# _C. Policy Measures To Date and Mounting Negative Economic Effects of Nonperforming Loans_

To deal with the economic stagnation and mounting financial sector problems, Japan's authorities initially tried to stimulate the effective demand by traditional fiscal and monetary policy measures to lighten the burden of bad debt - a balance sheet adjustment through economic expansion. Monetary policy initiatives to guide the interest rates lower during this period, although introduced only after substantial delays, can be characterized by an outward shift in the credit supply curve in the domestic credit market, as portrayed in Figure 13 by the shift in supply curve from S to **S2.** The performance of Japan's economy from 1992 to 1994, however, was so disappointing that the initial set of policies had no visible effect on the deepening problems.<sup>13</sup> The authorities, then, sought to accelerate the process of financial institutions writing off nonperforming loans by widening the interest spread - thereby creating a profit margin for lending operations - and by assets operations by the official funds in support of equity prices. **14** A wider spread helped the banking sector to write off bad debts out of increased operating profits. From a macro point of view, however, the credit crunch continued. Figure 13 describes the mechanism of the ongoing credit crunch. The deposit interest rate, which represents the cost of funding for the banking sector, is assumed to move in parallel with the lending rate. In a recessionary environment with a decline in confidence among the corporate sector, the demand for loans is weakened at any given interest rate, thereby causing an inward shift of the credit demand curve, such as a shift from D to DI Thus the equilibrium moves from point A to point B, with a lower level of credit extension and lending rates. In order for the financial institutions to accelerate write-offs of their nonperforning loans in the midst of a recession, the interest spread in their lending operations can be increased. As a result, the supply function shifts inward from S to Si, taking the credit market further down to a reduced equilibrium (a move from point B to point C). This inward shift of the credit supply curve is a phenomenon of a narrowly defined credit crunch.

Even if the increased spread persists and banks continue to pay off bad loans at the rate prevailing in mid 1995, financial institutions may not be able to wipe out a majority of bad debts before the turn of the century. The recent downgrading of Japanese financial institutions will inevitably raise their funding cQsts, and thus narrow spreads. The growth in loans and discounts extended by the banking sector have been stagnant throughout 1995. This translates into a year-onyear growth of less than I percent, thus dragging the growth of money stock, which has been increasing at the sluggish rate of not more than 3 percent a year (see Figure 6). Thus, the financial sector has hardly been playing its core role of financial intermediation for credit creation in the past couple of years.'<sup>5</sup> This, in turn, has been hampering a (strong) resumption of consumption and

**13** The compound causes of the slow recovery after the bubble burst were analyzed in the preceding sections. For more details, see _Economic Survey of Japan 1995._

- 14 Effects of assets operations by the official funds in support of equity prices on the macroeconomy will be discussed in Section VI.

- **15** Growth in the stock of high-powered money was offset by a decline in the money multiplier.

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