ICAS Spring Symposium

No. 2002-0508-YxM

Japan's Economy: Issues and Prospects

Yasuhiro Maehara

Spring 2002 ICAS Symposium

May 8, 2002 12:30 - 5:45 PM
U.S. Senate Hart Office Building Room 216
Capitol Hill, Washington D. C. 20510

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Biographic Sketch & Links: Yasuhiro Maehara

Japan's Economy: Issues and Prospects

Yasuhiro Maehara
General Manager
Bank of Japan Chief Representative Office in the Americas

Today I would like to talk about the recent development of Japan's economy and some of the important issues it faces. Before I move on, allow me to intone a litany. The views expressed here are my own and do not necessarily represent those of the Bank of Japan.

Let me start with the assessment of the recent economic development based on the Bank of Japan's semi-annual report called "Outlook and Risk Assessment of the Economy and Prices" released on April 30, which I call "the Outlook Report" for short.

The Bank of Japan began publishing the Outlook Report in 2000, which is released twice a year in April and October. This is intended to promote public understanding of the conduct of monetary policy by enhancing the transparency through a comprehensive disclosure of the views of the Bank's Policy Board members on the outlook for the economy.

According to the Outlook Report, Japan's economy continued to deteriorate during fiscal 2001 (from April 2001 to March 2002). Yet the pace of deterioration had somewhat moderated towards the fiscal 2001 year-end as overseas economies began to recover. During fiscal 2002 and early fiscal 2003, it is expected that an increase in exports and the progress in inventory adjustment will induce a recovery in production, which will lead to an improvement in corporate profits and capital spending, particularly in the manufacturing sector. At the same time, it is expected that the corporate sector will continue restructuring against the backdrop of intensifying global competition and the heavy debt burden. This will keep putting downward pressure on employment and wages. Therefore, it may take a significant period before the recovery in exports and production in the manufacturing sector spreads to the whole economy, including the non-manufacturing sector, small- to medium-sized firms, and the household sector. Overall, Japan's economy is expected to stop deteriorating towards the latter half of fiscal 2002, but the autonomous recovery is unlikely to gain much momentum.

Prices will stay on a gradually declining trend given downward pressure from both the demand and supply sides. The forecast of the majority of Policy Board members for the consumer price index excluding fresh food for fiscal 2002 is minus 0.8 to minus 1 percent. The following is the backgrounds to such a forecast. Given the outlook for demand, the output gap is expected to widen and exert persistent downward pressure on prices even though the short-term growth rate of supply capacity of Japan's economy seems to have declined to some one percent-plus on a year-on-year basis. Weak wage developments may also put downward pressure. Imports of low-priced goods, technological advances, and deregulation are likely to remain as the structural force putting downward pressure on prices. If the consumer price index excluding fresh food falls both in fiscal years 2001 and 2002, it will be a post-war record of a continuous decline for five years.

This is the standard scenario with respect to the economy and prices. The Outlook Report also describes upside and downside risks to this scenario.

The first risk is the uncertainty regarding the strength of domestic private demand such as private consumption and capital spending. The standard scenario assumes that capital spending will gradually begin to respond to the recovery in production and corporate profits. It also assumes that consumer sentiment will not noticeably deteriorate despite persistent pressure on employment and wages. Both of these assumptions are subject to uncertainty.

The second risk is the strength and sustainability of recovery in overseas economies. The Japanese economy's recovery in the initial phase depends largely on the developments in overseas economies and exports. Although the outlook for overseas economies has significantly improved compared to last year, there is still a possibility that recovery may remain relatively slow. While inventory adjustment in information-technology related goods has almost been completed, the momentum of recovery in final demand remains uncertain. Furthermore, we should pay due attention to the global economic implications of developments in oil prices, geopolitics, and instability of some emerging economies.

The third risk is the development in dealing with non-performing loans. Financial institutions are making further efforts to deal with the non-performing loan (NPL) problem as well as to enhance profitability by securing appropriate lending margins. These efforts are part of structural reform of the economy and industry and can be regarded as promoting more efficient allocation of resources.

If there is a further delay in dealing with NPLs or a significant amount of new NPLs emerges, public confidence in Japan's financial system could be impaired. The weakening of the financial intermediary function could have a negative impact on economic activity.

To complement the intermediary function of financial institutions, the role of capital market is critically important. In view of the successive bankruptcy of large firms since the autumn of last year, investors continue to be cautious in taking credit risks. If investors become further more risk averse, it might adversely affect economic activity.

The fourth risk is the development in key asset prices such as stock and property prices, and long-term interest rates. Stock prices have recovered somewhat, but have shown no clear trend as the performance of non-manufacturing sector's shares has been unstable. Property prices continue to decline. Long-term interest rates have been broadly stable at a little over 1% but carry potential instability given the level of government debt outstanding, which is among the highest in major countries.

Financial institutions remain vulnerable to market swings with a large amount of stocks still remaining on their balance sheet. The development of property prices affects the collateral value of existing loans. A large Japanese government bond portfolio at some institutions has made them more vulnerable to a rise in long-term interest rates if not accompanied by economic recovery.

So, if a significant decline in stock and property prices or a rise in long-term interest rates occurs, it could have a negative impact on economic activity. It could also erode the confidence of households and firms. On the other hand, should the asset prices rise significantly, reflecting, for example, the progress of structural reform, it could strongly support economic recovery through a reversal of the process just mentioned.

The fifth risk is the uncertainty associated with the progress of structural reform and its effects. In the short run, the progress in structural reform, including the disposal of NPLs by financial institutions, could depress economic activity through an increase in corporate bankruptcies and unemployment. In the long run, however, structural reform will induce the consolidation and revival of firms and stimulate economic activity. Once the path to structural reform is clearly identified and confidence in Japan's economy is restored in both domestic and overseas markets, there could be a positive impact on economic activity even in the short-run through positive asset price developments.

Having described the recently published Outlook Report, what are the major issues for Japan's economy over the longer term? I would like to take up three issues that seem to me rather important: deflation, non-performing loan problem, and structural reform.

It is particularly noteworthy that a combination of deflation and non-performing loan problem presents a formidable policy challenge. Debts held by firms and households are usually fixed at a nominal value, and cannot be adjusted for price declines. Therefore, repayment of debts becomes more difficult as prices decline and corporate sales and household income decrease. The gravity of non-performing loan problem aggravated by the heavier debt burden due to price declines is truly hampering the recovery of Japan's economy. Since there is a vicious circle in which an increase in debt burden interacts with a price decline, we need to tackle these two problems at the same time.

First, I would like to discuss the issue of deflation. As I mentioned, if the consumer price index falls both in fiscal years 2001 and 2002, it will be a post-war record of a continuous decline for five years. How can we get out of such a deflationary situation? In this context, we often hear the argument that "both inflation and deflation are monetary phenomena, and price declines can be stopped only by increasing money supply." The argument that "both inflation and deflation are monetary phenomena" holds as a long-term economic relationship when the amount of money changes significantly. When the amount of money changes to a certain extent but not on an extremely large scale, we can observe a loose relationship between money and prices if we look in the sufficiently long term. But, in the short term such as over a period of one year to a couple of years, unless the amount of money changes on an extremely large scale, the relationship between money and prices is not necessarily stable.

Theoretically, the argument assumes that when the central bank expands liquidity, money supply will increase, which in turn will push up prices and the level of business activity. In operational terms, the central bank purchases financial assets such as government bonds from financial institutions, in turn creating monetary base for them, and then they make lending and securities investment. However, what is happening currently in Japan is that, although funds are abundant in the financial market, they do not flow outside the financial market.

Among various factors affecting the movement of prices, the most fundamental factor determining the price development is the balance between the aggregate demand for and the supply of goods and services. As the supply capacity changes only slowly, it is the movement of demand that mainly determines the short-term supply-demand balance. If we look at the time-series data on the Japanese economy, prices begin to rise only after the growth rate recovers and the output gap narrows.

Therefore, in order to halt the continuous decline of prices, it is critically important to promote sustainable, not temporary, growth in the aggregate demand. The current difficulty in the conduct of monetary policy is that with virtually zero interest rates, the central bank cannot stimulate the aggregate demand.

Then, what is the role of the Bank of Japan in getting out of deflation? Before answering this question, I would like to emphasize that the Bank of Japan and the government share the same goal of preventing a further decline in prices and bringing the economy back to a sustainable growth path as soon as possible.

First of all, the Bank of Japan should tenaciously pursue the current monetary easing policy, so that it could support any positive movement in the economy when it appears.

Second, the Bank should provide liquidity in a swift and timely manner, if there is uncertainty or concern in the financial market for one reason or another, in order to avoid any disruption of the market.

Suppose economic conditions deteriorate further and there arises the increasing risk of a deflationary spiral. Such a spiral emerges when a price decline leads to a recession and this in turn triggers a further fall in prices. What could monetary policy do?

We are aware of the argument that the Bank of Japan should not only increase the outright purchase of long-term government bonds but also purchase any assets such as foreign-currency denominated assets, stocks and even the NPLs. Against this argument, let me point out the following.

First, as increasing the amount of liquidity gives only limited stimulus to the economy, the major benefit of purchasing such assets is mainly to influence their prices. In order to affect their prices, the purchase must be done on a large scale. Second, taxpayers may ultimately have to pay the price of possible losses resulting from this large-scale purchase. Third, such a policy implies that the central bank would conduct an operation, which is close to the domain of fiscal policy.

In dealing with deflation, what would be the role of the government? I think the government should foster conditions that are competitive and attractive in order to induce business fixed investment. For this, the government should deregulate, drastically review the taxation system, and steadily reform public corporations. Second, the government should try to relieve the anxiety of households about the future by reviewing the social security system, including pension benefits. Third, the government should make it sure that the disposal of NPLs proceeds as expeditiously and smoothly as possible.

Given that price declines will continue while structural reform progresses, policy-makers must prevent the decline in prices from leading to a deflationary spiral. Monetary policy must play an important role in this endeavor. But there is a limit to what can be achieved by monetary policy alone. Improvement of the social safety net through measures to secure employment is necessary to prevent a sharp decline in consumption. It is essential that we secure the stability of financial system as a whole when we push forward the disposal of NPLs.

In a liquidity trap, monetary policy loses effectiveness and the role of fiscal policy becomes important. However, the scope for mobilizing fiscal policy is limited in Japan given the high level of public debt. What government can do is to seriously review its outlays and taxation with a view to stimulating private demand or to ensure public confidence in fiscal discipline.

Let me turn to the second important issue, the non-performing loan problem. Japanese financial institutions have been making efforts to resolve this problem. In the past decade, many have disposed of the amount of NPLs exceeding their operating profits each year. However, the outstanding amount of NPLs has not declined because the amount of new NPLs has been more than that of old NPLs that are disposed of.

To address the NPL problem, many Japanese financial institutions have taken the steps, including (i) larger disposal of NPLs than planned for before the start of fiscal 2001, (ii) further cost-cutting, (iii) review of their lending conditions, especially interest rates, against different credit qualities of borrowers, and (iv) improvement of profitability. I should mention the recent efforts made to further accelerate the disposal of NPLs by banks. In the process of special inspections conducted recently, the Financial Services Agency took into account the market assessment of borrowers, which led to a substantial increase in NPLs due to reclassification. It decided to keep a sharp eye on the major banking groups by switching to a system of year-round inspections.

In the last phase of the resolution of the NPL problem, the removal of NPLs from financial institutions' balance sheet is necessary in addition to loan-loss provisioning.

Financial institutions are increasingly promoting liquidation of their loans by selling them to third parties while instituting reconstruction proceedings against distressed firms under the Civil Rehabilitation Law. For example, some Japanese banks are making use of the investment funds for corporate reconstruction, which also include foreign investment funds, for financial resources and expertise on how to liquidate their NPLs. Moreover, the methods that have not been common in Japan, such as debt equity swaps, will be used. It is expected that the Resolution and Collection Corporation will be utilized more actively, as its functions to reconstruct firms have been strengthened, and its terms and conditions for purchases of loans have been made more flexible through the recent amendment to the Financial Reconstruction Law.

There is a view that if banks were to speed up their disposal of NPLs too much, the economy could be adversely affected. To some extent, NPLs are simply the result of an economic slump. But at the same time, many are the loans extended to firms in those industries facing structural adjustment. If banks postpone the disposal of NPLs, this could delay structural adjustment, and ultimately delay the revitalization of the overall economy. Furthermore, the resolution of the NPL problem could have great significance in that it would contribute to restoring the financial intermediary function, which is an essential part of the infrastructure of the economy. If the disposal of NPLs is further delayed, there is a possibility that it might threaten the stability of the entire financial system through a further decline in market confidence in the soundness of Japanese banks.

While dealing with the NPL problem, Japanese financial institutions must work on improving their profitability since they have been required to dispose of NPLs whose amount is more than their annual operating profits.

To improve financial institutions' profitability in the long run, they need to establish new business models. Financial institutions should first identify areas where they have an advantage over other competitors, and develop a business strategy taking full advantage of their strong areas, and reallocate their business resources.

Business consolidation and reorganization through various measures such as mergers, establishment of bank holding companies, and business alliances have become common in the financial sector in the past few years. Business reorganization is taking place in various different forms, such as mergers between financial institutions beyond the confines of their own corporate groups, integration of trust bank business and securities business within financial groups, and plans for super-regional banks.

I hope that financial institutions' efforts to improve their profitability will contribute to promoting both the disposal of NPLs and the corporate rehabilitation, and to revitalizing the financial system. The progress in the disposal of NPLs, the corporate rehabilitation, and the financial system revitalization will bring about positive synergy effects, such that market confidence in financial institutions will be restored, which in turn will have positive effects on stock prices.

It cannot be denied that it will take time for the measures implemented by financial institutions to have positive effects. We should be bold and patient, and must keep making efforts toward this direction.

Finally, let me offer a few remarks on structural reform. Japan and other industrialized countries are facing intense international competition arising from rapid industrialization of emerging economies such as those in East Asia. This is a natural development for industrialized countries, and they must accept it as an inevitable challenge. They need to continue adapting flexibly to change their industrial structure, and fostering high value-added industries to lead the economy.

The key to a brighter economic outlook for the medium to long term is whether a sufficient number of high-productivity industries or projects that can point a direction for the economy will emerge in the private sector. To revitalize Japan's economy, it is essential to create the conditions where private initiatives and vigor are fully encouraged.

In this regard, issues concerning the taxation system and government financial institutions are being discussed in the Council on Economic and Fiscal Policy under the Koizumi government. In the tax system, the conventional principles of taxation, that it should be fair, neutral, and simple, will continue to apply. In addition, new perspectives will be vital in deciding on its reforms, for example, whether the tax reform can stimulate free and creative economic activity in the private sector, whether the new system would comply with globalization of economies and corporate activities.

Regarding government financial institutions, since the early 1990s they have increased their share in the total lending to the private sector, especially loans extended to large firms, which has now reached around 20 percent. If their share of lending is too large, the market mechanism may not work properly in the setting of lending rates. Moreover, the development of capital market can be held back because large firms will likely rely on government lending. In vitalizing the economy through the market mechanism, the reform of government financial institutions is also one of the essential tasks.

Structural reform entails the pain, but I think we should not easily resort to the measures alleviating the pain of structural reform. For example, in the process of consolidating firms and restoring the soundness of Japan's financial system, bank lending is likely to decrease and lending spreads will expand reflecting credit risk. Under such circumstances, calls for financial institutions to increase their lending are likely to emerge. But, actually, lending rates must be adjusted to appropriate levels according to the risks on loans, and the loans to inefficient firms must be reduced. Needless to say, any contraction of bank lending must not go so far as to make it difficult for viable firms to obtain financing. In this regard, the following points should be borne in mind. First, it is necessary to encourage the entry of new firms into the market as well as increase the pace of industrial restructuring, which will be accompanied by the withdrawal of nonviable firms from the market. Second, it is also useful to foster new ways of financial intermediation, in addition to bank lending.

It may seem contradictory, but I think the most effective and credible prescription to alleviate the pain accompanying structural reform is to steadily implement reform measures and to gain the confidence of economic agents and the market regarding the objective and the direction of the reform.

If, by undertaking solid structural reform measures, concerns held by households about future pension and social security systems are reduced, and if firms foresee an increase in productivity in the future, the spending activity of firms and households will be stimulated. Furthermore, if Japan's efforts in tackling structural reform are perceived favorably in the financial market, we can expect some positive effects of structural reforms to appear much earlier, for example, through a rise in Japanese stock prices.

I have to admit that we are still halfway to the goal of a revitalized economy, and the path ahead will not certainly be smooth. The purpose of advancing structural reform is to make the potential of Japan's economy materialize in a visible form. In the process, we have to face a low growth rate, declining prices, and pains such as increasing unemployment and bankruptcies in the short term. However, we have to bear in mind that such a painful process is inevitable if Japan is to demonstrate its potential and establish a basis for new development in the long run.

Thank you for your attention.

ICAS Fellow
ICAS Speakers
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Spring 2002