention.